Testing TradingMarket's Rule #5: The VIX 5% Rule

This is the fourth part of this week’s series on TradingMarket.com’s (TM) 10 Trading Rules. In this post, I’ll look at the fifth in TM’s list: the VIX 5% rule.

TM advocates not being long the market when the VIX is more than 5% below its 10-day moving average because this has historically indicated that the market was overbought. Per TM:

If you only follow one market sentiment indicator, it should be the 5% rule.

Ahem.

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[logarithmically-scaled]

The graph above shows a strategy that is long the S&P 500 from today’s close when the VIX closes above TM’s threshold (red), versus a buy and hold approach (blue), and for comparison’s sake, another that is long when the VIX closes below TM’s threshold (green), from early 1990.

Recall that TM’s threshold is 5% below the 10-day simple moving average of the VIX. This is a proof of concept so these results are frictionless (ignore transaction costs and slippage) and do NOT account for return on cash.

For the number lovers:

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TM’s 5% rule cuts out about 25% of the time in the market.

During that 25% of days, the market has generally traded neutral to bearish. This wasn’t true in the late 1990’s, but intermediate-term overbought indicators (like this one) in general didn’t work well in those go-go days (a product of euphoria).

I think it’s important to note that trading above the 5% threshold hasn’t necessarily been bullish for the market (just look to the bear market of the early 2000’s to confirm that), but that isn’t the way TM postured the rule. It was postured as a defensive indicator, not an offensive one.

So, do I agree that “if you only follow one sentiment indicator, it should be the 5% rule?” No, and for two reasons:

No one should be following just one market sentiment indicator, one strategy, or one anything – that’s just foolhardy.

I think that there are more effective indicators that can work in this intermediate timeframe.

The other articles in this series can be found here: Testing TradingMarket's 10 Trading Rules, Part 1, Part 2 and Part 3.