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VIX Rally Portends Market Move … Or Not

Fear Gauge signals The Top still out there


Just when you thought the VIX had retired for the spring we get … a rally!

Hard to conceptualize at such low absolute numbers, but options trading investors got kind of overbought last week. The CBOE Volatility Index (CBOE: VIX) closed on Thursday about 20% over its 10-Day Simple Moving Average (SMA). Think of VIX as a mean reverting rubber band. Deviations from that “mean” tend to snap back towards it. The trick is defining that mean itself. Moving Averages provide as good a definition as any.

The question then becomes about threshholds. We tend to use 10% as the first level. That is to say if VIX goes 10% above (below) its 10-Day SMA, VIX is considered overbought (oversold). And since VIX moves in opposition to the market, we can say the market itself is oversold (overbought).

But in my opinion the 10% Rule throws off too many signals. I would tend to look at it backwards. Note when VIX gets overbought and oversold, and then watch the market behavior. Let’s say VIX gets overbought, as recently. Did the market selloff pretty much halt in its tracks?

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Well, pretty much yes. Not that we exactly had the biggest selloff last week, but it did pretty much taper off as VIX got overbought. And when VIX closed near 20% over the 10-Day SMA, the selling ended.

So what’s that tell me?

I would say that the intermediate uptrend in the market clearly remains in tact. Everyone wants to call The Top, but at this point it looks more like a shakeout than anything else. Clearly a more serious shakeout in some spots than others (cough … Silver … cough).

Remember that with VIX — before 2008 — the world tended to view it as a fade. In other words “high” VIX meant to buy the market, “low” VIX meant to sell it. When that proved disastrous in 2008, the world’s opinion of VIX changed. It was now some sort of front-running seer of an indicator. If smart money was buying options, they must be correct. Except they’re generally not.

Follow Adam Warner on Twitter @agwarner.

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