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Have you ever noticed that some people are more sensitive than others? In fact, if your first reaction to that statements was, “hey, what’s that supposed to mean?”  then you may fit the profile. Interestingly, it is the same way in the stock market. Some sectors are simply more sensitive to the movements of the overall markets than others. For example, take the brokerage industry. When the stock market rallies, the brokers are very often among the best performers. And when the market goes south, the brokers often fare much worse than the overall market. So the obvious question is, “Is there a way to use this information?” Let’s take a look.

In Chart 1 you see iShares brokerage ETF (IAI) on the top and the VIX Index (ticker, well, VIX) on the bottom. The things to note are that when the VIX index (which essentially measures fear and complacency in the market by tracking the level of implied volatility on S&P 500 index options) reaches an extreme, it very often coincides with a turning point (in the opposite direction) for IAI.

Chart 1 – Brokers Index (IAI) and VIX Index
(click here for larger view) 

As you can see in Chart 1, IAI and VIX have an inverse correlation of something along the lines of –0.68 (a correlation of –1.00 would mean that they trade in an exactly inverse manner). This type of inverse correlation can be used by alert traders to take advantage of market extremes. In other words, if the VIX gets overdone on the upside, it is likely soon to fall. Given the inverse nature of the relationship between VIX and IAI it makes sense to assume that in this situation a bounce in IAI is possible. Please note in the chart however, that these “counter VIX” moves may not last very long. Thus a trader needs to have the proper mindset to get in fast and also to get out fast when the time is right.

One potentially useful tool is the 3-day RSI for both the VIX Index and IAI. When the VIX 3-day RSI rises to 85 or above and the IAI 3-day RSI drops to 15 or below, a potential short-term bullish alert for brokerage stocks. Likewise a decline by the VIX 3-day RSI to 15 or less signal accompanied by a rise by the IAI 3-day RSI above 80 can be a short-term bearish signal. Now for the caveat. No one should get the idea that this is a trading “system." It is more of a trading “idea”, and a gentle nudge to get traders to look at markets in different ways, rather than simply drawing a trend line or overlaying a moving average.

Chart 2 – 1/17 Buy Alert

One potentially useful thought might be to use options and to act at the first sign of a reversal rather than simply jumping in the moment the VIX 3-day RSI reaches 15 or 85. For example, if a trader bought a call option when a buy alert was signaled he might then sell that option when the 3-day RSI for IAI rises back above say 75 (again, please do not think of these as “trading rules”, but rather simply as trading guidelines and a good place to start for further analysis).

Table 1 – Buy Alerts and hypothetical option trades

No one should assume from the results depicted in Table 1 that this method is somehow the “holy grail” of brokerage stock trading. This is just an illustration of the results during a small snippet of time. The point is simply that the results suggest a good reason to take a closer look.

Summary

The idea I’ve presented here is an example of “going off the beaten path” and looking for potentially unique and hopefully profitable opportunities in the market. This method takes advantage of the fact that the tides of fear and complacency swing from one extreme to another among the ocean of investors. This “change of tides” can be viewed objectively via the VIX Index. This method also takes advantage of the fact that brokerage stocks as a whole, are highly correlated with the overall market, but tend to move further both to the upside and the downside.

Opportunities are everywhere in the stock market. The key is to find some objective way to take advantage of a particular recurring opportunity on a regular basis. The method I’ve described herein appears to offer some promise.

As always, time will tell.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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