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How to Trade the VIX: Using the "Fear Gauge" to Hedge Down Stock Markets

Stock-Markets / Stock Index Trading May 10, 2012 - 12:41 PM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleDon Miller writes: If you don't know already, it's time to learn something all serious investors should know: how to trade the VIX Indicator (VIX).

While most investors are scrambling to figure out whether the market is headed up or down, savvy pros use the VIX both as means of protection and a source of profit.


In fact, Money Morning Capital Waves Strategist Shah Gilani last week alerted his Capital Wave Forecast subscribers to a VIX trade that would add some protection to their portfolios.

"Call me a Nervous Nellie, if you like," said Gilani, "but I'd rather lose out on a hedge than get killed because I didn't have one on when the proverbial shot hit its mark."

That's why knowing how to trade the VIX is so essential.

But before we get into how to trade the VIX, we need to understand what the VIX actually is.

What the VIX Indicator Measures
Most investors think of the VIX simply as a "fear gauge."

But contrary to what most people think, the VIX doesn't measure actual stock market volatility.

In fact, experts view the VIX as possibly one of the best contrarian indicators in the business.

You see, the VIX tracks the trading in options on the S&P 500 to indicate how investors expect the market to move over the next 30 days.

For example, as investors buy more put options, they get more expensive and the VIX goes higher. Conversely, the reverse is also true: when investors sell options, they become cheaper and the VIX begins to fall.

The VIX then, is really a reflection of the price of calls and puts on the S&P 500.

It is quoted in percentage points and roughly translates to the expected annualized movement in the S&P 500 over the next 30 days. A VIX reading of 15 implies the S&P could swing higher or lower by 15% over the next 12 months, or about 4.33% over the next 30 days.

As a contrarian indicator, the VIX usually has an inverse relationship with the markets. When the market is rallying the VIX tends to drop; when the market is tanking the VIX tends to rise.

The scarier the broad market decline the higher the VIX tends to go - hence its reputation as the "fear gauge." In fact, during the worst part of the 2008/2009 bear market the VIX soared as high as 80.

In today's markets, however, a VIX reading greater than 30 is generally associated with a large amount of volatility and uncertainty, while values below 20 generally reflect less stressful times.

The VIX in Action
When the VIX fell as low as 16.6 on July 6 last year, Gilani warned investors to protect themselves against potential volatility.

"The low VIX creates an excellent opportunity for you to buy put protection at reasonable prices," Gilani said. "In the face of future unknowns, and as long as implied volatility is low, you should take advantage of cheap puts to add some portfolio protection ... just in case.

Exactly two days later the VIX began a relentless climb. Investors who heeded his advice were glad they did.

The VIX jumped to 48 and remained above 40 throughout October as the S&P 500 tumbled to a yearly low of around 1,100.

Meanwhile, Gilani had also advised his Capital Wave Forecast subscribers to hedge with put options in May and June.

On Aug. 8-- the day the Dow Jones Industrial Average plunged 635 points -- subscribers to Capital Wave Forecast locked in gains of 456%, 455%, 371%, and 197% on four of those holdings.

How to Trade the VIX
There are a few different options for investors who want to know how to trade the VIX.

If you believe that market volatility will surge, you can buy VIX call options (the right to buy) or puts (the right to sell).

Another approach would be to trade VIX futures-based exchange-traded notes (ETN) and exchange-traded funds (ETF), including the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ).

Because they are cheap to own and trade, they make for a fairly good, simple alternative for investors looking to hedge their risks and protect their profits.

But you don't have to trade the VIX directly to make money on it. Most often, the movements in the VIX are inversely correlated to the S&P 500 and the market in general.

That means trading S&P 500-based products with plenty of liquidity.

When the VIX is high you can buy the S&P 500 SPDR (NYSE: SPY), including futures and options.

Or you can consider a number of leveraged inverse ETFs, including the ProShares UltraPro S&P 500 (NYSE: UPRO) and the ProShares UltraShort S&P 500 (NYSE: SDS) when the VIX falls below 20.

Investors who want to trade the VIX should keep in mind that VIX-linked products are short-term trading tools for active traders who know the risks. That's why it never hurts to have the help of an experienced Wall Street professional.

Gilani said more VIX trades might be needed in the months ahead.

"If what's going on now keeps on going, we're going to have to add a lot more protection," said Gilani. "My hope is that this is a shorter-term panic selloff caused by profit-taking. That's how it starts, sometimes. But if it escalates it's going to be a long, hot, and sweaty summer."

To stay up-to-date with Gilani's market insight, just click here to learn more about the Capital Wave Forecast.

And now that you know how to trade the VIX, keep an eye on it. It's one of the best contrarian indicators in the markets.

Source :http://moneymorning.com/2012/05/10/how-to-trade-the-vix-using-the-fear-gauge-to-hedge-down-markets/

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