Volatility is often assumed to be a useful indicator. Many traders follow the CBOE Volatility Index (VIX) because they expect it to help them spot changes in the direction of price trends. VIX is helpful in finding turning points in the S&P 500 index because futures on that index are used to calculate VIX. In general, traders look for high levels as a sign of a market bottom and low levels as a sign of a potential top.
While VIX provides information about the general market, it doesn't say much about specific stocks in the market.
To find the right stock at the right time, traders need an indicator like VIX that can be calculated for any stock. So we created one: the Income Trader Volatility (ITV) indicator, a tool Amber uses in her Income Trader newsletter to spot potential options trades.
As you can see in the chart, ITV generally mirrors moves in VIX on SPDR S&P 500 ETF (NYSE: SPY).
We calculate this indicator by finding where the most recent close lies relative to the recent price action. For example, if the close is the lowest low in the past month, ITV would be at 100. ITV would be low when prices are near one-month highs. The calculation can be a bit confusing, so let's instead explain how it can be used.
ITV has been applied to Apple (Nasdaq: AAPL) in the chart below. There is also a 20-week moving average (MA) applied to the indicator. When volatility rises, ITV crosses above the MA, which we use as a sell signal. Buys are given when ITV falls below the MA. (Only one buy signal and one sell signal are highlighted in the chart.)
Since the beginning of 2000, 65.6% of the buy signals flagged would have been winners. Testing on all of the stocks in the Nasdaq 100 index shows a similar rate of success with 67.9% of all trades being winners. There was an average of 10 trades per year in each of the stocks that make up the index, and the system would have generated an average annual gain of 16.15%.
Over the time period used in the tests, the S&P 500 gained an average of 2.62%, including dividends.
We have tested ITV with a variety of stocks and have consistently found great results. Risk is also reduced with this indicator when compared to a buy-and-hold strategy.
The rules for this indicator are the same general rules that traders apply to VIX. We expect high levels in both indicators to be associated with market bottoms and low levels with market tops. We have refined the rules and developed a complete, but very simple, trading system based on volatility.
Another use of ITV is to find the best times for selling options. When volatility increases, options prices should also move up. This is a relationship defined in options pricing models. ITV provides a way to quantify when volatility is rising in an individual stock and provides a way to identify when volatility has stopped rising. That point in time should maximize the gains of an options seller.
Traders can apply a 10-day MA, for example, to the VIX to find similar trades in SPY. Long-term traders can use the 20-week MA.
Amber regularly uses this indicator in Income Trader when she searches for the best options plays each week. A testament to the power of this indicator is her track record -- over 90% of her trades have been winners. You can learn more about Income Trader and even sign up to get her next issue by clicking here.
(This article originally appeared on ProfitableTrading.com.)