Sunday, March 11, 2007

VWSI Snaps Back to Neutral

If you wanted to find an example in your investment textbook to illustrate “VIX Mean Reversion,” last week would be a classic case study. After soaring 75% in the week ended March 2nd, the VIX snapped back 24% this week, so that it now sits comfortably between its 10 and 20 day SMAs.

Perhaps surprising to some, this 24% drop is still less of a move than the VIX drops in each of the three previous instances in which the VIX Weekly Sentiment Indicator (VWSI) was at -10, as I discussed last week. It is enough of a move, however, for the current week’s VWSI to return to a neutral reading of zero. This roughly translates as the odds times the magnitude of another VIX spike are about the same as the odds times the magnitude of continued subsidence over the coming week. Said another way, there is a higher probability that the VIX will be lower on March 16, but if the VIX makes a significant move in the coming week, that move is more likely to be up than down.

In the event that you still have open positions resulting from a post-2/27 fade the spike strategy, this looks like a good time to start taking those profits. Keep in mind, however, that the VIX has a tendency to drop during options expiration. With the 10 day SMA of total put to call ratio currently sitting at 1.28, you can safely assume that it will need a Sherpa to stay at that altitude, suggesting that the market is poised to move upward and the VIX may have another leg down this week.

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

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