Monday, December 2, 2013

A Volatility Set Up For Trading SPX Into Year End

Volatility as measured by Vix spiked higher today for the first time in two months. There is a useful trade set up that is therefore worth noting.

One of the least interesting but most useful indicators in 2013 has been volatility.

Throughout 2013, Vix has been telling investors to stay long. When Vix is under 20, average monthly returns in SPX are 1.5% and returns are positive 77% of the time. In comparison, when Vix is 25-30, average monthly returns in SPX fall to just 0.2% and returns are positive only 52% of the time. The higher the Vix, the worse the returns. Details are here (post).

There were two prior periods like today when Vix was consistently below 20. Both lasted 4 years and are notable for having infrequent and shallow (5%) corrections.  Coincidentally, the prior periods were 1993-1997 and 2003-2007. Is this a 10 year cycle starting with years ending in '3'? Details are here (post).

A more frequently useful way to use Vix is to trade long equities when a volatility spike fades. Specifically, the set up is note when Vix has closed above its upper Bollinger Band and then to go long SPX after Vix has closed back below its Bollinger Band in the coming days.

We are noting this because today Vix closed above its upper Bollinger Band for the first time in almost two months.

Below are examples of this set up from 2012: the top panel is SPX, the middle panel is Vix and the bottom panel tracks closes above and below the upper Bollinger Band. The vertical green lines are signals to go long.

This set up is specifically for a short-term trade (1-3 days) although it has clearly worked for longer periods.

The requirement to wait for volatility to fade is specifically to avoid the buzz saw from a prolonged volatility spike like in August 2011 that sent SPX down 19% in a matter of weeks.

In the past year, there has been a specific pattern to volatility.

Starting in December 2012, there has been a volatility spike every other month (all even numbered, i.e., February, April, June, August, October). The pattern, moreover, has involved two (sometimes three) separate volatility spikes over a period of a week or so. Vix will close above, then below, its upper Bollinger Band each time. The second volatility fade (second green line) has been a great signal to go long for more that a few days (circles).

Today was the first close above the Bollinger Band for Vix since early October. The first fade below might be a good day trade. A second volatility spike and fade within a week or so, especially if accompanied by a fall in SPX and a sharp rise in put-call ratios, would likely be a kick off for a year end rally.