The VIX Tells the Tape's Tale

08/02/2010 12:00 pm EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, chief executive officer of Schaeffer’s Investment Research, writes in The Option Advisor that the volatility index’s moves could show the market the way.

The 200-day moving average of the CBOE Volatility Index has been quite significant over the years.

The breakout by the VIX above its 200-day moving average in September 2008 was followed by the huge fourth-quarter 2008 VIX spike as the market plunged; the breakdown below the VIX 200-day in March/April 2009 was followed by a 50% decline in the VIX over the following six months during which the market rallied sharply off its March lows; and the VIX’s move back above its 200-day on May 4, 2010 was followed two days later by the “flash crash” and a quick double in VIX levels.

I believe the VIX is now at a critical juncture. Pullbacks since the May “VIX fever” subsided have all been contained at the 200-day moving average. VIX pullbacks are almost always associated with stock market rallies, so it is not surprising that the rallies since May have disappointed, as they have ground to a halt each time the VIX has held at 200-day support.

And this connection is more than coincidental, as “protection buyers” look to purchase put options or VIX calls or VIX futures when the VIX is perceived as “cheap,” and these actions create short-selling activity that depresses stock prices.

In fact, there are those who say that the action in the VIX futures can be predictive of future VIX levels, and this VIX futures action right now has bearish implications.

I think it is pretty clear that the action in the VIX is going to resolve itself one way or the other before very long. If the 200-day moving average continues to hold (and if the VIX futures traders are correct), then we should see another VIX spike higher accompanied by a weak market.

But if the VIX 200-day were to break as it did in early 2009, we should be in for yet another surprising rally when investors are least expecting it. As Ryan Detrick [wrote on the Schaeffer’s Investment Research Web site]: “There have been net redemptions for three straight years from equity-based mutual funds. The last time we saw three straight years similar to now was 1979-1981. Looking back, not a bad time to be accumulating stocks ahead of one of the greatest bull markets ever.”

(The VIX closed at $23.50 Friday, which may be below its 200-day moving average—Editor.)

My advice is to retain long exposure but continue to hedge so you can stay whole during periods of market turbulence.

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