Can the VIX Tell You When to Buy or Sell?

I recently wrote an article on whether the golden cross on the VIX chart was bad sign for the market. Rennie Yang of Market Tells had this to say about it:

“Adam Warner � had a good post recently on applying technical analysis to volatility indexes (see post), with the upshot being that short-term moving averages like a 10-day are most helpful when dealing with the VIX.

“He notes a favorite indicator is a VIX 10% above/below its 10-day moving average, which signals an oversold/overbought stock market. Our own research backs this up, although we did find that using a 15% threshold improved reliability. I bring this up because, on Wednesday, the VIX closed a bit more than 15% below its 10-day average, suggesting the market is short-term overbought.”

The rule we refer to is that the VIX becomes oversold (overbought) when it closes 10% below (above) its 10-day simple moving average (SMA). And if the VIX is oversold (overbought), then the S&P 500 (SPX) is likely overbought (oversold).

Rennie refines the threshold to 15%, which produces fewer signals, of course, but more reliable ones, particularly one and two days out. He gets even better results substituting the CBOE OEX Implied Volatility Index (VXO), which is calculated using S&P 100 (OEX) options, i.e., the original VIX methodology.

He only looks at oversold VIX signals, but frankly, those will work better in that you will not get the slippage you get when the VIX goes overbought. Remember just a few weeks back the VIX got as much as 90% above the 10-day SMA, so you would eat up a year’s worth of good signals if you got caught with one bad one like that.

If I could refine this even further, I would add that whatever threshold you like with this indicator, you will find it works best if it’s a short-term contra trend move.

In other words, let’s say the market is in an intermediate-term downtrend (like, say, right now). Oversold VIX indications, like a move 15% below the 10-day SMA in this example, will often yield a good signal that a contra trend short-term rally within a longer-term downtrend has run its course. In plain English, that means it’s a propitious time to enter a bearish trade.

However, overbought VIX indications within an intermediate-term downtrend will not provide a reliable bullish signal for the market.

As I type, none of this sits in play just yet. VIX and VXO each sit about 5% above their respective 10-day SMAs. But if you believe the intermediate term remains down — and with SPDR S&P 500 (AMEX: SPY) below its 50-day and 200-day moving averages, that’s a sound opinion — then you should not read much into VIX or VXO even if (when) they do nudge higher.

Follow Adam Warner on Twitter @agwarner.

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