Battle Plan Trade of the Week: In Defense of the VIX

It's been a relatively quiet week in the TradingMarkets Battle Plan for traders of stocks, ETFs and options. We have begun building positions over the past few days, as stocks and exchange-traded funds have started to break out to the upside, becoming increasingly overbought. But for the past week there have been no notable exits to report.

One thing that has caught my attention over the past week has been a chorus of criticism against the VIX, the CBOE Volatility Index. Surprisingly, one of the sources of this criticism has been the commentariat over at Bloomberg TV, which has been suggesting that traders have been going broke trying to trade using this popular tool for gauging market sentiment.

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Unfortunately, there are as many ways to lose money trading as they are to make money trading. So who knows what mistakes traders who have lost money trading the VIX have been making. But Larry Connors long ago recognized one of the biggest mistakes that many traders make when trying to trade the VIX. It's time that traders, especially short term traders, reassess their understanding of the VIX and, hopefully, make it a constructive and profitable part of their daily trading strategy.

Larry's insight - which is re-introduced in his newest book, Short Term Trading Strategies That Work - was that using the VIX in a static fashion did not work. What might have been a "high" VIX reading at one point in time, may not be such a high reading at another point in time. While this might seem obvious now, after weeks with historically high VIX readings, the sad fact of the matter is that too many traders still think that a VIX over 30 or over 40 always means the same thing.

What Larry discovered, and has shown in both his work and his trading strategies, is that the VIX is best used as a dynamic indicator. It is the VIX's relationship to itself that matters most when using the VIX to help determine when stocks are more likely to outperform or underperform.

What specific tactic does Larry point to? He found that when the VIX is stretched by 5% or more below its 10-day moving average, stocks have tended to underperform over the next few days. By contrast, when the VIX is stretched by 5% or more above its 10-day moving average, stocks have tended to surprise traders and investors to the upside.

Look at the VIX over the past few weeks. While many in the financial media have been cheering the fact that volatility has been declining, we note that with the VIX streteched below its 10-day moving average, stocks really have not gone anywhere over the past few weeks. The VIX pulled away from its 10-day moving average around the 10th of December (and again on the 16th), suggesting that complacency was re-entering the market and that stocks would not move impressively to the upside. The S&P 500 closed near 900 late in the first half of the month and here, at the end of December, we see that the S&P 500 is more or less in the same position.

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David Penn is Editor in Chief at TradingMarkets.com.