VIX tracks market’s pulse
- SPX started this week by falling toward year-to-date lows
- Lower VIX levels when stocks fall can indicate potential rebound
- VIX signal preceded market’s two-day surge last week
When the stock market is falling, especially in the seasonally volatile fall months, one indicator is likely to be the focus of attention for many experienced traders.
That would be the Cboe Volatility Index (VIX), which reflects the options market’s expectations for near-term volatility in the stock market. In a nutshell, when the stock market climbs, the VIX tends to decline (reduced volatility expectations), and when the stock market falls, the VIX tends to rise (increased volatility expectations).
When that basic relationship breaks down, though, things can get interesting.
The stock market’s 2020 COVID sell-off provides a good example of what most people probably think of as “classic” VIX behavior: a rising VIX amid sharply falling stock prices. As the SPX tumbled 34% between February 19 and March 23, the VIX jumped from 14.38 to 82.69, the highest it had been since the 2008 financial crisis:
Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)
Aside from representing the typical stock-market/VIX relationship—falling stock prices, rising VIX—the chart also highlights the inherent contrary aspect of the VIX: Notable VIX highs often accompany significant market lows.
Before looking at what the VIX has been doing lately, let’s take a look at two episodes from 2019. In the first, when the SPX (top) formed a swing low in May, the VIX (bottom) jumped above 20. But when the SPX fell to a lower low in early June—something that “should have” resulted in higher VIX levels—the volatility index instead made a lower high:
Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)
So, instead of signaling it anticipated higher volatility as the stock market dropped, in early June the VIX was indicating it expected less volatility. The SPX rallied roughly 10% over the next seven weeks.
In the second example, after a sharp sell-off that bottomed on August 5, the SPX bounced, then retreated again to close lower several days later on August 14. Again, the VIX failed to reach its previous high when the SPX fell to a lower low, and the stock market again rebounded.
Now, let’s jump ahead to the past few weeks. The chart below shows the SPX rallied the day after it closed at a new year-to-date low on September 27 (1). The day after that it fell to a lower close (and intraday low), but the VIX—instead of rising—made lower intraday and closing highs (2):
Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)
Once again, the VIX was signaling less “concern” about volatility even though the stock market had fallen to fresh lows. This time, though, the SPX fell sharply the next day, September 30 (3). But the VIX repeated the pattern by closing lower and making a lower intraday high on this day, too. The SPX’s biggest two-day rally in more than two years followed.
These most recent examples provide two important insights: No signal, indicator, system, or trading premise is infallible. But if the SPX falls to fresh lows in the near future, many traders will be watching to see if VIX is higher or lower than it was on September 30. If it’s higher, it will suggest the options market is anticipating more potential downside. If it’s lower, it could reflect expectations for a rebound, temporary or otherwise.
As longtime traders know, the VIX may not always be “right,” but it often has something interesting to say.
Today’s numbers include (all times ET): NFIB Business Optimism Index (6 a.m.), Fed 5-year Consumer Inflation Expectations (11 a.m.).
Today’s earnings include: AZZ (AZZ), PepsiCo (PEP).
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