Stock market trading strategy with stellar returns and limited capital risk

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Stock market trading strategy with stellar returns and limited capital riskStock Market Trading Strategy With Stellar Returns and Limited Capital Risk

Added by: Teddi Knight on Feb 25 2013.

An excellent Stock Market Trading strategy that I use to provide exceptional returns with a strong level of protection against capital loss is designed around the VIX Index. This Stock Market Trading strategy has a solid track record in my portfolio that stretches back to 2003.

I have written a number of articles regarding the VIX Index as a market timing system but many investors are not aware of using the VIX Index as a Stock Market Trading strategy. Todays drop of 1.87% in the SP 500 provided a return in excess of 70% for my most recent VIX Index trade.

I have used the VIX Index for Stock Market Trading since 2003 after studying and paper trading it from 2000 to 2002. The VIX Index has options which while not the most liquid, certainly have enough volume to allow me to get filled on 50 to 100 contracts without any problem.

How The VIX Index Stock Market Trading Strategy Works

Using the VIX Index as a market timing system can be as complex or as simple as you want. I prefer simple. My strategy is basic. Whenever the VIX Index falls to $14.00 I buy the $14 strike calls on the VIX Index a minimum of 3 to 6 months out.

Boosting The Return

Often to boost the return I sell the $14 or lower put strike 3 months out as I dont mind being assigned at the $14 or $13 put strike since this is where I would buy my calls. I do not sell calls to turn my position into a credit spread.

Simple Works Best In My Book

I prefer to keep the trading simple which means selling puts when the VIX Index gets down to almost $14 or below and buying calls at the $14 strike.

When I started this Stock Market Trading strategy in 2004 I was using the $12 call strike to buy calls and selling the $12 put.

After the 2008 market crash I changed first to $15 and then in 2011 to $14 as volatility in the overall markets declined. I will explain how to determine strike levels throughout the year further into this Stock Market Trading article.

Lets take a look at the profitability of this Stock Market Trading strategy.

Stock Market Trading Strategy in 2013 with the VIX Index

How well does this system work? It is quite profitable with very little downside.

Below is the VIX Index since November 2012. On January 4 2013 when the VIX Index fell below $14 for the first time in months, I bought 25 April $14 call contracts for $3.95.

Total amount of capital spent = 25 call contracts X $3.95 plus $30 commission = $9905.00

This is not a strategy for those without patience. Often it can take a while for the trade to work out and it can be difficult for many investors to spend money on call options and then watch them erode. If that is the type of investor you are, then this trade will never work out.

VIX Index 2013 Trades to date

After January 4 when the VIX Index continued to fall my call options lost value which is only natural. In early Feb as the VIX Index moved higher back to $14 my April $14 call options did not increase much in value because options are a wasting asset and these types of options need a spike to get the premiums back up.

That spike came today when the VIX Index jumped up to $19.28 before closing at $18.99. I sold my 25 VIX Index call options for $7.15.

Sold 25 April $14 call contracts X $6.95 less commission of $30 = $17345.00

Return = $7440.00 or 75%. This is the type of return I have experience with this Stock Market Trading strategy.

The Rules I Follow

There are a few rules about this Stock Market Trading system that I follow.

1) Patience is absolutely essential.

2) I only use the amount of capital I can afford to lose. In my case around $30,000 is my maximum capital I would ever want to risk.

3) I set my alert within my discount brokers software to $14.00 on the VIX Index so I dont have to watch it. I will be emailed and text messaged when the VIX Index hits $14.

4) I always buy a minimum of 3 months out.

5) I always buy the $14 strike call.

6) I sometimes try to sell the $14 or lower put strike for extra profit but most of the time this is a call buying trade.

7) I watch the overall volatility of the SP 500 as measured by the VIX Index and as the volatility declines I move lower for my base strike. For example in 2004 I was using the $12 put strike. After the 2008 bear market crash I changed first to $15 and then in 2011 to $14 as volatility in the overall markets declined.

