VIX Looks Ready to Run

by Adam Warner | March 2, 2011 5:05 am

A funny thing happened to the CBOE Volatility Index (CBOE: VIX[1]) on February 22. It rallied as much as 30% before a modest decline near the close knocked the lift to about 27%. For options trading investors that’s one of the biggest one-day moonshots in VIX history.

What does it mean?

Well, we really can’t answer that question without the benefit of hindsight. VIX tends to mean revert, and clearly VIX gets overbought real fast in the short term when it rallies so much in one day. A common rule considers VIX overbought (oversold) when it closes 10% above (below) its 10-day Simple Moving Average (SMA). Well VIX closed 26% above the SMA on Feb 22nd. So time to look for a reversal, right?

Most of the time, yes. Especially when the short term signal in VIX, in this case overbought, conflicts with the longer term trend. And VIX clearly sits comfortably in a two-year downtrend.

But like all rules, the VIX 10% Rule fails. Often spectacularly. We saw an extreme example of failure in 2008, but we also saw a minor version in the April-May 2010 Flash Crash period. On April 27th, 2010, VIX rallied from 17.47 to 22.81, and closed a whopping 32% above its 10-day SMA. VIX then meandered below that 22.81 level for three straight trading sessions, and in fact dipped to just 8% above the 10-Day SMA heading into the weekend. Looked like the Fear Wave had passed.

In hindsight, that was a window of calm before an historic storm. VIX exploded to over 42 within the next week, and ultimately peaked over 48 on May 21, 2010. Throw it all together and VIX nearly tripled in less than a month.

Are we on the cusp of a rerun? VIX peaked last Wednesday at 23.22, then dipped back all the way to 18.35 at Monday’s close. As luck (skill?) would have it, it closed almost exactly at the 10-day SMA. And then after a brief blip lower, it has resumed rally mode.

I suspect we might have a serious intermediate-term trend change at hand. I don’t believe VIX goes quite as far and fast as we did last May. But I do expect this rally in VIX to continue. The question becomes how to play it.

We all know the awfulness that we call VXX or the iPath S&P 500 VIX Short-Term Futures (NYSE: VXX[2]). At least in terms of long term performance. But near term it can (and does) capture pops in VIX. It lifted about 50% in that April 27th to May 7th pop last year. Of course VIX ramped up about 250% in that same stretch.

Unfortunately, there’s no way to fully capture something like that VIX ramp. VIX futures go to discounts when VIX moves up so quickly. Not to mention it’s highly unlikely VIX sees another run quite that robust. But VXX now sits in a wheelhouse of sorts. March futures trade near parity to VIX now, while April carries a premium of under $1. So no serious premium erosion, or expense rolling out in duration now. So if you expect a little VIX strength, VXX is not bad now.

Of course, don’t trade without a net. This could also be yet another false volatility alarm. VXX has held at about 30 since last weeks pop. You really shouldn’t use VXX to chart any length of time, but by the same token I’d keep an exit price in mind. I’m long VXX vs. long extra VXX puts, so the position will stop me out if I’m wrong.

Follow Adam Warner on Twitter @agwarner.

Source URL: https://investorplace.com/2011/03/vix-looks-ready-to-run/

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