A couple of weeks ago, I responded to a challenge or invitation to overlay the VIX and VXN on a single chart and see what resulted. The premise was that the VXN tends to be more volatile than the VIX. Therefore, when the VIX outran the VXN, the two were out of kilter, the move overdone. A reversal might be in the making, with the VIX and VXN usually moving in opposition to the SPX and NDX. A reversal in these two volatility indices might suggest a reversal in the SPX and NDX, and likely in the broader markets. Verifying this effect might be of interest to our readers, my challenger suggested.
I started with the daily charts last week. Examining a three-month period verified that Mark Sebastian, former market maker and current Sheridan Mentoring program mentor, was onto something when he challenged me to study the interactions of the two. When the VIX was outrunning the VXN, either to the upside or the downside, a reversal in the two--and therefore in the broader markets--was often near.
However, Sebastian thought that those times when the normal relationship of the VIX to the VXN was out of kilter might do more. An out-of-kilter relationship might predict times when the NDX's move was about to outperform after a reversal. In a three-month examination period last week, a period far too short to constitute any kind of thorough study, I did see some consistency in the prediction that the move was overdone and that a reversal in the volatility indices and equity indices was near. However, I did not find the same consistency in the prediction that the NDX was about to outperform. I promised to look at intraday charts next. It's possible that Sebastian was referencing only those times when the VIX was higher than the VXN, outrunning it to the upside, due for a reversal back down. The NDX would then be expected to outperform to the upside after a reversal of its own. Therefore, I'll concentrate on a couple of such instances on a 15-minute chart. These instances were not cherry-picked but rather chosen at random.
Annotated 15-Minute Chart of the VIX and VXN:
Annotated 15-Minute chart of the SPX and NDX:
Even if the NDX's outperformance on that afternoon's rally wasn't huge, a day trader deciding how to capitalize on an anticipated rally might benefit from know which vehicle might be best.
Annotated 15-Minute Chart of the VIX and VXN:
Annotated 15-Minute Chart of the SPX and NDX:
A day trader who had elected to enter a bullish trade on the first VIX cross back below the VXN might well have been stopped out of the trade late in the afternoon of 11/12, when the VIX turned around and burst up above the VXN again, with the SPX and NDX both dropping again. Another instance of the VIX crossing back below the VXN occurred about 10:00 am the next morning, and that one was to stick until about 1:30 the next afternoon, when the VIX turned up again, its RSI moving back above 30 after having trended below it through a few hours.
Are these signals to be trusted? First, I wouldn't trust them enough to call them "signals." I no longer day trade, but when I did, I used such setups only to inform me that it was time assess risk in one type of trade and plan entries into another. Then I would let actual price action guide me. We spent a lot of time sailing when we lived in Port Arthur, and checking the weather report would tell us something about what to expect in our sailing outing. However, if, after we were out on the lake, the winds were coming from the opposite direction than that predicted by the weather report, we were certainly going to react according to the actual winds rather than what the weather report had predicted. I think of technical analysis as being akin to those weather reports while the actual price action was like the winds we experienced when out on the lake.
Back when I still day traded, I found that the volatility indices weren't always the best market-timing tool, particularly on short-term charts. However, the volatility indices were good at signaling that it was time to firm up profit-protecting and new-trade plans. Perhaps those plans would never be put into effect, but it was certainly time to do some planning, nevertheless.
I don't day trade any longer, so my day trading skills are no longer honed by watching the interplay of these charts day in and day out. However, I still think Sebastian is onto something, at least in as far as the worthiness of watching the interplay of the VIX and the VXN. Whether or not these anecdotal observations would hold up across a long period of time and whether or not they work in the opposite direction (VIX outperforming to the downside, a reversal back up through the VXN, and a subsequent outperformance by the NDX or SPX to the downside), I don't know. This article is already too long to go further. However, those adept at back testing and interested in any heads-up information such relationships might provide might find it helpful to do such testing. At least anecdotally in the small number of samples we've examined in these two articles, the concept proves intriguing.
Along with that observation comes a warning. Do not use such anecdotal evidence, especially such incomplete evidence, as a trading signal. If you're interested, investigate it for yourself and use the information to inform your trading plans.