8) You cannot over trade this strategy. Some years there are only one or two trades. This is not a strategy for those investors who like to always be trading. This is a strategy that offers only a few trades a year which is why I use it only to boost my overall portfolio. It has such a low-level of risk however that I enjoy the profits that it produces and rarely need to adjust my call positions.

To understand this simple strategy better lets look at past years.

Stock Market Trading VIX Index Trades in 2012

On September 14 2012 I bought January 2013 $14 calls which I sold on September 16 when the VIX Index reached $17.00. Two weeks later on October 5 I bought January 2013 $14 calls again which I sold October 25 when the VIX Index reached $18.00

VIX Index Fall 2012 2 trades

The trade prior was on August 13 2012 when I bought the January 2013 $14 calls and sold then on August 31 when the VIX Index reached $17.50.

VIX Index Index Trades August 2012

On March 16 2012 I bought the July $14 calls and sold them on April 9 with the VIX Index at $18.25

VIX Index March 2012 Trades

In 2012 then there were 4 trades. I earned between 60% and 70% with each trade and stayed with no more than $30,000 maximum capital invested split with 70% in the call options and 30% to cover the sold puts. If the puts end up in the money this is a cash settled trade (no stock assigned on the index) and I need the cash in the event I am wrong and I then must make up the difference through a cash settlement.

Stock Market Trading VIX Index Trades in 2011

2011 saw only one trade so obviously I was too low at the $14 strike and should have selected $15. On April 21 I bought the July $14 calls and sold them on May 9 2011.

Stock Market Trading Strategy With The VIX Index

To understand how to pick the VIX Index strike price I keep a watch on the previous year which obviously in 2011 did not work which is why there was only the one trade.

Stock Market Trading Strategy VIX Index 2009

In 2009 I did NO Stock Market Trading strategy trades using my VIX Index system as volatility was too high. However the decline was obvious to me but I still needed it to be below $20.00 before entering this strategy again.

VIX Index 2009 weekly chart

Stock Market Trading Strategy VIX Index 2010

In 2010 the VIX Index in April fell below $16 and I bought the July $15 calls. This was an excellent trade. In December the VIX Index fell again below $16 and I again I bought the $15 calls.

The pull back of the VIX Index to just below $16 I thought was an indication that in 2011 I should be using the $14 and not the $15 strike for buying calls. That was a mistake as I only had one trade in 2011.

VIX Index Weekly Chart for 2010

Periods Of Low Volatility

Lets go back to 2003 to 2007 to see how well this Stock Market Trading strategy performed from 2003 to 2007.

Stock Market Trading Strategy VIX Index 2003

In 2003 the bear market ended and volatility began to decline. I waited until October to finally buy my first set of $15 calls.

I noted though that the volatility was still declining. After the volatility spiked up in November to $18.98, it immediately pulled back lower. I moved from the $15 call strike to $14 and bought the $14 calls in December.

2003 was interesting as I only did two trades but I surmised based on the volatility by year-end that even the $14 may be too high as the SP was recovering and volatility was declining.

VIX Index chart weekly 2003

Stock Market Trading Strategy VIX Index 2004

2004 was an excellent year for trades. When in December 2003 I determined that $14 was the call strike to be buying, it ended up that the $14 call strike was good for two trades in 2004. One in March and a second in April.

The rise in April in the VIX Index was lower than the previous rise. Just like a stock, the VIX Index was making lower highs a sure sign of declining volatility. I therefore changed from $14 to $13.

This brought two more trades. July $13 and September $13. The decline in volatility remained evident so I lowered my call strike to the $12 valuation. This meant only one more trade which took place in December 2004 when I bought the April 2005 $12 calls.

VIX Index Weekly Chart for 2004

Looking at the 2004 chart we can learn that volatility does not impact the profitability of this trade. Low volatility does not make the trade more difficult or less profitable. Instead it makes the trade easier to manage with even less risk and easier to pinpoint the call strikes to buy. Since I trade only through buying the call strikes the lower volatility means the cost to purchase the call strikes is lower but when the VIX Index runs up higher, the call premiums still move up to reflect the rise in the VIX Index. Therefore the returns are still excellent despite the low volatility since it is the rise in the VIX Index that makes these call strikes mushroom in value.

