On most Friday’s, the CBOE Volatility Index (CBOE: VIX) has a predisposition for weakness. That’s because traders buying options on a Friday (especially late in the day) face three days of time decay, so they tend to lower bids to account for that.
But we have a notable exception to that “Rule”. Traders selling on a Friday (especially late) run the risk of a significant gap move when they return on Monday. If Fear of Big Bad Weekend News trumps Fear of Paying a Few Bucks of Decay, we see that complete reverse of the typical Friday effect. That is, volatility acts unusually strong.
Today sure sets up for the latter. A large gap down on a Friday morning clearly will tilt us more towards panic than worrying about decay.
There’s a very good chance that VIX closes quite overbought. I define that as closing 20% above its 10-day Simple Moving Average. It will get there if it closes above 20. Since VIX moves in opposition to the market, that tends to correspond to an oversold market. It’s generally a good time to initiate longs.
Obviously there are huge exceptions to that rule. Look no further than 2008. Overbought VIXs meant nothing, it just simply got more overbought. Or look at the May 2010 Flash Crash, a shorter stretch but a very, very painful time to be short volatility.
We all know VIX is a mean reverting instrument. So more often than not, selling volatility (or buying stocks) into “high” volatility will win. It’s just that the losses from fading into a huge spike can be brutal, so exercise extreme caution if you’re so inclined.