VIX Bounces S&P 500

Adam Hamilton     August 9, 2002     2875 Words


An old investing proverb bearing great wisdom that we all should carefully heed warns investors and speculators of the five most dangerous words ever uttered about the markets, “This time it is different.”


Among the most important strategic investing wisdom ever, the proverb simply states that nothing ever changes in investment and speculation.  A NASDAQ bubble enthusiast of early 2000 would have felt perfectly at home in the US in 1929, England or France in 1720, or Holland in 1637.  Time ebbs and flows, but the markets, and the primary forces driving them, never change.


Even the ancients possessed this timeless truth, as three millennia ago Israeli King Solomon wrote in his magnificent book of wisdom now known as Ecclesiastes in the Bible that, “There is nothing new under the sun.”  Whenever folks start talking about a “New Era” again, you can be sure that yet another speculative mania is upon us.


While believing that this time is different is exceedingly dangerous for investors and speculators, I may have finally stumbled across the three most dangerous words for an analyst to utter.  I now suspect they might be “Bear Market Rally.”


In my “Trading Volatility Bottoms” essay last week and in the August 2002 issue of our private Zeal Intelligence newsletter before that, I have been discussing volatility and its application in discerning short-term tradable bounces, or bear market rallies.  Even in the midst of brutal supercycle post-bubble busts there are periodic countertrend rallies, some amazingly strong and violent, that are fully tradable on the long side.


Even when the ultimate long-term secular bottoms of Great Bears are nowhere in sight, occasionally it makes sense to close short positions, take out some longs, and ride the irrational exuberance wave up for a few weeks or months.  Prudent speculators can make money both ways in bear markets, first on the primary long-term downtrend, and second by scalping short-term countertrend bear market rallies when appropriate.


Surprisingly, I have learned that the words “bear market rally” make a lot of folks really unhappy.  The hardcore equity bears, a camp in which I have found myself merrily sojourning in recent years, don’t want to wait a month or two for their shorts to start rocketing in value again, so they get upset at the bear market rally concept.


The perma-bulls, shell-shocked from the sickening and seemingly endless Great Bear mauling, are frantically searching for the final, long-term, super-duper, ultimate secular bottom.  They don’t want anything to do with the idea of merely a short-term explosive bear market rally in US equities if it is going to soon collapse and crumble to nauseating new lows.


Since I started talking about the high probability of the birth of yet another bear market rally just two weeks ago, I can’t count the number of folks who have told me that I am nuts, some politely and some viciously.  If I had an ounce of gold for everyone my recent bear market rally prognostication has upset, I could probably start my own central bank!  I guess bear market rallies have no friends, at least not until they have almost run their full course and are nearing exhaustion.


Nevertheless, the grand strategic goal of Zeal Research is to successfully trade the markets, fattening the portfolios of our clients and ourselves.  We are quite happy to ride any trend, whether we are feasting on the carcasses of a herd of freshly slaughtered bulls in the midst of a Great Bear market desert, or running with the bulls themselves in greener meadows when their enthusiasm waxes ecstatic. 


It makes no difference to us which way the markets are heading, we just want to know early so we can saddle the trend and try for a full 8 second bull or bear ride!


While last week I discussed using a moving average of intraday volatility as a short-term bounce point indicator, this week I would like to discuss one of the most rock-solid and reliable short-term trading tools in existence.  It is exceedingly easy to use, freely available on any financial website with market quotes, and has a nearly perfect track record when at its extremes. 


It never ceases to amaze me just how few mainstream investors bother to consistently follow it, yet many elite traders swear by its message.  Its lessons are unambiguous and it can yield potentially legendary profits if traded properly.  It is known as the VIX (pronounced “vicks”).


The VIX is known by its proper name as the OEX Volatility Index.  It measures the implied volatility in the prices of a basket of options on the S&P 100 index (symbol OEX).  The S&P 100 is a subset of the elite S&P 500 and tracks the largest and most liquid mega-caps in the index on which thriving options markets are maintained.


While the VIX, as I mentioned last week, is only concerned with a relatively narrow basket of US stocks, they are among the largest companies on earth and the pillars of the flagship S&P 500 equity index.  If your volatility studies are limited to only 100 US companies, the biggest and best in the S&P 100 are definitely the ones to follow.


In addition the VIX, unlike the 25-day moving average of intraday volatility I discussed last week, does not require a huge pile of raw data and lots of potentially tedious number crunching to figure out.  The real-time VIX level is available all day long from most market quote services.


Why does the VIX work so well?  The principles behind its success are very simple.  It measures implied volatility, and volatility itself is nearly a perfect proxy for general equity investor fear.  Here are some thoughts from my essay of last Friday on volatility studies in general…


“While long-term equity prices are driven almost exclusively by core fundamentals such as earnings and valuation, short-term prices are subject to the fickle whims of investor psychology.  Greed and fear have infinitely more influence on short-term market action than the strategic fundamentals that truly matter.”


“Greed and fear, while equally powerful emotions, are asymmetrical in the way they influence market behavior.  Greed develops and festers slowly, over many months or years, as one investor at a time gradually realizes that someone out there is getting rich in the markets so he or she decides that there is no reason why they can’t do the same.  Greed takes a long time to wax ecstatic and come to a boiling point among a large population of investors.”


