One of the most reliable market indicators is signaling an imminent decline in the market.
Earlier this week, the CBOE Market Volatility Index (^VIX) fell back toward its historical lows.
The VIX serves as a “fear gauge” for the S&P 500. The index measures the prices investors are willing to pay for options that protect the value of their portfolio. The lower the VIX, the less investors will pay to insure their stocks – hence the less scared they feel. And when investors and traders are complacent, they also buy assets they deem risky.
Basically, a high level of herd complacency dramatically increases the risk of a market reversal.
As we all know, there are no absolutes in investing. But low VIX readings have proven to be a good signal for market tops.
The chart below is a five-year chart of the S&P 500. Beneath that is a corresponding chart of the VIX.
So, as self-directed investors, how can we protect our buy-and-hold portfolios? More importantly, how can we bring in monthly income during difficult markets?
In the Options Advantage service I sell various forms of credit spreads. I also allocate a smaller, more speculative portion of the portfolio to buying puts.
By employing both strategies, I enjoy the benefits of trading short-term options with higher risk/reward alongside an income-generating strategy with a conservative approach.
Both are simple and easy-to-learn options strategies, yet very effective when traded in unison. I have the ability to bring in income while I patiently wait for a short-term extreme to enter the market in one of the ETFs I follow so I can enter a shorter-term directional trade.
It makes sense. And more importantly, it’s simple.
(In fact, I recently gave a webinar on how self-directed investors can learn how to apply my strategies.)
Let me go through one quick example of how I prefer to trade when the VIX is reaching historical lows.
The SPDR S&P 500 ETF (NYSE: SPY) is trading for roughly $140.
Knowing that the VIX is near historical lows, I might buy a few in-the-money puts, say the Sept 141 or 142 puts. Now remember, this is an unhedged position so your risk is in your position size. Keep it small. Buying puts is considered the more speculative, shorter-term play.
Simultaneously, I might dedicate a larger position in my portfolio to credit spreads.
Again, I explain the details of all this in my latest video. Understand I can’t really go into great detail here as I just don’t have the space. Plus, learning through a hands-on approach is far more effective.
Please understand, I’m not necessarily long-term bearish on the market. But when the S&P 500 nears its high for the year while the VIX is near its low, buying stocks with the herd does not seem like a good strategy to me. In fact, I’d do just the opposite.
It seems more prudent to use any sharp declines as opportunities to implement sound options strategies. Given the look of the chart above, we may be nearing the start of one of those steep declines right now. So prepare yourself. Be proactive with your hard-earned money.
Bulls, and obviously bears, will do better using such strategies as credit spreads and puts rather than chasing the market higher right now.