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Stay Safe in a Volatile Market

Volatility is here to stay – here's how to take advantage


Just when you thought it was safe to jump in the volatility water, bam — more bad euro zone news hits the tape.

The Volatility Index (CBOE:VIX) spent a rare day (for fall 2011) below 30 on Tuesday. But thanks to Wednesday’s huge sell-off, it now sits closer to overbought than anything else.

What’s overbought, you say? Well, I define that as 20% above its 10-day simple moving average (SMA) and/or at the upper Bollinger Band on the standard 20-day, 2 Standard Deviation look. And VIX pretty much hit both Tuesday.

That’s on account of VIX itself flying over 30% higher, something you don’t see too often. At least, you didn’t see it too often until this year, as pretty much all rules are made to be broken.

So what’s it all mean?

Well, the VIX is intended as a mean-reversion indicator. In other words, when it stretches too far above or below something we might define as a mean, we expect to see it snap back. In theory, this says you should fade moves that stretch too far. Because the VIX moves in opposition to the market, that says we want to go long when VIX gets overbought.

But if you do, tread very carefully. In 2011, an overbought VIX has gotten extremely – well — overbought. I use 20% above the SMA as a cut-off, mainly because it doesn’t happen that often. (The VIX would typically only stretch like that a few times per year.)

And now in 2011, that theory itself has become stretched. The VIX surged a record 71% above its 10-day SMA in August, so getting long the market when it crossed the 20% threshold proved disastrous.

We have a pretty obvious reasons for this constant surge in volatility. The correlation in the market has exploded this year. I cringe every time I hear someone on TV say “Risk On, Risk Off,” but that’s essentially the easiest way to describe it.

Everything moves as one big trade. Market volatility, proxied by the VIX, depends on two factors: the volatility of the stocks themselves that comprise the index, and the degree to which they correlate.

The higher the volatility of the components, the higher the index volatility. And the greater they correlate, also, the higher the index volatility. And right here, right now, it’s the extreme correlation that is putting a bid into market volatility.

If you’re trading, it probably doesn’t pay to stock-pick. With stocks moving in unison, better to just trade indices and index Exchange-Traded Funds (and, of course, their options).

Article printed from InvestorPlace Media,

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