Using the VIX to Gauge the Stock Market
If you have ever hung around a stock news channel for some time you have probably heard of how the VIX is doing. Have you ever wonder what it is and more importantly why so many people pay attention to it?
Simply put the VIX is just a mathematical measurement to gauge fear in the stock market. Specifically the S&P 500 stocks. Okay that might even sounds a bit scary. Think of the VIX as a number showing how fearful professional traders and investors are about the stock market. You see the VIX is a measurement of put to calls in the option market. The options market is a trading market where investors can buy and sell rights to a stock or group of stocks at a specific price on a specific day. Since these options follow the underlying stocks, then if people are really fearful and start buying put optidons or the right to sell a stock at a specific price, then the VIX will climb.
So what does all of this mean for you? Well by following the VIX you can usually see where the stock market might be going in the near future and more importantly how to manage your investments accordingly.
Think of the VIX as an alarm bell that goes off when investors get either too bullish or too bearish. You see the VIX will normally hang out somewhere in the upper teens to low 20’s. Now don’t worry about what that number means, just realize it is the just a value measurement. What is more important to you is, does the VIX move out of the normal range. For once it goes either above its normal range or below it- then it is singling that something is afoot and you need to be watching carefully. As the number goes higher, it will indicate that there is more fear in the market. In fact if the VIX spikes to around 30 or more, it could be indicating that a bottom of a selloff may be near. If the number goes below hanging out in its normal range and goes down to a low teen number it could single there is too much optimism in the market and it could be that a selloff may come in the near future. There is a caveat to this. The number can hang out in the low teens for a very long period, so a low VIX number means be cautious but, don’t run for the hills just yet. If the number does spike, then that is a better gauge of too much fear and you can feel better that you can get back in the market.
Now the VIX is not a panacea, but if you add it into your normal investing analysis, you have a better chance of seeing how the rest of the world is viewing the general market. That information can give you a better inclination if you should be investing with confidence or if you should be stocking up on food and shot gun shells for life as we know it is about to end.
Investing for the long term in a short term professionally traded market
The stock market is fixed. At least that is what some say and from the perspective of the average investor it could seem like it. You will hear stories of inside deals and how this trading company is tied to that one. Well there is some truth to these statements to a degree. But the reason for that truth may not be what you think it is. Traders are very short time investors. So to them it really isn’t as important if the underlying stock is doing well in business. What matters to them is that how much money they are making on an investment and often that investment is for a short period of time. They are not doing this because it is evil, its just that’s how their business model works and how they make money. If you have every thought of buying the “hot” toy for Christmas and then selling it to the poor person who couldn’t buy it, then you are doing the same thing these traders are doing.
The question then becomes how can you make money in this world of short term investors. Well unless you can invest like them, then don’t play their game. Instead play the long term investment game. Stock traders that invest for the short term are only worried about the “action” of the stock. The stock itself is the product, not the underlying business. For you, playing the long term game, you will be looking to make money from how the business is doing. When doing this type of investing, there are some actions you can take to really help out.
First get out of watching an investment second by second. If you are a long term investor, your main concern is how the business is doing not how the stock is doing. So only watch the stock from time to time. Pick a solid company, stay with it for a while and watch the stock with the understanding that you can be more successful by playing the long term.
Next consider finding a company that pays a dividend. It is funny for some time there has been a regular debate about paying back investors. Some people say a company should buy back stock to increase the price, while other say just give the stockholders a dividend and pay them for holding the stock. Well is you are a long term investor a steady stream of cash coming from your investments can be a great way to go. Think of this as your service payment for being a loyal investor in a company that you believe in. Now this strategy can be a very profitable way to go. Let’s say that you have a timeline to hold onto a stock for 10 years. The stock pays back 3% of its value each year in dividends. Well if you hold it for 10 years you will be getting paid 30% of the value of the stock, plus the stock will usually remain fairly close to where you bought it or will climb. If it goes higher, not only do you get money from dividends, you get stock appreciation by the stock share climbing over that period of 10 years. Those are two good things to happen in a multi-year investment.
When it comes to stock investing have a clear understanding what type of investor you are. If you are in the stock for the long term because it is a solid company. Then look for ways for it to pay you to keep the stock. But, keep perspective on the stock and don’t get wrapped up in the hype of the short term traders, as they are not the same class of investor as you, the long term investor.
Should I listen to a stock tip or guru
You just heard a new stock tip while eating lunch with your friends. Or you’re watching your favorite stock report and a guest cannot stop raving about a particular stock and company. What should you do? Should you run away, call the police to have the person arrested for a pump and dump scheme. Or perhaps you should rush home and dump all of your life savings into the stock. Well the answer is it depends.
Is there a problem with trusting a total strangers to make your investment decisions? Perhaps, the big question probably should be; why would you trust a total stranger to give you stock advice? So maybe the answer is yes and no to listening to a stranger’s advice. How’s that for a decision and answer. The truth is that sometimes you might get a really good idea from someone else, whether they are a professional investor or someone on the street that you just happen to overhear. Maybe the best way to handle it is to have a plan for those great tips you hear.
First one thing you need to know. If a professional recommends a stock like on a TV station, they do have to disclose if they are an investor in the stock. This is true whether they are long the stock (they own the stock for appreciation) or they have a short position (they can make money off the stock decreasing in value). Also, realize that someone might be making money off that tip they just gave you, this is true for professionals and the common person on the street. In fact, a few years back there was a pump and dump scheme where people were “accidently” leaving stock tips on answering machines. The caller would leave a message like it was meant for their friend and they just happened to dial your number by accident. Then they left a message for their friend not knowing it was on your machine. The problem was it was a fake call to pump a worthless stock. So people were thinking that they had just gotten the tip of a lifetime. Sometime beware of advice you get.
