Wednesday, October 22, 2008

Stretched VXO Not Bearish

A common misconception among traders is that an extremely low VIX or VXO compared to its short-term moving average has bearish consequences. On Tuesday the VXO closed over 15% below its 10-day ma for the 2nd day in a row. Below is a test that shows results of shorting the SPX when the VXO is stretched below certain levels for at least 2 days in a row. It covers once there has been a reversion to the short-term mean:

The system as designed shows a slight edge when there is a mild VXO stretch. As the stretch gets larger the edge disappears. To understand why this occurs, consider what would cause the VXO to get extremely stretched, as opposed to slightly stretched. A mild stretch might be the result of a typical move higher in the market. An extreme stretch is more likely to be the results of a strong thrust higher in the market. If the market is truly strong, then the result will be more upside – not downside.

When trading below the 200-day moving average the difference is even more pronounced.

Here we see the mild stretches have more bearish implications. A drift higher in a downtrending market can offer short opportunities. A strong move higher, on the other hand, can lead to a vicious short-covering rally – not something you normally want to step in front of with short trades.

I used some other studies back in May to illustrate these concepts as well.

There are indicators suggesting short-term downside, such as the volume study I posted yesterday. The extremely low VXO is NOT suggestive of a selloff, though.

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