Connecting the Dots: The Stock Market Hot Potato: Volatility, the VIX, and You!

“When did Noah build the Ark, Gladys? Before the rain, before the rain.”

—Nathan Muir (Robert Redford), in Spygame

If you’ve ever walked a dog, you know about the zigzag path that dogs take down a sidewalk. After all, there are great odors to sniff on both sides of the sidewalk so your dog will veer far to the left, take a few deep sniffs before veering off to the right to see what olfactory surprises the other side holds.

About the only thing that’s certain is that once your dog reaches the far end of his leash, it will swing back to the middle of the sidewalk before taking off for another trip to the extreme ends of the leash.

Human psychology, when it comes to investing, isn’t so different. Investor sentiment swings from extreme readings of euphoria and anxiety and extremes of fear and greed.

Like our friendly dogs on a walk, we investors swing from the far left to the far right of the Wall Street sidewalk.

There is a way to profit from the human emotions: the VIX, or CBOE Volatility Index.

Some of you already know plenty—probably more than me—about the VIX, but for those that don’t, here is a quickie tutorial.

The VIX, often referred to as the “fear index,” is calculated by the Chicago Board Options Exchange (CBOE) and measures market expectations of short-term volatility.

The VIX is derived from prices investors are paying for options on the S&P 500 Index and measures the market’s expectation for stock market volatility over the next 30-day period.

NOTE: There are three volatility indices: the VIX, which tracks the S&P 500; the VXN, which tracks the Nasdaq 100; and the VXD, which tracks the Dow Jones Industrial Average.

The VIX was created in 1993 and investors have been using it to hedge against severe market movements ever since; it’s one of the most closely watched indicators in the market.

The VIX has been very useful in helping spot major stock market turning points. As the above chart shows, the VIX has historically spiked after major investment calamities, such as the 2008 financial crisis and the dot-com bubble.

Conversely, the VIX has plunged to extreme low readings (in the “teens” as measured by the VIX) at stock market tops. When the stock market is rocking and rolling, investors lose all their fear and dogpile into the stock market.

As the above chart shows, whenever the VIX falls into the teens, it’s one of the most dangerous times to be in the market and one of the most rewarding to invest in the VIX.

Where is the VIX today? The VIX is well below the levels seen at the time of the 2008 crash, when the index jumped as high as 80, and is now in the 15 range.

How can you invest in the VIX? There are three ways: futures, options, and specialty ETFs.

There are eight different ETFs that track the VIX, but the most liquid—and one that I use—is iPath S&P 500 VIX Short-Term Futures ETN (VXX).

In fact, since starting my short-only service, Rational Bear, I have recommended VXX on five different occasions. And—knock on wood—it has been a profitable recommendation 100% of the time.

Above are the trade-by-trade results of my VXX recommendations. If you had invested $100,000 into those, all of my VXX trades, you would now be sitting on almost $135,000.

Yup, a 35% gain in three months!

Of course, past results don’t guarantee future returns and more importantly, timing is everything when it comes to investing, so I suggest that you wait for my new VIX buy signal before jumping in.

However, with the VIX index now in the teens, it’s in the sweet spot of producing the biggest rewards AND it’s an excellent way to protect your portfolio from the next bear market.

Tony Sagami

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.