Mark Sebastian, former market maker and current mentor with the Sheridan Mentoring Program, challenged me to compare the VIX and VXN, looking for times when they diverged. He thought the results might be interesting to our subscribers. Maybe they will.
Before looking at a chart, let's pause for a brief review. Most subscribers are familiar with the VIX, the volatility index that, according to the CBOE, provides an estimation of the "market's expectation of 30-day volatility." Some subscribers may not know that other volatility indices exist, too. The VIX is calculated by employing a carefully constructed mix of at-the-money SPX options, so estimates expected SPX movement. For more information on how the VIX is calculated, look at this archived Trader's Corner article. Other volatility indices include the VXN and RVX, the NASDAQ and Russell 2000 volatility indices, but you can find volatility indices for the OEX, EuroCurrency, gold, and crude, too.
However, my challenge was to compare the VIX and VXN. Sebastian felt that periods when they got out of synch tended to precede certain moves in the markets.
Let's take a look at a chart, looking for times when the two appear to be out of synch. Before looking at the chart, I have no idea what will constitute "out of synch" so let's just get started. Remember that my articles are roughed out in advance, so these charts are not current.
Annotated Daily Chart of the VIX and VXN:
I did not document the times when the VIX outstripped the VXN, but they both turned on the same date. Remember that these four points document only the last two times they turned on separate days to the downside and the last two to the upside. This is far from a scientific sampling.
What happened to the markets when the VIX was outstripping the VXN?
Annotated Daily Chart of the SPX and NASDAQ:
So what do we know so far? We first must realize that looking at a three-month chart is a far from exhaustive study, but at least anecdotally, Sebastian appears to be onto something. Times when the VIX is outstripping the VXN, either to the upside or to the downside, appear to represent market extremes, times when a turning point might be near.
I say "near" because a cursory examination of the chart turns up a period of about two weeks in middle September when the VIX had begun outstripping the VXN to the downside before the volatility indices quit chopping around and rallied, with equities rolling over. The same thing happened in the middle of October.
The daily chart of the volatility indices might not provide the best market-timing tool. However, coupled with other signals that a market turn might be near, including clues seen on the VIX and VXN charts themselves, this certainly proves thought provoking.
Sebastian thinks it's more than thought provoking. He believe these times when the VIX and VXN get out of synch might provide hints of times when the NASDAQ's resultant rally might outperform the SPX's, when the VIX has outstripped the VXN at VIX/VXN highs. I saw that on one example here, but not on the other, but this has been a cursory look only on the daily chart. Might an intraday chart provide more insight?
We'll look next time.
For now, I find it interesting that the VIX had begun outstripping the VXN when that first chart was snapped. According to our short-term anecdotal evidence, it might have been nearing a time for the volatility indices to bottom and turn up again, either the kind of two-week-chopping-around period which was occasionally seen or into an actual volatility rally, with a resultant downturn in the markets. In the week since that chart was snapped, the volatility indices dropped a bit more, with the VIX now crossing up through the VXN, which has now turned up, too. Neither the VIX nor the VXN has done anything more than hook up slightly, so it remains to be seen whether this is just another of those two-week periods in which the volatility indices circle each other before heading one direction or another or if this is one of the times when both rally hard, to the detriment of equity prices.