Filtering the trend
An important part of the puzzle when trading with the VIX is the 10-day simple moving average (SMA) applied to the volatility indicator itself. This will give you a visual representation of the price action at work and provides a key part of our trade trigger (see “Trade filter,” below).
The rules for the setup condition are:
1) When the VIX rises 10% or more than the 10-day SMA, the first condition is set. Next, look for:
2a) The following VIX price bar must reverse and close below the intraday low of the VIX price bar that registered the highest intraday high;
2b) The following VIX price bar is an inside bar that must be followed by a VIX price bar closing beneath its intraday low.
When these conditions have been met, then enter a long position in the SPY exchange-traded fund or the E-mini S&P 500 futures contract.
This method also is useful for trading options. Because it uses volatility as the focal point to time the stock market, you can use volatility strategies to trade the “vega,” or volatility, of the index’s options rather than focus on just price.
Baron Rothschild preached that you need to enter the stock market when there is “blood in the streets,” but that is easier said than done. The market’s volatility is dynamic and ever-changing. A market can decline, but there always is the risk that it can decline further. Investors need a guide. Measuring volatility and using it to time emotional extremes can be that guide. It gives you an edge over the traders and investors that often are wrong.
Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.