VWSI Drops to -6 as Markets Ponder a U-Turn

For four days last week, the VIX show hints of coming back to life and on Friday it roared back, posting a 24.1% gain, the third largest single day move since May 2006. Friday’s VIX spike capped off a week in which the VIX gained 5.23 points, or 29.5%, to 22.96. This also happens to be the VIX’s highest close in over a month.

From Monday through Thursday, the VWSI stuck stubbornly to a zero reading, but Friday’s action moved the indicator to -6, suggesting that the broader market indices may be oversold at this stage.

Just as I was last week, I am more bearish on the broader markets than the VWSI would suggest. In my view, the relevant time frame for the bears has now been extended: instead of merely having to prove that a selloff was more than a one day wonder, now the task at hand is to string together two ugly weeks in a row in order to take the wind out of the bull’s sails. Tomorrow is almost certain to open down as continued selling pressure from Friday carries over to the open. The question is whether the selling can be sustained or if enough buyers will be brave enough to jump in to ease the selling pressure. The second half of tomorrow’s session and all of Tuesday’s action – unhindered by government data, but still at the whim of corporate earnings – should have a great deal to say about how the rest of the week will go. The bull market may be long in the tooth, but the bulls still have a good case for a continuation of the five year bull trend – at least for now.

(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.)

Wine pairing: When the VWSI hits -6, you need a big wine to balance it out. My recommendation is a zinfandel. For those who may have missed it, in addition to VIX and More, I occasionally blog at Zin and Pinot, a blog dedicated to my love of wine – and evidence that I am quite partial to zinfandel. As this is the first time we have hit a VWSI of -6 since August 2006 – well before I began blogging about volatility and vineyards – I will refer the reader to a set of links to eleven of my favorite zinfandel producers that I maintain on Zin and Pinot.

In the last week or two I have sampled several zins from Hartford Family Winery, including a 2003 Highwire Vineyard and a 2004 Dina’s Vineyard. Alas, I am afraid I am down to my last bottle of the 2004 Fanucci-Wood Road Vineyard, which is probably my favorite of the Hartford zins from the past few vintages. The winemaker generally favors dense fruity wines from old vines of up to a century or more in age. Expect a lot of alcohol here too, usually in the range of 16% (one in my cellar has 17.1% alcohol, according to the label) though you would be hard pressed to identify it amidst a silky smooth mouth feel.

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.

Today's VIX Readings are Relatively Tame

So far, I am not impressed by the 11% move in the VIX, which is currently trading a little below the intra-day high of 16.87.

It is going to take a VIX of at least 18.42 to move the VWSI to -6 and get me into the VIX options game today. At 16.77 we are currently still at a VWSI of 0.

The larger question, at least for me, is whether the recent pattern of higher lows in the VIX means we are ushering a new volatility trend. So far that is what it looks like, but I'd like to see at least one more month of data before I jump to any conclusions.

VWSI at -6 when the VIX hits 16.35 -> short the VIX

This is my signal to go short the VIX. I'm starting with credit spreads: the June 15 / 17 calls and the June 16 / 18 calls.