Volatility is Falling…or Is it?

The VIX looks mild at first glance, but divergence shows traders' confidence is shaken

   

Now, the VIX has been dropping for the past couple of days, which is inverse to the S&P 500. That is as expected. You’ll notice that the trend of the S&P 500 is actually quite positive. And yet, the lows corresponding to each of those highs over the past couple of weeks since the middle of November—they correspond, accurately, as we would expect.

However, what’s been happening is that the VIX — if we draw a little support line trending along of the bottom of it — it’s also trending up. Now that’s something I look for that’s very specific. So in other words, if the support line for the VIX is trending the same direction as the trendline or resistance line for the S&P 500–that in and of itself is a bit unusual. And that indicates that basically, investors, every time they get more confident, they actually get a little less confident than the spike before. So over the last couple of weeks, we actually have this situation where traders are getting a little less and less confident every time the market starts to rally.

Now, we saw something akin to this back in August and September. You can see this—we had the support line for the VIX trending up a little bit during the period of time where the market itself—resistance for the market looked really positive. What we would have liked to have seen in this market environment is something like this, where the VIX was trending down earlier this year with a nice upward trending market at the same time. So as long as that happens, if we’re in the middle of February wondering what to do, we’d be a lot more confident that buying the dips is maybe a good idea.

However, when you get a divergence like this, that starts to stand out to us. Now, is the market guaranteed to go down? No, probably not. But it does create a higher probability that resistance will be tougher to break through. I think right now is a great time to be thinking about this as the market has been running up a little bit as traders buy into the idea that the so-called fiscal cliff is going to be avoided.

John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.



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