Volatility insider

08/02/19
  • Lower VIX accompanying lower SPX a potentially bullish signal
  • When stocks and the VIX both rise, down moves sometimes follow

Wednesday’s FOMC meeting is in the books, the jobs report comes out today, and we’re inching closer to what is traditionally the market’s most volatile period of year. With stocks still hovering at relatively lofty levels, traders will be weighing the likelihood of another push to new highs against the odds of a downturn.

Regardless of which way they’re leaning, many of them will likely be keeping a close eye on the Cboe Volatility Index (VIX), the widely referenced market “fear” gauge. There’s good reason to keep it on your radar.

Since November 2017, the SPX has closed lower the day after the VIX signal 69% of the time.

The VIX is based on the implied volatility of S&P 500 (SPX) options—the market’s expectation of future volatility baked into SPX options prices. Basically, options implied volatility typically increases when the market is anxious (i.e., when stock prices are falling) and decreases when the market is relaxed (when stock prices are rising).

As a result, the typical SPX-VIX relationship is an inverted one: Generally, when the SPX rises, anxiety declines and the VIX falls; when the SPX falls, anxiety rises and the VIX rallies. So, when the SPX and VIX stray from this basic relationship, experienced traders tend to pay attention. Let’s consider two principles:

Principle 1: When the SPX swings to a lower low but the VIX makes a lower high (instead of the expected higher high), it can mean the market is experiencing less fear as it falls to new lows—a potential setup for a market rebound.

Principle 2: When the SPX rallies and the VIX also rises, it may indicate heightened anxiety about the up move—which can sometimes signal a possible down move.

S&P 500 (SPX) and Cboe Volatility Index (VIX), 12/4/17–8/1/19. Less fear despite lower market lows.

Source: Power E*TRADE


The chart above highlights three instances of Principle 1, from February 2018, October 2018, and May–June 2019. In each case the SPX made a lower swing low (top half of chart) that was accompanied by a lower VIX high (bottom half), and in each case the SPX rebounded, to varying degrees.

Moving on to Principle 2, “When the VIX clicks,” which appeared in this space in early November 2017, noted that days the SPX and VIX both close higher are relatively commonplace—and didn’t appear to have much significance. But days the VIX closed higher when the SPX made a longer-term high (defined as at least a 50-day high) were rarer and, arguably, more significant.

That analysis identified 111 such days over the previous 20 years (the most recent one at the time was on November 6, 2017), and found that the SPX closed lower nearly 60% of the time the next day—no small feat, given the SPX’s historical odds of closing higher on any given day are around 53.5%.

So how has this pattern performed lately? The same setup has occurred 16 times since November 2017, and in 11 cases (69% of the time) the SPX closed lower the next day, and sometimes followed through for several days after that.1 The chart below shows the three most recent examples, from April 29, June 20, and July 15 of this year:

S&P 500 (SPX) and Cboe Volatility Index (VIX), 4/11/19–8/1/19. More fear despite higher market highs.

Source: Power E*TRADE


Although in the April 29 example the SPX closed higher the next day (and made a higher intraday high the day after that), it quickly reversed to trade lower for more than a month—in fact, until early June, when the market turned higher after the lower SPX/lower VIX pattern highlighted in the previous chart. The other two instances were followed by smaller SPX pullbacks.

VIX signals aren’t flawless—and they’re not always frequent—but the reason many long-time traders monitor them is that they can provide an “inside look” at market dynamics, and hint at when a move, either up or down, is running out of gas.

Market Mover Update: Despite early bullishness, the SPX reversed to close in the red yesterday, in keeping with its historical tendency for weakness on the first trading day of August. And American Electric Power (AEP) rallied more than 1.6% intraday, reversing a recent pullback.

Today’s numbers: Jobs report (8:30 a.m.), International Trade (8:30 a.m.), Consumer Sentiment (10 a.m.), Factory Order (10 a.m.), Baker-Hughes oil rig count (1 p.m.).

Today’s earnings include: Exxon Mobil (XOM), Chevron (CVX), Seagate Technology (STX).

 

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1 Supporting document available upon request.

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