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The Right Way to Use the VIX to Profit and Avoid Losses

Stocks in this article: VXX SPY IVV SH DOG

If the SPX (S&P 500) did go down significantly, the value of those put premiums would rise proportionately. The faster this happened the higher the price rises.

So the "implied volatility" factor measures the demand for, and thus the increasing price of, the SPX puts.

In the past the VIX indices (yes, there is more than one) rise sharply and remain high during major market crashes, making this a potentially amazing tool to help with exit and entrance strategies.

It really boils down to doing one's best to emulate what the so-called "smart money" is preparing to do as far as protection against nasty market surprises.

The VIX fluctuates between 11.30 and 37.22 around 95% of the time. In the past, the upside range has taken the VIX as high as 80, as the 5-year chart above demonstrates.

The 2-year chart (above) may provide more relevant insight as to the ranges we might encounter in the present economic environment.

Besides VXX, the S&P SPDR ETF (SPY) or the iShares S&P 500 Index ETF (IVV) may be a good way to invest in sync with the VIX.

For those investors who may want to go short before an impending stock market drop you could consider the ProShares Short S&P 500 ETF (SH), or if you preferred to short the movement of the Dow Jones Industrials you could use the ProShares Short Dow 30 ETF (DOG).

In my discussions with Brown, I asked him his take on the best way for an investor to spot a major market drop. His answer was twofold:

  • 1. Watch for the S&P 500 to drop below the 200 trading day (12-month) moving average and...
  • 1. See if the VIX rises above 37.22 and remains above 37.22 for at least 20 days.

This system is by no means fool-proof, but historically it has a high degree of efficacy.

It's very important for traders and investors to remember that low values of the VIX are mostly meaningless.

Brown put it this way: "You may hear that market participants are complacent when the VIX is low and hence a crash is coming. Nothing could be further from the truth."

A low value for the VIX, he explained, simply means that the stock market is moving mainly upward and that large institutional fund managers see no need to waste their money buying SPX puts as portfolio insurance.

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