Use the VIX to Time Market Opportunity

09/30/2011 7:00 am EST

Focus: MARKETS

Dave Whitmore

Senior Strategist, Trading Education, E*Trade Financial

Investors are best served being alert for new opportunity amid market volatility, says E-Trade’s Dave Whitmore in Part Two of his interview with MoneyShow.com. He suggests watching a weekly chart of the VIX volatility index to gauge upside spikes that often precede a market turning point. (You can read Part One of the interview, in which he talks about indicators to watch, here.)

Kate Stalter: Let’s talk a little bit about the recent and current market volatility. It’s something that’s a lot of traders and investors understandably have gotten spooked by. But talk about some of the opportunity it can offer, Dave.

Dave Whitmore: Volatility is often tracked by an instrument that many people know, called the VIX, the volatility index, and it expresses how much expectation for high price volatility is in option prices right now.

If you were to go to a longer-term chart of the VIX and look at the weekly over, say, five years, you’ll see that many times the VIX has an extreme spike—and they’re very visible. You can see these spikes. Very often those mark low turning points in the equities markets.

Right now, in this most recent volatility, we’ve just experienced, the weekly VIX spiked up to 48, which is almost exactly where it was back in the extreme volatility of May 2010 and June 2010 when the flash crash occurred. So we’ve spiked right up to that same point.

Whenever this has happened, it usually expresses extreme pessimism and fear that is creeping into the market, and that can often point to opportunities.

Here’s the thing about trading this way: It means thinking contrarily. It means being brave enough to step up when others are stepping away. Thinking that way is sometimes difficult, but there is a lot of literature that says when all about you are losing their heads, something wrong with that line maybe you could help me with that quote Kate,

Kate Stalter: Remain calm while others are using and losing their heads, right? Something like that.

Dave Whitmore: Exactly, so that’s the idea. If we’re in this extreme period and that means the VIX is telling us that we are in “oversold territory” and due for a bounce, then the brave trader will be looking for long opportunities in that situation.

What would one do to find those? Sometimes I think about Investors Business Daily. They have a big section on the best industry groups.

Many prudent traders say the place to look for coming strength is to see where relative strength is right now. One little exercise I use to see where relative strength might be occurring on a sector basis, is I use point-and-figure charts from stockcharts.com.

Point-and-figure charts will give you a mathematically calculated assessment of whether the stock is in a bullish trend, a bearish trend, and it will even give you a price objective on there. You glance down, and it actually tells an interesting story about where there’s strength right now.

There’s a lot of the strength in the sectors right now that are often thought of as defensive groups. You’ve got utilities, health care, and consumer staples showing strength. But at the same time, technology and consumer discretionary are also showing strong point-and-figure chart patterns.

This is a little bit interesting: You’ve got consumer discretionary, which is sort of a bet on a healthy consumer and improving economy, but at the same time defensive sectors like utilities, consumer staples, and health care.

At any rate, my point is: If I was to take today’s volatility as an opportunity, and the VIX seems to be saying that that might be the case, and I was to go fishing, I would go fishing in ponds where there might already be strength.

I just gave you one example of where you could go find information like that. There’s a variety of others. I would imagine that most brokerage firms have tools just like E-Trade that allows you to see sector strength and weakness. That’s the kind of pond I’d be fishing in.

Kate Stalter: In addition to looking at sector strength and weakness, when investors or traders are looking at the actual instruments they could be using, what are some strategies? For example, ETFs or individual stocks? How would they go about that?

Dave Whitmore: The ability to make an investment, sort of a tactical investment on a sector or an industry group, has never been easier with the advent of exchange traded funds.

Just to back up, exchange traded funds are index funds that happen to be traded on an exchange, and they have the characteristics of stocks, so they have continuous pricing through the day. You can use leverage, such as margins. There are options on many of them, and again, they trade throughout the day. It’s a viable trading instrument.

In each of these cases, the nine primary economic sectors, the Select Sector Spiders. There’s one for each sector. Many sectors then have industry group ETFs within them.

It sort of goes back to the discussion about assessing your own risk. If the investor has first made a hypothesis about what’s going on, like, “I believe consumer discretionary will do well.” If you believe that’s your stance, step one, the simplest way is to take a look at a sector ETF.

But maybe you want to put a little more elbow grease into it, maybe you want to take a look at that sector, dig down into it and attempt to find stocks that appeal to you that way. If you were to do that, once again now you have the capability of using margin leverage if you want to double the leverage that you’ve got, use a dollar to buy two dollars worth of stock.

Or you’ve got a variety of option strategies, and option strategies, as I’m sure you know, let you turn that risk dial very finely. You can get extremely aggressive and you can get rather conservative using option strategies. You know that’s the sort of thinking sequence that a trader can go through.

First point, what do I think the trend of the market is, what do I think the mood of the market is, do I want to be long or short, which side do I want to be on? The trend is my friend, right?

Second part, which ponds do I want to fish in, where do I think they’re biting, where do I think there’s strength or where’s weakness to avoid?

And then within we have to make sure we’re educated in our product choices, and find a vehicle that matches up best with our risk tolerance and our pocketbook.

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