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What's Wrong With The VIX\?

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What's Wrong With The VIX?

I've watched the VIX off and on for many years now, and I can say with conviction that the indicator is acting stranger than at any other time in my memory. For those of you just joining us, let's recap how the VIX normally works.

The VIX is a sentiment indicator that is calculated using the implied volatility of the eight most heavily-traded front month put and call options on the S&P 100 index (OEX). Typically the VIX moves contrary to stock prices. As the market rises, the VIX falls, and vice versa. Over the past several years, the VIX has traded in a fairly predictable range between 20-30. Excursions above the 30 level have led to blow-off declines in the market, which have been quickly followed by strong rallies. Declines in the VIX below 20 have been great opportunities to buy back-month puts and hold on for the eventual market decline.

Clearly we haven't seen a VIX reading below 20 in quite some time, as the broad market has continued to post lower highs and lower lows all year long. The last time the VIX tested the lower end of its 'normal range was back in late May, when the OEX trading up near 550. But it is the recent VIX behavior that continues to have me perplexed.

In conjunction with the broad market drilling down to fresh multi-year lows in late July, the VIX spiked into the high 50's. That led to the broad markets launching higher into mid-August, with the OEX pushing as high as 487 before rolling over with a vengeance. It was interesting then, that the VIX never fell below the 30 level, as investor fear clearly remained at an elevated level. That inflection point in late August resulted in the VIX pushing back up above 50, as the OEX fell back to test its July lows. Looking at a daily chart of the OEX shows the potential for a solid double bottom near the 385-388 area. But once again, the VIX is failing to relax, as it is stubbornly holding near the 40 level. The chart below shows the relationship between the VIX and the OEX over the past 5 months.

S&P 100 Index (OEX) vs. Volatility Index (VIX) - Daily Interval

While the VIX has definitely relaxed off the 50 level in the past couple weeks, it is somewhat telling that it has not fallen nearly as precipitously as it did following the market bottom back in July. The initial rally off those lows had the VIX falling into the low 30's within the first week of that rally. It looks like market participants are less sure of this rally and that nervousness is keeping the VIX higher than we might expect following a 17% rally off the lows of a couple weeks ago. Perhaps that nervousness (higher VIX) is providing the wall of worry necessary for the broad market to keep working higher over the near to medium future.

If so, then maybe there really isn't anything wrong with the VIX. We just have to modify our view of its behavior to fit with the current market environment. In an attempt to get our view to match that of current market behavior, let's take another look at the charts above. The descending trendline shown on the OEX chart began back in early March and capped the rally attempts both in May and then more recently, in late August. So it is that much more significant that on this most recent rally, the OEX has actually pushed through that trendline, while at the same time the VIX is holding at a higher level. Since we know that the VIX 'wants' to return to its historical range, the fact that we have cleared that descending trendline, we could make the argument that the elevated VIX represents the 'rally potential' currently present in the broad market.

Another interesting observation is that the OEX is currently holding right near an important level of recent resistance. Note that the 458-460 level turned back the bulls both at the end of July (on the way up) and in early September (on the way back down). So what we really need to see is the OEX push through this level with conviction (read:volume), both to justify further upside and confirm the breakout over that descending trendline.

So where does the VIX fit into all this? I'm glad you asked. Let's come back to the point I made earlier about the VIX stubbornly holding above 39, and I think the action of the VIX is integrally tied to how the OEX behaves around that 458-460 resistance level. A breakout over 460 will likely have the VIX falling pretty sharply, while a failure to clear this level should have the VIX moving back up towards the top of its recent 39-50 range.

S&P 100 Index (OEX) vs. Volatility Index (VIX) - Daily Interval

I find it interesting that the market really hasn't suffered any significant profit taking since rebounding from the lows a couple weeks ago. This is in sharp contrast to the behavior from late July and early August. At that time, the initial rebound went through its first bout of profit-taking only a week after the bottom was put in place. But after that bout of profit taking, the OEX rebounded right back up to that same 458-460 area, before plowing higher. Note that when the OEX pushed through this level, it was accompanied by the VIX breaking from its consolidation near 39, very quickly falling back near the 30 level, as the OEX rose to its eventual August peak.

From a purely logical and fundamental basis, the market has no reason to go up from here, and on that basis alone, I would look for a serious bout of selling, leading the VIX back towards the top of its recent range. But as we have seen so far this week, logic is not the dominant force at work in the market. Today's nearly 8% rally in the SOX following KLAC's abysmal earnings report last night is just the latest example.

While the VIX is by no means a leading indicator, I think in its current state it is set up to potentially give us a great confirmation if the broad market rally persists. If the OEX does continue to defy logic and break out, along with the VIX breaking down, I would take that as a strong signal that this rally still has some room to run. One way or another the VIX needs to relax from its elevated state. Whether that comes about from a breakdown from current levels or from one more push higher and then a rollover isn't the real key. Once it moves back under the 39 level, that should set the wheels in motion for a move down to at least test the top of its historical range (20-30), and that is only going to happen if the broad market extends its rally significantly above where it sits tonight.

As a point of reference, the VIX has been above 30 now for 16 weeks, an inordinately long period of time. Looking at historical charts of the VIX, the next longest period of time where the VIX remained above the 30 level was in the fall of 1998, when the VIX remained elevated for 9 weeks before tumbling back to earth. And when it did, it presaged a tremendous rally into the end of the year. Sure we're in the clutches of a powerful bear market and many aspects of our current situation are different. But it is in looking for the historical similarities, that we find the seeds of potential profit. Hopefully I've helped you to see some seeds ready to sprout.

Best Trading Wishes!

Mark



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