WEBINAR: Najarian/Malandrino WEBINAR: Our Best Ideas
CLICK HERE FOR INVITE AND TO REGISTER
Everyone watches the CBOE Volatility Index (VIX) as a measure of expected risk and market sentiment. I've argued before that many of the ways traders try to make sense of VIX don't work ( "How to Perform Technical Analysis on the VIX"), but here are two more valuable methods. We can use these two tests to see whether recent market weakness is reason enough for investors to hedge their portfolios.
1. The momentum of volatility
Fig. 1 shows a daily chart of VIX along with two short-term moving averages. This is a deceptively simple, but effective chart because it captures one of the most important aspects of volatility: in the short term and during market sell-offs, volatility exhibits momentum effects. Over the long term, volatility is mean-reverting, and that makes short-volatility strategies and positions profitable (look at XIV). But during those periods where you want to hedge, the opposite behavior holds - the more volatile the market is today, the more volatile it is likely to be tomorrow.
A signal based on moving averages can serve as an effective "first responder" to warn of changes in the market climate. Right now, this signal is indicating a "risk off" environment. We won't be adding new long stock positions at this time, and will begin reducing long exposure if the signal strengthens. The momentum of volatility is a key input in the VXH hedging strategy that we publish.
2. The realized volatility of volatility
Another feature of risky market environments is that they exhibit high volatility of volatility: no matter what the absolute level of VIX might be, in the past the riskiest periods have coincided with a VIX that deviates from its local mean more widely than normal. To quantify this estimate, we can look at the standard deviation of daily VIX changes relative to the distribution of those changes in the recent past. At higher quantiles, short-term VIX standard deviation indicates that the market is becoming collectively more uncertain about the future. Right now, the realized volatility of volatility is not even close to flashing a warning signal: it is below the median value of the distribution over both the prior quarter and the last year. We would not want to scale aggressively into hedge positions until this signal changes.
OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.
Jared can be followed on Twitter at twitter.com/CondorOptions.
Select the service that is right for you!COMPARE ALL SERVICES
Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV