The CBOE Volatility Index (VIX) is a widely followed sentiment indicator. When VIX is high, it indicates that traders are worried about market declines. StreetAuthority writer Amber Hestla-Barnhart recently showed a chart of VIX with SPDR S&P 500 (NYSE: SPY) that demonstrates fear rises with a price decline and fear peaks as prices near the bottom.
This simple chart may not allow us to predict market turns, but it offers extremely valuable information. VIX can be used to confirm trend reversals. If VIX drops as prices rise, then it would indicate we have probably seen the bottom.
Because VIX is calculated from the premiums traders pay on options contracts, its value is specific to the S&P 500 Index. Other calculations of similar indexes are published for the Nasdaq 100, the Dow Jones Industrial Average, the Russell 2000, gold, oil and euro futures.
Limited availability led author and trader Larry Williams to develop an indicator he calls the "VIX Fix," which can be applied to any stock or ETF. The chart below shows SPY with the traditional VIX in the middle and the VIX Fix at the bottom. A 20-day moving average (MA) has been added to each indictor. The general trends in both indicators is the same, but I think the VIX Fix makes sharper moves and is easier to interpret.
The VIX Fix uses the same general formula that is used to calculate the stochastics indicator. The difference between the highest close in the past month and today's low is divided by the highest close in the month. That ratio is multiplied by 100 to scale the indicator from 0 to 100. The formula would be:
[Highest (Close, 20) - Low] / [Highest (Close, 20)] x 100
Where "Highest (Close, 20)" means the highest closing value in the past 20 days and "Low" refers to the current day's low.
This indicator extends the powerful concept behind the VIX to any stock or ETF. Applying a simple trading strategy to SPY shows how well this indicator can work. If fear is rising, then we expect the market to offer a buying opportunity and we will go long when the VIX Fix is greater than the 20-day moving average. The system will be short when fear is falling and the VIX Fix is below the 20-day MA.
This system is not designed to catch tops and bottoms, but is designed to test how useful the VIX Fix is. It is not optimized and could be improved upon, but it works fairly well.
This system would be a winner on 69% of the long trades and 57.9% of the short trades. As the chart above shows, traders would be short SPY right now based on these rules.
VIX Fix can be applied to any market, and when testing it on the stocks that make up the Nasdaq 100 index, we also see profitable results. Long trades were profitable 63% of the time and 56.9% of the short trades were winners. Using a basket of 40 ETFs offering exposure to international stock markets, 63.7% of long trades are winners and 54.3% of short trades are profitable.
Right now, the VIX Fix points to Market Vectors Russia ETF (NYSE: RSX) as a buy. A buy-and-hold investor would have lost about 18% of their money if they had bought RSX when it began trading in May 2007. The VIX Fix trading system would have delivered a gain of more than 81% during that time and 65.4% of all the trades would have been winners.
Action to Take --> Buy RSX at the market price. Set stop-loss at $28.35, about 5% below the current price (that is the average loss on losing trades with this strategy). Set initial price target at $37, the target from a consolidation pattern that has formed since last spring, for a potential 24% gain.
This article originally appeared on ProfitableTrading.com
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