VIX is Chartable but its Message Unclear

Parsing this statistic to the nth degree may tell little

   

We get letters … some of them not only civil, but downright excellent. Like this.

“Adam – It seems to me that many of the old school options traders look at the CBOE Volatility Index (VIX) as solely a statistic and therefore not worth doing technical analysis on. Many get really worked up when a chart guy sets a target and especially if anything other than a trend line is used. Yet many chart guys claim they use technical analysis on the VIX successfully. Additionally, I know that every major Wall Street firm is now trading Volatility as an asset class both on a proprietary basis and with (High Frequency). It creates a dilemma.”

To which I responded:

“I would say though there’s no simple answer. I mean you CAN chart it, just have to account that it’s not a stock, it’s a statistic. Like Netflix (NASDAQ: NFLX) can go from 50 to 100 to whatever and stay there, but VIX won’t. It lingered high longer in 2008 than ever, but still ultimately mean reverts. VIX also can’t go to 0. So to some extent there are short-term trends you can chart, but over time it will find its way back the high teens/low 20′s.”

Let me clarify that a bit.

A stock has supply and demand. It has levels with some significance where longs get trapped and have to bail out, or shorts get squeezed and cover. And so on. VIX is a statistic. It indexes implied volatility on the S&P 500 Index options  (SPX). There are really no supply/demand characteristics associated with any point. Traders can sell SPX options at 15 volatility and buy those same options back at 20 volatility and actually make money. How dat? Well, perhaps enough time passed that they earned premium decay on their shorts. Likewise, a trader can buy 20 volatility and sell the same options at 15 volatility and make money if the underlying index moved enough. VIX is truly just a number.

I am fairly certain I count as old school in this regard. I was an option trader on the American Stock Exchange when the VIX debuted in the 90′s, and frankly we ignored it. You have a whole board of options in front of you in various stocks, and you pretty simply get a feel for volatility trends without indexing specific numbers. So seeing every tick in VIX parsed to the nth degree does drive me nuts. The general level of VIX tells you something, but very specific levels, really not so much. If SPX lifts a bit, VIX will go down if for no other reason than the skew on the SPX board. Higher strike options trade at lower volatility than lower strike options, so it stands to reason that if the higher strikes have greater weight in the VIX calculation, then VIX itself will go lower. My point would be that the move in VIX was just noise. You’re using it to try to gauge sentiment. Well, sentiment hasn’t moved at all, yet VIX is lower.

We also have calendar quirks. Ahead of holidays, VIX declines as traders pay less in premium for time. We also see this effect on Fridays, followed by a reversal on Mondays as the calendar catches up to the options prices.

Throw this all together and we have a chart that may or may not mean all the much. But that’s not to say there’s nothing we can glean. I do believe watching VIX versus short-term moving averages has some value. If nothing else, VIX does mean revert. If it extends too far from its 10 day statistical moving average, VIX often moves back towards it. And when VIX does not mean revert, that tells us something too, namely we have a trend move (in the market) upon us.

Follow Adam Warner on Twitter @agwarner.


Article printed from InvestorPlace Media, http://investorplace.com/2011/01/vix-is-chartable-but-its-message-unclear/.

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