Normally, we look at VIX levels to determine how understated or overstated the implied volatility of the stock market, via the CBOE options premiums, may be. High VIX levels – anywhere near 35 — usually signal a market bottom or the end of a corrective period for stocks. That’s because high VIX levels indicate capitulation and fear through overzealous volatility premiums by options traders.
Low VIX levels – somewhere near 12 – signal a higher probability for a market correction, or the end of a bullish period for stocks. That’s because a low VIX reading indicates a certain level of complacency by options traders –and complacent is one thing you don’t want to be when trading stocks. You can see these tendencies on the long termed VIX chart below. The VIX doesn’t stay still forever.
But what about trends on the VIX indicator – especially when viewed in conjunction with trends on the S&P 500? The chart below may appear to be a bit confusing. But I’d like to walk you through it to see if we can’t spot some tendencies for market movements as determined by VIX trend analysis.
I’ll go through the observations in point form – feel free to add comments and your own observations regarding this chart. Remember, this is fairly new work for me–I’ve only begun studying the relationship of trends in volatility vs. stock market movements, and would be happy to hear of anything readers are exploring relating to this topic. A reminder—I define a trend as a successive series of peaks and troughs in one direction (i.e. higher highs and lows in an uptrend, lower highs and lows in downtrends). Flat peaks and troughs indicate a consolidation pattern. Uptrends are best defined by their rising troughs, downtrends by their falling peaks. Following that protocol- and remembering that VIX can be a bit more choppy than a nice tidy stock trend, here are my observations:
- In the early 1990’s, the trend was down for the VIX—and up for stocks
- From 1995 to 1998, the VIX rose — along with the stock market — and the correlation between them became less negative (more on this below).
- In the late 1990’s and early 2000’s, the VIX was flat and choppy, leading into a top and— downtrend for stocks into 2002.
- From 2003 to 2006, the trend was down for VIX —and up for stocks
- From 2007 to 2008 the trend was up for VIX, leading into a —down trend for stocks by 2008/9
- From 2009 to 2014, the trend was down for VIX— up for stocks
- From mid-2014 to current, the trend appears to be changing to up for VIX and (so far) flat and choppy for stocks – again as defined by higher lows and higher highs—so far anyhow.
I’ve also drawn a correlation study (bottom pane) of the two indices (VIX vs. S&P 500). The correlation line (bottom pane) shows a tendency for a fairly negative relationship between the VIX and the S&P500—ranging from negative 0.9 to negative 0.5. This gives validity to using it as a measurement for market extremes and turning points. Since 1990, there were a few times that relationship failed—circled on the chart. They were: 1998 (“Asian Contagion” world stock and bond market correction), 2008-9 (housing/commodity bubble & crash) and recently. The correlation indicator briefly spiked into “neutral/ non-correlated” territory in early 2015. Hmmm…
The VIX is nearing the bottom of its historic trading range. Sitting somewhere near 13 at this juncture, the tendency is for a correction to follow on the markets somewhere within 2-3 months of this level being reached. Further, a series of successively higher peaks and troughs since mid-2014 suggests a new uptrend for the VIX. Meanwhile, a series of flat peaks and troughs (no new highs or lows) on the S&P 500 since early 2015 suggests an ongoing consolidation pattern for stocks. If history is a guideline:
- The current low level of the VIX
- It’s current uptrend
- It’s return to a negatively correlated indicator (after a brief spike to non-correlated in early 2015)
–should lead into further choppy sideways, or indeed even a bear market for the S&P 500.
I was on BNN yesterday for their afternoon MarketCall show. Here is a video of the show opening, and my current market outlook.
This bear doesn’t like your HUV entry. The bullish percent in the Nasdaq is rising. There are several January gaps to fill. There is significant Nasdaq holding in the S&P 500. Exceed resistance points and you will have a short covering rally. Ideally, I would like to enter this trade on a day where the indexes are rising and the bullish percent is falling,coupled with low trin. I don’t read the news anymore because I feel the old Soviet axiom applies. The news is not the truth and the truth is not the news. I think liquidity drives the markets. In the last several days the treasury has added liquidity by paying down debt. They are also doing so with mortgage backed securities operations. Check this out.
https://www.treasurydirect.gov/instit/annceresult/press/press_cashpydwn.htm . I would expect more upside in the next couple of days. When the market started falling in January they were withdrawing liquidity. One must factor in share buybacks in as well.
Yes, so far the hedge is hindering the portfolio. Your observations could be correct- thanks for the input Bert.
VIX LAST TRADING IS AT 12.74 (-3.58): PMO AND MACD BOTH IN OVERSOLD TERRITORY. HOW ABOUT CBOE OPTIONS TOTAL PUT/CALL RATIO INDEX ENDING BULLISH AT .62 MATCHING THE LOW OF THE YEAR AND THE LOWEST SINCE AUGUST OF LAST YEAR JUST BEFORE SIGNIFICANT DOWNTURN IN STOCKS. THE ATR (AVERAGE TRUE RANGE) IS ALSO ON THE RISE, A CONCERN.
Yes–put to call ratio is 0.62 and that’s actually below last summer before the you-know-what hit the fan. We are moving more out of high beta and into low beta. We maintain our hedges–patience me thinks.
Keith , do you think is prudent to sit on the side lines with 100 % cash at this point , with last few years of gains . I am small , flexible midterm amature trader who stay out off energy and commodity sectors in 2014- 2015 , except strategic trades , with ok track record 🙂
Mike–cash has only one disadvantage–missing out. If that potential doesn’t bother you, then by all means it can make sense. Risk / reward is certainly skewed negatively right now–but that does not imply that markets can’t keep going up. Look at 2000, or 2007. Both times had high PE, high optimistic sentiment, diverging INDU/TRAN, and other factors. Yet things went up for many, many months before they rolled over. The only lesson I gain from this phenomenon is that the longer an overdone market climbs, the harder it falls. Thus, I view interim moderate corrections as healthy. When they don’t happen with a certain degree of regularity, we should be concerned.
So far, we have seen a few smaller (roughly 10%-20%) corrections since the 2009 bottom–in 2010, 2011, 2014, 2015 and early this year. So I feel that the big picture is still healthy, despite my call for a correction pending sooner rather than later.
BTW–the long low volatility rise between 2011’s summer correction and the October 2014 correction was of greater concern to me than at most other times in my career. Again, corrections along the path are better than none–which was the case during that 3 year run.
To deal with the risk of correction–We balance cash with stocks, and then add a bit of hedge (10%) to offset some of the risk of our stock holdings.
You may be more comfortable in just going to cash. And there is nothing wrong with that, so long as you don’t get too uptight if markets trend higher.
There is no “right” answer.
Thanks Keith , you bring very good points , do you think staying with value plays like POT will limit the downside in case of correction, this stock is down almost 45% ytd and most likely not going out of business or is there any other sector you will suggest to hide when things go nuts , meaning VIX hitting 40
I haven’t researched POT specifically so cant offer insight there–but generally gold can be a good spot, and limit your stocks to low beta–you can find out beta by going to the TSX website–they track beta.
sounds good , will do
I note your pick on BNN: How well does HUV.T track the VIX? Does it degrade over time, regardless of what VIX does?
Maria–all VIX ETF’s do experience the effect of cantango. That is, the erosion of time value as the ETF rolls contract to contract. There is less contango on rolling the shorter contracts as HUV does, but its still there nonetheless.
Thus I view this as a relatively short termed hold–I look for 18-20 on the VIX as a reasonable target to exit the ETF. A faster moving VIX might put it to 24 but that the best case situation