Learn to use the Stock Market Fear Index to Maximize Your Profits
Jason Brizic
June 10, 2011
There have been some amazing stock market declines since the 1987 crash of 25% in one day. I wasn’t invested in the stock market in 1987, but I have been an avid market participant since 1992. I experienced the 2000-2003 bear and sidestepped the 2008 crash. Rampant fears lead to jaw dropping selling.
“Buy when there is blood in the streets…”, said the shrewd Mr. Rothschild. I am not fan of central bankers, but Rothschild's advice here is excellent. In other words, “Buy when others are fearful; sell when others are greedy.” You can use the S&P500 volatility index (aka the fear index) to help time your buying and selling of the stock market.
The following excerpt comes from a 2008 Zeal article that I link to at the end of this “Tip of The Week”. This is a concise explanation of the VXO index.
To drive such exceedingly rare big down days [he’s talking about the 7% down days in 2008], incredible levels of fear are necessary. Fear is such a fascinating emotion. Its potency is very asymmetrical compared to greed. Fear flares up much faster. But like greed it still leads traders to make poor decisions. So all good traders must ultimately suppress their own fear to escape its bad influence. Then they must simultaneously game others’ fears by going long when popular sentiment is scared, which leads to great bargain prices.
While this ethereal emotion is not directly measurable, some great tools exist which infer its levels. My favorites are the implied volatility indexes. These brilliant tools collate and analyze real-time options trades on stock indexes, actual bets made with real money, and distill them out to one number. It expresses the annualized expected volatility of an index over the next month. An implied volatility level of 30 indicates options traders expect 2.5% swings (30% divided by 12 months) in either direction in the coming month.
The flagship volatility index is the venerable VIX. Launched in 1993, it estimated near-future volatility in the S&P 100. The S&P 100 is the top 20% of the S&P 500 stocks, or the biggest and best American companies with very high trading volumes. In times of great distress, it is these S&P 100 companies that are sold the hardest. Their great liquidity ensures traders can sell fast with minimal price impact for any individual trader. So when fear drives selling, these elite companies are the go-to stocks to cash out.
Unfortunately today’s VIX is not this original battle-tested version. In September 2003 the same VIX moniker was given to a totally new implied volatility index based on the broader S&P 500. This sounds innocuous and reasonable, but the VIX’s custodians also considerably changed its calculation methodology. Thus today’s VIX has never been tested in a stock bear so we have no idea what extreme fear levels for it really are. Thankfully the original S&P 100 VIX was preserved in the form of the VXO.
2) Buy the S&P 500 Index ETF (ticker SPY) when the VXO goes above 50. Fear is greatest above 50 on the VXO.
There are other long and short S&P 500 ETFs and ETNs listed here: http://etf.stock-encyclopedia.com/category/s&p-500.html I just picked the biggest ones for an example.
Here is the link to the article on the VXO and its inverse relationship to the SPX (S&P 500 index). I can’t explain it any better than the guys at Zeal LLC as you can see from the excerpt above: http://www.zealllc.com/2008/vxospx2.htm
http://www.myhighdividendstocks.com/category/tip-of-the-week
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