Tuesday, November 16, 2010

VIX Punches Through Upper Bollinger Band

The VIX has no idea what is going on in Ireland and has no way of knowing whether the markets are underestimating or overestimating the full extent of the European sovereign debt crisis, not only in the Emerald Isle, but also in Greece and Portugal.

While it is always important to be well-informed when it comes global political and economic flash points, most VIX traders prefer to take a technically-based approach to trading volatility. In this vein, the simplest and most effective approach is to fade any VIX extremes. I have covered many ways to measure VIX extremes in this blog. One of the simplest is to use Bollinger bands to identify VIX values which are extreme enough to invite high probability mean reversion trades.

The chart below is a daily bar snapshot of the VIX, with standard Bollinger band settings (20 days, 2.0 standard deviations), showing that the recent VIX high of 23.06 is well above the 22.45 upper band level of the current Bollinger band settings. For most VIX traders, this means a short VIX play is in order, irrespective of events on the ground in Europe.

For those who are new to volatility trading, keep in mind that VIX spikes have a habit of clustering and creating a vicious cycle. One only has to scroll back six months to see what happened the last time concern about European sovereign debt soared, sending the VIX from 15 to 48 in the space of a month.

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[source: FreeStockCharts.com]

Disclosure(s): short VIX at time of writing

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