What to Make of the Cheapest 'Overbought' VIX in Years

The VIX is absolutely low, but relatively high

Jul 28, 2015 at 8:38 AM
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As we just noted, the CBOE Volatility Index (VIX) is cheap in absolute value. But there's another side to that coin.

Yes, VIX is high vs. itself. By "itself," I mean its 10-day simple moving average (SMA). VIX closed about 25% above its 10-day SMA, and we all know what that means: more tables! Or at least the same table, only updated.

150728Warner

This "rule" won't keep working forever. We're six years into a strong market, and I conveniently only run this table back six years. If I went back to 2008, you'd see some absolute disasters. Overbought VIX got more overbought … then again, basically every contra indicator failed. If I went back to the beginning of VIX time, you'd see more of the same as what you see here. 

It's generally correct to get bullish when VIX gets overbought. In fact, before 2008, and absolutely speaking before 2001, VIX was pretty universally considered a mean-reverting statistic. It was just another sign of an extended move. What the accidents of 2000 and 2008 taught us was that moves can often get extended, and we "crash" off already-oversold conditions. 

In all fairness, though, no one had heard of the VIX until after 2000. It wasn't anything at all magical; it was just something up on the Quotron (look up Quotron, kids!) that we all ignored. It wasn't tough to know what was happening in volatility when all you were doing all day was pricing options vs. public order flow.

I don't really believe an implosion is about to happen now. I mean, anything's possible, but my guess is that if we get ugly, it's more 2011-style ugly. 

If you want a scary parallel, check out those July 29, 2011, returns. Ugly, ugly, ugly. But it's not a perfect match. VIX was in the mid-20s at the time … and I'm sure someone was saying it should have been much higher. And hey, they were right for a change.

As to VIX itself, this is an unusually low absolute level for it to get overbought. In fact, this would mark the second-lowest absolute level amidst a 20% violation since 2009. The lowest was last July, when VIX got overbought at a mere 14.54. And that wasn't a real good signal at all. We basically caught our breath and got more overbought two weeks later. Returns were flat one month out, and actually weak three months out. 

We're kind of in the middle of these two scenarios. VIX is absolutely low, but relatively high (if that makes any sense). And clearly the news flow is quite bad. Greece was overcovered, but a crash in China is obviously not something to take lightly. There are no Chexits and Cheferendums out there to make fun of. 

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

 

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