The Most Popular, Yet Useless, Market Tool
Monday, I shared a process for finding your edge.
You’ll recall there were three steps:
I noticed something about the markets that tracked with how I wanted to trade.
I developed a system for predicting the moves I was looking for.
I added a way to produce trading signals from this system.
This might sound like a unique experience. But really, it’s a framework for how anyone can find their edge.
Remember – having an edge is all about looking at the markets differently from everyone else. That’s why the most successful investors consistently cite a proprietary system, indicator, or outlook that sets them apart.
If you follow this framework, you will as well.
To prove it, let me show you how I did… and wound up building an award-winning volatility indicator.
The Big Issues With VIX
Some years ago, I began closely studying the CBOE Volatility Index (VIX).
VIX is a popular volatility indicator. It’s called the “fear index” because it rises as prices fall.
The chart below shows this relationship, with the VIX in blue and the S&P 500 ETF (SPY) in black.
(Click here to view larger image.)
This chart shows the S&P 500 from back in 2015. VIX is at the bottom. You can see it moved higher as the SPDR S&P 500 ETF (SPY) fell in mid-August. It declined as SPY recovered.
Because of this, VIX looks like it’s useful. But that’s just it – VIX only looks like it’s useful.
The fact is, the VIX doesn’t show you anything you don’t already know. By the time it starts to spike, stocks are already falling. You can try to short stocks on a VIX spike, but it also doesn’t tell you if that fall is likely to continue.
That’s because of what the VIX actually is. It’s the expectations of volatility in the S&P 500 over the next 30 days. When stock prices recover, expectations quickly reverse.
In short, it’s noisy. The relationship between VIX and stock prices isn’t clear. And I knew there had to be a better way to know when stocks were about to fall, and keep falling.
To fix that, I did a couple things.
First, I inverted the VIX. Now, VIX would fall along with stock prices instead of rise.
Next, I charted the moving average of the inverted VIX against stock prices. Now the VIX would fall before the S&P 500, and the signals would last longer than the original VIX.
The inverted, slowed-down VIX is the orange line in the chart, overlaid on the SPY price action in black. You can see how the orange line fell ahead of the August crash, even as prices were rising.
Now, the VIX was useful. But there was another problem I had to fix.
Taking the VIX Universal
VIX only applies to the S&P 500. If I wanted to trade more than SPY, I needed to keep tinkering with it. And I trade a lot more than SPY.
I noticed that the orange line I created looked a lot like the stochastics indicator. Both lines oscillate from low to high values, showing overbought or oversold conditions.
Since I knew the stochastics formula just puts the current price in historical context, I started applying that formula to VIX.
With that, I essentially had a VIX that applied to any stock. After a few more tweaks, I developed a system for predicting the moves I was looking for.
Two steps down and one to go. Now I needed a way to generate timing signals.
That was the easy step. I simply added a moving average to my indicator.
The result is in the next chart.
(Click here to view larger image.)
This system acts like VIX. It rises when prices fall. When the indicator (red) crosses above its moving average (blue), we have a sell signal. A break below its moving average is a buy signal. You can see how the July 2021 buy signal and November 2021 sell signal in TSLA would’ve helped you profit.
That’s the logic of my favorite trading tool. And if you’re a longtime reader of mine, you know that this research eventually led to me winning a Charles H. Dow Award in 2015.
Laid out this way, you might think this indicator sounds simple. It’s VIX, tweaked with the stochastics formula, with a moving average.
But that’s good in my opinion. Simple ideas work well in the stock market. Complex systems with many variables never deliver the expected results.
I’ll have more to say on this indicator in the future. Today, I wanted to share how this process of tweaking and creatively refining eventually worked for me.
You can use that process, or develop your own process. Regardless, it’s important to understand that this is how traders find their edge.
I encourage you to sit down with a chart and sift through the various indicators available. Dig in and change the variables, invert it, add moving averages. You might just find something totally unique that helps you master the markets.
Senior Analyst, True Options Masters