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Is a Fearless Stock Market Cause for Concern?

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8/14/2013
Chad Karnes, Chief Market Strategist 
 
Is the VIX flashing a warning sign of trouble ahead for stocks?

Before the mid 2000’s, the market relied on the VXO (CHICAGOOPTIONS:^VXO), which measured volatility of the S&P 100 options (CHICAGOOPTIONS:^OEX) to gauge fear.  This indicator is still around, but less popular than the VIX which focuses on the S&P 500.  The Nasdaq 100 also has its own volatility index, the VXN (CHICAGOOPTIONS:^VXN)

The VIX indicator is one of the tools used to gauge fear. By measuring the implied volatility of the S&P 500 index options, the VIX tells us the market’s expected volatility over the next 30 days.  When the VIX (CHICAGOOPTIONS:^VIX) rises, expected volatility of the S&P 500 index (SNP:^GSPC) rises, and when the VIX falls, expected volatility of the index also falls.  Often a rise in the VIX corresponds to a fall in the S&P 500 as volatility is associated with falling markets more than rising markets.  

Tricks with the VIX

The VIX typically performs opposite of the S&P 500 and bottoms when the markets are topping and tops when the markets are bottoming.  This is shown below with a standard long-term chart of the VIX index compared to the S&P 500. 

 




But, having the VIX and the S&P inversely correlated with one bottoming while the other is topping out can be confusing and counter-intuitive.  Luckily, we can look at the VIX differently.

The VIX Flip

One way to analyze negatively correlated assets such as the S&P (NYSEARCA:SPY) and VIX is to invert one of them.  To do this we simply make the VIX a fraction by dividing it by one and then plotting it alongside the market.  The chart below provided in our ETF Technical Forecast on 07/31 and updated through today shows that result and findings, the flipped VIX. 


This chart now allows the VIX to move in the same direction as the S&P to better compare them apples to apples. 

What is the Flipped VIX Telling Us?

The S&P is shown in red and the inverted VIX in black.  It is easier to see on the “flipped” chart how the inverse VIX's tops and bottoms typically follow alongside the S&P’s very closely.    

Using these techniques helped us see some great VIX buying opportunities one of which we outlined for subscribers in our June Profit Strategy Newsletter on 5/24 with the VIX below the 15 level where we wrote, “we now recommend buying VIX JUL 13 calls at $370.” 

On 6/24 the VIX shot up to 20, our VIX JUL 13 calls soared to $680 and we advised taking profits of 84% on half the position.  We closed the rest on 7/5 for a combined return of 55%.

Shown by the black dashed trendlines in the “flipped” chart above, the inverse VIX was not making new highs in May, even though the market was.  This is called divergence and is a sign the VIX was showing relative strength and a better candidate to hedge your portfolio than outright shorting the market.  It also was a warning sign that the markets indeed were about to pullback, which they did.

A similar formation is occurring once again as the S&P makes new highs but the VIX does not make new lows.  This is shown by the above chart of the inverse VIX.  In black, it is not making new highs above its March levels, although the S&P in red is. 

WATCH: Why the VIX is the Go-to Fear Indicator

The VIX is likely warning that the risks to bulls is now elevated, just as it was at the March, April, and May price peaks, just before the VIX rallied significantly. 

Once I see a confirmed trend change on the VIX, it will likely again be time to buy VIX calls for a high probability trade setup.  The expectation would be another VIX rally to at least the upper teens from its current price around 13.

VIX linked ETPs include the ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY), the ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY), and the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY).  Leveraged and VIX ETPs have many risks associated with them which is why we prefer the purer VIX play of call and put options. (Read "Revisiting the Good, the Bad, and the Ugly of VIX Trading.")

Tools like the flipped VIX can help us to identify key inflection points in the market and trends for profiting that otherwise are missed with traditional analytical tools. The ETF Profit Strategy Newsletter and Technical Forecast tracks the VIX along with other major asset classes to locate high probability trading setups every Sunday and Wednesday evening.

