Reducing overall market exposure according to market volatility

[caption id="attachment_311" align="aligncenter" width="500" caption="S&P 500 and VIX"][S&P 500 and VIX][][/caption]

With VIX at a multi-year high and the current market turmoil, it seems to be a good time to write about market volatility.

Market volatility is a two-edged sword. Day traders dream of catching the 800 point swing in the YM contracts. Yet, most would lose more being stopped out before giving up and then missing the swing. For long term traders, these 800 point swing could cause panic (if you're on the wrong side) or doubts (should you or should you not take the profit?).

Based on my brief experience in day trading and futures markets, I am not one to play with fire. For my longer term plays, I am feeling the pain as we speak. Thus, it is important to realize that although market volatility is very tempting for quick profits, greed never pays in trading. Another characteristic in a highly volatile market is that there're a lot of emotions going on. As you know, emotions can cloud our judgement. It's more difficult to trade when you're filled with panic, fear, greed, excitement, etc.

In other words, market volatility is bad because 1) large swings both ways at any time and 2) lots of emotions in the market and yourself.

To minimize your risk, it's better to minimize your exposure to the market at times of high volatility. Thus, I use the rule that...

If 50 dma of VIX > 20, then reduce position size to some % (i.e. 50%) of usual amount.

As a corollary, here's another interesting idea. It's widely known that markets tend to creep up and plunge down, i.e. rising slow and steadily, and fall quick and hard. Looking at the 50 dma VIX, it's actually a quicker indicator for the 2007 top than my previous 2-line EMA indicator for market sentiment. Conceptually, if we accept that bull market is slow and bear market is fast, then this idea of using VIX to signal bull/bear sentiment do seem viable. However, there's already too many IF's and assumptions for me to take this seriously. Therefore, let's just stick with using volatility for managing position sizing only.

[S&P 500 and VIX]: http://traderpau.files.wordpress.com/2008/10/2008-10-08-vix1.png