Is is Time to Fade the VIX Spike?

The 'classic' CBOE Volatility Index (VIX) is a little less overbought than 'new VIX'

Dec 11, 2014 at 8:37 AM
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So a Twitter friend tweeted me this yesterday:

It's somewhat moot now; they're both way overbought. But anyways …

Remember VIXMO? It's actually CBOE Volatility Index (VIX) with the old methodology. Until recently, VIX only included two S&P 500 Index (SPX) monthly options cycles in the calculation. The Chicago Board Options Exchange (CBOE) changed it to include the nearby weekly series, as well. In my humble opinion, it was a good change, as adding more classes can only help VIX give a better picture of implied volatility.

But, they still calculate VIX minus the weeklies -- and that's VIXMO. So, in a world without updated methodology, VIX is not as overbought. Does that matter?

It shouldn't. Now is the time where I remind everyone that it's all a continuum and no one single number or level is ever magical. If VIX is 19% above its 10-day simple moving average (SMA), it's more overbought than if it's 18% above -- and 20% is more overbought than 19%, 21% is more … OK, you get the point.

If you believe that at the end of the day, VIX is a mean-reverting instrument and that the market, generally speaking, moves in opposition to VIX, then the more overbought VIX gets, the better odds if you're fading the move via buying equities.

As I've mentioned often, I use the 20% cutoff for many reasons. It's a nice round number that gives a nice quantity of official "signals," and it works fairly well. Here's the updated table on signals since 2009.

VIX signals since 2009

We're only two months out from the Oct. 10 signal, but barring a big sell-off over the next month -- or this current move picking up steam -- that's going to bump up the returns on the three-month hold nicely. Still, it remains a better relative play in the one-month window, which makes intuitive sense. It suggests that fear has gotten over-extended and we're due for some sort of snapback. You'll never time it perfectly on a regular basis, but if there's any such indicator out there, no one's sharing it with us.

How that applies to now is anyone's guess. This whole theory assumes there is an actual market decline to fade. Well, so far we've seen a tiny one by historical standards. We're down a little over 2% and VIX is up about 50%. The volatility action suggests it's a fade, no matter what volatility indicator and threshold you employ.

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

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