Modalities of the 'Imminent' VIX Spike

These days, you can’t escape the public outcry: traders want their VIX spike, and they want it now.

Not too long ago, the vicissitudes of the VIX used to be the privy of a fairly limited group of options traders - those that had ears to hear, as it were.  Now, if you hear or read phrases like “bear market,” “20% decline,” and “market bottom,” odds are that the phrase “VIX spike” isn’t far behind.  Nevermind whether the increased VIX coverage is appropriate or accurate or remotely helpful.  Thanks, CNBC!

The net effect of the VIX’s coming of age is that everybody and his brother now “knows” that we won’t have a short-term tradeable market bottom until the VIX spikes up into the 30 range.  Well, that claim may have held true in the recent past, but it denotes a more complex relationship than people seem to realize.

So what’s the relationship between VIX spikes and market bottoms?  Three schools of thought here, most easily viewed in modal terms:

1. Necessity: a VIX spike is necessary for a short-term (1-3 month) market bottom to form.  This sure seems to be the consensus view these days.  Every blogger under the sun is writing that indexes won’t find a bottom until we see “a spike in the volatility index (VIX) followed by massive capitulation.” [link]  But it isn’t just individual traders who are taking this view: when you have analysts like Ryan Detrick saying things to the Wall Street Journal like, “It doesn’t have to top 30, but it does have to spike,” it’s no wonder people are insisting on some impressive upward protrusion on their VIX charts.  Some of the VIX coverage these days is so dumbed down, it might as well be done on a flannel board.
2. Probability: a VIX spike is suggestive of a short-term market bottom, and such a bottom may be less likely without a corresponding panic. In his Barron’s column this weekend, Larry McMillan only just barely put himself in this camp (rather than in the Necessity camp).  He spends most of the column trying to debunk all the reasons others have given for why we could see widespread panic but not see that panic reflected in the VIX.  His conclusion is that, no matter what else happens, people will eventually freak out and buy SPX puts: “This market decline probably will end as all others have — with traders panicking and the VIX spiking upward.”  Plenty of other credible sources (Brett Steenbarger, for example) seem to have roughly the same view: maybe we can move higher without some dramatic VIX-y capitulation, but it sure doesn’t seem likely.
3. Possibility: a VIX spike is suggestive of a short-term market bottom, but there’s no reason to lean so heavily on this one metric.  This isn’t nearly as sexy a view, and advocating a wider, more cautious, and more nuanced approach to causal claims obviously isn’t going to get you on television.  But the VIX wasn’t actually created to provide swing traders with buy signals, believe it or not.  Jason Goepfert of SentimenTrader mentions in a note this morning that neither put volume nor implied volatility spikes are required for markets to bottom.  Adam Warner has been making the VIX-agnostic case in several recent posts.  Dr. Duru concludes that while a VIX spike may be sufficient condition for a market bottom (no one is going to disagree with that), “it is not a necessary condition.”  Last, and certainly not least, see Bill Luby’s discussion on why a market bottom without a VIX spike is entirely possible, reasonable, and historically supported.

We would fall squarely in the third group, for several reasons.  Despite McMillan’s reservations, the trend is squarely in favor of traders using hedging products in addition to (or even instead of) SPX puts, which would loosen the oft-touted correlation between the VIX and investor fear.  Second, remember that a key component of VIX spikes has been sudden and surprising broad market selloffs; but it’s just not possible to characterize this bear market as a surprise, and we wonder whether any bad news (short of Israel invading one of its neighbors, perhaps) would come as a genuine surprise in this climate. 

Finally, there are always reasons that markets can rise without first undergoing some cathartic panic; right now, equities seem to have been depressed somewhat artificially by an overextended rally in commodities, such that any retreat in crude oil prices can easily spark a market rally.

The bottom line is that the VIX is just one of many valuable sentiment indicators, and traders shouldn’t focus unduly on any one tool.

Comments

[logicalthought:]

How about this one: We DO "need" a VIX spike to mark a bottom, only it'll be something like twice as big as the spike that "the consensus" is looking for (i.e., maybe to 60 or 70, rather than 35).

2008 Jul 08 06:29 AM

[fxtrader07:]

thanks for this well written article. looks a bit like the shorties are staring at the vix, too looking for the ultimate signal to cover - which may not come.
in fact, it could be argued that the record high short interest in individual stocks (often 15-30% of the float and with 15+ days to cover) is a key reason that a vix spike will not occur this time around - taking cash on the sidelines as well as short sellers by surprise. even if you account for a the groing number of long/short equity funds which obviously contribute to a higher overall short interest the fact of the matter is that a lot of people are either short or hedged via individual stocks (often banks retailers and homebuilders) therefore, the need to buy oex-puts might not arise this time, as the author rightly suggests, too.
what to look forward to? perhaps, a violent summer rally out of the blue which leads to a pnic dumping of oex-puts by disappointed hedgers and a wild short covering in individual stocks, expecially if and when the May-highs get taken out in the indexes.
as news follow stock price actions (the silliest reasons always serve as ex-post explanations) some folks might even conclude that THE BOTTOM WAS IN and a new bull market began and get sucked into the mother of all sucker rallies

2008 Jul 08 08:39 AM

[Urbane Gori...:]

I doubt that anyone **really** thinks you can only have a bounce if the VIX spikes... More than likely, just as I like to see an equity come off a stochastic past the 20, this is a kind of safety issue for most investors. In other words it's a confirmation. For the record, even though the VIX hasn't hit 30+, the DOW, SP500 and NASDAQ all appear to be bottoming according to the weekly slow stochastic. However, none have pushed through the 20 yet. And, yes, I have lost money depending on the stochastic as well... Such is life!

Thx jegan ;-)

2008 Jul 08 03:11 PM