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Volatility Jolts Back To Life - Offers Buy Opportunity at Trader’s Narrative





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The CBOE volatility index (VIX) has been trading in a moribund trading range downwards for the length of this cyclical bull market. Recently it scraped the bottom of the channel when it traded down to an intra-day low of 15.23%.

But with the news of Greece’s downgrade from Standard & Poor’s the market tumbled and the VIX spiked higher. By the way, is anyone curious as to why the market is suddenly listening to rating agencies? These were the same firms who slapped AAA ratings on sub-prime mortgages, more than 90% of which have descended into junk status now.

So refresh my memory, why exactly should anyone care what rating agencies think? Why are they moving markets instead of being charged for fraud? After all, deals like the infamous ABACUS simply could not have happened without their explicit consent.

Getting back to the VIX: it spiked on Tuesday April 27th 2010 to the highest one day change (30.6%) since October 22nd 2008 (31.1%). Of course, in contrast to today’s subdued volatility levels, it was trading at 70% back then. These extreme spikes are very rare, having only occurred 8 times during the lifetime of the VIX index (including this most recent example). Usually they coincide with structural events that trigger widespread panic. For example, the Asian financial crisis, the 9/11 WTC attack, the 2008 credit crisis, etc.

As Bill Luby suggests, the smart thing to do is to fade these volatility spikes. The corollary, as this chart shows, is that it has also been smart to go long equities:

S&P500 compared to relative VIX Apr 2010

What you are looking at in the above charts is the S&P 500 for the duration of the most recent cyclical bull market compared to the relative distance of the CBOE volatility index to its own simple 50 day moving average.

I’ve mentioned the idea of looking at the relative VIX before. The advantage is that we smooth out the distortive effect of periods, like the current one, where the index moves to an extreme level, thus making comparisons to the past difficult. Instead of looking at the nominal level, this method allows us to compare the current reading to the most recent trend and identify spikes more clearly.

It isn’t a perfect correlation but usually when the relative VIX spikes and then falls lower, the S&P 500 makes an intermediate low. This short term guide can be coupled with the technical rationales we’ve already discussed for the primary trend: Technical Reasons for More Stock Market Gains.

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11 Responses to “Volatility Jolts Back To Life - Offers Buy Opportunity”  

  1. 1 Wayne

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    One question concerning the buy signals on the above chart. If the buy arrows were drawn, when VIX ranged x% from it’s moving average, then this is a very compelling chart. If the buy arrows were drawn to correspond with peaks in VIX, then the chart contains self fulfilling prophecy as VIX contracts 90-100% of the time that the market rallies and vice versa.

    But I have seen similar studies before by NDR and tend to want to agree with the message. Bear mkts usually begin with a roll over period, instead of a sharp hard one day reaction to a news event.

  2. 2 Babak

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    Wayne, you’re right. I didn’t draw the arrows according to a hard and fast rule, just wanted to point out the relationship. But if we go with, say, a 20% relative move away from the 50 day MA, then that leaves us with 4 signals. The Jan 2010 one arguably failed while the jury is out on the most current one. The other 2 were good signals.

  3. 3 Wayne W

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    Babak,

    We had two 9 to 1 down to up volume days in the last ten days, one on Tuesday and one back on expiration Friday. If my source is correct, Desmond, who has studied such ad nauseum, suggested that the low was not in yet. commenting that two such signals this close to a high would result in more downside. I hope I’m not misquoting him. He looked off the mark as the market turned up sharply on Wed and Thursday, but he looks a little smarter today.

    I should have some news for you next week.

  4. 4 daniel

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    Say, how did you create that price relative to 50MA? It looks like you are using stockcharts.com, but I can’t figure out how to replicate it. Thanks.

  5. 5 Babak

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    Daniel, there are several ways. The way I did it was to use the PPO indicator with 1,50,1 as the settings.

  6. 6 Aristotle

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    Babak, Great Blog! I read it regularly.

    Wayne - I also enjoy your rigorous analysis. It’s best to backtest these kind of things to see what works on a sustainable basis.

  7. 7 MatthewC

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    The last two instances of 90% Down Volume days near a market top (before April, 2010) were Oct 28 and 30, 2009 and June 15th and 22nd ,2009.

    Prior to the 2007 top there were also back to back 90% days in July 24th & 26th , 2007, Feb 26th & March 05 of 2007.

    Although any 90% Down day (volume or volume points) is indicative of high emotion, I would be somewhat cautious with comparisons because the volume of Citi (C) is so high as a % of NYSE volume that removing that one stock alters the recent data enough to take away the 90 pcnt day status of some of those days.

    FYI

  8. 8 Alex

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    A better way to look at Vix’s spike is to check out the percent move in a short time frame, such as 5TD. Since 1991 this is a good bull pattern with horizon to the next 4 months (only in 2008/2009 failed to a great amount).

  9. 9 MatthewC

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    re: volatility

    The best book I know of on using the VIX for trading is Larry Connors book titled Trading Connors VIX Reversals.

    He and Greg Che did an outsdanding job of identifying and testing various trading strategies. The book details the strategies and the percentage of success you can expect.

    ie CVR 3 has an historic 68% success rate: For Buys — the low of the VIX must be above its 10 day average, close at least 10% above its 10 day average. If both are met, buy the market at close and exit when VIXtrades back below its 10 day average. Reverse for sells.

    Its a great book. I am not sure if its still in print, but you might be able to pick up a used copy or check Larry Connors web site.

  10. 10 Wayne W

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    MC
    thx for your input on both above subj’s

    I have piddled with 90% days a bit, but have found other measures of upside to downside volume more useful for my personal taste, such as 5 day moving averages, so I can’t speak with a lot of authority on implications of the last two 90% down days. I did do some research on the statistical significance of the two previous upside ones that we had in a one month period back in Feb and March and all indications were that they were very positive. And I believe I agree with you that downside ones are definitely not the reverse of the upside ones, and the limited research I did on the subject suggested that the downside ones tend to positively compliment the upside ones.

    Dont be such a stranger. You know we really should do lunch, or at least exchange email addresses.

  11. 11 Fibocycle

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    Fading the VIX while going long the market has been a profitable strategy–especially if a filter is used in conjunction with the VIX. I have posted a graphic showing the VIX and the SPX with a 14 period RSI. It appears that implementing the strategy when the RSI is below 30 is a profitable venture. Not monitoring the RSI can lead to becoming trapped in BLACK SWAN EVENTS like SEPT 2008-March 2009.

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