There Are Only Two Emotions That Move The Market… Here’s How To Profit From Them: While Other Investors Worry About Economic Data And Earnings Reports, Get An Edge By Following This Key Indicator A Smart Profits Research Report
From the Mt. Vernon Research Team Investors buy and sell stocks based on two primary emotions: Fear and greed. - Fear: A nervous investor dumps his share in Company A because a slight downtick makes him scared of losing his profits.
- Greed: A hungry investor rides his shares in Company A, ignoring the warning signs because he’s confident (sometimes too confident) that the bad streak will end quickly, handing him more money.
This isn’t always a bad thing. Fear can save you from going bankrupt. Complacency can triple your earnings. These two forces are at work every single trading day and the fear/complacency ratio is relative to every investor, both professionals and amateurs alike. The way people invest is dependent on their comfort level between the two, and it’s largely responsible for what moves the market. But rather than leave your investments at the mercy of other investors’ emotions, you can actually use investor/market sentiment to your advantage when making your decisions. This emotionally charged investment cycle is documented by the Chicago Board Options Exchange Volatility Index also known as the VIX. And the good news is that the VIX isn’t as chaotic as the factors that make it up. It trades between 10 and 50 and you can easily follow it to determine how “jumpy” the market is and guide your buy and sell decisions. Here’s how it works… Two Ways To Measure Market Volatility Constructed in 2003 years ago by the Chicago Board Options Exchange, the index is calculated based on prices for options on S&P 500 stocks. Why options? Because no other investment is driven by fear and complacency more than options. And because option prices specifically incorporate a premium for volatility, the VIX gives an instant measurement of investor sentiment over the next 30 days. Here are a couple of ways that it does so… - An Expansion In Option Premiums: This signals that the trading range of the underlying securities (i.e. stocks) is widening. A broader range reflects increased volatility – and that means increased risk. Increased risk raises option premiums, thus giving the CBOE a concrete VIX measurement. For example, many institutions and mutual funds purchase S&P 500 options to hedge their portfolios. Increased demand for options – a result of increased fear or complacency over market conditions – has the effect of increasing options premiums.
- Call/Put Options: When an investor buys call options contracts, he basically thinks the underlying security is going to fall. When he buys puts, he thinks the security will fall. This gives him the right to sell a specified amount of shares (one options contract equals 100 shares) at a specific price within a specific time. So let’s say you own shares of a certain company that have performed well, but you think it’s due for a pullback. Instead of selling your shares, you can hedge your position against that risk by purchasing some puts. The more calls or puts purchased on the S&P 500 index itself, or the stocks within it, this is indicative of how fearful or complacent the market is – and the VIX will reflect that.
But you don’t have to trade options to use the VIX. The savviest pros use it to increase their chances of making good decisions with stock and option trades. Here’s how… Using The VIX To Your Advantage The VIX is essentially a “weather vane” that you can use to tell you when the market is overextended in one direction – and could be set to turn. Here’s how to read it… - When The VIX Is Low: This implies that investors are complacent, happy to believe that the market will continue to rise. They will overlook bad news, warnings, and high valuations, and instead hold overly optimistic expectations.
- When The VIX Is High: This number implies that investors are nervous and fearful of market shocks. It often means prices will lurch up and down a lot. Every time a stock falls a little, more investors will sell, causing a bigger drop.
So for example, when the VIX is high (between 40 and 50), it means fear is becoming overplayed and the market could be about to move to the upside. This is a good opportunity to go long while stocks are cheap. On the other hand, if the VIX is very low (under 20), it’s a signal that the market might be about to peak. This is a good time to hedge your positions, or pare down your holdings while you can still sell for them for a good price. Opposites Attract… The Winning Track Record Of The VIX History proves that this theory is a reliable indicator. Although the VIX is a very recent concept, the CBOE has recreated its performance, dating back to January 2, 1990. Its findings show that since that time, the index has generally trended in the opposite direction of the S&P 500. For example, when the VIX peaked in 1990, 1994, 1997, 1998, 2001 and 2002, it coincided with important market lows. And major lows in the VIX have coincided with a number of significant market tops as well. This chart, plotting the movement of the VIX and S&P 500 from May 1997 to May 2007, illustrates the converse relationship perfectly. 
As the old market adage goes, “The trend is your friend.” And this is exactly why the VIX can prove extremely useful when timing your investments. No matter what kind of investment strategy you have, there are a few key approaches you can take to protect yourself from a big shift in volatility. - If You’re A Long-Term Trader: Be aware that volatility contractions typically lead to subsequent breakouts. Many top traders use various forms of volatility contraction signals as entry points for trades.
- If You’re A Swing Trader: Many swing-trading systems are well-served by including a volatility screen to make sure that the markets are not too overheated or contracted before you trade.
- If You’re A Day Trader: Make sure you understand the current volatility environment, and don’t try to demand more from the market than it’s willing to give you. If the average range of the market you’re trading in is only eight points, don’t stay in trades waiting for 20-point moves.
Make Money While Others Are Losing… And “Xcelerate” Your Profits Imagine you’re a golfer about to tee off on a par 5 hole and the wind is driving against you. While you can’t stop the wind blowing, if you wait a moment or two and take your swing after the wind dies down a bit, you can gain an extra 20 yards, just by timing your shot better. Likewise, while it’s almost impossible to predict market moves exactly, there are tools that can help you gain an advantage. And the VIX can help indicate when it’s a good time to put your money into the market, or take it out – and do so before the notion occurs to other investors who aren’t using the VIX as a guide. So next time you think you’ve spotted a major market turn, check a chart of the VIX. If you find it trading at an extreme, your forecast of a significant trend change could be right on the money. And if you’ve caught the VIX trading at a bearish extreme, you may get to buy those stocks you’ve been watching at just the right time. And at the right price. Let’s say you think the market is about to endure some increased volatility. Rather than sit back and do nothing, you go long on the VIX when it’s at 15 – a very low number (indicating that investors are complacent). Within a few weeks, your forecast is correct and the VIX jumps to 20. As many other investors are probably panicking and selling off their positions, you’re sitting pretty, watching your long position go up – even when the market is falling. “Controlling volatility” may seem like an oxymoron, but it’s possible. And if the VIX acts as a weather vane, then the Xcelerated Profits Report editors are the weathermen. The team of professional traders use tools like the VIX all the time to gauge the market’s direction and predict financial storms, so they know exactly when and where to place the best trades. In fact, they’ve built up a 90% success rate on their recommendations. For more details, click this link. Good investing, The Mt. Vernon Research Team P.S. For more on the VIX, the CBOE website is packed with great information. Check it out here. Related Articles: View the complete VIX research report in PDF format. Smart Profits Research Report Archives Copyright 2007, Mt. Vernon Research, 105 West Monument Street, Baltimore, MD. 21201 | 
