As any investor can attest to, things are not always what they seem. Take volatility in the market. It’s bad, right?

Not necessarily. There is an often-misunderstood index that tracks the market’s volatility called the VIX. Basically, the index measures the implied volatility of the S&P 500-stock index over the next 30 days.

Sound like mumbo jumbo? Not so fast.

In 2008, I was involved in a fund that included heavy investment in a volatility fund. As the VIX spiked higher in October, I saw the strongest yearly returns in a venture I had ever been part of. It was awe-inspiring to witness the power of the VIX in a properly designed portfolio.#-ad_banner-#

You may have heard of this index in the financial media. If you’re like me, you may have discounted it as some type of complex indicator for option traders only, with no relevance to the stock market.

Wrong. Not only does the VIX help project stock movements, it is easy to interpret using a few little tricks.

Based on an idea credited to professor Robert Whaley, the VIX was first used in 1993. The VIX is a weighted blend of prices for a range of options on the S&P 500. The options are based on the expected volatility or price change over the next 30 days.

Think of options as an insurance policy. Insurance is priced based on the likelihood of an adverse event occurring.

Simply put, the higher the VIX, the more professional traders expect that stocks will take a downturn. The number of the VIX represents the annualized expected percentage down move of the S&P 500 over the next 30 days. (If you are mathematically inclined, the VIX is calculated as the square root of the par variance swap rate for the next 30 days.) The number has been as low as 9 and as high as 89 during the financial turmoil in 2008.

A helpful way to look at the VIX is as the inverse of the S&P 500: As the VIX moves higher, the S&P 500 moves lower. When the VIX moves lower, the S&P 500 generally travels higher. The VIX is called the “fear index” for a reason. The higher the fears in the market, the more traders hedge their positions with options, driving up the price of the options, therefore the price of the VIX.

Now that you understand what the VIX is, how can you put it to work?

Professional traders don’t use the VIX as a static number. They use it in relation to its 10-day simple moving average.

Author Larry Connors calls this the 5% rule. Whenever the VIX is trading 5% below its 10-day simple moving average, the S&P 500 has lost money on a net basis five days following. The opposite has also been extensively tested. Whenever the VIX has been 5% or more above its 10-day simple moving average, the S&P 500 has earned returns better than 2 to 1 compared with the average weekly returns.

On a relative basis, the VIX is signaling overbought and oversold conditions. In other words, the edge is in buying stocks when the VIX is at least 5% above its 10-day simple moving average. In addition, sell or don’t buy stocks when the VIX is at least 5% below its 10-day simple moving average. It’s the time-honored “buy the fear, sell the greed” axiom in action.

Action to Take –> Remember the VIX whenever you are thinking about buying or selling a stock. See where it is in relation to its 10-day simple moving average and factor this information into your decision.

This article was originally published at InvestingAnswers.com:
How You Can Profit From ‘The Index Of Fear’

P.S. — An eccentric Texas woman who dodged the 2008 financial collapse says the market is ripe for a pullback. This is the same analyst who’s produced annual returns of up to 510% and has picked winning investments roughly 85% of the time. To learn how she’s protecting her portfolio today, click here.