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Using CBOE VIX to determine market entry points


dabuff
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"Be greedy when others are fearful." - Buffett

 

Does anyone use the CBOE VIX to time stock/index purchases? It would be interesting to see how a dollar-cost averaging method of buying into an index fund would fare if it were to buy more at times when "fear" is high.

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Sometimes simply shorting the VIX can be a good value.  The VIX levels are mean-reverting and the futures curve is typically contago, allowing a shorter over the long term to make a reasonable profit.  Additionally, there are leveraged ETFs (TVIX & UVXY) that compound this with the structural issues that naturally cause decay to value over time.  Check out the long-term charts of VXX, TVIX, and UVXY.

 

The problem with this is the VIX can shoot up to multiples of where it was at recently (and theoretically to unlimited high levels), thus exposes a shorter to risk of complete loss of capital.  This can be mitigated by capitalizing your trade with far more capital that required by your broker and limiting your position size to a very small portion of your overall portfolio.  TVIX's history only goes back a few years, but I calculated over the last few decades, the index that TVIX is hinged to produced a maximum trough-to-peak rise of 15x.  You can further reduce your risk by shorting at times the TVIX/UVXY has already risen multiples from a recent trough.  For instance, shorting TVIX @ 15, I would suggest having a minimum cash set aside of roughly $80 per share (15x trough of $5.31).  Double-digit annualized returns (on the full capitalized trade amount) can easily be earned by shorting at points like these. 

 

If the risk mitigation of overcapitalizing the trade and shorting only at points where it has already risen multiples is still too much risk for you, you can cap your risk entirely by simply buying calls against your short or just by buying puts. 

 

edit: The "unlimited" risk potential of a rise in the VIX is already organically hedged to a degree in that the "natural decay" of leveraged ETFs accelerates as volatility increases.  So as S&P 500 volatility increases, so will the value of the futures held by TVIX/UVXY...however, there will also be a corresponding increase in VIX futures volatility, which will accelerate the natural decay of the ETF. 

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4 years since I read this article but I remember it was interesting so I'll post it here:

 

http://news.goldseek.com/Zealllc/1314374831.php

 

I remember that watching VXO is better than VIX.

(Edit: So read it again. VXO basically only calculates S&P100 option pricing and only ATM options thus making the level of fear more apparent. More in the article...)

 

We saw a spike on the 24th but it was very brief and it didn't offer lots of bargains so I mostly withheld from buying. I think it's a great tool to help you determine (in part) when to buy and to give you the confidence to actually do it.

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Here is where shorting VIX/VXO or any related leveraged product could go wrong:

 

2008’s ultra-rare stock panic drove a fear super-spike the likes of which hadn’t been seen since the last extreme selling event in October 1987.  On October 19th, 1987 the stock markets crashed with the SPX plummeting an unbelievable 20.5% in a single trading day!  This blasted the VXO from its prior-day close of 36.4 straight up to its all-time high of 150.2!  Actual crashes easily shatter the normal stock fear ceiling.

 

 

I don't want to be margin called because I shorted a 3X leveraged VIX short at 40 that went to 150... You need a lot of capital ready at the exact time you need to be buying stocks. No thanks.

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I don't want to be margin called because I shorted a 3X leveraged VIX short at 40 that went to 150... You need a lot of capital ready at the exact time you need to be buying stocks. No thanks.

 

You didnt read what I wrote then.

 

I said there are ways to short without risk of margin calls.  Buy puts.  Short + Buy call.  Buy Put Spread.  Short Call Spread.  All of these have specific amounts of capital at risk. 

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I don't want to be margin called because I shorted a 3X leveraged VIX short at 40 that went to 150... You need a lot of capital ready at the exact time you need to be buying stocks. No thanks.

 

You didnt read what I wrote then.

 

I said there are ways to short without risk of margin calls.  Buy puts.  Short + Buy call.  Buy Put Spread.  Short Call Spread.  All of these have specific amounts of capital at risk. 

 

Hey Watsa,

 

Sorry, my post wasn't really directed to you specifically. In the "what are you shorting today?" topic I spoke about the possibility to short SPXU at some point. Then I read your post diagonally and thaught about it some more. I missed the last part about option strategies to hedge extreme events. I understand you felt addressed, my bad!

 

All in all, I'd say it's too much of a hassle. I'd rather just buy cheap that dropped a lot (think small cap commodity etc) at points of extreme fear.

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