Quite the impressive CBOE Volatility Index (CBOE: VIX) rally in the past week and change. On July 7th, the VIX closed at $15.95, off an intra-day low reading of $15.30. Yesterday (Monday) VIX closed at $20.95, off a high reading of $21.93. Low to high, that’s a 43% rally in a mere seven market days. Not quite “flash crash” impressive, but impressive nonetheless. On a close-to-close basis, it’s a still-robust 31.3% lift.
Using the 10-day Simple Moving Average as a proxy for a short term *mean* and 10% deviations as a threshold, VIX had one of the quicker turns from overbought to oversold you will see. On July 7, it closed about 11% below the 10-day SMA. On July 12, a whole three sessions later, the VIX closed 16% above the 10-day. And in the subsequent four sessions, it more or less maintained that overbought level.
The original idea behind the VIX was to fade deviations. That is, go long the market when VIX gets overbought, and short the market when VIX gets oversold.
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First off, forget the oversold VIX indicator, it really doesn’t work. It’s a sign of complacency, and complacency can linger. Now, 10% above the 10-day SMA does not make a terrific trading signal either. You would get in too-early, too-often. But it’s a good marker for the overall state of the market.
If in hindsight you see VIX (and the market) turn on a dime when it gets a shade overbought, you can pretty much enter “buy the dips” mode. If, like now, we tend to go from oversold VIX to more oversold VIX, it’s just not a great sign. I do believe a 20% stretch from the 10-day SMA is an extreme, and we’re one more blip away from that now. But that’s probably just a short-term oversold bounce.
I’ve bought some VelocityShares Daily Inverse VIX Short-Term ETN (NYSE: XIV) into this, and will buy a little more into further VIX strength, but it’s just a relatively short term trade at this point in my humble opinion.
Follow Adam Warner on Twitter @agwarner.