High Probability Trading: The VIX Does Not Work Except When it Does
About 30 minutes before the market opened this morning, a crawler across the bottom of my TV screen read:
“VIX Doesn’t Work As Signal for Returns in S&P 500, Birinyi Research Shows”
The CBOE Volatility Index, or VIX, measures the implied volatility of options on the S&P 500. It is a very popular tool for traders who use the VIX to gauge levels of fear or complacency in the market. Traders use the VIX to trade both markets like the ^SPY^ as well as trading the Volatility Index itself through instruments like the ^VXX^.
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Traditionally, traders have looked at low VIX levels as potential opportunities to buy and high VIX levels as potential opportunities to sell or sell short. Birinyi’s research, according this morning’s online article at BusinessWeek.com suggests that it is time for this tradition to pass.
Specifically, Birinyi Associates looked at the performance of the S&P 500 when the VIX was trading above its 50-day moving average and when the VIX was trading below its 50-day moving average. What their research found was that the VIX was a “coincidental indicator with limited predictive value.”
We disagree. The research that Larry Connors and his team at Connors Research has done shows quite the contrary. When used properly, they found that the VIX remains an excellent tool – particularly for short term traders looking to take advantage of markets when they reach extremes.
Larry Connors showed that when traders compare the VIX to itself over the short term – for example, comparing the VIX to a 10-day moving average of the VIX – this widely used indicator actually has a very good track record of helping short term traders anticipate and trade market turns. The trick is to see the VIX as a very dynamic indicator, not a static one.
As just one instance, Larry Connors observed that “since 1995, whenever the VIX has been 5% or more above its 10-day moving average, the S&P 500 has achieved returns which are better than 2-to-1 compared to the average weekly returns of all stocks.”
At the same time, when the VIX is 5% or more below its 10-day moving average, the S&P 500 has tended to underperform for the next five days. This research is also since 1995.
There are additional differences between the Birinyi Associates study and the one done by Larry Connors and Connors Research. As another example, the Birinyi Associates study tended to look at longer term performance of 90 days rather than the sort of time period a short term trader would be interested in.
Of course, today’s column isn’t intended to invalidate the Birinyi study. But it is intended to (again) rescue the reputation of the CBOE Volatility Index from charges that it doesn’t work, or doesn’t work any more. The VIX, like many, many technical tools including the Relative Strength Index, works just fine when used properly.
For more on short term trading strategies using the VIX, click here to read my column, “Trading the VIX: Short Term Strategies for High Probability Traders.” And for even more information, including market timing strategies using the VIX, consider picking up a copy of Larry Connors’ book Short Term Trading Strategies That Work – now at a new, low softcover price.
David Penn is Editor in Chief at TradingMarkets.com.