When the VIX wakes up, I take notice. Spikes to 40 are extremely rare. They’re reserved for those few episodes when the denizens of the Street are weeping and wailing. In case you missed it, fear came to town on Wednesday. He terrorized the children and castrated bulls. But, as is usually the case, his entrance signaled the end of the damage, not the beginning.
At least in the short run.
But it’s virtually always that way. Traders panic at market bottoms, not tops. Capitulation comes at the tail end of a correction, not the beginning.
Say what you will about the VIX and its flaws, but it’s one of my favorite indicators for signaling when contrarians should turn optimistic. In yesterday and today’s Trader’s Lounges, I discussed the implications of the VIX flying to 40 and what my playbook is when it happens. Since some of you aren’t able to join these daily hangouts, I wanted to relay my message in this week’s blog.
When the VIX is high (which I define as a spike above the upper bollinger band and/or a rip to 30 or 40), then it usually means a market bounce is imminent. Thus, I respond in the following three ways.
First: Avoid entering new short trades.
Second: Tighten stops or take profits on existing short trades
Third: Bet on a bounce with naked puts or bull puts
Let’s take a closer look at each.
No New Shorts
If a bounce is indeed likely, then adding new bear trades is a bad idea. On top of that, the risk-reward for short plays is usually terrible once the VIX is at 40 because the market will be extremely oversold.
How do you think you would have felt on Thursday with bear plays entered on Wednesday? Not great, I bet. It’s no fun having a trade go immediately against you. Such is the risk when plowing into new shorts in high VIX conditions. If you’re going to do it, then day trading is preferable to swing trading. Tight stops are needed, in other words.
Ring da Register
When the VIX is skirting the stratosphere it will look like the smartest thing to do is let your bear positions ride. After all, the market is melting. You just made a ton of money and it seems inevitable you’re about to make a bunch more.
But you probably won’t! Now’s the time to tighten stops and harvest gains. Unless you like the idea of sitting through a bounce and having your profits dwindle.
Fade the Crowd
The final idea is not for the faint of heart. It requires bravery in the face of cowardice. You have to steel yourself and buy while the lemmings are vomiting. You’re embracing contrarianism with a counter-trend trade.
Short puts and bull puts are the instrument of choice because options premiums are extremely high. The lofty VIX allows you to sell way, way out-of-the-money thus providing a wide margin of safety.
This is a concept outlined in the Bear Market Survival Guide and I call the “Fade the Fear” trade.
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