Things to Know About Volatility and Why VIX Signals Work

Things to Know About Volatility and Why VIX Signals Work
The VIX Measures FEAR     High VIX readings mean that fear is also high, whereas low VIX readings mean that fear is low.  Backtesting various VIX reversal signals has proven that the VIX can be used to predict market direction about 60 to 70% of the time, the more VIX signals the better.  What this means is that when the VIX is at an extreme (meaning everyone thinks the market will continue in that direction), a top or bottom is usually in place and what usually happens is the market reverses in the opposite direction. Volatility (VIX) Tends to Trend     This means that if the VIX rises today, it has a higher than average chance of rising tomorrow.  This is even more significant at market extremes and right before market reversals. The VIX is Dynamic    What this means is that you can not predict market direction simply by the level of the VIX.  In the past, many traders simply bought the market when the VIX goes above 30 and sold the market when it traded down to 20.   Because the VIX and volatility is constantly changing this strategy simply doesn't work.  Now, more than ever, it is the relative level of the VIX that is important, not the absolute value. Volatility is Mean Reverting     This means that periods of high volatility will be followed by periods of low volatility.  This was academically proven over 50 years ago and is one of many market truths.  This is important because when the VIX has a low reading and begins to revert to its mean, it is also accompanied by a market that begins to sell off.  It is the same for when the VIX has a high reading and changes direction, this typically is accompanied by a market that begins to rally. VIX Reversal Signals	What is the VIX? The VIX is a measurement of the implied volatility of the at the money OEX Index Options.  Markets Rise When High VIX readings usually happen after markets go through sharp sell offs and when fear is rampant. During these times, sharp upside reversals often occur. Markets Fall When Low VIX readings usually occur when the market rises.  This tends to show that complacency exists in the minds of most market participants and a sell off is near.
There have been many books written about the VIX and signals have been developed that help traders pinpoint when the market is most likely to reverse.  What all of these signals have in common is that they use various means to determine when the VIX is at an extreme and either reversing or about to reverse.  While historically these individual VIX Signals have worked 60 to 70% of the time, that is no longer the case in today's market.  Why is this?  Because EVERYBODY knows about them and is watching them.  Whenever a system or strategy becomes known to too many people, it often fails to live up to the results it once had.  However, that being said, when multiple VIX Signal are generated, there is still a very high probability of the market reversing.