Rob Hanna at Quantifiable Edges has a study up this morning with the title VXO Suggesting A Pullback Is Likely. In his previous Is A Low VIX A Short Trigger? Rob concluded, contrary to popular wisdom and quite correctly:
“Owning the S&P 500 when the VIX was more than 10% below its 10-day moving average was significantly more profitable on average than owning it when it wasn’t.”
Quoting Rob again, the important distinction to make is that “when the VXO becomes extremely stretched, as it is now, then that changes,” with an extremely low VXO “very suggestive of short-term bearish implications.” [Emphasis in the original]
My initial thought upon reading this is to recall an important VIX heuristic that VIX trades have a higher expectancy when the VIX is extended to the upside than to the downside. My second thought was that the reason the VIX (or VXO) typically gets extremely extended to the downside – at least relative to a 10 day moving average – is that volatility is usually reversing a large upward spike.
My research shows that since 1990, the 30 instances in which the VIX was lowest relative to its 10 day moving average (at least 18% below it) were good times to be long the market, on average. In the one to two week time frame following the relative low readings in the VIX, there was small advantage to being in the markets; after two weeks or so, the advantage for longs becomes more pronounced.
The bottom line is that while the VIX and VXO are well below their 10 day moving averages (yesterday was a record in that regard for the VIX), just last week they were extremely extended above their 10 day moving averages. This week’s extreme readings are as much a residual effect of the extreme readings in the opposite direction as anything else. For now the VIX looks to be in a range that is consistent with macroeconomic conditions, futures prices, and recent volatility. For those that follow the VIX:VXV ratio, it is currently at 1.03, also suggesting that volatility readings are in a ‘normal’ range given current circumstances.