VIX Surges, Uptrending. What Happens Next?

Volatility as measured by $VIX has made double digit percentage moves recently and has broken above its 50 day moving average. What might this mean for the market going forward?

After falling beneath its 50 day moving average in July 2010, $VIX has maintained a slow and steady downtrend. As volatility decreases, we expect stocks to trend upward, and that is indeed what has happened over the past 8 months.

On February 22nd, $VIX jumped over 26% and tacked on another 6% the following day. This surge vaulted the fear index firmly above its 50 day moving average. Since that day, the market has seen a minor correction and is continuing to consolidate.

Let’s take a look at what has happened in the past after $VIX has gained more than 20% in one day or has crossed above its 50 day moving average.

Rules:

• Buy SPY when $VIX  gains more than 20% in one day
• Buy SPY when $VIX crosses above its 50 day moving average
• Sell SPY X days later

All trades made at the close. No commissions or slippage is included. All SPY history was used.

Results:

Summary:

• There were 263 instances of the $VIX Cross above the 50 day Moving Average.
• There were 37 instances of the $VIX surging more than 20% in one day.

The graph shows (red line) that a one-day surge in $VIX has been bullish immediately after the event. As one would expect, the returns are volatile after such a surge. The near term performance (10 days out) tops out just above +1.5%, and then performance drops off sharply over days 11 – 23. In fact, this makes sense as a surge in volatility can signal that the market has been shaken awake from a low-volatility snooze fest. After the initial event is digested and any oversold conditions or technical concerns are worn away, the market tends to move back down as the fundamental picture emerges and is addressed.

The $VIX cross shows much less volatile returns, at least initially. Volatility does not present itself until roughly 35 days after the setup occurs. Looking at this setup on a chart, it appears that during a bull run, $VIX will trade beneath the MA50 for weeks at a time, and only surge above it on a market pullback. Thus, buying SPY after a $VIX cross above its own MA50 means that one will be buying dips and betting on volatility to mean-revert. This has been a good strategy over the years. In 2009, using this setup and selling 20 days after the buy resulted in gains greater than 60%.

Sometimes a picture is worth a thousand words. I figured I’d save myself 500 words and present a graph with arrows showing both setups. I adjusted the hold time for each trade to be 10 days.

Green up arrows show the buys and red down arrows show the sells.

What does it all mean?

On Friday, SPY closed pennies beneath the 20 day moving average. The bull run is certainly still intact. While a surge in volatility signals more volatility is ahead, it doesn’t seem to mean that the bull run is over. Both studies show that the SPY may shrug off this correction and get back to hitting new highs. An important caveat is that I did not include a surge in oil prices, nor did I include a revolution in the Middle-East. Either variable could have a significant effect on market performance going forward.

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