Which Way The VIX, Which Way The Market

Includes: SVXY
by: Peter F. Way, CFA


The reason for this discussion at this point in time is the building likelihood of a market correction in the near future as indicated by our analysis and its past record. To illustrate, we present how the VIX index has changed, following prior appearances of the array of imbalances between its upside and downside concerns. We follow that by a similar analysis of the VIX-tracking analysis of the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY).


Since early in the establishment of listed options markets, investment professionals have known that securities uncertainty, or volatility, has a mean-reverting nature. As a result, options professionals tend to trade the implied volatility of a stock, as it varies from its historic norm. They determine the volatility of the security by solving the options value equation backwards, using the market prices of the options as values and finding the implied uncertainty that fits those prices.

Due to the "herd effect" of market-leading stocks, the implied vols of the S&P 500, found by that inverted analysis of options on the SPX index, became a market standard for reflecting on potential stock market direction. That data took on a life of its own when in 1990 the CBOE created the VIX, or volatility index, based on the S&P 500 options.

The VIX index soon established a probable (but not entirely reliable) pattern of movements inverse to stock market index prices. When the VIX was low, sometimes stock indexes suddenly plunged, raising fears and uncertainty that caused the VIX to rise.

With greater reliability (although not certainty) elevated VIX levels usually were followed (at some point) by market recoveries. So the VIX became a professional's tool to add to the mystique of market prognostication.

Eventually not content with just the index to refer to, some 16 years later (in 2006) the CBOE began trading options on the VIX. Now the convolution of estimates of the estimates of volatility, and what they might mean to market values and direction entered the scene.

Since, as we have repeatedly claimed, stock investing is a (very serious) game, driven by changing strategies of principal players, no simple mathematical or "mechanical" fixed-rule solution to the problem of where prices are headed next is likely to be found. Instead, some help may come from a greater understanding of the changing reasoning of the players themselves.

That is why we pursue a form of what has become known as "Behavioral Financial Analysis." We separate our approach from the typical academic literature on the subject because of its generic focus on human errors. Instead, we consider what we do as "Intelligent Behavioral Analysis" since its focus is on what knowledgeable people do that is helpful, rather than erroneous.

Further explanation can be found in Seeking Alpha articles here and here.

The product of our analysis differs markedly from the VIX. That index measures the amount of uncertainty apparently present currently in the market's most professionally-followed pricing metric. Its only directional implications are from historical experience.

Looking at how essential market professionals protect themselves by hedging against risks they must take, we learn the proportions of their price directional concerns now, before the fact, about what may be coming in the foreseeable future.

The balance between their upside and downside prospects provide a fine and valuable means of discrimination between market direction and its likely extent. No crystal ball, but something of a fog-cutter at least. And only one of telling likely odds and payoffs of what may happen next, if human nature persists and the dominant group of market influencers does not change radically or suddenly.

Now the analysis

The first presentational format is tabular, in which columns provide periods of increasing time following the presence of daily forecasts, while rows provide discrimination of the balance between upside and downside prospects. The rows are arranged to cumulate from the extremes at top and bottom, to a totals or averages row (in blue) at mid-height.

Since we are dealing with quite sophisticated measures and vehicles, and are alert to the typical time horizons of the professional participants involved, the time periods shown are quite short by conventional investment standards - 16 looks at 2-day intervals, or about a month and a half of market days. But market corrections typically can be quite sudden, and surprising.

Over the past 4-5 years, here is how the VIX price has changed, on average, during those subsequent 32 days, given various proportions of upside to downside forecasts, indicated in the left-hand colored columns.

(Click to enlarge)

The nature of the VIX is to hover in the area of 12 to 15, signifying a low level of concern while normal market growth is occurring. Overconfidence or irrational investor exuberance may be accompanied by declines in the index to 10 or below.

(Click to enlarge)

(used with permission)

The past 6 months of daily VIX forecasts is pictured above. Each vertical line is a forecast range, and the heavy dot is the current index value. Its position within the forecast range is measured by the Range Index, which tells what percentage of the range is below the current value, here only 4%.

In the table above the picture, that 4% of downside compares with 96% of upside, so the present Reward to Risk ratio is some 24 to 1, or greater than 20 to 1 but not quite 30 to 1.

The magenta numbers in the 30 : 1 row signify its approximate position. That column of numbers counts the number of days out of the 1133 total where such a forecast level or more extreme was seen.

Given that the VIX is calibrated in percentages, an 8% rise from a current level of 13.84 would change it to 21 or 22, near its recent peak in June, as seen in the lower picture above.

Since most investors either are not aware of VIX options, or are averse to using such instruments, we use an ETF to translate the potential market intelligence suggested by the VIX data. The particular ETF, SVXY appears to be quite complicated, but because it re-inverts the inverted nature of the VIX index to stock prices, we have a vehicle that goes up when the VIX suggests a strong market, and goes down when trouble appears afoot.

Here is its past 6 months daily forecast history.

(Click to enlarge)

(used with permission)

The inverse relationship between these two forecast history pictures should be apparent. High VIX numbers have been great buying opportunities in SVXY, and a sustained low VIX is a caution to any SVXY holding.

Part of our established practice in measuring the effectiveness of market-maker forecasts is to use the top of their forecast ranges as unchangeable sell targets for that forecast. In this picture that rule proves out visually, as the tops of low Range Index SVXY forecasts are regularly surpassed by subsequent SVXY market quote heavy dots.

And a more telling record is to look at the same kind of tabular price analysis for SVXY as was initially shown for VIX.

(Click to enlarge)

Here we have a shorter history to work with, only 331 days, and a pattern of Range Indexes opposite to the VIX, with only few low R.I. cases, but extremely profitable ones.

And now, with a high Range Index of 59, dangerous, or at least restricted opportunities appear to be at hand.


Market-maker hedging in sophisticated market-sensitive instruments suggests we may be approaching at least a moderate market pull-back over the course of the next few weeks. No clear single reason is apparent, although the usual backdrop of a "wall of worries" can sometimes turn into an unstable avalanche of concerns. Or not. But something has the pros behaving more cautiously than usual. Summertime jitters by the second-string juniors left in command by the beach-gone top brass? Or a reasoned alert by them in defense of a potential attack of market terrorists in search of an easy triumph? Who knows?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.