In theory, technical analysis should work on just about anything with a price driven by supply and demand. Stocks, bonds, commodities, currencies, real estate, crypto – you name it. Remember, technical analysis deals with analyzing the behavior of market participants. It can help you spot trends and patterns. It tells you who’s in control and when their reign has ended. It helps identify low-risk entries and obvious exit points.
But what about using it on implied volatility? Does it work the same way?
Yes and no.
What the VIX Measures
Since the VIX is the most popular index measuring implied volatility, let’s focus on it. It’s easier to understand what technical analysis tools work and don’t work on the VIX if you first understand what it measures. There are two ways I like to explain it.
First, the VIX reflects demand for one-month S&P 500 Index options. When demand for options rises and premiums inflate, the VIX rises. When demand for options falls and premiums deflate, the VIX falls.
Second, the VIX is a volatility gauge reflecting how much movement is expected in the market. When investors expect more movement, the VIX rises and vice versa.
The price of most assets can theoretically rise indefinitely. At the same time, most assets can fall to zero or worse (see oil in 2020!). But the VIX is a curious case. Theoretically, there is no ceiling or floor. But in practice, there is. The VIX is unlikely to rise and stay above 32. And it’s even more unlikely to fall and stay below 10.
Here’s why.
Extremely high periods of market volatility are temporary. Sure, a bear market or crash can send the VIX into orbit, but sooner than later, cooler heads prevail, and the market settles down. That causes the VIX to drop back down to Earth. So you can’t draw a trendline on the VIX when it’s rising and assume it will continue. You know it’s transitory!
Here’s another way to think about it. A VIX of 32 corresponds with 2% daily moves in the market. A VIX of 48 corresponds with 3% daily moves. A VIX of 64 corresponds with 4% daily moves. The reason the VIX won’t spike to 64 and stay there for any length of time is that the S&P 500 can’t continually move 4% a day. Cooler heads eventually prevail, things settle down, and the VIX retreats to lower levels as the market returns to normal. It happens EVERY SINGLE TIME.
The same reasoning applies to a low VIX. A VIX of 16 corresponds with 1% daily moves in the S&P 500, and a VIX of 8 corresponds with 0.5% daily moves in the S&P 500. There’s a theoretical floor in the VIX above zero because the stock market won’t stop moving. Sometimes it gets quiet, really quiet. Low volatility periods can drive the VIX into the single digits. But it rarely stays there because options traders aren’t idiots – at least not in aggregate:). They know that eventually, something will spook the market, causing volatility – and thus the VIX – to rise from the basement.
Throw it all together, and it makes sense that the VIX mean-reverts.
Key Takeaway
The best technical analysis indicators and tools for the VIX play well with mean reversion (think bollinger bands). The worst indicators to use on the VIX are trend-following ones (think moving averages).
Want More? Here are a half dozen other articles I’ve written on the VIX:
All Hail the Great & Powerful VIX
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