So I saw this tweet:
“VIX briefly traded above MM 0/8ths= 18.75, A breakout is bearish for the market … ”
Not sure what exactly that “MM 0/8ths” means, but I would agree that’s a breakout level by other criteria. Namely it puts the CBOE Volatility Index (VIX) more than 10% above its 10 day statistical moving average (SMA).
Here’s my quibble though. A VIX breakout is not bearish for the market, its bullish. At least in the short term.
At its core, VIX is a mean reverting statistic. Moves in one direction tend to get retraced. Or at least they see some pause. The 10% Rule is the most popular, but there’s nothing magical about that number. I have seen 5% and 15% rules as well.
Of course not every VIX move reverses. Sometimes 10% over the SMA quickly becomes 30% above, or much more. But that’s more the exception than the rule. The problem is, those blast-offs are the incidents we remember, not the six times leading up to it that VIX didn’t break out. But I wouldn’t go just trade religiously off this.
What I would do is use subjective interpretation. The market is pretty clearly in an intermediate-term up trend, albeit one that is sputtering now. VIX is in an extended downtrend. Ergo when VIX gets overbought in the short-term, it’s a counter-trend move. More often than not, those counter-trend moves fail. In other words, mean reversion kicks in. So I would work backwards and take clues from VIX as to the viability of the longer term trends. If in fact VIX fails at the extension beyond the 10 day SMA, I would take it as a clue that longer-term market rally remains just fine and I would look for bullish market trades on mini-dips. If VIX does break out, I’d reconsider that take on it.
What I wouldn’t do is assume every short term trend in VIX follows through. They invariably don’t, and will give way too many false signals before that one great one.
So a reasonable strategy is to fade VIX moves, but with disciplined stops. Here’s a hypothetical play. If VIX is in a longer term downtrend (like now), sell SPDR S&P 500 Index (NYSE: SPY) puts when VIX gets 10% or so above its 10 day SMA. Buy back if VIX crosses back under the SMA. Stop the trade out if VIX gets 15% above.
Not at all recommending that, just saying that’s the general approach I would take until there’s a clear trend change afoot.
Follow Adam Warner on Twitter @agwarner.
