On a recent business trip to Atlanta, I was able to spend time with another seasoned trader. You will be hearing his name in the coming months – but for now, we will just call him T.G. He and I were discussing the present craziness in the market. And we shared with each other the actions we take when things get like this.
The CBOE Volatility Index (VIX) was hitting all-time highs at the time, so our discussion turned to this indicator. The VIX measures volatility in the market by looking at the pricing of S&P options in the front two months (the next two calendar months). A high VIX means the market is more volatile. A low VIX means the market is not so volatile.
I have been watching the VIX for a long time, and have used it to profit from time to time. Usually, I do that by taking advantage of large moves in one direction or the other to make contrarian plays on the overall market. But I learned a new way to use the VIX from T.G. – as a trade allocation tool.
For example, from July ‘07 through July ‘08, the VIX traded in a range between 20 and 35, for the most part. When the VIX recently jumped to over 50, T.G. knew he could cut his trade allocation in half. Because the volatility had doubled, he could get the same amount on his gains with half as much money committed to the trade. Therefore, if he normally put $10,000 into each trade, he could now cut that to $5,000 in each trade with the same monetary targets.
So if the VIX is low and the average movement in a day is only 1-2 percent, he can expect to make approximately $150-$200 per day on the $10,000 trade. If the VIX is high and the daily moves are 3-4 percent per day, he can expect to make $150-$200 on the $5,000 trade.
In a volatile period, it is better to have less money at risk and more cash on the sidelines. The method that T.G. explained to me is certainly worth considering as a way to lower your allocation without lowering your reward.[Ed. Note: With the market’s crazy fluctuations, it’s more important than ever to keep your investing strategies simple. Market analyst Rick Pendergraft has put together an educational program that lays out the simple steps you need to take to make money in any market condition. Not only do you get three months of Rick’s best recommendations, you also learn how to make good investment choices yourself.]