When it comes to trading the markets we need to be aware that it has a volatility of its own. Volatility means price movement. When we understand what environment we are with regard to that volatility we are better prepared to protect our investing capital. We also get a clue as to what may be soon to happen with the overall market direction.
There are different volatility indices for the market. There is the one for the S&P500 is the $VIX, the volatility for the S&P100 is the $VXO and the one for the Nasdaq is the $VXN. The one that I use is the one for the S&P100.
A low VXO generally means that:
- The volatility on lots of stocks are now low
- The daily ranges on stocks with low IV’s will be smaller
- It represents an overall sense of complacency in the marketplace
- This complacency is usually followed by higher share prices.
On the other hand a higher reading on the VXO means that:
- The volatility on lots of stocks are now higher
- The daily ranges on stocks with low IV’s will also be larger
- Higher IV’s mean that share prices will now be going lower
- A high VXO also represents an overall sense of fear in the marketplace. If this fear continues it can lead to panic selling
So, how does one interpret the VXO?
- When the VXO is in the teens then the market’s volatility is low and stop loss has the capacity to protect our positions.
- When the VXO is in the 20s and 30s the volatility is now high so depending on the IV on our stocks we may need a higher stop loss.
- When the VXO is in the 40s, a stop loss may not protect your position and you need to consider being hedged instead.
Our Smart Traders members love hedging 🙂
Hedging is really cool because you do sleep better at night. Losses are kept small and sometimes you can profit from trades that don’t go your way!
Let’s look at a case study:
This was a trade I took in February. My intention was that Amazon (AMZN) was going to go up in the next 3-4 days. It did not happen but went down instead.
Hedging the position certainly provided me with all the protection and even turned out to be profitable in the wrong direction of the trade!
Isn’t that cool?