Don’t Get Blindsided by the Next Volatility Outburst

Most investors were caught off-guard by the stock market’s sharp correction in January.

From their price highs to their lows the S&P 500 (NYSEARCA:SPY) fell 6.1%, the Dow (NYSEARCA:DIA) 7.4%, and the Russell 2000 (NYSEARCA:IWM) 8.6%.  Investors went scrambling as the downturn quickly became the largest pullback in seven months, rivaling June 2013’s 7% pullback.

Many investors keep talking about how they expect a pullback at sometime, primarily because it has now been 575 days and counting since the last 10% correction, but most don’t know when it will occur or how to prepare for it.

No one has a crystal ball, but there are ways to shift the odds in your favor.

Not the Fear Index, but the Greed Indicator

In early 2013, we observed a remarkable trend.  The VIX was providing clues about temporary market tops. We first discussed it in our weekly Technical Forecast and followed up in our monthly Newsletter.

The VIX index (NYSEARCA:VIXY) tracks the volatility of S&P 500 options.  When volatility is low, the market is typically rising. And when volatility rises, the market typically is selling off.

But just as there are extremes in fear representing buying opportunities in the market, there are extremes in greed and complacency in the markets, setting up opportune selling opportunities.  The VIX (NYSEARCA:VXX) indicator has been wonderful at pinpointing extremes in complacency and greed, showing us again and again conditions that were ripe for market selloffs and perfect for buying portfolio insurance.  Throughout most of 2013, the market pullbacks were typically pretty small, but they still sent the VIX skyrocketing.

One of these times was on 5/24/13 when we recommended buying VIX July $13 call options for $370.  The VIX was trading below $15, helping to identify extreme complacency in the market.  Within the next month the VIX was around $20 as the markets fell a few percent.  We recommended selling half the VIX call option position for an 84% gain, soon after exiting completely for a combined 55% return.

Like Clockwork

But there has been an even greater phenomena occurring with the VIX over the past year that ETFguide subscribers have been privy to.  In addition to giving us clues that complacency is high and the market is ripe for a pullback, the VIX also offers a great opportunity to hedge such risk.  Buying the VIX when it falls to certain levels has proven to be a great strategy time and time again.

In our December Technical Forecast published 12/29/13, we advised subscribers again they should be looking to buy the VIX, by writing: “I like buying March $11 or $12 call options to take advantage of hedge prices that are again at multi-year lows.”  When the cost for the VIX is low it means protecting your portfolio also is inexpensive.

As we like to say: the time to buy home insurance is before a disaster strikes, when coverage is still affordable and available –  not after the home is already on fire.  Buying the VIX when markets become complacent is a way to buy insurance while it is still cheap.

WATCH:  “Apple – A Great 2014 Short Setup” (Our video from early January, just days before Apple’s 8% selloff)

Buying VIX (NYSEARCA:UVXY) cheap also is a great way to profit significantly when the markets inevitably do pullback.  This January market decline sent many of the call options we issued a buy alert on, including those outlined in our 12/29/13 Technical Forecast, up over 100%.

Time and again we have been banging the table about buying the VIX when it reaches key support levels. And while it has paid off significantly a few times, more importantly, it has also kept losses low on these VIX positions as the downside in owning VIX options has been limited when the markets show such complacency.

Where to Now

The following chart shows how much the VIX (NYSEARCA:TVIX) gained since the latest buy suggestions in late December.  We also provided stop locations as well as profit taking updates.

On 1/8 and 1/20 we reiterated via our Technical Forecast the VIX long trade as we explained, “Buying in the money VIX options is a running theme for readers as the VIX has rarely spent more than a week below current price levels”.  We also included supplementary charts as backup.

Since rallying over 70%, the VIX has now pulled back, as would be expected with a recovery in the markets.

If the VIX falls back further it will offer another similar opportunity to buy portfolio protection cheaper than at most times in history.  And, based on the VIX’s recent past, buying portfolio protection at such times has offered many high reward / low risk profit opportunities.  When the market has its next inevitable selloff, it will likely send the VIX back into the upper teens, offering great upside potential with limited downside risk.

The ETF Profit Strategy Newsletter and Technical Forecast uses market sentiment, fundamental and technical analysis to keep investors ahead of the markets.  Our latest research examines the VIX’s key support level, its two month pattern, when and how to profit from it, and how it can protect your portfolio during the next market downturn.