Trading on volatility is one of the most dead-simple strategies you can use to book quick profits.
The formula works as follows…
When the Volatility Index (or VIX) drops below 15, you should be selling stocks – or at least be taking defensive positions. And when the VIX is above 30, you should be buying stocks.
That’s because higher volatility indicates that investors are panicking and selling off shares out of fear. And smart investors swoop in to take advantage of the attractive valuations.
On the flip side, when volatility is low, it shows that investors are getting a little too complacent, which means that a correction is likely imminent. For example, the VIX rested consistently below 15 twice over the past 20 years: In the late 90s before the dot-com bubble burst and before the Great Recession hit in 2007.
What about today?
Currently, the VIX is hovering above 16 – and it’s dipped briefly below 15 a few times since August.
So given the indicator’s history of spotting a major market downfall, you should be hitting the sell button now, right?
Not so fast. Other factors are making today’s situation much more complicated.
You see, when the VIX is at 40 or 50, there’s no question you should be scoping out deals right away. Since it doesn’t usually take long for investors to come to their senses – and, in turn, buy up stocks again.
Unfortunately, the same can’t be said when the VIX is low, mainly because investors can remain complacent for years at a time.
Especially now that there’s one thing sure to keep investors happy for the foreseeable future: easy money.
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There’s an old adage on Wall Street I’m sure you’ve heard before: “You can’t fight the Fed.” That is, when the Federal Reserve has adopted an easy money policy, the chances are better than ever that the market will pick up steam.
More specifically, with interest rates so low, investors are encouraged to make riskier bets. Meanwhile, activity in the economy picks up as investors deploy cash in places like real estate – or purchase goods like cars, appliances, etc.
In other words, as long as there’s easy money, a low VIX level doesn’t necessarily mean a correction is on the way.
And since the Fed has indicated that it has no intention of raising rates for at least two years – longer if necessary – we might be in the clear for a while.
However, there is a wild card on the horizon that could derail this easy money party: politics.
Why? Well, regardless of who gains control of the White House come November, there’s going to have to be some serious negotiation about taxes and spending.
Now, before you fall out of your chair laughing at the prospect of anything “serious” coming out of Washington, consider the implications of nothing being done at all…
Taxes will rocket higher. Spending cuts will make it into the public sector. And the combination of the two could spank the market to the tune of 20% or more. It’s a sobering prospect, to be sure.
The good news is that the current low VIX level shows investors believe that some deal will be made. However, since we’ve been trained to expect the unexpected, it may be a good idea to check your positions and initiate some defensive measures between now and the New Year.
Ahead of the tape,