Tuesday, October 21, 2008

VIX Drops 20% in One Day…Again

Sometimes a big move in the VIX is significant and sometimes it is a lot harder to interpret. On the surface, yesterday’s 24.7% drop in the VIX – the second largest one day move down in percentage terms – appears to fall in the latter category.

From 1990 through 2005 the VIX fell 20% on only two trading days: once in 1993 and once again in 1994 (see green arrows in top graphic). Each instance signaled a bottom and about a three week bounce. The markets then moved up sharply in 1995, but it is a large stretch to say that the VIX offered any signal about a move that was at least nine months away.

After an 11 year drought, an uptick in volatility brought the 20% drop back into vogue in the middle of 2006 and including yesterday, there are now six such instances in the past two years and four months. The bottom chart also marks these 20% drops with green arrows, which once again tend to signal bounces of no more than about three weeks.

In general, I do not consider a 20% one day drop in the VIX to be particularly significant. In most cases this is merely a statistical quirk which results from the typical mean reversion process that appears while volatility retraces the path of a previous upward VIX spike. In such instances, the initial VIX spike is the more noteworthy event.

Now for one of my favorite phrases: “But this time it’s different!”

In all fairness, I can make a slightly different case for the current environment in that the eight week VIX spike that topped out at 81.17 was so severe and persistent that it is not so much the extreme fear that is important from a trading perspective, but an indication that a diminution of that fear is taking place. In many places in this country, people have not been this fearful in 75 years, so any indication that fear may be starting to reverse direction is indeed significant.

Let’s see where we are in three weeks…

[source: StockCharts]

1 comments:

David M Gordon / The Deipnosophist said...

Why do I rely on your insights, Bill? Evidence #1...
"...it is not so much the extreme fear that is important from a trading perspective, but an indication that a diminution of that fear is taking place. In many places in this country, people have not been this fearful in 75 years, so any indication that fear may be starting to reverse direction is indeed significant."

Whereas other market commentators quote the absolute level of this or that indicator as somehow meaningful -- in this instance, the VIX index -- you seek and discern changes, often subtle changes. Leave everyone else their headlines for direction; the clues, subtle though they often are, provide true guidance, and (coming) direction.

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