The overextended VIX situation I pointed out last week has resolved in classic fashion. I had discussed that some people use the VIX as a primary overbought/oversold indicator, and treat a move of more than 10% from its 10-day SMA as a trade signal.
Here’s a one-month chart of the S&P over a chart of the VIX from yesterday (Friday Jan 27) back:
The VIX peaked at 14.56, 24% above its 10MA on Friday Jan 20. The rubber band was stretched extremely tight, and bounced right back, as seen in the chart above. As the VIX made a return to its 10MA over the ensuing week, the S&P rose about 25 points in unison.
I’ve also labeled on the chart the point where the VIX hit 10% above its 10MA at the open on the first trading day of 2006, and rebounded all the way back down to the moving average as the S&P climbed almost 25 points in one day.
Please be aware– the VIX can return to its moving average without the S&P making a significant rise. However, in order for that to happen, the S&P has to experience an extended sideways movement.
I’ve never used this indicator as a trade signal, but I’ve often referred to it as confirmation of an overbought/oversold condition. When I get time (I average about 4 hrs of free time a week right now), I’ll do some research and post statistics on how reliable this indicator has been in the past. It should be interesting.
What does this mean for the market? The rubber band is right back in the middle of its range, meaning there’s no strong options pressure on the S&P in either direction right now. If Friday Jan 20 was the beginning of a downtrend, the resistance to that downtrend (i.e. rebound buying pressure) has now subsided, and the downtrend can resume. However, there’s also no overt selling pressure evidenced in this indicator right now, so it gives us no clear read one way or the other.
As with many oscillators, this one loses most of its meaning unless it’s at one extreme or the other. But when it is, it can certainly help to confirm whether you’re on the side of probability. What was it Jesse Livermore said? Something along the lines of, “It’s not important whether you’re on the long side or the short side, but that you’re on the winning side!”