Timing Your Buying Decisions With The
5% VIX Rule
Over the past few months, we have looked at the times that
you should potentially be entering the markets and when you should be avoiding
the markets. We saw that on a short-term basis it was better to be buying 10-day
lows on the S&P 500, instead of 10-day highs. We saw that waiting for the market
to drop 3 days in a row was superior to buying after it rose 3 days in a row. We
also saw that there was a bigger edge buying when the S&P 500 closed in the
bottom 1% of its daily range versus buying when it closed strongly in the top 1%
of its range. Most of what we saw was counterintuitive, the complete opposite of
what is preached. And more importantly, instead of hearsay and opinion, all this
information was statistically backed and based upon the market's performance
over the past 15-20 years.
This Week's Market Lesson
This week, let's go further. Let's look at when not to
be buying. As important as it is to be a buyer when markets are most
advantageous, it's just as important not to be buying when the market has no
edge. As we just mentioned, there has been little to no short-term edge buying
10-day highs, buying after the market has risen 3 days in a row, and buying when
the market closes strongly. And, another time to not to be buying stocks is when
the VIX ($VIX.X | Quote | Chart | News | PowerRating) (CBOE Volatility Index) is trading 5% or more under its
10-period simple moving average. Why? Because had you bought the S&P 500 every
time the VIX was 5% or more below its 10-day SMA, and exited a week later over
the past 18 years, you would not have made money! The market has risen 431.59%
during this time and yet none of this gain (net) has occurred when the VIX was
5% below its 10 day-sma. Unreal, isn't it?
When Is The VIX 5% Below Its 10 Day
Moving Average?
When everyone is jumping up and down. Lots of excitement
out there, lots of warm fuzzy feelings about how the market looks. It usually
occurs at the same time that the market is making new 10-day highs and/or is
closing at the top of its daily range (and further confirming some of the things
that you've learned over the past few months). It's happening after all the good
news is already reflected in prices. Yes, things look great. But, as we have
learned, prices already reflect this. Buying into these periods of time has led
to "dead money". There's no edge whatsoever.
The Stats
Let's look at the details behind our findings. First, the
VIX has closed 5% or more below its 10-day simple moving average about 1/4 of
the time during the past 18 years. Over the past 4533 trading days, we've seen
it close under this level 1,123 times. The market has risen over the next 5
days, 599 of these times (53.2%). This 53.2% is 4% less than if you had bought
the market every day over this period and exited one week later. The S&P has
risen approximately 902 net points during this time frame. But, it all came from the
times the VIX was 5% or less under its 10-period moving average. Your average
weekly percentage gain (and this is before commissions) was zero. That's right,
a tremendous upward bias and it has all happened when the VIX was less than 5%
below its 10-day ma.
How Can You Apply This Information For
Your Investments and Your Trading?
First, there is no guarantee that what has happened over
the past 18 years will happen in the future. But, assuming the VIX remains a
valid indicator of market sentiment, you can apply these findings as follows:
1. When you are looking to enter a new trade during these
times, you may want to wait until the market becomes less overbought. Simply
waiting until the VIX was not 5% below its 10-day ma, has proven in the past to
be a better time to be buying stocks. The statistics more than bear this out.
2. This may be as important as #1; You will likely want to
be more aggressive in locking in long gains during this time. The more the VIX moves
below its 10-day sma, the higher the likelihood of a reversal. And, this
reversal may eat into and even completely take away from your existing profits.
3. Further on the VIX stretch. When the VIX has closed 15%
below its 10-period moving average, the average one-week losses have been steep.
It happens a few time a year and those are the times to be especially vigilant
about not entering the market.
4. Being 5% below its 10-day ma doesn't mean the market
has to reverse. The rally can and many times will continue. We just know that
over the past 18 years, on a net basis, it's been dead zone with no edge.
Finale
The point of this week's lesson is to discuss why you
should not be buying overbought markets. There are many ways to measure an
overbought market, but in my opinion, the 5% VIX Rule is among the best. It's
statistically backed and it allows you to measure the health of the market on a
day-by-day basis. Also, I have a lot of research on when the VIX stretches above
its 10-day ma (some of it can be found in the
University Section and
The Market Bias Section of TradingMarkets.com ) and I'll share some of this
research with you in a future column.
Have a great week trading (and if you have any questions
about any of this, please feel free to email me at
LConnors@tradingmarkets.com).
Larry Connors
