One of the biggest mistakes an investor can make is to expect a trend to cease just because it has been ongoing for some time. After all, as I have often noted in my weekly newsletter EPIC Insights markets will do what they want and those of us expecting a change based solely on the belief that patterns must eventually change are often left staring into space.
An example of this uncertainty is the performance of the CBOE Volatility Index (VIX). VIX is one of the most widely used measures of investor sentiment. Based on option prices, rising VIX is seen as an indication of fear because as investors become more cautious, they are willing to pay for put options to protect their portfolios. Conversely, falling VIX is seen as bullish. As investors become more optimistic, they eschew the need for downside protection and buy stocks.
Those who trade VIX take a variety of approaches. Going back to 1999, VIX has averaged 22-close to the current reading of 23. While the average is observable, the range is extremely wide. When risk was ignored in 2005 to 2007, VIX often traded below 13. When some feared the end of capitalism during the fall of 2008, VIX spiked to 80.
Given such a wide range, I have never been a believer in applying long-term mean reversion strategies to VIX. After all, someone who saw it rise from 10 in early 2007 to 30 in August 2008 would logically have predicted that the level would fall and elect to go short the index. Then VIX raced higher and remained above 30 for nearly a year. What was a well-reasoned mean reversion trade led to frustration and losses. Knowing this, instead of using a long-term approach, I would rather use short-term patterns to predict where VIX will be in a few months and position myself to profit from the expected move.
From my view, VIX has been caught in a persistent down-trending trading channel (black lines) that is now consolidating (green lines). While both of these events are easy to witness on a chart, determining the timing of the next move is more difficult. Since the down-trending channel extended six months, which is longer than I initially thought it would, our focus is now on the consolidation pattern. Having seen VIX remain in a tight range for the last three months, we should expect prices to finally move in a more directional manner and I believe that direction will be lower.
During the channel period, VIX broke above its upper trendline on multiple occasions (points 1 and 2). These breaks higher may have suggested the trend was reversing, but instead lower levels followed. Had each spike ended at a higher level than the preceding one, the evidence that the trend was reversing would have been clear. Instead, the opposite occurred.
Classic technical analysis tells us that a series of lower highs is bearish. Within the consolidation pattern, VIX made another two attempts to move higher (points 3 and 4). When these movements failed, the index registered additional lower highs, confirming my bearish thesis and indicating that when the current consolidation completes VIX will continue lower.
With the technical picture pointing to lower volatility, the fundamentals support this view as well. With market pushing higher, signs that the recession is ending, and people becoming more optimistic, VIX will drop. While some will correctly note that we could benefit from declining volatility by buying an index fund, I would rather bypass second derivative ideas and focus directly on the instrument being studied.
For the retail investor, trading VIX is somewhat complicated. Although there are ETNs that allow you to trade VIX, I am unimpressed with their correlation to short-term price movements. Instead, to profit from a decline, I will use VIX put options. Buying at-the-money puts for November offers great upside for a small initial investment. As always, we will keep our option positions small to provide us flexibility in the future. I recommend shorting VIX by purchasing a position in the VIX November 25 put (VIX+WE).