Weekly ETF SPY: Is The VIX Already Stretched Too Far?

The VIX has rallied more than 30% in 2 days. This VIX move is in harmony with VIX seasonality. How much up side potential is left after such a huge move and what are the odds of further gains?

On February 14, we took a closer look at VIX seasonality. The featured VIX seasonality chart is one of the most unique VIX research tools. It predicted a VIX spike in late February.

The February 14 article pointed out that: “The average February to March VIX spike is less than 10%. Obviously, there’s more potential upside in 2013 as the debt and deficit ceiling quandary has the potential to springboard the VIX from its 73-month low.”

From low to high the VIX jumped 31.57% the last two days (Tuesday – Thursday). Now what?

Yesterday’s strong follow through pushed the VIX above the upper Bollinger Band. A close above the upper Bollinger Band is generally an indication of an overbought condition.

Obviously the tight VIX trading range has compressed the Bollinger Bands and narrowed the spread between the upper and lower band. This may lessen the effect of this signal, but it shouldn’t be ignored.

On February 4, the VIX also closed above the upper Bollinger Band (black arrow on the chart). The VIX was back below it the next day and the S&P closed at 1,511. The close below the upper Bollinger Band was a VIX sell signal (buy signal for stocks).

From there on the VIX almost declined 10% while the S&P 500 rallied as much as 20 points.

Yes, those aren’t huge moves, but small trading profits pile up too over time. More importantly, the Bollinger Band provides a stop-loss guideline for VIX long position (i.e. VIX calls or VIX ETFs like VXX or TVIX).

How so? A close back below the upper Bollinger Band usually means that the VIX spike is ready to pause (or already over). It might be time to ‘eat your ice cream before it melts.’ In other words, lock in gains.

In rare instances the VIX will “climb up the Bollinger Band” (an expression coined by one of my subscribers). This usually coincides with a waterfall decline in equities.

Unless the major averages drop below nearby key support, such an event is rather unlikely.

VIX Seasonality Suggests Higher Readings

The VIX is back to 2007 levels and actively defying the contrarian implications of extra low VIX readings. Will the VIX drop much further? A look at VIX seasonality provides some clues.

When complacency reigns, investors get wet or at least so goes the saying. The CBOE Volatility Index (VIX) has been trading below 15 for all of 2013, but the only ones getting ‘wet’ are VIX bulls and stock bears.

Still, the VIX is at a 73-month low and eventually there’s some money to be made buying VIX calls or long VIX ETFs. When will that be? VIX seasonality provides some clues.

VIX Seasonality

The first chart provides a visual of VIX seasonality based on data from 1990 – 2012. A devisor has been used to equally weigh each years’ performance.

In an average year, the VIX has seasonal lows in early and late February before spiking to an early March high. This would provide a short window for a seasonal move higher.

The average February to March VIX spike is less than 10%. Obviously, there’s more potential upside in 2013 as the debt and deficit ceiling quandary has the potential to springboard the VIX from its 73-month low.

However, the VIX seasonality chart suggests to eat your ice cream before it melts. In other words, locking in any gains (or carefully managing any gains) before the early-March seasonal high is prudent.

S&P 500 Seasonality

Most of the time there’s an inverse correlation between the VIX and the S&P 500. When the VIX goes down, stocks go up and vice versa.

Does S&P 500 seasonality confirm VIX seasonality? It would in a perfect world, but investing is about odds, not perfection.

The second chart plots overall S&P seasonality (1950 – 2012) and post election year seasonality against VIX seasonality. VIX seasonality (blue line) is inverted for easier comparison of trends.

The dashed red lines mark three trends that line up. One is a mild early-to mid February sell signal (sell signal for stocks, not VIX) followed by a weak late June buy signal and a strong October buy signal.

S&P seasonality also suggests that any February correction may be short-lived.

Seasonality charts capture the general trends of more than six decades and averaging of trends eliminates a lot of ‘seasonal noise’ along with potential setups.

Nevertheless, when seasonality agrees with other indicators (like sentiment, technicals, fundamentals) we get a stronger signal. This could be the case right now.

Long VIX ETPs include the iPath S&P 500 Short-Term Futures ETN (VXX) and VelocityShares Daily 2x VIX Short Term ETN (TVIX).

Short S&P 500 ETFs include the Short S&P 500 ProShares (SH) and UltraShort S&P 500 ProShares (SDS).