The psychologist Abraham Maslow famously said, “When the only tool you have is a hammer, everything looks like a nail.” It has become increasingly common to see financial journalists and bloggers refer to the VIX as an indicator of market sentiment and sometimes of market direction, and those authors inclined toward technical analysis even apply their tools to draw predictive conclusions. But the VIX doesn’t seem to act very nail-like in spite of the best efforts of hammer-wielding technicians.
The premises on which most technical analysis relies don’t apply very well to the VIX (or to any other volatility index), since volatility indexes have some distinct and unusual features. Recall that the VIX tracks the 30-day volatility implied by S&P 500 index options; it is a wholly derivative product, not an underlying in its own right, and is not traded in the way you might trade the S&P500 ETF (SPY) or the Nasdaq 100 (QQQQ). So, for example, traditional notions of support and resistance will not apply here. We will look at three cases in which traditional technical analysis is singularly unhelpful when analyzing the VIX.
Examples of this imperviousness
1. Support and resistance don’t matter. Bill Rempel, who writes a helpful stock blog, recently called a “triple top” around 36 in the VIX:
The VIX has triple-topped, while the S&P 500 has double-bottomed with a significant positive divergence in breadth. [link]
A couple points stand out: in the first place, there aren’t any traders out there borrowing VIX shares to short at 36, and there aren’t any VIX longs who have been dumping their positions to take profits at 36. There are no VIX shares; and while you can trade VIX futures and options, those products are supervenient on the primary index. So the very notions of supply and demand that give legitimacy to the practice of tracking support and resistence levels in technical analysis are not applicable when it comes to the VIX: the index could “quadruple top” tomorrow, and then shoot up to a new high for the year at any point in the future, completely ignoring whatever prior visual resistance cues that may have appeared.
Another point to note is that those highs of 36-37 in the most recent VIX spikes only printed intraday for a short time before falling back down – and those days could have just as well printed intraday highs of 40 or 50 if there had been some really extreme panic in the options for several minutes. In other words, the specific intraday numbers have to be treated with a lot more flexibility than you’d normally treat the data on an equity chart.
2. Long term moving averages don’t matter. David Gaffen over at the excellent Wall Street Journal Marketbeat blog reported some comments last week that, in truth, were being repeated by nearly everyone:
The VIX closed at 22.36 Wednesday, the lowest close since December 2007 as investors reassess risk. Mr. Haslett says it would take “a tremendously bad group of earnings to really hit the market too badly” for volatility to spike again.
Not everyone is as sure, though. The economic situation remains fraught with peril and earnings season has started out with a handful of hiccups, and while the VIX has dipped below its 200-day moving average in the last few days, Credit Suisse strategists note that the index has struggled to stay below that average in the last year. [link]
The claim is that the 200-day moving average should act as a kind of support, such that any move below that average would be short-lived. In fairness, that average seems to have held on at least two recent occasions, and may do so again. But the movement of the VIX price above or below its 200DMA is not by itself a significant data point. Sure, a pronounced and sustained shift above or below that moving average may signal a secular change in investor sentiment, but that change would be easily visible both in the price action and in the world in general, with recourse to any technical indicators being somewhat superfluous.
While volatility indexes seem to be mean-reverting in the very short term, it may not be appropriate to expect long term moving averages to behave for the VIX in the ways that they behave for ordinary equities.
3. Correlation does not imply causation. This last example comes from an email newsletter recently issued by the Johnson Research Group:
Here are three technical points – both good and bad – to keep an eye on for a hint of the next directional move: CBOE Volatility Index (VIX): The VIX has been trying its hardest to break below the 22 level, a level of significant support. A move below this mark would fuel another round of buying in stocks. That said, the VIX’s failure to break below 22 by Friday should put the bulls back on guard for another decline. [link]
The claim that a VIX move below 22 would “fuel another round of buying in stocks” is just false. It is the fluctuations in the S&P 500 index (SPX) that “fuel” changes in the VIX, not the other way around. The fact that relatively lower VIX numbers correlate with rallies in equities by no means implies that a move lower in the VIX could in any way cause a stock rally.
And what’s more: it’s not all that unusual for the VIX and the SPX to fail to correlate. On Friday, April 11, 2008, the SPX dropped 27 points and the Dow Jones Industrials fell 256 points. Yet the VIX only rose by a point and a half, a decidedly lackluster response by any account. These instances of non-correlation have become so common that they are no longer that surprising.
To conclude, the volatility indexes are very helpful, in conjunction with other indicators, for assessing market sentiment, and perhaps even for generating very short-term trading signals. But trying to apply traditional technical analysis to these unusual products is likely to produce a lot of false or at least unhelpful conclusions.