Were You Watching The VIX?

Events in Japan may have serious consequences for global markets. As we have already seen US markets have traded lower erasing all of the gains since January. The Nikkei in Tokyo fell by 16% in just one session at one point last week. This type of action will not subside anytime soon. As I wrote in recent alerts, the VIX or Volatility Index had been trading at levels that advised caution and even lightening up on stocks. Volatility has soared in the past few sessions and is getting dangerously close to breaking out to the upside. Unlike bullish stock behavior which makes us money when prices go up, the VIX works in the opposite fashion. Being ready and understanding what is happening is as critical right now as making the right picks.

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When the VIX moves higher it indicates that investors are making bearish bets, buying more put options ( options that bet on share declines) than call options (bets that shares are going higher). If the VIX breaks through 35, panic is around the corner and a flash crash in the US markets will likely happen soon after. If it breaks 45, we will be in panic mode and the markets will likely already be down another 10% from where we are now. The all clear sign would be a fall in the VIX into the teens again…and it would have to trade there for several days. In a moment I will repeat some advice I gave you a few weeks ago when I first started to get nervous about the high levels in the market. I am not in any way implying that I knew an earthquake was going to strike Japan. However it pays to watch the VIX as it can predict the velocity and magnitude of a correction when it trades in the mid teens…where it was prior to the current correction.

The problem with the VIX is that when it trades at low levels it can do so for a long period of time. But when sentiment turns for any reason, investors sell first and ask questions later. The Japanese situation was and is a catalyst that opens the eyes of investors and injects a dose of uncertainty into the markets which forces nervous investors to sell and lock in profits.

A Black Swan Unfolding?

A black swan event is an event of low probability and high consequences.  When a black swan occurs, all bets are off. The fallout can be beyond severe as we recently witnessed with the meltdown of the housing market which led to the near collapse of the global financial system.

The situation in Japan could be the next black swan. The point here is to be able to recognize it AND be ready to act before the dust settles. By that time it will be too late as chances are you will either be facing huge losses and not be able to act or the opportunity will have passed too quickly.

The Japanese black swan is the confluence of three factors, a massive earthquake, a devastating tsunami and a nuclear event all occurring simultaneously. The fallout is still occurring and opportunity awaits.

Here are several things that you should be doing now:

Make sure your trailing stops are in place so that you do not ride stocks all the way down if they indeed head back to the levels we saw in 2008 and 2009

Use a strategy such a put selling once the market begins to reverse course. A reversal will be signaled by a reversal of trend in the VIX. That may occur after a massive sell-off which pushes the VIX into the 40s first. If it trades at 45 or higher start selling puts to generate income

Concurrent to selling puts, start buying LEAP options (long term options) on high beta stocks like those in the tech sector

Buy stocks in sectors that will be beneficiaries of investor sentiment going forward. These will be stocks in the oil and natural gas sector. For now, nuclear fuel will be the least attractive option for energy generation. Solar is another avenue, though still too expensive.

Events that are out of your control and mine do not have to leave you paralyzed as an investor. There will always be a tomorrow and it will have to be paid for regardless of what is happening in Japan, the Middle East, North Africa or even Washington DC. It’s up to you to focus on the reality of survival while still being compassionate to the plight of others.

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