Volatility Never Takes a Vacation

03/04/2011 1:00 am EST

Focus: OPTIONS

Price Headley

Founder and Chief Analyst, BigTrends.com

The latest action in the VIX shows a key line in the sand, but all signs point to persistent volatility and “whippiness” in the markets for the short to medium term.

By Price Headley

The CBOE Volatility Index (VIX) measures the implied volatility of S&P 500 Index (SPX) options.  We've studied and utilized the VIX for years as a measure of trader sentiment and fear/panic/wall-of-worry sentiment levels. Certainly, extremes in the VIX can often be used as pivotal turning points in market timing, but also quite often (especially in recent years), it can be a good leading indication of a volatile, “whippy” market. Individual investors can trade the VIX through the Barclays iPath S&P 500 VIX Short-Term Futures ETN (VXX) and Barclays iPath S&P 500 VIX Mid-Term Futures ETN (VXZ), which track VIX futures prices and their options.

The VIX has basically been in a steady downtrend since a spike in May 2010, but we've recently seen an upward burst, likely due to unpredictable political events overseas and a subsequent rise in certain key commodities like oil. Nonetheless, the recent move in the VIX is interesting from a technical perspective. Take a look at the daily chart below:

chart
Click to Enlarge

So, we can see above that the 18/18.5 level has increasingly become an important "line of demarcation" in recent months. Basically, this area is acting as kind of the benchmark below which traders are feeling relatively calm and perhaps complacently bullish, while above that level, fear and panic levels are rising.

The recent gap up in the VIX on Feb. 22 has now formed an interesting "island" technical pattern—we haven't yet filled in the gap on the downside. Until we do (which may not occur for some time), volatility and whippiness in the stock market is likely to persist. Also note that during this same move, the VIX moved above both its top acceleration and Bollinger bands. It hasn't done this in quite some time, and this is another indication that volatility may continue to linger in the short to medium term.

Conclusion

Bottom line, the recent VIX activity and pattern is causing us to be somewhat more tempered in our stock market outlook, as risk appears to be lingering. The VIX breaking back down below 18 (for more than one day) would likely be a healthy sign for another strong leg up in the market.

By Price Headley of BigTrends.com

Related Articles on OPTIONS