More option traders go broke trying to pick the bottoms of the stock market than profit by trying to do so. However, if you use the Chicago Options Exchange Volatility Index (VIX) with a few key indicators, you can trade quick snapbacks in price with relatively little risk. The VIX is valuable because it reveals sentiment amongs option traders in the S&P 500 and, because the majority of traders are wrong at extreme readings, you can make a quick profit if you use these steps to measure extreme points in the VIX.
VIX and the S&P 500
Go to a computer and log on to a free charting service such as FreeStockCharts.com and click the "New Price Chart" tab at the top of the screen. Input "VIX" as the symbol to pull up the price chart for the VIX itself. Take note that the VIX has an inverse relationship with the S&P 500, which means that as the S&P 500 is falling, the VIX is rising. The VIX rises because herds of traders are buying put options in the S&P 500, which drives up the price of the VIX.
Click the "Indicator" tab and select the Relative Strength Index, or RSI. This indicator measures the move of a defined period of price action and the strength of that move. Edit the reading of the RSI to a 3-period setting while editing the overbought reading to a 90 reading. Because the VIX has an inverse relationship to the S&P 500, this shows you that the S&P 500 is oversold during a decline in its price action.
Click the Indicator tab again and select the Bollinger Band indicator, which will overlay the price action on the VIX with a median line in the middle, with two bands outside the range of the price action itself. John Bollinger, inventor of the Bollinger Bands, discovered that that price action had a tendency to revert to its average price after fluctuating up and down from that baseline. The Bollinger Bands calculate the volatility at a 2 standard deviation setting. This is important when using the VIX as an indicator because once price reaches one of these bands, it helps you measure whether the VIX is revealing an extreme sentiment in the market.
The Setup & Trigger
Watch the VIX as it begins to rise due to the S&P 500 falling in price. When the VIX reads a 90 or above in the RSI, then confirm the extreme sentiment when the VIX moves up into the upper area of the Bollinger Band on your price chart. Once those two indicators read at extreme levels, wait for the next VIX price bar to trade and close down. If the following VIX price bar closes down below the low of the preceding bar, then buy the S&P 500 call options and exit when you hit your profit target.
Crowds are Often Wrong
The beauty of the VIX trading strategy is that crowds are often wrong. As more and more option traders buy put options, the more likely momentum will shift. This is a bit of a contrarian strategy, but it is remarkably consistent in spotting quick reversals. Still, be sure that you always use risk control and if the call option loses its price value by 50 percent or more, then exit the trade.