How Volatility (VIX) Can Help You Become a Better Trader

To most people, when you mentioned the word volatility they cringe.

As a trader and investor, you should be embracing volatility. Without any volatility, there would be no price movement and it would make investing that much more difficult.

Today's installment from the series, 'Trading Lessons From A Hedge Fund Trader' will focus on Volatility S&P 500 VIX and S&P 500 Index SPX as per our reader's request for research, available here at BehindWallStreet.com. 

Many traders follow the VIX, which is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index. The VIX measures the implied volatility of the S&P 500 index options.

Understanding volatility can help you become a better trader. The basic idea when you're in a position or considering making a trade is to try and understand the current environment. The VIX is a quick way to determine the level of tension currently in the market.

This is the S&P 500 with the VIX below it on a two-year daily chart. 

A couple of interesting points; first note that the market tends to rise as volatility drops. This is because markets drop faster than they go up, causing an increase in volatility. That's why the stock market never "crashes up", but down. For other markets like commodities, they can move actually move just as fast on the way up, but that doesn't apply to equity markets.

Short-term pullbacks cause a temporary spike in volatility, which active traders can utilize. 

These spikes, (note the circled areas of the VIX) are not buy signals but should be alerts that a potential opportunity is opening. Again, we are trying to build a picture of where the market is and how best to position your trades.

Since the beginning of 2013, the VIX has spiked several times to the 20 area, which should have been alerts to look for long trades. 

Why are we looking for long positions for most of 2013? 

Notice the arrows corresponding on the S&P 500 chart. This is a classic bull market. Following the breakout in late January of 2013, this broke a previous resistance level (the horizontal line).

Following that occurrence, each selloff (low point) was higher than the previous low. Each subsequent high was also higher than the previous high. This is what a bull market looks like and as a trader you want to look for opportunities to buy when others are selling in such an environment.

The spikes in the volatility index are a signal that at least over the short term there was a large movement in the price, specifically to the downside. Once you see that, you don't necessarily want to buy blindly, but simply wait for a reversal in the market to give you the signal that the bull market will continue.

Note that not all moves up in the volatility index are equal. If the volatility index moves from the mid teens up to the 20 area, that is a relatively minor pullback in the market. However, if the volatility index accelerates through the 30 area, that is an extreme event which signals massive moves in the market both to the upside and downside.

Back in 2008, the volatility index peaked around 90, which shows you just how crazy the market was back then. When volatility is so high, this means that day-to-day the moves will be extremely violent. Even still, for the long-term investor this could provide opportunities, but one needs to significantly reduce size and watch your stoploss levels.

There are no secrets to being a profitable trader. What you're trying to do is figure out where the market is, and what is the highest probability position. By incorporating the volatility index, this will help give you a gauge of overall market sentiment. 

When you see the volatility index spiking, you should be alert and look for possible entry points. This does not mean you should be buying, but simply aware that the current environment is moving at a faster than average pace and this could be an opportunity.

For information regarding stocks we do like, check out our Flagship and ETF Newsletter.

This is a cursory look at the VIX Volatility Index and we are not making any specific buy or sell recommendation but merely voicing our opinion of the current situation. Each individual investor must conduct their own due diligence of both the company, the market sector as well as their own financial situation and risk parameters.

By Joel Laceda - October 16, 2013 BehindWallStreet.com