Follow us on Twitter @ ETFguide

CommentsAdd Comment

jersey guy said on August 14, 2013
  Last sentence, I meant to say: "This match can be delayed, but not postpone indefinitely......"
 
 
jersey guy said on August 14, 2013
  Hello grant8 - Just a student of history, I am not a political scientist.
Last time around the Israelis wanted a date certain or a redline drawn to when the USA would take action against Iran. That did not happen.

Netanyahu this time around will demand a date certain from the USA. The fact that this has had little media coverage, tells me its very serious. There was one report about this on FOX News, but the reporting died down after that.....The Arab Spring has turned out to be an excuse for the Hatfields (Shiite) and the McCoys (Sunni) to fight it out throughout the region (ie., Iraq, Syria, Egypt, Yemen, etc), that is why the USA has not gotten involved (eg., no troops on the ground). It would not surprise me if this spreads even further to other countries in the region.

The Israelis have the most to lose if there is an arms race between the Hatfields and McCoys and the USA knows it. This match can be delayed, but not postpone.
 
 
CARLOS said on August 14, 2013
  The Market Police (see Federal Reserve, SEC, CFTC, etc.) are always concerned about when asset prices go too low. Here's what they almost always invariably resort to: buying worthless assets, banning short selling of stocks, and other subversive methods.

On the other hand, the Market Police do nothing about when the market goes too high. Isn't it oddly sinister how they equate fast rising markets with "balance and orderliness" whereas fast falling markets are not? Clearly, they have their biases. And volatility free stock market is in the good interest of mankind. (chuckle, chuckle)
 
 
grant8 said on August 14, 2013
  Hi Jersey Guy,

You've really become the political scientist. The Middle East unrest has been with us for thousands of years and yes it's not getting better. And Israel doing a pre-emptive strike on Iran would only further the chaos. (iShares Israel ETF EIS is +4.28 ytd, I don't own it)

Oil at $200/barrel is a bold call. Are you long oil stocks or physical?

 
 
jersey guy said on August 14, 2013
  Just to put those comments into context, here is what I wrote earlier on another related story:

We coming up on the one year anniversary of Bibi Netanyahu speak to the UN about the Israeli RED Line, dated 27 Sep 2012. Iran has not stop developing more Nuclear materiel and they have apparently completed the so called dome of immunity (underground harden bunker).

Dont bluff and not be ready to be called by Iran.....Fed tappering could be linked to that politic event, since we know QE will push the global markets higher (if a war or a prolong attack is required by the USA). Taking out the Iranian Nuclear materiels will be a market moving event to the downside, as OIL will spike to $200/barrel or higher.

The Israelis will not sit by and watch Iran develop the A bomb, they will take action (with or without USA support). Lets recall that the ETF Guide once predicted that the markets would re-visit the 2009 lows again in the Monthly newsletter.
 
 
jersey guy said on August 14, 2013
  The FED has my back has been the Wall Street mantra for the last five years with QE infinity in place.

However, the Joint Chief of Staff is in Israel again this week and he wants to get assurances that there will be "NO" pre-emptive strike against Iran.

Here is the lanugage from that article:
Iran's nuclear program was at the center of discussions on Wednesday between US army chief General Martin Dempsey and Israeli Defense Minister Moshe Yaalon, public radio said.

"The Iranian regime is involved in all of the conflicts in the region," the radio quoted Yaalon as saying during talks in Tel Aviv with Dempsey which were also attended by Israeli armed forces chief of staff General Benny Gantz. Iran was also the focus of talks Dempsey held on Tuesday with Prime Minister Benjamin Netanyahu.

The radio said US military commander wanted to ensure Israel would not launch a pre-emptive strike against Iran's nuclear program, which Israel sees as geared towards developing an atomic warhead.


Here is a quote from that same article that talks about Iran's rhetoric about Palestinian peace talks:

Iran's supreme leader Ayatollah Ali Khamenei on Friday warned the Palestinians against renewed peace talks, saying they would be "detrimental" to their cause. Negotiations, warned Khamenei, would only "encourage the aggressors to increase their aggression and suppress the rightful resistance of the Palestinians."

 
 
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