The VIX Spike is a Self Fullfilling Prophecy

All you hear traders talk about these days is how they want to see the VIX spike before they proclaim a short term bottom is in the market.

Not too long ago, the VIX (Volatility Index) used to be the privy of a fairly limited group of options traders - those that had the ears to hear, as it were.  Now, if you hear or read phrases like “bear market,” “20% decline,” and “market bottom,” odds are that the phrase “VIX spike” isn’t far behind.  Nevermind whether the increased VIX coverage is appropriate or accurate or remotely helpful.  Thanks, CNBC!

The net effect of the VIX’s coming of age is that everybody and his brother now “knows” that we won’t have a short-term tradeable market bottom until the VIX spikes up into the 30 range; a self-fullfilling prophecy?  Well, that claim may have held true in the recent past, but it denotes a more complex relationship than people seem to realize.

So what’s the relationship between VIX spikes and market bottoms?  Three schools of thought here, most easily viewed in modal terms:

1. Necessity: a VIX spike is necessary for a short-term (1-3 month) market bottom to form.  This sure seems to be the consensus view these days.  Every blogger under the sun is writing that indexes won’t find a bottom until we see “a spike in the volatility index (VIX) followed by massive capitulation.”  But it isn’t just individual traders who are taking this view: when you have analysts like Ryan Detrick suggesting to the Wall Street Journal, “It doesn’t have to top 30, but it does have to spike,” it’s no wonder people are insisting on some impressive upward move on their VIX charts.  Some of the VIX coverage these days is so watered down, it might as well be done on a flannel board.
    
2. Probability: a VIX spike is suggestive of a short-term market bottom, and such a bottom may be less likely without a corresponding panic. In his Barron’s column this weekend, Larry Mcmillan only just barely put himself in this camp (rather than in the Necessity camp).  He spends most of the column trying to debunk all the reasons others have given for why we could see widespread panic but not see that panic reflected in the VIX.  His conclusion is that, no matter what else happens, people will eventually freak out and buy SPX puts: “This market decline probably will end as all others have — with traders panicking and the VIX spiking upward.”  Plenty of other credible sources (Brett Steenbarger, for example) seem to have roughly the same view: maybe we can move higher without some dramatic VIX-y capitulation, but it sure doesn’t seem likely.
    
3. Possibility: a VIX spike is suggestive of a short-term market bottom, but there’s no reason to lean so heavily on this one metric.  This isn’t nearly as sexy a view, and advocating a wider, more cautious, and more nuanced approach to causal claims obviously isn’t going to get you on television.  But the VIX wasn’t actually created to provide swing traders with buy signals, believe it or not.  Jason Goepfert of SentimenTrader mentions in a note this morning that neither put volume nor implied volatility spikes are required for markets to bottom.  

   We would fall squarely in the third group, for several reasons.  Despite McMillan’s reservations, the trend is squarely in favor of traders using hedging products in addition to (or even instead of) SPX puts, which would loosen the oft-touted correlation between the VIX and investor fear.  Second, remember that a key component of VIX spikes has been sudden and surprising broad market selloffs; but it’s just not possible to characterize this bear market as a surprise, and we wonder whether any bad news (short of Israel invading one of its neighbors, perhaps) would come as a genuine surprise in this climate.  Finally, there are always reasons that markets can rise without first undergoing some cathartic panic; right now, equities seem to have been depressed somewhat artificially by an overextended rally in commodities, such that any retreat in crude oil prices can easily spark a market rally.

The bottom line is that the VIX is just one of many valuable sentiment indicators, and traders shouldn’t focus unduly on any one tool.