The Link Between Overbought VIX and SPY Bottoms

By now, you know the drill. The market sails along, hitting marginal new highs, and volatility contracts. And then, wham -- news (or worries of future news) hits, and next thing you know, we've lost all those hard-earned gains in a heartbeat. And CBOE Volatility Index (VIX) lifts.

We're on the cusp of another overbought VIX, approximately the umptillionth overbought VIX since the start of 2014. I define it as a close 20% above its 10-day simple moving average. It tends to be a decent contrarian tell … at least, it has been good since 2009. And it was good before 2008. In 2008, going long on "overbought" VIX likely cost you a small fortune.

A couple notes, though, before you go out and buy. Here's the current version of the table I periodically run:

So maybe it's not the umptillionth violation. But it is potentially the seventh in 14 months, and that's a lot. I consider it a separate incident from when VIX goes 20% above the 10-day on a closing basis, and then closes below the 10-day. The "duration" column measures the length of the incident, in trading days. The blanks on the table are to avoid overlaps in the given time frame.

Until proven otherwise, buying when VIX closes overbought and then holding for a month continues to work. The median return is 4.08%, versus 1.77% on a random one-month hold. What's more, it has worked nine straight times, although one of them was 0.01%.

Oh, and I added another column: "Days Until SPY Bottom." That is how long it took SPDR S&P 500 ETF Trust (SPY) to bottom (on a closing basis) after VIX went overbought. That refers to a bottom within the move in question, not some sort of ultimate mega-important generational bottom. As such, I didn't go out forever. The longest ones were 15 days, by this definition. The shortest were zero days, meaning SPY did actually bottom on the day VIX closed overbought.

That actually happened six times in 20 incidents, which is a bit better than I would have thought. More typically, SPY bottoms about three to four trading days later. Anecdotally, that sounds about right, though I'm sure I'm afflicted with a bit of recency bias.

Long story short, the best play over the last two years was to get long a few days after VIX got overbought. Nothing lasts forever (even cold "November Rain"). This is all a slice of VIX in a generally up market. Until fading strong VIXes fails, though, why fight it?

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