Stocks follow VIX lead

It wasn’t exactly Black Friday, but it felt almost as rare—a down day for the S&P 500 (SPX), even if it was only off by 3 points.

One of the hottest starts to any year in the history of US equities got a small splash of cold water with yesterday’s mildly lower SPX close, breaking the string of six consecutive higher highs and higher closes that started 2018. It was only the seventh time since December 1 that the SPX traded below the two previous days’ lows on an intraday basis, and the first time this year.

But there was one bit of information that pointed to a good chance for a downtick on Wednesday—the convergence between the S&P 500 (SPX) and the CBOE Volatility Index (VIX) that had taken place over the previous two to three days.

The VIX, which is the widely watched “fear gauge” that measures expected market volatility, tends to move in the opposite direction of the market—hence those nasty VIX spikes that accompany market sell-offs (and, some say, indicate oversold points) as well as the persistent VIX lows that appear when a market is pushing to ever-higher highs (sometimes interpreted as complacency and increased risk for a sell-off).

The SPX and VIX don’t have to close in opposite directions every day, but “When the VIX clicks” discussed what can happen when they move in the same direction for too long or too strongly, especially when both close higher—e.g., when the SPX and VIX both close up and the SPX also makes a new 50-day (or longer) new high. That means the market’s expectation of future volatility is increasing when the market itself is rising significantly—a red flag that can signal better than average odds of at least a short-term down move.

SPX and VIX, 12/20/17 – 1/10/18

Source: OptionsHouse

It was a signal that triggered on Monday, and guess what? The SPX totally ignored the hint and closed higher on Tuesday. Nothing works all the time.

But it happened again on Tuesday, and this time the VIX closed up more than 5%. The VIX is no stranger to big daily percentage moves, but a gain of this size on a day the SPX also closed higher is relatively rare—only 44 previous instances in over two decades, in fact. In the first three days after such SPX-VIX up days, though, the SPX closed lower than the initial day more than 60% of the time. (Tuesday was also the third consecutive day the VIX had closed flat or higher and the SPX closed higher—another sign the typical SPX-VIX relationship was getting stretched.)

Stock traders have—understandably—been balancing enthusiasm over the market’s hot streak with concern about getting caught in a sharp downturn. The VIX isn’t perfect, but it’s one of the few independent inputs traders can use to gauge when a market run is potentially running out of steam, at least temporarily.

That helps whether you’re already long and are looking to take profits, looking to go short, or looking for the next pullback to get long.


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