From the March 2013 issue of Futures Magazine • Subscribe!

Leveraging the VIX to spot trend changes

History repeats

Most traders get hurt when the trend changes because they ignore signs that the tide has turned. Methodologies such as market-timing windows and the Gann price/time square are key here. Using the VIX also can provide perspective, but remember, when the VIX is low, it does not mean the market will keep rising. Conversely, a high VIX does not always translate to lower market prices.

Looking at a long-term S&P 500 chart, certain themes emerge (see “Highs & lows,” below). Over this period, traditional intermediate-term corrections and bear markets tend to terminate near 45%, while bull markets terminate in a range from about 9%-15%. During the 2008 financial crisis, the VIX spiked to 89.53%, which was a generational extreme. Since that time, many bears have expected each crisis to replicate 2008.

But consider the pure statistical message of the VIX over the last 20 years: That high was hit once out of 20 times, a 5% probability, which isn’t good. Is it smart to expect a market to crash? History says no, yet traders look for this result constantly. That’s an important lesson from the VIX that often gets overlooked. Remember, as we just noted, when the VIX gets low, the market tends to top; when the VIX is high, the market tends to bottom. And swing traders, beware — the 30-day anticipation calculation may not work if you are trading close to a high or low.

A better approach to using the VIX is to realize that it should fall in value as the market rises, while a falling market should coincide with a rising VIX. A rising market means the fear level tends to drop, and a sinking market should be accompanied by an indicator that shows fear is rising. If that doesn’t happen, there’s a problem. If the market sinks, but the VIX doesn’t rise, it’s an indication of complacency. In “Sentiment: Putting trading into context” (October 2012), we learned how complacency is a characteristic of an early stage correction or bear market. 

If a rising market is accompanied by a VIX that doesn’t drop, that means the market is rising on a consistent fear basis, which also means it could be rising on a wall of worry, a key characteristic of a bull market. Those looking for a trade with a duration of longer than a few days to a couple of weeks should consider holding the position longer if the VIX doesn’t drop (by much). The takeaway here is that fear, or lack thereof, is the fuel that drives both bull and bear markets. The VIX chart from 2009 shows a slow move downward with several sharp spikes that indicated fear rose quickly on the pullbacks (see “Sticking points,” below).

Like all generalities, there are exceptions. The VIX bottomed at 9.39% in December 2006, yet the market didn’t start peaking until the July-to-October period the following year. Then again, it’s rare to see the VIX register such a low reading. Bernard Baruch (the Warren Buffet of the first half of the 20th century)  said he didn’t mind missing the first and last 10% of a move so long as he could participate in the middle 80%. By the time the VIX got so low, a market top was going to happen. It wasn’t a matter of if, but when. 

Recent bottoms also are instructive. When the market bottomed in 2011 amid a debt-ceiling debate, the VIX hit 48.20%, and then 37.38% when it was retested again in October. Thus, the suggestion that a VIX over 45% indicated an intermediate- to long-term low gave the market a lot of fuel to move higher. On the other hand, when the market bottomed in June 2012, the VIX reached a high of 27% (see “Spikes are relative,” below).

Do not anticipate the same kind of market move with a rally originating from a VIX of 27%, or lower, as you would when the market bottoms at a VIX of 36% or 48%. The October 2011 low in the S&P 500 with a high VIX reading produced a 32% move to the April 2012 high.The June 2012 low with a much lower VIX reading only produced roughly a 16% move by the September high. By the time the market found the next low in November 2012, the VIX only was in a range from roughly 15.93% to 18.64%. This indicates that while long-term traders seem to enjoy low volatility, history suggests they would be better off taking a longer-term position with the VIX near 30% or above.

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