I rarely disagree with with Mark Hulbert. He’s a longtime observer of the market and its players. Indeed, his tracking service keeps a keen eye on most of the newsletters that offer advice to investors.
However, Mark’s take on the VIX in the Sunday NYT was simply wrong:
"Does the VIX, nevertheless, have a role to play as a contrarian market-timing tool? Some market timers think it does, provided they focus on its recent trend rather than its actual level. These contrarians consider fast rises in the VIX to be bullish, on the theory that investors are quickly becoming scared. By the same token, rapid declines are taken to be bearish, since it must mean that investors are becoming smugly confident.
The Hulbert Financial Digest also failed to find support for this interpretation, however. On average, the stock market in the past has performed no differently after rapid rises in the VIX than it did after rapid falls."
Have a look at the chart below from the article:
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click for larger chart
Graphic courtesy of NYT
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You can tell Mark was never a trader: any keyboard jock worth his salt looks at those VIX peaks and thinks "BUY." Each major spike — depicted less usefully here as a percentage, rather than a numeric basis — neatly coincides with an excellent buying junctures: 1997, ’98, 2002 — even the short rally in 2001. (The percentage basis seems to work better at bottoms than tops)
Indeed, whenever the VIX spikes over 50, if you are not at least thinking about buying stocks, then you have no basis for calling yourself a contrarian. And if you can find any additional confirming indicators with the VIX up that high — its time to back up the truck.
For more on the VIX, see page 18 of Contrary Indicators 2000 – 2003 Bear
There are caveats to any statement such as that, but the bottom line is that a VIX spike tends to accompany a panic sell off — and that’s why it makes for a good buy signal.
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Source:
If the Contrarians Are at the Gate, They May Just Be Lost
By MARK HULBERT
Published: August 21, 2005
http://www.nytimes.com/2005/08/21/business/yourmoney/21stra.html
There are several factors that create rise in implied volatility, one being supply/demand. when floor traders only buy options they will lower volatility usually well below the vol of the stock. Floor traders rarely find themselves buying options as the market is liquidating. Nine of ten times they are typically selling and ocassionally over sell createing a spike in implied vol. This is due to the fact that nearly ever local if not all are short iv and theres very few sellers.
I don’t pay as much attention to the value of the VIX, but, to its direction:
1) VIX climbing, sell
2) VIX falling, buy
Of course, extreme values of the VIX should warn us of a probable reversal.
So, if the VIX number is high, there’s a good chance that when it starts dropping, the market index will reverse and become a strong buy. And viceversa.
put-call ratio may figure into this discussion (not sure)
http://www.investopedia.com/terms/p/putcallratio.asp
Barry:
As an options trader for the past 28 years (I started as a wee lass of 3), I agree with you with regard to the VIX and its use as a contra-indicator. Before the VIX was around (pre-1993) we had to rely on baskets of vols (implied vols on stocks which were widely held, had high option volume, etc.) and even then we found that extreme highs in implied vol were reasonable “buy” indicators. Where the work got interesting was in the timing. While this is trader specific (not everyone can afford the same drawdown,etc.) it’s worth mentioning that it is not a coincident indicator. I’m curious if you’ve done research on the time delay between peak observation on the VIX and the market trading higher.
One very important item:
I read somewhere. I can’t remember where nor have I been able to deepen much into the matter. But, the corporate bond insurance industry seems to have grown enormously, and these guys, in order to protect themselves, short options of the underlying co’s stock.
The point is, that this hedging would be the reason for the low volatility we are seeing in the stock indexes for quite a while.
It makes sense, and would explain low volatility.
If anybody knows something, I would appreciate the post.
I found the article from Howard L Simons:
http://www.thestreet.com/_tscs/options/futuresshocktsc/10218156.html
CDS — or credit default swaps is the instrument which is used to protect the risk of holding a particular co’s bond.
Barry,
On Aug 8th, I commented in Market Soapbox:
http://naybob.blogspot.com/2005/08/market-soapbox-080805.html
“Something that should be investigated is buying futures in the VXD (DJIA) and VIX (SP500), these indices measure volatility in the associated indices options. They both hit ALL TIME lows on July 20th.
Volatility at an ALL TIME LOW means theres no FEAR in the market, and thats when you should worry the most. Since the 20th, volatility has increased by 20 – 25% (a nice profit on the futures), and the VIX/VXD futures are still buys at these prices.
Whether it be geopolitical mania buying or panic selling, we believe volatility will be on the rise in the markets prior to year end.”
Those VIX/VXD futures have moved nicely since then.
Naybob,
Last I heard VIX/VXD futures were a fool’s trap.
Has liquidity improved?
I hereby predict that by Nov 15 vix would be trading at least higher than the current price of 12 . Would go to 15 by nov 15 2005
Of this I am sure of a 75 percent confidence level .