Predicting Volatility with the VIX (Part 2)

09/30/2009 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

The VIX can be used as an analytical tool to identify entry and exit opportunities, or periods when market risk is likely to be higher or lower. This information is especially useful because it is not just another iteration of a price and time study, but is derived from investor expectations for near-term volatility. The VIX is obviously useful as a way to analyze the stock market indexes, but in this article, I will show that it can also be used to help identify opportunities in the intermarket environment.

The VIX has a propensity to channel, which can make analysis very easy. Channeling markets (like trending markets) are predictable and can be very profitable when they are consistent and extended. Technicians always struggle with the transition from a channel to a trend and vice-versa, so the VIX's tendency to channel for long periods is extremely convenient for a technical trader.

Within a channel, support and resistance levels become triggers for entries and exits, or serve as warnings that risk is rising or falling. In the chart below, you can see an extended channel on the VIX from 2004 - 2007. When the index approached resistance, the stock market had a tendency to rally, and it was an excellent timing signal for new entries. Conversely, when the VIX was bouncing off support and "fear" was beginning to rise, covering long positions in the stock market was a more prudent course of action. In the video, I will walk through how those signals compared to the actual price action on the SPY (S&P 500 ETF).

Weekly Chart of the VIX
chart

We recommend that you spend some time looking through the historical charts of the VIX and comparing it to a chart of the SPY or S&P 500 index. It should be clear how the VIX could have been used to identify buy and sell signals. Even when volatility is elevated beyond historical levels, these support and resistance bounces can be helpful. In the video, I will illustrate how this analysis can be used within the current high-volatility market environment.

Although the VIX is based on the volatility of the S&P 500 index options, it can be useful as a general measure of investor sentiment in the intermarket environment. For example, forex traders are aware of a periodically strong correlation that the USD/JPY exchange rate has with US equities. The bullish trend on the VIX in the first and second quarter of 2009 has shown that USD/JPY shorts are at risk and that an extended trend to the downside is unlikely. The VIX can also be used to help forecast and analyze yield trends, bond prices, and commodities. In the video, I will cover an example of this kind of intermarket analysis.

Now, watch the video for more details:

By John Jagerson of LearningMarkets.com.

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