Tech Talk: Views on VIX

10/09/2002 12:00 am EST

Focus:

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

While the $VIX–an indicator of market volatility that measures the "fear" among options traders–may mean little to long-term, fundamentally-oriented investors–it is an extremely important indicator for more technically-oriented traders. Indeed, it is one of the few technical indicators that has garnered the attention of the media–in large part due to its success at identifying the interim lows set in both September 2000 and again this past July. However, two leading technicians–Richard Rhodes and Larry McMillan–caution that interpreting this sentiment indicator may be more complex than it appears on the surface.

Richard Rhodes, editor of The Rhodes Report, explains, "There is an old saying, When they are a yellin’, you should be sellin’; and when they are a cryin’, you should be buyin’. Thus, we turn to the volatility gauges–and more specifically the CBOE Volatility Index or $VIX as it is commonly known. There has been an inordinate amount of attention given to this indicator both in the trade and in the media, thus meriting our comments on how we view this indicator at present. Based on the $VIX, volatility is rising. But it hasn’t risen to levels associated with past intermediate-term lows of significance. In essence, bear market rallies occur when the market is perceived as over-sold, which is clearly a $VIX reading of 45.00 or above. However, bear market rallies relieves the same oversold $VIX level that caused the rally to begin with, thereby causing it to return to more reasonable and less oversold levels upon which market participants return to the ‘sell-side’.

To wit, this is the reason we are witnessing sharp one-to-three day rallies in which prices move anywhere from 4% to 6% higher, only to turn lower once again as further selling begets selling. This is the context within which the indices are currently trading, and given that markets go further and farther than anyone expects, the current decline could retrace another 10% to 15% on the downside, with a $VIX reading upwards of 60.0 before we see a rally that is deemed tradable. Until then, expect rallies to fail, and declines to follow-through, irrespective of the fact nearly everyone is leaning towards an October low. They can’t tell you why it should bottom–just that it has in the past. But, hasn’t this bear market confounded everyone? And wouldn’t everyone be surprised if it did not bottom as the consensus expects? We think so, and thus we remain firmly in the bearish camp until proven otherwise. So…they ain’t a cryin’ yet, and we ain’t buyin’…yet!"

Larry McMillan, editor of The Option Strategist, adds, "The volatility of the broad market continues to increase. To wit, the record for consecutive triple-digit closing movements by the Dow was set during the last two weeks–six days in a row. As a result, $VIX is quite high and this is causing all sorts of analysis–much of it by people who had barely heard of $VIX a year ago. As might be expected, much of the analysis is erroneous in such a situation. Frankly, with actual volatility so high, $VIX is about where it should be–slightly higher than actual volatility, thereby reflecting a risk premium for the traditionally volatile month of October. Therefore, we don't consider volatility to be making any particular statement about market direction right now–despite the relative furor in the media over the high levels of $VIX.

One particularly misleading fact has been stated in a number of places: that when $VIX is over 40 that it is bullish. It might be, if actual volatility is at lower levels. But when actual volatility is very high, as it is now, $VIX has to be over 40 or it would actually be 'underpriced.' As is the case with most sentiment indicators, it is a mistake to use a fixed number to describe whether or not it's giving a signal. The only way that $VIX could give a buy signal now would be for it to spike to extremely high levels (probably into the 60's or 70's) and then spike back downward."

Special Notice from the Money Academy
Larry McMillan, hailed by his peers as an option strategist without equal, will join Larry Williams and Gerald Appel in "Everything You Need to Succeed in the Stock Market," a Money Academy presentation in New York on October 22 and 23, 2002. Scheduled in conjunction with The New York Money Show, the limited-registration event is a comprehensive one-and-a-half day program geared toward serious investors and active traders who are willing to dedicate the time and effort to learn from the experts. Call 1-800-970-4355 for registration information.

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