“When the VIX is high, it’s time to buy. When the VIX is low, it’s time to go.”
This catchy investment advice comes from financial advisor, Andy Tanner, who’s known for his podcast The Cash Flow Academy Show and several best-selling investment books.
The VIX is the Volatility Index, created by the Chicago Board Options Exchange (CBOE), and it’s widely referred to as the “fear index” or “fear gauge.” The more volatile the market is, the higher the VIX.
This number is expressed in percentage points, and it translates roughly into the expected change in the S&P 500 index over the next 30 days. The number is then annualized to come up with the final figure. It’s based on the pricing of the S&P index options.
As a reminder, an option is a right (but not the obligation) to purchase an asset at a given price. The higher the volatility, the more expensive the options are to buy. When volatility is high, investors like to buy and sell options to hedge their bets and protect their portfolios.
For example, if the VIX is 10, then it represents an expected annualized change (up or down) of 10% or 0.83% (10% divided by 12 months) over the next 30-day period.
Why Is the VIX Important?
For short-term and day traders, a high VIX creates immediate buying opportunities, but for long-term investors, knowing the VIX can help you plan your strategy so that you’re poised to make money, even if the market takes a dip.
Last year around this time, the VIX was at around 19, but currently, the VIX is near an all-time low at just over 12. This is a direct result of record-setting highs of the S&P 500, which the VIX is based on. As this index creeps higher and higher at a steady rate, volatility has remained low.
Beware of FOMO – Fear of Missing Out
As markets climb, there’s always the question of how high prices will go. Currently, we’re on a positive upward trend, and “fear of missing out” continues to fuel the buying frenzy. History repeats itself, and it pays to notice patterns.
We saw the same irrational optimism in the dot com boom (and inevitable bust) in the late 1990s, and again during the housing frenzy in 2006 and 2007. Before the 2008 financial crisis, anyone with a pulse could get a loan. These lax lending standards helped fuel homebuying on the promise of ever-rising prices, which would allow buyers to refinance.
On the flip side, fear of losing money happens in the midst of a downturn. No one wants to be the last one holding the proverbial bag, so they panic and sell at massive losses, too scared to hold on and wait for a recovery. In March 2009, the stock market bottomed out, and people who had purchased at the peak saw half of their investment vanish. There was a race to the bottom as investors desperately tried to cling to whatever was left, even if it meant selling their shares for pennies on the dollar.
This emotional thinking is the exact opposite of the most fundamental investment advice – buy low, sell high. Yet, almost all investors have fallen victim to this pattern at one time or another. It’s human nature, and it takes extreme discipline to avoid this wealth-decimating trap. Removing emotions from your financial strategy is easier said than done.
Going Against the Grain
Warren Buffett of Berkshire Hathaway is one of the few investors that has managed to remove all emotion from his strategy. He says, “We simply attempt to be fearful when others are greedy, and to be greedy when others are fearful.”
If you follow Buffett’s advice, then now is the time to be fearful because everyone else is greedy. On the other hand, selling your shares in your favorite gainers could mean leaving money on the table. There’s a reason that market veterans have mantras like, “momentum begets momentum” and “the trend is your friend.” If you cash in now, you could miss a significant portion of the upside.
Find a Happy Medium
Unfortunately, none of us have a crystal ball, so we don’t know where the peak is. What we do know is that now is probably not the best time to enter the market and buy stock. You’ll likely overpay.
Our suggestion: Use call options instead of buying stock outright. This strategy allows you to simultaneously manage your risk and take advantage of the economy’s momentum. With a call option, you reserve the right to buy a stock at an agreed-upon price. If the stock market continues to rise, then you’ve locked in the lower rate, allowing you to realize an immediate profit.
If the market dips and begins to go into freefall, then you have no obligation to buy the stock. You can wait until a better time to enter the market, and all you’ve lost is the few dollars you paid to purchase the option.
In addition to an extremely favorable upside, and a controlled, limited downside, call options allow you to manage a large portfolio without a large cash outlay.
You can buy call options through both retail and online brokers. Because they add to the complexity of a trade, it’s crucial that you choose a broker that’s responsive and charges a reasonable options contract fee.
