The following is an excerpt from an article written by Len Yates discussing the potential use of $VXX and $VIX36 as a tool which signals possible market tops and bottoms. For students of volatility based trading follow Len’s instruction and verify the method. For newcomers to the world of Options Trading access a free trial of OptionVue 6 from this web site and try it out. Questions may be sent to paul@options21.com.au
Kind Regards
Paul Wise.
“Now I would like to tell you what steps I take to view these two indicators within the OptionVue program and how to interpret them to detect signals of possible market tops and bottoms. If you have a few minutes, I think you should actually do this and see for yourself what we are talking about. (Note: You must be a subscriber to the QuoteVue service.)
1) Enter the symbols $VXX and $VIX36 into your Quotes Display.
2) Obtain complete price histories of the $VIX and $VIX36 by opening their price charts.
3) Open the $SPX price chart.
4) Click the button that opens the indicators window along the bottom of the chart. (It’s the third button to the left of the red X button.)
5) Click the button to the right of that button to open the Indicators Settings window.
6) Select the very bottom radio button — Relative strength. For Base Asset, enter $VXX. For Number of Periods, enter 4. Click OK.
Now you are able to view a smoothed $VXX value over history. Use the wand to see specific readings. All that matters is absolute levels. Notice that when the $VXX was high (i.e. at or above 2.50), it has signaled several important tops. For instance, scroll back to May 2008, see the $VXX at 3.50, and look at what the market did during the next eight weeks. It does not matter that the $VXX held its high level for only a few days. Once set in motion, the sell-off goes to completion. The $VXX can help you know when the bottom has been reached with a reading in the area of -3.50. However, when watching for a bottom, it is important not to smooth the $VXX, but rather readings. (To view history this way, go into the Indicators Settings window and change the number of periods to 1.)
By the way, you’ll notice that the VIX premium indicators were showing wildly negative numbers during the worst period of the crisis — from 9/12/08 to 12/05/08 — and were useless during that time. I do not know why this happened or if it could ever happen again.
Also, please realize that even though you selected the Relative Strength indicator, the program is not actually doing a relative strength analysis here. It is simply displaying the historical values of the $VXX or $VIX36. This was accomplished by programming OptionVue to recognize these two specific symbols and to behave differently when working with them.
What the $VXX does during the sell-off does not seem to matter much. It can swing between +1.50 and -1.50 and do all kinds of things, but these movements do not seem to be useful. In my experience, the only things that matter are when the $VIX makes (and holds for a few days) an extremely high level (signaling a top) or when the $VXX is at an extremely low level (signaling a bottom).
If you have time, change to looking at the $VIX36 and see that it also has value as an indicator and should be interpreted in much the same way.
The highest reliability kind of trade you can use with this information is simply to take a long term (i.e. approximately 8 weeks) short position and leave it on the whole time. If you try to jump out at certain times and back in at certain times, you might be able to achieve better returns, but you also may not.
I enjoy trying to play the daily moves, but I have to admit that I do not always succeed in enhancing my returns by doing so.
Having said that, I want to bring your attention to the remarkable “topping” signals that were recently given by the VIX premium indicators, first by the $VXX and then by the $VIX36.
The $VXX was seen to have readings in the area of +2.50 to +3.00 for several days between December 29th and January 8th. These are extremely high levels and match two similar instances back in 2008, both of which were followed by significant sell-offs lasting several weeks. The persistence of these high $VXX levels over a period of several days is also significant, in my opinion. Therefore the $VXX has given a definite signal to go short.
Following directly on the heels of that, the $VIX36 spiked to 11.65 on Jan 11, 2010. This is the highest level ever seen during the history of collecting this index (since August 2007). Such a high reading adds confirmation to the bearish signal from the $VXX.
And now we see that the market has actually begun to sell off. Thus we will be playing this for further downside until we see a signal from the $VXX that the selling is over.”
Len Yates, President of OptionVue Systems.