As we can see from the above chart, which tracks the five-day moving average of VIX versus the SPX for the past three years, important lows in markets have tended to see spikes in short-term implied volatility (credit to Index Indicators for the chart and data below).
Interestingly, if we bought SPX when the five-day moving of VIX was less than 15, the next five days in SPX averaged a loss of -.04%. That would have resulted in a cumulative loss of -3.42% during a period in which the market rose by almost 47%!
Conversely, if we bought SPX when the five-day moving average of VIX was greater than 15, the next five days in SPX averaged a gain of +.52%. That would have resulted in a cumulative gain of nearly 41%, versus the buy-and-hold of 47%. In other words, the vast majority of the market’s gains have occurred during periods of elevated short-term volatility.
My point here is not to suggest a trading system, though it’s not difficult to conceptualize one from the idea of relative volatility spikes. Rather, the point is that comfortable markets–those with modest volatility–have yielded negative returns. Uncomfortable markets have yielded the bulk of market returns.
A trader’s returns have been directly proportional to his or her ratio of courage to fear. Buying ugly markets has made superior returns; stopping out of long positions on ugliness has led to negative timing alpha. Buying stocks when fear is gone and markets are orderly has not paid off.
If there’s a formula for trading success, prudent courage is not a bad start. If there’s a formula for trading failure, acting on fear–fear of missing out, fear of losses–is also not a bad start. It’s amazing how ramping up trading risk/size and trading frequency can turn prudently courageous traders into fearful ones. If there’s a formula for risk-taking, trading the largest size that enables you to stay prudently courageous during times of ugliness is a good starting point.
Further Reading: Why Success Lies on the Other Side of Fear