Using the VIX to Forecast the Market’s Direction

I recently had a trader ask the question, “Can the VIX be called ‘oversold’ if you can’t trade it?”

Before you respond, “Of course you can trade the VIX,” let’s make it clear that he is referring to the actual VIX, not VIX trading products like futures, ETNs based on the futures, or options based on those futures and ETNs.

I have preached time and again that you must use extreme caution when charting the VIX. The VIX is a statistic, not a stock, and there some big differences to account for when applying stock charting “rules” to the VIX. For starters, the VIX does not have the same supply/demand dynamics as a stock. It can’t go to zero. It can fly north, but high levels are unsustainable.

Despite all those caveats, I would answer in the affirmative. You can safely refer to the VIX as “overbought” or “oversold.” In fact, that’s how best to use the VIX, because at the end of the day, it mean reverts.

One of the easier VIX rules to follow compares the VIX to its 10-day simple moving average (SMA). If the VIX closes 10% above (or below) the 10-day SMA, we consider it overbought (or oversold). The VIX is a contra indicator, so if it is overbought, the market is oversold and can provide decent entry points, and vice versa, if the VIX is oversold, then the market is overbought.

Of course, nothing works quite so simply in the real world. While the VIX does exhibit mean reversion tendencies, it can go way beyond these parameters, particularly on the overbought side of the equation.

Check out this chart of the VIX compared to the 10-day SMA from mid-April to mid-June.

VIX 1-Day SMA Chart

If you went long the market on an overbought VIX in late April and/or early May, you got absolutely clocked. During that time, the VIX peaked around 60% over the 10-day SMA.

By and large, I find using an overbought/oversold VIX as indicator works best when it moves in opposition to the longer-term market trend.

Take now, for example. We clearly sit in an intermediate-term uptrend. An oversold VIX is consistent with that longer-term trend, and thus, does not provide good entry points, in my humble opinion. Instead, I would look for instances of an overbought VIX here and use that for timing bullish market plays.

How can you tell whether that overbought VIX is the end of a short-term downtrend and not the beginning of Armageddon? You can’t. The same way you can’t on any other indicator that tells you a move has gone too far. It’s probability. As with anything else, use caution and/or stops.

Follow Adam Warner on Twitter @agwarner.

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