Adam Warner

Can the VIX Tell You When to Get Long or Short?

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I've often heard the question asked, can you chart the CBOE Volatility Index (VIX)? Or, better yet, can we glean anything from a VIX chart?

Opinions on the answer to this question are divided. I would suspect that, in general, those outside the options biz are more likely to endorse VIX charting than those in it, but that doesn't mean they're wrong. However, I would caution that many principles of "regular" charting are a bit shaky when it applies to the VIX.

Remember first and foremost that the VIX is not a stock; it's a statistic that's designed to estimate volatility of an S&P 500 (SPX) option with 30 days until expiration. As such, normal rules of supply and demand that we use to gauge chart points on a stock simply do not work as well on the VIX.

Let's say for example that Trader Joe spends $4,000 on at-the-money straddles in SPX with the VIX at 25, and SPX rallies. He's now effectively long, so he sells some e-mini S&P 500 futures against the straddle he owns.

Now let's say SPX retreats and he buys it back and earns $2,000 on the flip. Meanwhile, the VIX has declined to 21, but he can sell his straddle back out for $3,000. The fact that implied volatility dipped 4 points does not bother him; he lost $1,000 on his actual options between the dip in volatility and the time decay, but having the position allowed him to take advantage of the realized volatility in SPX itself.

And that's the whole point, the option trader has all sorts of moving parts to consider. There's implied volatility, of course, but there's also the action in the underlying instrument itself, and then there's the time value.

In the above example, the most important variable is the speed of the move in SPX. If the flip took a day or two, the decline in volatility would not matter much to Trader Joe. But if it takes two weeks, perhaps instead of $3,000, he only gets $1,500 if he tries to re-sell the straddle.

If the VIX was a stock, no one could profit buying it at 25 and selling it at 21. But someone could load up on SPX options with a 25 volatility and sell them out at a 21 volatility and still come out a winner pending the particulars of realized SPX volatility and the overall timing of the move.

That does not mean charts have no value, however. We still have psychology. Active traders are far from oblivious to volatility. But to me, the best way to chart it is in the very short term.

The VIX is a mean-reverting instrument at its core. Big deviations from the "mean" tend to reverse in relatively short order.

The 10-day moving average is perhaps the most valuable measuring stick. Once the VIX gets 10% above the 10-day simple moving average (SMA), it's considered overbought, and 10% below is considered oversold. And since the VIX moves in general opposition to the market, it's a good time to look for longs when it's overbought and shorts when it's oversold.

Of course, that's just a guideline. The VIX flew 45% above the 10-day SMA Friday, so going long when it pierced the 10% level worked very poorly … as it did all throughout 2008.

So by and large, don't expect any magic from VIX charting, but don't throw out the idea entirely.  

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