Mr. VIX’s Wild Ride

What do the VIX rally and subsequent sell-off mean for traders?

No sooner did we return from our turkey-induced coma than we found our beloved VIX commencing a pretty robust pop that began Friday, and to levels north of 23 no less.

Now I realize that may not sound like much, but it’s a two-month high and a break above the recent range of 18-22 that has bounded us since early October. What’s more, this puts the VIX more than 10% above its 10-day simple moving average (SMA) and above the standard 20,2 Bollinger band. In other words, the VIX actually was a tad overbought.

But this didn’t last long. By today’s close, the VIX had given it all back and then some. So was there any signal from this action?

There are two schools of thought regarding such a move in the VIX. A contrarian would point out that an overbought VIX equals an oversold market, and would look to fade it. That is, he would make some bullish market plays (or bearish VIX plays).

A “smart money” VIX adherent would say that the options market has spoken, and it expects rough waters ahead. He would consider a VIX pop an ominous sign of a market break ahead and look at bearish plays, or at least buy protection on a bullish portfolio.

So who’s right?

Well, I tend to side with the former. I have spent the past 20 years watching options trading and the ebbs and flows of volatility. Sometimes rising volatility begets ever more volatility (e.g., the Lehman Brothers implosion in 2008). More often than not, though, fear exceeds reality. Yes, we could get some sort of Irish contagion. Or North Korea could throw another fit. Or maybe Mr. Market is getting a little apprehensive about something not quite on the radar yet. However, typically, the market discounts current headlines and fear recedes.

Now, stock charts don’t look so hot with a few exceptions. But I would read the current volatility picture as a slightly bullish. I’m modestly long and hedged with the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) and iPath S&P 500 VIX Mid-Term Futures ETN (NYSE: VXZ).

Some of you might be wondering why I would go near VXX after spending so much time pointing out all of its flaws? Well, some of those flaws are not applicable at the moment.

December VIX futures now trade near parity. January futures carry a premium in the $2 range. Rolling the two still presents a problem, but you don’t have to pay the daily futures erosion right now as you did three months ago when premiums were closer to $6 for the second month out.

Follow Adam Warner on Twitter @agwarner.

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