Schaeffer's Trading Floor Blog

Does the Market's 'Fear Gauge' Have a Magic Number?

Whatever metric you use on VIX, view it in shades of gray

by 4/15/2014 7:26 AM
Stocks quoted in this article:

We must be getting close to a near-term top in the CBOE Volatility Index (VIX). I say that because I see Zero Hedge looking at it or rather, looking at someone else looking at it:

While US equities have spent much of the past several weeks under pressure (the NASDAQ bio tech index has fallen over 21%, the NASDAQ Comp is down over 8% and the S&P 500 is down over 4%), BofAML's Macneil Curry is concerned that the VIX index suggests conditions should deteriorate further before greater signs of a base materialize.

Hey, I actually agree with that! I'd substitute "could" for "should" in that last sentence, but I expressed those same sentiments Sunday night. I'm encouraged, tell me more!

Since 2012 most tradable market lows have come only after the VIX has pushed north of 20%. It is currently only 17%.

OK, I got my hopes up too soon, as that lost me a bit. 2012 seems like an arbitrary end point. We've been in an uptrend for about five years -- why lop off three of them? Or maybe even four of them, as it says "since 2012," which might mean we're talking about just 2013 and the first quarter of 2014.

What's a "tradable market low," anyway? One that preceded a nice bounce? Well, that part is true. But they were all also great times to just get long and hold. "Tradable market low" implies you bought and sold somewhat quickly. The buying part worked ... but the selling part? No way to know without specifics, but I'm guessing lots of money was left on the table.

OK, I'm being picky. No matter what you did when VIX closed above 20 over the last 2.25 years, you did well. My biggest problem with this sort of analysis is that it's looking backwards, selectively and unclearly choosing end points, retro-fitting conclusions, and creating a rule that has no long-term basis for success.

We're in a low-volatility regime now, and have been for the last few years, depending on how you define it. The forever-term mean of VIX is about 20, but in low-volatility regimes, the mean of VIX is probably more like 15. In those times, a VIX of 20 is high, so it's not at all out of bounds to say or imply that it's a good time to look for a market low.

What I also take issue with is making 20 VIX out to be a magical level of some sort. If you consider VIX a contra-tell of sentiment, any higher VIX means you should get more bullish than you are at lower VIX. The market should do better after 17 VIX than it does after 16 VIX, should do better after 18 VIX than after 17 VIX, and so on.

I like using deviations from moving averages or violations of Bollinger Bands as the definition of an "overbought" VIX. But I understand most people just use absolute numbers in VIX and go from there. It's not optimal, in my humble opinion, but it's not disastrous. I'd just suggest that whatever metric you use on VIX, view it in shades of gray. Higher shows more fear than lower. Twenty is just a number in VIX; it's not at all magic.

Why's that an important point? Well, maybe you caught five tradable lows in the last 2.25 years going long when VIX closed above 20. But maybe you missed 10 other pretty good tradable longs that you could have started scaling into when VIX hit 17 or 18 or 19.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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