For the past couple of weeks I’ve been obsessed with the Volatility Index (VIX).
“It’s too low,” I said. “The Bollinger Bands are too tight. Periods of low volatility are always followed by periods of high volatility.”
Since a rising VIX usually goes along with a falling stock market, I’ve been cautious on stocks. And, up until Friday, I’ve been wrong.
Folks following my advice over the past couple of weeks missed out as the S&P 500 rallied from 3100 in the middle of November, to over 3150 by the end of the month.
But, being a successful trader over the long run isn’t about maximizing profits. It’s about minimizing risks…
Rather than trying to squeeze the last penny out of a profitable trade, traders are usually better off moving to the sidelines when the risk of an adverse move outweighs the potential reward.
So, in mid-November, when the VIX was sitting around its yearly low and the Bollinger Bands were pinching together, I started advising folks that the risk in the stock market looked to be greater than the potential reward.
And the market continued higher.
We’d seen this movie before. And we know how it ends – usually with a sudden and swift decline.
But the market never makes it easy. So, it had to make being cautious look like a foolish idea for a while. But caution is not foolish. In the long run, caution is smart.
Most folks lose money in the stock market because they let their emotions dictate their trades. They buy stocks into overbought conditions because they fear they’re missing out on potential profits. Then they end up selling stocks in a panic when the market falls because they fear the world is ending.
Over the past week we’ve seen both of these conditions.
Going into last week I admitted stocks were likely to move higher. But, I wasn’t willing to buy in anticipation of that move because the potential risk of a VIX sell signal suggested I was better off on the sidelines.
Of course, stocks moved higher going into Thanksgiving. And, yes… I missed out on a 1% weekly gain. Since Thanksgiving, though, the S&P 500 has given back all of those gains and then some. The index closed yesterday about where it was in the middle of November.
So, if you stayed on the sidelines then you haven’t missed anything. It’s been a roller coaster run up and then down.
Now, though, with the VIX at a much higher level – near 17 – the risk of a continued move lower in the stock market has ceased. In fact, the VIX is now on the verge of a buy signal when it closes back inside its Bollinger Bands.
My point is the S&P 500 isn’t much lower than where it was in mid-November. But, with the VIX at a higher level, the risk of buying stocks today is much less than it was three weeks ago. The probability of a successful trade is much higher.
As a trader, it makes much more sense from a risk/reward perspective to be looking at buying stocks into the recent decline – which is creating oversold conditions – than it did to buy into overbought conditions a couple of weeks ago.
Best regards and good trading,
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