“The proper way to use the VIX is to look at where it is today relative to its 10 day simple moving average. The higher it is above the 10 day moving average, the greater the likelihood the market is oversold and a rally is near. On the opposite side, the lower it is below the 10 day moving average, the more the market is overbought and likely to move sideways-to-down in the near future.”
This wisdom is further distilled into what TradingMarkets calls The Trading Markets 5% Rule: “Do not buy stocks (or the market) anytime the VIX is 5% below its [10 day simple] moving average.”
Today the CXO Advisory Group is out with their analysis of the 5% rule. They conclude that “the TradingMarkets 5% VIX rule is of limited practical use and does not support a standalone trading strategy that keeps up with buy-and-hold.”
But before you click on to the next story, you should note that the CXO analysis actually goes far beyond an evaluation of the 5% rule and looks at returns for the S&P 500 index for all 1% increments from 0-10% above and below the 10 day SMA. CXO’s graph of the results, which I have included below, clearly shows that the 5 day SPX return is strongly correlated with increasingly higher readings in the VIX’s 10 day SMA. This should be of no surprise to regular readers, who by now are surely used to feeding at the trough of mean reversion.
The difficulty, according to CXO, lies in translating the VIX-related edge into a trading system that beats a buy and hold strategy, particularly when the 5% rule calls for being in the market only about 55% of the time.
My take is that the TradingMarkets 5% rule, just like the MarketSci.com approach I outlined last week, is a valid and tradeable way to use the VIX to time the markets. For better or for worse, for now I will leave it up to readers to see how well they can use this data to develop a robust trading system that can outperform a buy and hold approach.