Two Ways to Interpret the VIX

Includes: DIA, QQQ, SPY
by: Investment Pancake

The thing is, contrarians just don’t get it when it comes to the volatility index (the “VIX”). Contrarian investors believe, correctly, that bull markets are born in rampant and widespread fear, and that bear markets feast on complacency.

Based on this belief, contrarians will look to the VIX as an indicator of fear in the marketplace. The thought goes that when the market carves out a lower low, and the VIX fails to notch a higher high, complacency reigns and further declines in equity prices are likelier than not to occur in the near term. Conversely, when the VIX spikes higher each time the market carves out a lower low, fear is spreading and a market bottom is apt to form in the near term.

Okay, so far, so good, but there’s a fly in the ointment. Fear, like greed, knows no limits. How can you quantify how much fear is “enough” for a market bottom? If you are a contrarian, you can’t.

On a fundamental level, the problem is that contrarians see the VIX simply as an indicator, whereas traders look at VIX options exactly the same as they look at any other asset or trade. This is a key distinction, because traders don’t need to know the relative extent of fear or greed when it comes to an asset (or a trade). All a trader needs to know is that when the price of an asset (or a trade) runs into technical resistance, you’re apt to see a trend reversal.

Here’s the practical upshot. At an inflection point towards the end of a major down trend in the equities markets, you should not be surprised to see a pattern of lower lows in equity prices, and a failure of the VIX to notch higher highs. A contrarian would interpret this failure as investor complacency, and would argue the equities market has not hit bottom. By contrast, an options trader will conclude the price of VIX options has hit a wall of technical resistance and is, for that reason, prone to collapse. The options trader also knows that in the context of a major trend reversal, the price of VIX options and equities are often (but not always) inversely correlated. So in contrast to the contrarian theorist, the options trader will see a stalled out VIX as completely consistent with an equities market bottom.

How does this relate to today’s market? Well, it is worth observing that the VIX appears to have hit a “double top” pattern at 80. A double top trading pattern is a preliminary signal of a major trend reversal. And what’s more interesting is that this double top in the VIX is accompanied by a nearly historic wall of worry in the equities markets which ordinarily should lift the price of VIX options. If the price of VIX options cannot go higher on this type of sentiment, it’s getting easier to make a case that the VIX could drop from here, which could be accompanied by higher equities prices.

Contrarians, on the other hand, have interpreted the failure of the VIX to make higher highs as a sign of investor complacency in the equities markets – not something you hardly ever see at a major market bottom. There’s the reason why some contrarians can’t see much hope that the stock market has hit bottom.

So who is right? The answer is that by definition, the guys who set asset prices are right. For that reason, I’d watch how options traders respond if the price of VIX options fails to catch support at the 50 day exponential moving average, or the November low of around 48. And if the price of VIX options cannot catch technical support at these levels, then it will be more constructive to view this as a technical trend reversal, rather than a sign of investor complacency.

Disclosure: The author owns no positions in any security mentioned in this article