Option Watch: Sept 16, The VIX Stretch
September 16, 2008
It’s been a historic week on Wall Street. A well-documented financial crisis’ spearheaded by Lehman’s (LEH) Chapter 11, Merrill’s (MER) quick run to the corporate altar with BofA (BAC) and a $40.0B plea by the world’s largest insurer AIG (AIG), which has escalated into a potential Fed-backed bailout have made for volatile conditions and equally mesmerizing headlines worthy of the worst of times and, potentially, better times to come.
To think we’re not even halfway home to Friday and expiration… Well, that’s not exactly true for all bulls, bears and hedge hogs as Lehman’s essentially worthless stock paper are a testament. For most of us though, there are still plenty of opportunities available in the stock and options market, which ultimately, will still be around when the dust settles and a more confident investor returns once more. It’s hard to fathom right now, but it will happen as it always does.
One of the best “technical tells” which I know of that points to an obviously panicked investor and a situation that, despite the gravity of it all, has been likely overplayed, comes to us from the CBOE Volatility Index ($VIX). Below, we’re looking at an annotated daily chart of the “VIX”, which spells out to astute traders, not an uptrend, but a mean-reverting instrument that’s currently stretched.
The tool which I use and coined the “VIX Stretch” isn’t original material, but why re-invent a wheel which works consistently? The VIX Stretch generates a potential signal of the broader market (typically the S&P500) at extremes when the VIX reaches a price 15% removed from its 10-day simple moving average. “Removed” means the signal can work during times of both complacency, when the VIX is 15% or more below its 10-DSMA or like our current situation, when price is stretched above the moving average. Tuesday’s terrible highs were a full 32% above the short-term trend-line, before establishing a reversal candle i.e. gravestone doji.
Figure 1: CBOE Volatility Index ($VIX)
Market volatility could always trend higher, which it already has over the past year and a half. However, that doesn’t take away from this short-term tool which works on the principle of mean reversion and to which the VIX is a slave. This strategy can also work as a longer-term signal, when conditions are truly extreme,to which this corner can appreciate as being one of those potential times.
Also emphasizing the VIX Stretch as being in play for those looking to bargain hunt is a couple of other signs worthy of some consideration. First, with the body of the VIX fully outside of the upper Bollinger Band, we have additional confirmation of the severity of the market’s sell-off. Both January and March, saw very similar price action in the VIX and in front of what become very playable lows in the market. For its part, the July low in the broader market registered a VIX Stretch, but the price action remained within the Bollinger and ultimately, registered a weaker signal.
Additionally, a comparable chaotic and volatile environment in keeping with our other recent bottoms, as well as many market bottoms, means the worst for most stocks, could very well be behind us in the near-term. Finally, the broader market as represented by the S&P500 (SPY) has undercut, not only its July lows (sorry, Dr. Cramer), but also its year-to-date bottom. And personally, that’s another deserved event worthy of the “MOOyah!” and not the proverbial “BOOyah!”
So, how does one play a VIX Stretch signal? Large caps, which have betas in excess of one (i.e. more volatile than the market and which have been commensurately punished) are one logical group that traders might pursue. Traders will want to design a strategy which should receive the benefit of being correct about elevated implieds likely to decrease in the short-term. Also, the position should profit as the stock in question finds higher prices. Bull verticals are certainly capable of this type positioning. And for more advanced traders, a strategy such as the broken wing fly can certainly benefit nicely from the siphoning of risk premiums and higher prices.
One caveat to using individual stocks, even if currently highly correlated to the market, is company specific risk. Traders should always be aware of whether earnings and / or a scheduled company event such as product announcement or FDA results are imminent. If the stock happens to fall into the category of potential financial shrapnel, I’d also pass on any positioning, as the VIX Stretch rule book is essentially thrown out the window.
The reason for passing on a stock which shows any of the above possibilities is our work using the VIX and the broader market’s own pin action, are potentially much less instrumental in helping a position. To which, if you want to find the next flight to safety equity vehicle before investors don the bull goggles, Mr. Market i.e. the SPY, shouldn’t be forgotten, as it makes for the ultimate choice.
Chris Tyler
Staff Writer & Options Strategist
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The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.
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