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By Karim Rahemtulla

With light trading volume on the U.S. exchanges in the run-up to the New Year, many investors’ thoughts have already turned to what the early part of 2011 has in store.

The smartest ones with the best chance of getting a leg-up on the crowd are watching the CBOE Volatility Index (VIX).

With the stock market’s recent ascent to new 52-week highs, the VIX has moved in the opposite direction and moved close to its 52-week low of 15.23 points just before Christmas. It’s currently rebounded a bit and now trades around 17.20.

If you’re not already doing so, this is something you need to pay attention to as we roll into 2011. Here’s why…

What is the VIX?

In short, the VIX is a measure of the stock market’s “pulse.” That is, it gauges investors’ mood, based on options trading among S&P 500 companies.

It’s easy to remember the relationship, as it works in the opposite way to the market. If more investors are buying calls, they’re betting that stocks will rise. As a result, the VIX will head lower amid perceived complacency.

If there’s more put option-buying, it’s a sign that investors expect stocks to fall. This fear will cause the VIX to rise.

Reading the VIX

When it comes to using the VIX’s movements with your trading decisions, the index has established trading ranges and specific points that you should monitor. When the VIX trades…

~ Above 40 Points: Investors are in panic mode.

~ Above 50 Points: Investors are in all-out selling mode.

~ Higher Than 50 Points: This is a rare occurrence (it’s only happened twice before), but if it happens, back up the truck and buy S&P call options in anticipation of a reversal.

~ Between 20 Points and 30 Points: This is the toughest range to gauge, as the market isn’t giving a clear signal.

~ Under 20 Points: The market is heading into solid bullish territory and investors are feeling really good.

~ Under 15 Points: Investors are feeling too good and complacency has set in.

And we’re close to this latter range at the moment…

What the VIX is Telling You to Do Right Now

When the VIX drops into this 15-point range, you need to start thinking about being more defensive with your investments.

The problem is, the VIX can trade in these low ranges for weeks, even months. This means you must be counter-intuitive. That is…

  • Start making plans to lighten up on positions, or…
  • Take measures like selling call options against your positions. This is a very difficult thing to do from a psychological standpoint, since you have to wrestle with your emotions.

Don’t worry, though… because whenever the VIX has fallen below 15 – and especially if it falls into the 10-12 range – it’s always been a good time to sell (even if it sometimes takes a while before being proven right).

The key question to keep in mind is this: Is the next 10% or 20% climb worth the possibility of suffering an even bigger decline on the way down?

Remember, the market tends to fall much faster than it rises and it’s always harder to get out once panic sets in. On the way down, investors invariably pick the worst point to sell because they’re shocked by the speed of the movement.

Don’t fall into that trap, because when the market is falling, you need to be flush with cash in order to scoop up the bargains.

Here’s what you should do…

When the VIX Falls, Raise Cash

As a general guideline, raise cash at levels that correspond with the VIX.

That means with the VIX under 30 points, your cash levels should start to accumulate, maybe at a rate of 2% for every point lower on the VIX.

However, with the VIX currently around 15-17 points, you should raise cash at a rate of 5% for every point that it drops. If the index falls under 12 points, that number should rise to 10% for every point. If the VIX trades at 10 points or under, your cash position should be at least 50%.

These are guidelines that I’m adopting for my portfolio. While it may seem overly conservative, you only need to look back two years and remember exactly how you felt. By being flush with cash, and also holding a substantial equity position, you may lose a bit of money on the way down, but at least you’ll have powder ready for the huge bargains that invariably pop up during a panic.

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Source: What Is the VIX Telling You to Do Now?