June 23, 2014 5:00 am 32 comments Views: 13623
We’ve been talking a lot about the RSI indicator lately and rightly so. It has proved to be a valuable indicator at highlighting potential turning points. Just last week we took a look at using the VIX index as another way to locate potential turning points. If you will remember, the VIX is often referred to the “fear index” because it tends to climb when market volatility shoots up. Market volatility often climbs during times of panic; thus, the use of the term “fear index”. In this article I would like to combine the RSI indicator with our VIX index. That is, I will be using the RSI indicator but will not be using closing prices as the input to the indicator. Instead, we are going to apply an RSI indicator to the VIX to generate our buy/sell signals. More specifically, a two-period RSI. The concept described in this post is called VIX RSI Strategy and was found in a book called “Short Term Trading Strategies That Work ” by Larry Connors and Cesar Alvarez. The concept is rather simple but produces excellent results since 1983. In summary, we are buying pullbacks in an uptrend and we are simply using the VIX index to help us gauge when the market is experiencing a pullback. What
makes this trading system concept interesting is we will be basing our buying signals not exculsively on the price of our market but, we will be using the value of the VIX index to generate both our buy and sell signals. Below is an image of the S&P cash index with the VIX below it. Notice how the VIX tends to spike when the S&P cash market is creating new lows. The VIX has an inverse relationship to the price action on the S&P. Thus, we often see the VIX making new highs as the market is making new lows.
Inverse Relationship Between Market Price (ES) and VIX index
Knowing how this relationship works we can try to create a simple trading system by basing our buy signals on both the the VIX and price action of our market. We will continue to use the 2-period RSI on the price action of the market to determine our exit point. BY combining both a price based entry signal and a VIX based entry we signal we have confirming our entry signal with two different methods. This should help use locate very productive entry points. Below is an image which shows the 2-period RSI indicator applied to the VIX index.
2-Period RSI Applied To The VIX Index