We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. ~ Warren Buffett
The crowd is always wrong. Majority of the investors lose money because they buy high and sell low. This is a result of making investment decisions based on greed and fear. We are all emotional beings. Is there a strategy where we can keep our emotions at bay and act contrary to the crowd?
The Volatility Index (VIX) forecasts the future volatility of S&P 500 based on past price movements. It is commonly known as the fear index where an increase in VIX indicates a sell off in the S&P 500. If VIX is an indication of fear, are there practical means to exploit it for buy and sell signals? Being a derivative of VIX, does it lead the S&P 500 index? My initial exploration on VIX and SPY were encouraging.
To give the necessary credit, I got the VIX idea from Victor Niederhoffer’s book, Practical Speculation. He said the normal level of VIX is 25 and anything above means investors are fearful and anything below means the investors are greedy. Hence, he recommended to go against the crowd by buying the first time VIX closes above 30 and selling them when VIX first closes below 25. The trades yielded an average 3.4% per trade and two small losses at the time of his writing.
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
There is scope to improve this strategy. One, to include a stop loss to ensure we do not suffer from large paper loss should VIX goes further up from 30 to 50-60. Two, push the profit taking at a lower VIX value so as to increase the profits of the trades. Third, include short trades to take advantage of the downside and market crashes.
The preliminary rules and parameters used were only for long positions:
Entry – Buy S&P 500 ETF (SPY) when VIX break below 30.
Target Profit – Close SPY when VIX moves back up to 20.
Stop Loss – VIX goes above 40.
Below is a chart for 2011-2012 to show the inverse relationship between VIX and SPY.
Results for the above parameters for the past few years:
Playing around the parameters and rules of entries and exits will yield very different results. The methodology would require more back testing and refining to be more robust and profitable. I am looking for someone who is strong in programming or familiar with back testing trading strategies. Drop me a mail and see how we can work together.