We’re in a pattern not seen since 1992 and 1987
I believe the market
action on Friday was so unusual that it should be noted. What made
the action so unusual was not the fact that the market rose, although that in
itself is becoming less common these days. The market had been oversold on a
price basis and sentiment gauges like the VIX had been showing relatively
extreme fear for several days, so a bounce was bound to occur. What was so
unusual was the weakness of the bounce combined with the strong selloff in the
VIX.
As a quick refresher, the VIX is a measure of the
implied volatility of S&P options. A rising VIX is an indication of fear among
options traders, while a falling VIX can be an indication of complacency. Much
of the time a chart of the VIX will look like a mirror image of an S&P 500
chart. This is because fear levels tend to rise when the market sells off and
lessen during an uptrend. Past studies have shown that when there are sharp
spikes in the VIX, this often leads to a short-term rise in the market. The
study I showed in last Wednesday’s column used a 10-day moving average in
looking at the relative level of the VIX. As we saw then, when the VIX gets
substantially stretched above its 10-day moving average, there is a high
likelihood of a bounce.
Now back to Friday’s unusual action. Here’s what
occurred. The market bounced, which was expected, but the bounce was weak. The
S&P 500 didn’t even gain 1%. Meanwhile, the VIX, which closed Thursday more than
12% above its 10-day moving average, dropped so sharply that it closed Friday
below its 10-day moving average. In other words, it took just a very small move
for people to lose their fear of the market. My initial instinct was that this
was not a good thing. Markets do better when doubt and fear are prevalent. A
good bounce is typically one that people doubt. To confirm this I looked back in
history.
I first did a study to see how many times the
market had managed to gain 1% or less while the VIX moved from a position of 12%
or more above its 10-day moving average to closing below it. The answer: only
twice — and it had been 13 years since this last occurred. The only instances of
this were on October 28, 1987 and June 19, 1992. Since my sample set was far too
small to tell me anything, I decided to expand the study.
Therefore I looked for the following conditions.
1) The VIX closed yesterday at least 5% above its
10-day moving average.
2) The VIX closed today below its moving average.
3) The S&P 500 gained less than 1% today.
If all of the following conditions were true, I
would look to short the market at the close and cover my short 10 days later.
The above conditions occurred 38 times since the
VIX was established in 1986. The results were as follows:
23 of those 38 times (61%) the market was trading
lower 2 weeks later.
Gross profits from shorting would have been more than twice
the amount of the gross losses.
These results helped to confirm my belief. The
quick move south by the VIX helps put this bounce very much in doubt. (By the
way, volume also stunk — which doesn’t help.) Risks have not been lessened.
Continue to proceed with caution.
Best of luck with your trading,
Rob
P.S. If you have interest in learning more about
the VIX, Larry Connors has done numerous studies. This article may be a good
place to start.
https://tradingmarkets.com.site/stocks/education/traders/01112002-22317.cfm
P.P.S. For those who may be looking to expand their use beyond just market
timing, my Hanna ETF Money Flow System utilizes the VIX in generating trading
signals for spread trades.
Rob Hanna is the principal of a money
management firm located in Massachusetts. He has spent the last several years
developing and refining methods for trading in stocks across multiple time
frames. He selects stocks using both fundamental and technical criteria, and
then trades them using technical analysis techniques.