When the VIX clicks
US traders who woke up bright-eyed and bushy-tailed this Monday to get an early jump on the market news likely ran into some pretty positive headlines. The US market had ended the prior week with another record high and stock index futures were up pre-market, so many traders may have been looking forward to another week with plenty of buying opportunities.
S&P 500 (SPX) 10/12/17–11/08/17

Source: OptionsHouse

The US market did, in fact, make a new high on Monday, but by the end of the day, there was one indication stocks may have been set to take a breather, and it revolved around the VIX.

The CBOE Volatility Index—or VIX—represents a 30-day estimate of market volatility based on the implied volatility of S&P 500 options. It is often used as a contrarian indicator by traders and investors: Extremely high VIX readings often coincide with market bottoms, while very low readings are typically associated with investor “complacency” and can accompany market highs.

That’s the cocktail-napkin pitch. But the VIX-stock market relationship is far from the simple dance sometimes portrayed in the financial news. As recent history has shown, the VIX can remain at or near record low levels for months as the market continues to grind higher. There’s no “magic” VIX level that signals a bull market has topped, or a bear market has bottomed.

For shorter-term traders, though, the specific relationship between the S&P 500 index and the VIX on a given day can sometimes indicate when the market might be temporarily out of line—such as when both the S&P 500 and VIX both close higher. All else being equal, a strong up close in the S&P 500 in a rising market would be expected to produce a lower close in the VIX.

But that’s not what happened this Monday.

An up-VIX, up-S&P day isn’t that rare. There have been around 500 of them over the past 20 years, and the S&P’s typical performance in the five days after them has weaker than the index’s average, especially in the first two to three days.

VIX - 10/12/17 - 11/06/17

Source: OptionsHouse

But if you dig a little deeper and look at days both the VIX and S&P close higher when the VIX is making new highs, the story gets more interesting. Consider days the VIX closed higher (after closing lower the day before) when the S&P also made a new 50-day high and high close—which is what happened on Monday. (The relationship could be defined many other ways—this is just one example.) Such days have occurred 111 other times over the past 20 years, and the S&P 500 was, on average, lower over the next five days—anywhere from 55-60% of the time. That may not sound too impressive, but consider what happened next:

·         On Tuesday, the S&P formed an outside day (higher high and lower low) before closing down.

·         On Wednesday it also followed through to the downside, formed an inside day, and closed almost unchanged.

So what happens next?  No one knows.  But recent market action can serve as a powerful reminder that stock and index futures traders should keep an eye not just on the VIX, but the VIX in the context of the S&P’s broader price action.


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