Much ink has been spilled about the CBOE Volatility Index (CBOE: VIX) by market pundits, bloggers, and options trading fans desiring to throw in their two cents on how to use this market volatility gauge to divine the future. And why not? As volatility trading rises in popularity it’s only logical that chatter will increase about the de facto benchmark for market volatility. Before setting out to use the VIX as your favorite new tool, however, you should first become familiar with its personality and other behavioral tendencies.
Even a brief study of the VIX reveals how often it exhibits mean reversion. Unlike a stock which can theoretically trend up indefinitely or down to zero, over time the VIX tends to revert back to some mean price. Like a rubber band stretched too far in one direction, the VIX tends to snap back when it reaches extreme highs or lows. The difficulty then lies in identifying the value of an extreme level. Unfortunately, both the mean and extreme values of the VIX tend to shift over time. In quiet times when the market is lulling market participants to sleep with its lack of volatility and playing of Enya in the background, the VIX may oscillate in a range between 10 and 20 with the mean residing around 15. On the other hand, when the market is taking participants on its own version of Mr. Toad’s Wild Ride by lurching wildly to and fro, the VIX may establish a new range at much higher levels.
Rather than flying blind, how about charting the VIX in conjunction with an indicator well known for its ability to identify extremes in price? This indicator is also designed to adapt to recent market conditions. In an attempt to provide more accurate signals it constricts in times of low volatility while expanding in times of high volatility. Have you guessed the indicator yet?
Bollinger Bands.
Of all the indicators competing for a space on your charts, Bollinger Bands seem to be tailored made for a statistic like the VIX. Consider the following chart of the VIX with Bollinger Bands. The included Bollinger Bands use a 20-day simple moving average with the bands set at two standard deviations. Notice how well the Bollinger Bands have nailed the extreme highs in the VIX over the past year. Though the peaks in the VIX have gotten progressively lower throughout the chart, the bands have still been effective at signaling each extreme.
VIX and Bollinger Bands
Lest you think the VIX-Bollinger Band combo is the Holy Grail, keep in mind there is always the occasional bad signal. Like every other indicator under the sun, the Bollinger Bands do occasionally get it wrong with April 2010 serving as a prime example.
Follow Tyler Craig on Twitter@TylersTrading.
