Trading Stock Indexes Using VIX

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Today we're going to talk about trading stock indexes using the VIX. The VIX stands for the volatility index, and it is the measurement of volatility on the S&P 500. Now, most people trade S&Ps, just based off of S&Ps themselves, but today we're going to show you is that volatility is actually an excellent indicator of future direction of the S&P. So let's get into it. 

I'm going to share with you part of a trading plan that we use that we call the VIX spike system. So, what is the VIX spike system? The VIX spike system identifies spikes in volatility in the S&P 500, where it creates a favorable environment to go long spy or to go long S&Ps to mean reversion that accompanies extremes and volatility. So basically, anytime volatility pops, that means S&Ps are usually selling off, and when volatility gets to an extreme, it usually identifies a low in the S&P in which we go long to play for mean reversion back. We don't go short in this system, it's long only and you'll see the rules here in a minute.

Anytime we write a trading plan, we always document our beliefs. My good friend, Dr. Van Tharp used to say all we do is trade our beliefs. Any idea that you have about a system that works or a method that works or fundamental versus technical analysis, trend following versus mean reversion, whatever it is, all of those are beliefs. So you believe in it so you trade it. This is why some people can be trend followers and make money and some people can be mean reversion traders and make money. It often appears there's not necessarily a right or wrong answer. You see trend followers lose lots of money and mean reversion traders that lose lots of money. If you don't believe in something, you cannot trade it. That's what Van would always teach. So if you don't believe in a trading system, you should stay away from it. That's why we always start by documenting our beliefs. 

Here's the handful of beliefs that back the VIX spike system. First of all, Spy, the S&P 500 and vix, the volatility index, are inversely correlated, so breaks in S&P lead to increases in volatility. Thus, the VIX will spike, it'll go up rapidly when spy or S&Ps break. In a bull market, S&Ps are prone to quick reversions after breaks. So every time the market pulls back, it'll pop right back in, they'll pull back it'll pop up, pull back, it'll pop up. So we're identifying these pull backs to play for these little pops back to the mean. Volatility expansion is unsustainable and eventually leads to volatility contraction. Volatility moves in impulses, it doesn't go steadily up it impulses up, explodes up and then it has quick reversion to the mean. Remember, volatility is a measurement of fear and fear is not a casual thing. Fear isn't an immediate thing. When volatility is extreme, it could get more extreme, but the most likely path is volatility contraction. So we may see volatility go up and go up and go up and then it comes back and the more extreme the volatility gets, the more violent the reversion. 

Let's talk about a trade setup. The VIX spike system involves two different indexes, it involves S&Ps or spy and vix. S&Ps  must be in a bull market for this system to work best. So this system, we didn't use it all last year, because we were in a bear market. It turned off. If you'd ran it last year, when it was turned off, it wouldn't do very well. This goes back to one of our beliefs: that no system works all the time, you have to understand what environments it works in and what environments it doesn't. When it's in bad environments, you need to turn it off, or seriously cut the size to its allocation. So in this simple system, we're going to use the 200 day moving average, to monitor the type of market environment we're in. If we're above the 200 day moving average, we're going to call it a bull market and the VIX spike system will be on. Now, we also look at the five day moving average. If the five day moving average is above the 200 day moving average, the system has permission to trade. Basically we got to be above the 200 day moving average. That's really it in a nutshell and we're going to look at the relationship of price to the five day moving average. 

So on the vix index, we're going to evaluate it with a momentum indicator called RSI, the relative strength indicator, founded by Welles Wilder. A lot of people use RSI, but we use it in a slightly different way. We're actually using RSI on the VIX to time up trading spy. So we measure the current day's eight period RSI in the previous day's eight period RSI, we measure the difference between the current day and the prior day and if that difference is greater than the vol spike threshold of 10, we have a valid entry signal. So basically, if from yesterday today, if the VIX spikes enough, we get a signal. Now, what RSI does is it measures the acceleration of the VIX from the current day relative to the previous day, and we enter the position when vix acceleration is greater than its threshold it means the market is oversold, volatility is overbought, S&Ps are oversold. 

Now there's no stops in this system. In fact, removing stops altogether improves the performance of the system, stops kill this system. With no stops being used, a loss greater than one R is possible. Now we utilize options when we do this system so we don't even have to worry about that. You can do it in underlying, you can do it in options. Here we're just focused on doing an underlying and then we're going to exit and there's really one way we get out. One way only. We get out when the S&P, when spy has a daily close above its five day moving average. So when the VIX spikes, S&Ps are breaking and they're below their five day moving average. As soon as we close back above the five day moving average we get out on close. That's the exit, the only exit. 

Our entry pattern, we're going to enter the position on close when the difference between the current day's eight period VIX, RSI and the previous day's eight VIX. RSI is greater than the VIX spike threshold of 10 and then we will enter twice, we'll enter once, and then we will scale in and average down. So our scale in, after receiving an initial entry signal, a one time scale into the trade is valid if spy closes lower than the close of Industry Day. So if we buy and then spies down the next day, we can add, we can scale in. 

Here is how it works. We'll go through a couple of different charts. Basically down here we have the VIX. This is the graph of VIX and here's a graph of the RSI in the VIX. Here's the average true range. Here, we close below the five period moving average and we get a VIX spike above 10. So we go long and as you can see, the next day is down again. So we close lower so we scale in and we add another unit we do equal size units, one unit one unit, and then we hold it till we close above the five period moving average, which we do right here. You can see other versions, you can see here's a long and an exit. Here's a long, a scale in, an exit. A long, a scale in, an exit. A long, a scale in, an exit. A long, an exit. A long, an exit. 

So that's how it works. It's a simple system, but it's a different take on it. What I want you to do is use the concepts of this system to challenge your beliefs about trading S&Ps because one of the things you'll find is that using the VIX is an incredibly useful tool to be able to improve the quality of your S&P trading. Not only that, you can also look at trading VIX , instead of S&Ps. VIX is the ETF on the VIX and essentially when you're short VIX it's like being long spy. You can find some amazing trades there too, but I encourage you to go look at volatility because the VIX is a really reliable indicator for future direction. So, I'll see you next Tuesday, when I bring you another technique similar to this to help you take your performance to an elite level. Have an amazing week. We'll see you next week. Bye.