Two things to take away from the 2004 chart.

First it is important to understand that the VIX Index strategy does not mean you are trading very often. 2004 was a busier year than most and that still only meant 5 trades. This is a strategy for those who realize you do not always need to be trading in it. It is definitely a strategy for those who have a great deal of patience.

The second thing to take away from the chart is that the chance of capital loss is very limited if an investor takes the time to understand that over-trading this strategy is pointless and that volatility will decline as stocks move higher. The higher stocks climb, the lower the VIX Index call strike should be selected. 2004 was a recovery year for the SP 500. As the SP moved higher the volatility fell. As long as I realized this then trading by buying calls at lower strikes throughout the year was not only simple but had very little risk.

Stock Market Trading Strategy VIX Index 2005

The following year 2005, was another good year despite the lower volatility. The VIX Index never broke above $19 in 2005. I stayed at the $12 call strike level and did 4 trades during the year. These are marked with an X. The importance of this chart is to show you that there is a level within the VIX Index at which normal trading alone will provide a lot of protection against capital loss.

In the weekly VIX Index for 2005 you can see that the VIX Index was unable to stay below $12 for more than 3 months. Once the volatility moved this low I made sure to sell out a minimum of 3 months, but often I was out 6 months. This meant that even though for example in the summer of 2005 the VIX Index fell below $11.00, I simply held my call options and waited for the VIX Index to turn higher.

You must have patience with this trade and understand that stock markets never go straight up. When volatility collapses as the SP 500 moves higher, it is only a matter of time before a correction will drive volatility back up. Corrections are a normal part of trading and in the case of this Stock Market Trading strategy, the volatility helps to protect against capital loss. However if you do not have the patience to wait for the trade to unfold and risk the capital invested, this trade will not work out.

VIX Index Weekly Chart for 2005

Stock Market Trading Strategy VIX Index 2006

2006 saw only two trades as I continued to stay at the $12 call strike level. The first call purchase though was excellent as I held into June. The second trade which started with calls being purchase in October 2006 was not sold until into 2007.

Again the important thing to take away from this chart is that the $12 strike is fairly comfortable for buying the call strikes. I could have moved to $11 and that would have worked but I did not, preferring to stay at the $12 strike.

VIX Index Weekly Chart for 2006

Stock Market Trading Strategy VIX Index 2007

The last chart is for 2007. 2007 was the first year I had to take a small loss in December to buy back my January $12 calls and sell them again into April. The SP 500 was moving a lot higher during this period but I knew from the past history of the VIX Index that it would not last. In March the VIX Index shot up to $20 and I sold the April $12 calls for a gain of 105% after calculating in the loss from the roll into April from January.

Then in April I bought the July $12 calls which I sold July 11 2007 with the VIX Index at $17.50. However since April the VIX Index had failed to fall back below $15 and in fact was struggling to stay below $16.

Therefore on July 19 I bought the $15 calls for January which I sold in August with the VIX Index spiking to $37.00. That was the best trade using this strategy since I had started. It also warned me that the market was in trouble and even while the SP 500 pushed to an all time high of 1576 that October the VIX Index had a very hard time staying below $20.

VIX Index Weekly Chart for 2007

From using this strategy you can see that the returns are exceptional and as a bonus, it also acts as a warning signal to advise when all is not well with the overall market environment.

Summary-Stock Market Trading Strategy VIX Index for 2013

Where the markets will go from today (Feb 25 2013) I can only attempt to predict. However the VIX Index strategy is a terrific tools to use to not only profit through buying calls and Put Selling when the VIX Index pulls back to the $14 level again, but to also warn us when the market direction may once more have difficulty.

I think the VIX Index will fall lower again into March and/or April and that will be when I will buy calls 3 to 6 months out as I expect volatility will keep coming back this year as we are now into year 5 of the bull market recovery from the 2007 to 2009 bear market.

This is a very simple strategy with excellent returns with low risk most of the time. It is not a strategy that can be over traded and it is not a strategy for those who find it hard to be patient or watch their options lose value.

Any questions about this strategy you can post them to the comments below or email me at teddifullyinformed

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