Sometimes it feels like this bull market will never end …
We’ve had years of outsized market returns at this point … and even though there’s always someone banging on about a “correction” coming our way … any downturns we’ve seen have typically been short-lived, and often underwhelming.
This week we’ve seen the S&P 500 (Ticker: SPX) close at new all-time highs …
And, maybe unsurprisingly, the market’s “fear gauge” (aka the VIX) is hitting new post-pandemic lows, closing on Friday at just 15.65!
Chart courtesy StockCharts
The VIX is often seen as a measurement of investor perception of risk, so with the index now sitting below 16 – after hitting a COVID high of 85 just over a year ago – it seems like investors are feeling pretty confident that there won’t be any wild market movement coming our way in the near future.
However … how do you make sure you’re not getting too confident?
Like I said, we’ve been in the middle of a historic bull market for years now.
And while we typically view a lower VIX reading as a signal of investor confidence …
Technically, the lower VIX reading isn’t just signaling lower expectations of a downturn … It is signaling lowering expectations for movement in either direction.
Therefore, the new VIX lows could also be a sign that the seemingly-endless upside we’ve enjoyed may be slowing down in the not-so-distant future.
Now, remember that the SPX and VIX typically have a negative correlation (when the SPX is up, we expect to see the VIX down, and vice versa). And while the VIX can still head quite a bit lower than where it is currently perched, there isn’t a whole lot of relative downside left for the “fear gauge” to fall.
Yes, we’ve seen the VIX hit lows under 10 in the last five years, but a move from 15 to 10 is significantly smaller than the move from 85 to 15 …
So with less potential downside of the VIX, again, are we seeing a sign that there may be less potential upside for stocks?
Alternatively, could a sudden VIX spike spell out big trouble for equities?
And what does this mean for us as traders?
It’s time to take a hard look at your current portfolio risk, and imagine where you’d like to see yourself if this bull market does start to stall out.
Don’t Risk It All
Too many options traders consider “risk management” as an afterthought.
Especially if you’re unfamiliar with all of the elements of risk in your portfolio, and unsure about how you’d react to a worst case scenario for every trade you’re currently holding, it’s probably a good time to “look inward” and make sure you’re poised to “trade another day” no matter what happens next.
After all, poor risk management is one way to see all the gains you’ve enjoyed over the last few years quickly reduced to zero.
Going into each trade, it’s important that you have a trading plan in place. This trading plan should cover not only what happens if the trade goes your way, but also how you’ll react if the tides start to turn against you.
And furthermore, if there’s an entirely unexpected turn of events, it’s important to know how you’ll analyze the situation, and how you’ll plan a reaction. By determining your own reaction to deviations ahead of time, you’ll be able to solidify your own trading process.
By having a trading process in place, and not just reacting to events as they happen, you greatly improve your chances of success.
In a similar vein, you should know the criteria you’ll assess for all of your trades before you take the trade. By knowing your “trade screening” criteria ahead of time, you up your likelihood of taking rational, well-considered trades, as opposed to trading on excitement or emotion.
Executing good trades – trades that you are confident in (for more reasons than just “feeling good” about it), that you have planned, and that you know how to handle whether things go according to plan or not – is the number one thing you can do to manage your risk.
Dealing with bad trades, however, is arguably equally as important, as one bad trade can easily wipe out ten good ones. Knowing where your lines are drawn before you enter is essential. When will you exit? What’s your loss tolerance? Again, how will you react if things go entirely unexpectedly?
It’s hard to think straight when you have money on the line, but if you have previously established money management, trade management, and risk protection guidelines in place, you will be able to avoid the temptation to “let a loser ride” when you shouldn’t.
If you don’t already, having a “risk management” partner – even just someone to bounce ideas off of, or to offer a second point of view – can be invaluable for your trading. When you’re “in the weeds” it’s too easy to get tunnel vision, and lose sight of all of the dimensions of a trade. By having a partner that can offer you a different perspective, you’ll be better able to determine your own blind spots and further refine your trading process.
Plan for the best, prepare for the worst, and remember … “By failing to plan, you are planning to fail.”
Your Only Option,