12 May 06: VIX Showing Oversold

May 13, 2006 at 10:00 am by Will

In my post last January on the “VIX Fade Trade,” I explained how many traders use a simple comparison of the VIX (market volatility index, based on the S&P 500) to its 10-day SMA as an oscillator. Whenever the VIX gets more than 10% above its 10ma, they consider the market oversold and look to buy. If it gets more than 10% below its 10ma, they look for shorting opportunities. Some make it even simpler than that, and just buy or short the Spiders themselves.

I don’t use the VIX as a sole indicator. No one should. Anyone who remembers the times the VIX spiked above 40 knows that blindly trading one indicator can be treacherous, because when the signal is wrong, it’s waaay wrong, and you can give back all your gains in an instant. A version of the Black Swan phenomenon. Trade your system, but always have in the back of your mind the possibility of the rare event that hits like a tidal wave, and consider that unlikely possibility in your positioning. Nothing can make you want to jump out of a window like watching years of hard work go up in smoke in one day.

Let’s look at that VIX:

VIX chart

The VIX closed about 16% above its 10ma Friday. What does this say about the next few days?

  • The probability is that the market is temporarily overstretched to the downside. Traditionally this portends sideways movement or a rally in the near-term.

  • Next week is options expiry. Market tends to normalize the last 3 days of expiry week. Combine that with the VIX situation, and anyone in puts that expire next Friday (as I am) should be watching their charts very closely for any signal to get out. There may not be much more money to be made before expiration. Tighten that belt up; don’t fart around and loosen your stops at this late point. (BTW, anyone in calls besides the commodity guys already got stopped out, right?)

  • For daytrading, as always I’d have short candidates and long candidates for Monday, and trade the break of the market. Expect more consolidation than selling since that’s what probability clearly favors, so the long candidates will have more of my attention.

  • If the market should happen to sell, sell, sell on Monday, we’d be hitting the fear triggers in some of the “I’m in for the long-term” water cooler jockeys, and we could see a nice violent downdraft. That’s very unlikely, but if you have a couple of quality short candidates ready, that’s the type of rare event that can make you big money in one day. Don’t ignore that outside possibility.

Cheers. Let’s watch.

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