When the VIX registers a double-digit gain in a single session, it certainly gets traders’ attention.
But should it?
The U.S. stock market declined 1.2% on Wednesday as investors grew concerned about the potential end of quantitative easing and the oncoming government spending cuts known as “sequestration.” Despite this relatively modest downturn, the CBOE Volatility Index surged 18.8% to 14.62 — its largest one-day increase since Nov. 9, 2011.
This represents a substantial VIX move for a run-of-the-mill down day, but this type of disconnect isn’t a new development. In fact, relatively minor downturns in the market have consistently led to substantial increases in the VIX throughout the past year. More often than not, however, these big moves haven’t led to downside follow-through in the market.
In fact, the actual results have been exactly the opposite.
In the past 12 months, there have been 15 one-day, double-digit percentage moves in the VIX. On 12 occasions, the S&P 500 finished higher five trading days out from the spike in the VIX. On the three times in which the market closed lower, the average loss was 1.2%; but in the 12 times it finished higher, the average gain was 2.2%. Overall, stocks averaged a gain of 1.5% in the five days after a double-digit rise in the VIX.
In total, the market has gained nearly 14% in this 12-month interval.
One reason for the periodic VIX spikes is that investors have shown a hair-trigger tendency to load up on protection at the first sign of market weakness. This probably is an indication that investors’ underlying conviction has remained weak even as stocks have closed in on record highs. Nevertheless, the numbers show that this approach has proven ineffective the majority of the time.
In short, investors would have benefited nicely from immediately using the spikes in investor fear as an opportunity to buy the dip. This would suggest that even though Wednesday felt like a very tough day for the market — and was accompanied by a great deal of doom-and-gloom talk on TV — it might be dangerous to quickly assume this is the beginning of the long-awaited correction.
It’s especially important to take with a grain of salt the countless articles that will tell you this is the time to load up on volatility ETFs such as Barclays iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX). Such products remain inefficient ways to play VIX moves due to their inability to track the index consistently. On Wednesday, for instance, VXX rose just 8.6% — meaning investors could have been dead-right on the direction of the VIX but missed more than half of the move in the index.
This isn’t to say investors are completely in the clear right now. Headline risk is high given the oncoming sequestration deadline, and stocks are coming off of a huge run. Further, the VIX still is low on an absolute basis despite its big gain Wednesday.
But until the evidence shows the trend from the past year has reversed, investors need to be careful in putting too much weight on single-day moves in the VIX.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.