Monday, January 25, 2010

The VIX and Top Picking

In response to my previous post regarding the rapid rise in bearish price action, Siull asked how one might identify a top in the VIX.

Remember, the VIX is a statistic that tends to exhibit mean reversion over time. With few exceptions (2008) it's fairly easy to bet that sharp rallies in the VIX will be short lived. The other thing to keep in mind is that most traders use the VIX as a contrarian signal, an approach which probably gave rise to the popular phrase, "When the VIX is high, it's time to buy; when the VIX is low, it's time to go." In other words, VIX spikes tend to coincide with short term market bottoms. Though the phrase implies one could use the VIX for buy and sell signals, in my experience it's much easier to identify a peak in the VIX (buy signal) than a trough (sell signal).

Why?

When complacency becomes entrenched, it tends to stay awhile. Whereas fear and panic can come and go rather quickly.

Like any other methodology there isn't one fail proof technique that works in identifying a top in the VIX every time, however there are a few popular signals I've adopted from others that seem to work the majority of the time. One of the most obvious technical indicators that complements the VIX quite well is Bollinger Bands. Over the last 6 months, the VIX has probed above the Bollinger Bands four times (not including the current VIX spike). Each one signaled a short term bottom in the SPX and subsequent buying opportunity.
[Source: EduTrader]

What if this time is different? What if the uptrend in the SPX is toast and we're back to a bearish trend? If I'm all out bearish on the market and am not comfortable using VIX spikes to enter bullish trades, then bare minimum I would avoid entering new bearish plays when the VIX is overbought and may consider it as a signal to take profits on short term bearish plays.

In addition to Bollinger Bands I've also seen traders compare the current value of the VIX to a 10 day moving average or to recent realized volatility such as 10 or 21 day HV.

4 comments:

Anonymous said...

Thanks very much for the post and the answer.

This method has been working until now, it sounds fine to me.

Cheers,
Siull

Tyler Craig said...

no problem Siull. Thanks for the question-

troylab said...

This is a great tool that I love to use. A simple trick to clean this up is to combine it with the 50 day moving average (larger trend.) Meaning you take the Bottom Signals (VIX closing above the upper BB's) only above a rising 50 ma - this is what has happened the last three or four signals. You only take the Top Signals (VIX closing below the lower BB's) only when the S&P is below a dropping 50 MA. The current signal is a Top Signal under a flat 50 ma - not as good as the past few we have gotten. Just a quick and easy clean up for a great tool!
Nice work on this blog!!

troy

Tyler Craig said...

Great points Troy. I agree the VIX is more useful when used in correlation with your outlook on the SPX. I think the 2007 to early 2009 time frame showed us all how VIX signals aren't near as potent when the SPX is in a free fall versus when it's in an uptrend above its 50 MA.