VIX Investing: Beware This Misunderstood Index

| September 15, 2011 | 0 Comments

Boy, this market is a doozy…

European debt worries are once again pushing the S&P 500 into an all out volatility free-for-all.  Take a look at the volatility index (VIX) and you’ll see what I mean…

The VIX spent the past few weeks above 35- a sign of high investor anxiety.

How can you tell investors are chewing their fingernails?

The VIX tracks S&P 500 index option activity.  And when institutional investors see increasing downside risks, they start buying S&P 500 index put options to hedge their portfolios.  This increased put buying sends the VIX higher.

Many stock market pros see the VIX as a measure of fear in the marketplace.

When the VIX is high (like it is now), investors are fearful.  On the other hand, when investors are complacent and everything is hunky dory, the VIX is low (between 15 and 20).

Some investors think the VIX can be used as a signal to buy stocks.

In fact, there’s an old stock market rule of thumb that goes like this…

“When the VIX is high it’s time to buy, when the VIX is low it’s time to go.”

What’s it mean?

When there’s fear in the marketplace (like right now), investors tend to throw their wits out the window.  Good stocks with solid fundamentals tend to get thrown out like the proverbial baby with the bathwater.

According to the rule, that’s when smart investors should swoop in to buy oversold stocks.

When the markets eventually rally and the VIX returns to a low level, your heavily discounted stocks will be sitting on substantial gains.  That’s when you collect your profits and ride off into the sunset.

Sounds simple right?

Hold your horses…

Like many things in life, the devil is in the details when using the VIX as a buy indicator.

For example…

The VIX is high right now, but how do we know it won’t continue even higher… like it did in 2008?

If you loaded into stocks when the VIX was ‘high’ back in September 2008… your portfolio went along for a hairy (and likely stressful) ride in the markets.

In fact, by the time the S&P 500 bottomed in March 2009, it had dropped 40% from the September 2008 levels where you bought in.  In other words, just because the VIX is high- doesn’t mean it can’t go higher.

So be careful using the VIX as a buy indicator…

Creating a list of companies with strong fundamentals and attractive technical entry points should be at the top of your to-do list right now.  There truly are some great companies trading at ridiculously cheap valuations.

But whatever you do, don’t load your portfolio up on stocks just because the VIX is high.

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Category: Technical Analysis

About the Author ()

Justin Bennett is the editor of Commodity ETF Alert, an investment advisory focused on profiting from the ebb and flow of important commodities via ETFs. The commodity veteran and options specialist is also a regular contributor to the Dynamic Wealth Report. Every week, Justin shares his thoughts with our readers on a variety of commodity-related topics. Justin is also a frequent contributor to Commodity Trading Research’s free daily e-letter. And he’s the editor of another highly successful and popular investment advisory, the Options Profit Pipeline.

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