What should you do if you hear of a tip? The more you hear tips the more you might hear the phrase, do your own due diligence. If someone tells you that, this is a good thing as it means that they want you to check out the stock first. Not all investments are meant for every person. You might be a long term investor and this stock looks like a good short term pop, but then sink like a rock. So for you it might not be the best investment.
No matter what you hear, always do your own due diligence. This means investigate the stock to see if it is a good fit for you. That is what you should do whenever you hear a great tip. Look at the stock, check things like it P/E, earnings, value, recent history of the stock price, etc. Investigating the tip could be the way that you get a great opportunity. Notice though that the main key to the tip is knowing if the stock is right for you. That is how you can keep a tip from getting you in trouble.
So there are no problems with listening and maybe even acting on a stock tip as an investment. The real key is to know if the stock is right for you and understanding that the person making the tip might have a hidden motive to seeing the stock go up or possibly down.
Using options or LEAPS to make your own dividend
If you are a bit more advanced in your stock ability and you have started using options as part of your strategy, you might want to explore more strategies for making money. One potential program that has limited downfall and increasing your potential returns is selling an option above the current price of the stock, what is called a covered call option strategy. By using this method you can develop your own dividend stream from long term investments that do not pay dividends. In fact, some investors have been so successful at this method they derive monthly income in the thousands.
Recall that an option on a stock is the ability to either buy or sell a stock at a specific price on a specific date. Some option expire in less than a month others might expire in several years- these last ones are called LEAPS. All that the option does is give the holder the right to buy or sell a stock to the person who “wrote” the option. Basically it is a contract to deliver a stock at a specific price on a specific day. Now let’s say that you have 100 share of XYZ stock. The current price of the stock is $50 and you expect to hold on to the 100 shares for a few years. However, if the stock were to go to $75 you would be willing to sell the stock at that price. Also, XYZ does not pay dividends, so all you are hoping for is appreciation in stock price.
With those points as the backdrop now you have an opportunity to make your own revenue stream. Let’s say that call options for XYZ for 6 months from today for the price of $75, is trading at $1.50. This means that someone buying that option are paying $150 for the right to buy 100 shares of XYZ at $75 per share in 6 months. You can write a call option or sell it into the market and get paid the $150 for your option. Now you will need to keep that stock until the option expires in 6 months, or it is exercised at the $75 or you buy back the option. But, what you have done is guaranteed yourself selling the stock at $75 per share- a $25 profit per share from where it is today. Also, you are making $150 just for telling someone that you will sell your shares to them at that $75 in 6 months. Basically, you have made a money stream on your stocks without the stock paying you a dividend. Believe it or not, there are plenty of investors that this is the main source of their income in investing. Most never even sell the underlying shares, because the price never grows that much as the price that they have written the option for.
Options are not meant for everyone and you want to make sure that you are very comfortable and understand the risks associated with options. This is because if the stock does hit the $75 mark in our last example, you will have to sell the 100 share to the person who bought the option from you. This is true even if the price goes to $100, because you have sold them the option at $75. You can buy back that option and release you 100 shares from being sold to the person, but, you might have to spend more than the $150 you sold it for. So if you go this route of writing options on stocks that you own, know that there are downsides. This is one of the reasons options are considered very tricky and should only be used by experienced investors. But, if you play your investments right this could be the way to increase your profits. Finally, never sell an option without having the 100 shares of the underlying stock as you can get into serious trouble for you are on the hook for those 100 shares.
Developing an investment strategy
You are ready to take the plunge and start controlling your investments yourself. Or you are sick and tired of paying others to manage your money and now you are ready to do it yourself- as you figure at least I can’t do any worse than the professionals on the stock market. Well then congratulations as you are willing to take control of your own destiny. Yes you can do just as well, if not better than the profession. But, there are a few things you need to think about before you get started.
Among the first questions should be what type of investor are you, and then develop a strategy to fit that mold. The biggest problem that new investors make or those that are taking over their investments is they go into the process without understanding themselves and how that will impact their investments. You see a strategy or plan can help you more effectively manage your investments and keep you out of trouble. The plan can be very simple, but you need something to be your guide otherwise you have a definite chance of screwing up.
So how should you develop your strategy? Well the first thing to do is figure out what type of investor you are and what funds will you be using for the investment. You might be a long term investor, developing your retirement. In this case, you want to look to ensure that your investment is strong and you won’t lose too much if you make a mistake or the stock decision goes against you. After all it took you awhile to get all that money, now you don’t want to lose it on a bad investment decision. On the other end of the spectrum, you might have extra money that you want to make some more money with it. In this case you could take on a bit more risk and look to make a quick return. So this is the first step: know your goals and the type of investor you are.
Once you have defined what type of investing you will be doing. (Yes it is possible that you could be several types at once- then make sure you have or only use money allocated for that investment type.) Then it is time to set out your plan or strategy. Write up your plans or guide as this will help keep you focused on your goals. Write out your goals- are you looking for dividends or is stock appreciation you goal. Then once you have the goals written out and your plan set the parameters for how you will achieve these goals. This is where you want to say… I want to earn 25% back on my money. Or I want to keep stocks in this investment for X amount of time. Or you might want to say I will look to make this much from this period of time. You see here all you are trying to do is set out the investment goals. That way you know when you have met those goals. If you are looking for 25% return, once it hits that mark, sell and move on to another investment. That is the goal of a strategy to make and measure what success in an investment is.