With US stocks as volatile as they are this year, knowing when to add or reduce long exposure is key to maximizing every money-making opportunity this market offers. If you manage money for others, this may be the difference between keeping and losing customers in 2022. If you trade for yourself, playing the bounces and lightening up into the declines will have a large impact on your ability to play a really tough tape.
The CBOE VIX Index is a very useful indicator to help you with this challenge, and we use it regularly in our work at DataTrek. The key to its utility is longevity: the VIX has been around since 1990. That history gives us a wealth of information about where it trades through market cycles. Here are the key numbers you need to know:
- The VIX’s long run average daily reading (1990 – present) is 20.
- The standard deviation around that mean is 8 points.
- When the VIX hits 28 (1 standard deviation above the mean), we know market volatility is unusually high. Since 1990, the VIX has only closed at 28 or higher 12 percent of the time.
- When the VIX gets to 36 or higher (+2 standard deviations), we know there is an exceptional amount of uncertainty about the direction of stocks. Such VIX levels are very unusual, occurring only in 4 percent of all the trading days since 1990.
This math helps us make money, because since the VIX measures uncertainty (its nickname is the “fear gauge”) stocks tend to fall when it is rising and rally when it falls. Consider the following data from 1990 to the present:
- Whenever the VIX has hit 36 or higher, the S&P 500 has gone on to rally by an average of 15.8 percent over the next 6 months. The win rate here (percent of times this strategy makes money) is 85 percent.
- In the year after a VIX reading of 36 or higher, the S&P 500 averages a gain of +30.1 percent. The win rate here is 96 percent.
Takeaway: history back to 1990 shows that VIX readings of 36 or higher signal long-term investment opportunity. This may not be a fool-proof strategy – the win rates are not 100 percent – but it is certainly one to consider in the current high volatility environment.
As for how the VIX can help us with shorter-term trading opportunities, consider the following graph. The blue line is the S&P 500 since December 2021. We have noted the VIX levels at the index’s various highs and lows in 2022. The VIX readings marked in red line up with near term highs for the S&P, and those marked in green correspond to near term lows.
Two points on this data:
- Every tradable low this year has occurred when the VIX is above 28 (the 1 standard deviation reading), and March’s powerful snapback rally occurred just after the VIX was at 36 (the 2 standard deviation reading).
- VIX readings between 17 – 24 have signaled near term stock market tops this year. The midpoint of those readings is 20.5, right on top of the long run VIX average. It is worth noting, however, that we have not had a VIX close below 20 since early April and the last market top (early June) only saw the VIX get to 24 – 25.
Takeaway: recent S&P/VIX trading patterns say to add stock exposure when the VIX gets close to its 2 standard deviation level (36) and reduce exposure when it drops to 24 – 25. We don’t expect these levels to change until either the Russia-Ukraine war comes to an end (allowing for lower oil prices) or the Federal Reserve changes its policy stance once inflation is under control.
Final thought: trading and investing in volatile markets is very difficult, and the only way to get through to the other side is to set up a rules-based gameplan and stick to it. We use the VIX as a part of that playbook because it spans +3 decades of market history, and it is freely available. Our edge is straightforward: we dig into the numbers with statistical analysis and keep clients updated regularly on whatever this indicator is telling us. Yes, we also have +40 years of Wall Street experience and share our impressions with readers. But … The data should always come first on the investment journey. That’s why our firm’s name is DataTrek Research.