Option Investor
Trader's Corner

Will the VIX Establish a "New Normal" Range?

Printer friendly version

Talk has circulated lately about a "new normal" range for the VIX, the CBOE volatility index. Dan Sheridan and the CBOE's Peter Lusk are two who have speculated about such a new normal range. In a seminar presented in Houston on October 30, 2008 and in a November 6 webinar for CBOE, they espoused their belief that the VIX may establish a new normal range of 35-65. Sheridan believes that new normal range may persist for a month or two, and he's advising his mentoring students accordingly.

Of course, as this article is edited about midday on Friday, November 21, 2008, the VIX reaches above 70, well outside that new normal range. Does that throw out the whole theory? Not necessarily. First, let's look at what Sheridan and Lusk where thinking, and then we'll study some charts to see if we can find any validity for their theories there.

For the next month or more, Sheridan postulated, trades that would normally be entered when the VIX is low and expected to bounce could be considered when the VIX approaches 35-37. Such trades would include those that would benefit from an expansion in volume such as long options, straddles, calendars and double diagonals. Trades that would normally benefit from a contraction in volatility should be considered when the VIX is near 60-65. These would include credit spreads and butterflies.

While Sheridan isn't a big proponent of technical analysis, often heard referencing technical analysis as "Fibonacci Gubinacci," I am a fan of both Sheridan's suggestions on risk analysis and technical analysis. His statements piqued my interest. Does technical analysis support the theory that the VIX might establish a new normal range for a period of time?

Monthly Chart of the VIX Snapped and Annotated November 21, 2008:
[Image 1]

Depending on where the VIX closes at the end of November, this chart could suggest two possibilities. One is that a new range is being established that would have the low for the VIX near 60 and the high near 110, if another black arrow were stacked on top of the three here. (And, yes, for those that wonder, the VIX can move above 100 percent, but I don't think I want to be trading if it is.)

However, November hasn't ended yet, so there's still the possibility that by the end of November, the VIX will have moved down to or below about 60-62. That event, if it occurs, certainly suggests the possibility, for monthly closes at least, of a range of about the width suggested by Sheridan. This chart hints of a range of about 32-62. It does allow for spikes outside that range, and we're certainly having one now. We just don't yet know the end result.

At the time of that seminar and webinar, another chart had posed the possibility of near-term support and resistance close to those Sheridan suggested.

Annotated Daily Keltner Chart of the VIX, Snapped and Annotated at the Close of 11/07:
[Image 2]

The VIX has of course since broken through that potential Keltner resistance that was holding it back two weeks ago, breaking out again on that chart and the weekly one. The weekly one still shows some enticing similarities to Sheridan and Lusk's numbers, however, with an important caveat.

Annotated Weekly Keltner chart of the VIX, Snapped and Annotated 11/21/08:
[Image 3]

Of course, none of these charts proves that Sheridan and Lusk are right, but these charts employing various aspects of technical analysis suggest that the theory of a new normal range should at least be given some thought.

What does this mean for the trader who is not employing the strategies that Sheridan mentions? For one, if there's a big relief rally that propels markets up into strong resistance at the same time the VIX is approaching 32-37, I'd give strong consideration to whether I had too many bullish trades at risk in my portfolio. I'd be making just-in-case plans for protecting any bullish profits I had accumulated. Because of demonstrated potential support near 56-60, however, we now have to be careful of rollover potential if the equities have been rallying and the VIX drops again toward that 56-60 level. These charts present the scary possibility that Sheridan and Lusk were onto the right idea proposing a higher "new normal" range for the VIX, but that it might be higher than they supposed, from near 60 up to near 100.

However, that 56-60 VIX support is obviously going to break at some time or another, and it's always possible that the next test could produce the break beneath it on a weekly close. I think, barring a collapse of the global financial system, that the break could be close. If that support breaks on a weekly close, the VIX may be signaling that it's time for one of those mythical relief rallies that holds, and then it's time to be watching those support levels, the bottom of Sheridan's and Lusk's proposed range, for rollover potential.

Trader's Corner Archives