Tuesday, July 24, 2007

VIX Has More Room to Run

Thanks in part to a strong earnings report from Amazon (AMZN), the VIX dropped back to 18.55 by the time of its 4:15 ET close, down from an intra-day high of 19.09.

How high will the VIX go from here?

Turning to the VWSI, I note that it closed at -3 today, indicating that there is still a fair amount of room for the VIX to run without getting overextended. For the VWSI to reach -6 tomorrow – the point at which I generally look to fade the move with options – the VIX will have to touch 19.26. Also consider that a VWSI of -8 requires that the VIX hit 19.46 tomorrow; the maximum reading of a VWSI of -10 would result from a VIX of 21.21. So, if it turns out that today’s 19.09 is not a near-term high in the VIX, I would expect to see the VIX topping out in the 19.50 – 21.50 range. (Note that all VWSI numbers are reset at the end of each day, so these thresholds are moving targets and will be lifted higher by a gradually trending VIX.)

One way to illustrate the moving target aspect of the VMSI is to look at the VIX’s somewhat analogous moving average envelopes. Shown below are the 10% (dotted green line) and 20% (dotted purple line) moving average envelopes that surround the VIX’s 10 SMA (solid blue line.) As the VIX has trended upward over the past three months, the moving average envelopes have risen with it, so while the 17.08 and 18.98 VIX spikes in early and late June look like breakouts that are highly susceptible to the gravitational pull of mean reversion, today’s runup to 19.09 looks much more like normal oscillation around an uptrending mean.

Of course the VIX should not be the only tool in your toolbox. When I look at put to call ratios, new highs and new lows, as well as other market sentiment data, the case for the VIX topping out soon looks fairly strong to me.

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