The Significance of Oversold VIX

When is an oversold VIX a good indicator?

Oct 27, 2015 at 9:27 AM
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We often write about overbought CBOE Volatility Index (VIX) and what it all means, but we don't talk much about oversold VIXes. Hey, VIX is mean-reverting, right? So, shouldn't it mean-revert from the downside, too?

I tend to take it as given that an overbought VIX means more than an oversold one. Overbought signals fear, and that's a strong emotion. We're all wired to hate losses. Oversold signals complacency and apathy, and we're not so wired to act much when it happens. That's kind of the definition of apathy, of course.

But is that really true, as far as VIX is concerned? Well, let's see.

I used VIX 15% below its 10-day simple moving average (SMA) as a proxy for oversold. In the 5,727 trading days since the SPDR S&P 500 ETF Trust (SPY) began, VIX has closed more than 15% below its 10-day SMA on 130 occasions. Many of these are clusters. In fact, we were in one of those clusters last week. After winnowing these out, I came up with 50 separate oversold VIX "events."

They're all here in chronological order. In the one-month window, the results are kind of mixed. SPY sees an average return of 0.3% after going oversold by this definition, vs. 0.66% in any random one-month window. But if you look at medians instead, then SPY appears to outperform off oversold VIX, 1.5% vs. 1.1%.

Why the disparity? As you might have guessed, there were a few very ugly trades in there. If you bought the "signal" of Jan. 28, 2009, you dropped 15.4% in a month. Likewise, the Nov. 3, 2008 trade lost 10.8%.

In fact, this leads to an observation: We need a certain backdrop for an oversold VIX. Namely, we need an overbought SPY. If nothing's going on, VIX just doesn't tend to drop 10-20%. Virtually every one of the 50 instances on the table is the result of strong market rally following an abrupt market dip. We have several instances in 2008-09, others in 2001-02, and still others after the bull market corrections of 1998 and 2011. There's also an incident post-Flash Crash in May 2010. We don't see nearly as many oversold VIXes in generally calm times. It didn't happen at all between November 2002 and June 2006.

I still don't believe oversold VIX is a good indicator, but it's not really for the reason I had in my mind. It's not because of complacency driving inaction. Rather, it's just a function of the longer-term market backdrop. If we're in a rather deep sell-off, oversold VIX seems like a good marker for the culmination of a short squeeze. If we're in a generally strong market, oversold VIX doesn't appear to tell us much of anything.

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


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