There are many ways to calculate a trader’s profit (if any) from the stock market. The most common is called the Volatility Index (VIX), which divides the total market value by four: the average spread between the highest and lowest levels of the past 200 trading days, the annualized return of 10 percent over the past three years, and the monthly return over the past four years. The more volatile the market, the higher the percent of return that the trader profits – if all else is equal.
The average Volatility Index for U.S. equities is 7.6, which means that there are nearly eight times as many short positions as long during any given trading day. For example, on Dec. 31, 2015, there were nearly five times as many long positions in the S&P 500 as there were shorts.
But just because volatility indexes are fairly good at measuring volatility isn’t enough to make them a good predictor of profit, because they also suffer from sampling error. This is where the model behind the Volatility index makes a major mistake. On average, short-sellers sell stocks with a short-term price close to the closing price a few days later. So, on Dec. 31, the average day-to-day volatility in the S&P 500 ranged from about 11 to about 19, and that was almost exactly the same as a year earlier and even less than five years before that.
It turns out that there is a big difference between the average day-to-day volatility and the average over the course of months or years: The average daily volatility in the S&P 500 was 4,873.8 on Jan. 18, 2012, or 11 percent below the level for the last year – even though it was in the midst of a bear market.
The other thing to look for is when a short sells a stock. If a short makes a short sale during a rally, that means he sold the stock in the days after it’s up and when prices start to decline. The average daily volume of stock sales on Dec. 31, 2013 was 1.9 million, or 3.1 times the amount of sales two days before that.
The Volatility Index was a perfect predictor of profit for a simple reason – it showed that the market was moving to a correction. (For more on how to measure your own performance, check out our Stock Market Performance Calculator.)
How was the S&P 500 index used
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