I have written to you often about volatility in the marketplace and how it can be measured, interpreted and profited from. The most dangerous time for investors is not when the markets are in panic, free fall or correction. In those times, it’s quite evident what is happening around you and your reactions to the situation can be measured either by the panic in your actions…most people look at market corrections as selling opportunities…you know, buy high, sell low.
But, the time when investors really should be paying attention to what is happening in the market is during times of complacency. These are times when everything is moving higher, the talking heads are unanimously bullish, and the news coming from indicators such as housing and job growth is positive.
Complacency can be measured in the market by the performance of the Volatility Index or VIX. This index identifies specific ranges that signify specific periods in the market. When the VIX is over 40, it signals panic. When it’s between 30 and 40, people are getting nervous. Between 20 and 30, the market is trading with neither high nor low volatility (of course the closer to each end point and the more pronounced the level of volatility). It’s when the VIX trades between 15 and 20 that the real problems set in.
Between that level investors are approaching complacency. At 20, they’re feeling pretty happy. At 15, they’re positively giddy. Those are levels that we have been testing (between 15 and 20) for several days. Consequently, this has coincided with the Dow, the S&P 500 and the NASDAQ setting new 52-week highs. In the case of the Dow and the NASDAQ, both have set multi year highs.
In the past, when the market has traded at 15 or lower on the VIX, it has proved to be the time to SELL stocks and head for the sidelines. This signal, just like the one that tells you to BUY stocks when the VIX is higher than 40, has never been wrong.
Here’s the problem though. Markets and investors can stay complacent for long periods of time. In some cases, you can measure complacency in months. So, if you were to sell, you may regret the decision for many months to come. Unlike panic, which subsides quickly, complacency can send bullish markets into new territory daily.
The best strategy to employ during periods of complacency is beginning to either lighten up stock positions or tighten up sell stops, assuming that you have them. If you don’t it’s time to institute a strategy. The one I would recommend is called a trailing stop strategy. When you employ a trailing stop strategy you are employing a method that protects your profits. Unlike a stop-loss that tries to limit your losses, a trailing stop strategy should be put in place on stocks that are already profitable. It works like this:
Say you own shares of Company X, which you bought at $6 and they are trading at $10. Institute a trailing stop of 20%. Every time the shares move higher, the trailing stop is adjusted with the movement. So, at $10, the trailing stop is at 8. If the shares were to move to $10.50, your trailing stop would move up to $8.40 and so on. Sounds like a pain in the rear right? Well, lucky for you, most online brokers now offer trailing stops in their array of options for their customers. Just place the instruction and its done automatically for you. By using trailing stops you can ensure that a good chunk of your profits will be protected during periods of volatility or panic.