Schaeffer's Trading Floor Blog

Should You Go Long After the VIX Breaks Out?

The SPY tends to outperform in the months following a surge in the VIX

by 7/11/2014 7:46 AM
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So we opened yesterday with our biggest downside gap in just short of forever … otherwise known as about five months. If you were in a pool and had to guess the reason for the next big volatility day, and you chose "failing Portuguese bank" -- congrats, you win!

I'm sure someone, somewhere, had this on their radar … at least the "struggling bank" part. I doubt too many had the notion that this would spark a pretty sizable global sell-off. And if they really did have that notion, this probably wasn't the first sell-off catalyst they had on their radar. If there's one thing I've noticed about most perma-skeptics, it's that they see a meltdown emanating from all sorts of different events. It's very tough, bordering on impossible, to select THE catalyst that was actually the correct one.

But anyways, THAT moment looks upon us. Or not. Who knows, really? But just in case…

In the last five years, we have had 15 somewhat distinct instances where the CBOE Volatility Index (VIX) has closed more than 20% above its 10-day simple moving average (SMA). My math tells me that comes out to about three instances per year. I say "somewhat distinct" because I defined it as at least three weeks since the last VIX breakout.

Anyways, here's a look at them:

SPY Performance After a VIX Breakout

The table shows the one-month and three-month returns in the SPDR S&P 500 ETF Trust (SPY), if you went long on the day the VIX closed more than 20% above its 10-day SMA. At the bottom, I show the average and median returns under that scenario, as well as the average and median returns if you randomly bought and held at any point over the last five-plus years (this data starts on July 1, 2009).

Keep in mind, we're not overbought in the VIX quite yet. But it would hardly shock me if we got there soon. The VIX is very low, so it wouldn't take much -- probably a close in the high 13s. Incidentally, it's been 5.5 months since the last instance. The VIX doesn't get overbought on a regular schedule, but that's a fair amount of time since the last instance.

I usually cull out overlaps, but I didn't bother in this case. I'm not calling this a trading system; it's just for information.

And that said, it remains correct to fade overbought VIXes in this bull backdrop. Just being long is a good idea too, of course, but you have outperformed the market a bit if you bought when the VIX got stretched in both the one-month (2.28% vs. 1.31%) and three-month (4.69% vs. 3.8%) time frames.

Of course, there are accidents. You got drilled in both April 2010 and July 2011.

It does make intuitive sense. Buying into a pullback in a longer-term bull trend is always a good plan. With the benefit of hindsight, we know that the longer-term arrow has remained in the upright position. We obviously don't know if that will hold true going forward.

To sum up, I'd say we're certainly due for something resembling a VIX pop. And it's highly likely that fading that VIX pop will turn into a good trade. But "rules" are made to be broken, and one of these shakeouts will hurt more than normal. I have no idea if it's the next one.

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

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