“Fear, on the other hand, often strikes the whole herd of investors at once out of the blue like a bolt of lightning.  Some unforeseen bad news explodes onto the scene, or prices drop rapidly, and, like a flock of sheep, the chilling specter of fear leads to sudden mass selling movements.  There is not often a long gestation period for naked fear, it can rear up rather quickly.”


“It is this dark fear welling up deep within investors’ and speculators’ hearts that leads to volatility extremes, huge spikes in volatility accurately flagging interim selling climaxes.”


The VIX works because it measures spikes in implied volatility coinciding with extreme investor fear, which almost always signal a short-term market bottom, or bear market rally bounce point.  Following the classic contrarian investment strategy of buying low and selling high, the absolute best time to buy is when everyone else is terrified, when the VIX explodes.  It is a tough internal emotional battle to consistently pull this off, but the immense rewards are well worth the effort.


Our graphs this week simply compare the S&P 500 to the VIX.  The ultimate US equity index is graphed in blue and slaved to the left axes.  The VIX is graphed in red and calls the right axes its home.  First, as usual, is a long-term overview graph to show the key S&P 500 and VIX relationship in proper strategic context.



The first important attribute of this graph to note is the historical range in which the VIX has traded recently.  Since 1997, for almost six years, the VIX has generally bounced around between 20 on the low side and 50 on the high side.  As the VIX simply quantifies implied options volatility on the S&P 100 index, a low value generally means calm, sedate markets and a high value means violent markets plagued with breathtaking and chaotic volatility.


Remember that investor psychology, greed and fear, are the primary drivers of short-term equity market movements. 


When the majority of investors are wallowing in the comforting mud hole of naked greed, they tend to grow complacent.  Think back about the average NASDAQ investor in late 1999 and early 2000.  They figured they were the smartest investors in the history of the world and they were absolutely convinced that the US markets would rise 50%+ a year forever and that every investor could retire with immense wealth in the not-too-distant future. 


When greed and complacency abound, volatility tends to decay dramatically as no news, good or bad, can alter the indifferent worldview greed breeds.  We should expect the VIX to scrape its lowest depths during these indifferent greedy periods of market history, around a VIX level near 20 since 1997.


Fear, on the other hand, is a vastly more sudden emotion than greed.  When investors get scared, they want to sell right now and salvage the remainder of their capital as soon as possible.  They shoot first and ask questions later when they are really spooked.  During these panicky times, market volatility abounds and the VIX rockets up to extreme heights, approaching 50 since 1997.


Among all Warren Buffett’s countless utterly brilliant quotes, one in particular is among my all-time favorites.  Mr. Buffet said, “Be brave when others are afraid, and afraid when others are brave.”


Buffett’s awesome wisdom is the very key to contrarian investing!  Be brave and buy when chilling fear abounds, when there is blood running in the streets and everyone is terrified!  Be afraid and sell when greed runs rampant and everyone thinks the markets are heading to the moon, get out while the getting is good!


Enter the wondrous VIX, an amazing tailor-made volatility index that provides an outstanding empirical proxy of general investor sentiment, of popular greed and fear in the equity markets.  Others are afraid when the VIX approaches 50, marked with the green bar above, and that is when contrarians should consider buying like crazy.  Others are brave when the VIX approaches 20, marked with the red bar above, and that is when contrarians should consider selling with reckless abandon.


Zooming in on the last three years or so, we can actually easily see and even quantify the immense success in trading the US equity markets solely on the basis of the VIX, which is quite probably the ultimate short-term trading indicator at this moment in history.



OK, one simple rule to remember.  Go long the US markets when the VIX approaches 50, go short the US markets when the VIX approaches 20.  Piece of cake right?


Since 2000, this single morsel of market wisdom has yielded enormous profits for prudent contrarian speculators.  As the graph above shows, buying on VIX spikes and selling on VIX troughs has yielded some pretty stellar entry and exit points.  The profits shown above are S&P 500 index profits measured from the exact days of VIX tops to VIX bottoms and vice versa.  The VIX didn’t catch the interim highs and lows in the S&P 500 perfectly, but it was pretty darned close!


The VIX has only approached 50 twice in the graph above, and the first time, at the post-9/11 market lows, flagged a perfect long entry point for an excellent bear market rally.  If you went long the S&P 500 on the day of the September 20th, 2001 VIX spike to 49, you could have earned a 16.3% return by selling at the VIX bottom of 19 on March 27th, 2002.


Time warping back to March 22nd, 2001, the VIX approached 40, not quite our ideal 50 target, but this still would have been a tradable rally since it was indeed a characteristic VIX extreme volatility spike similar to others seen in recent years.  While not as crystal clear as the 50-ish monsters, the lesser 40 spikes are also tradable.  You could have made 10.7% going long on the VIX 40 and selling at the next VIX trough, 20 on July 2nd, 2001.


Average long side profits trading the high VIX extremes ran 13.5% in the past few years, not too shabby for quick trades with a few month time horizon.  As one would expect, however, in a massive secular bear market in the midst of a supercycle bubble bust, the greatest profit opportunities are not on the small countertrend bear market rallies but on the primary bear downtrend.


The VIX has flagged three fantastic short opportunities since 2000, with the index approaching or piercing 20 each time, indicating extreme greed and indifference.  If you would have sold short the S&P 500 at the VIX trough lows and covered at the subsequent VIX spike tops, fat profits of 26.2%, 20.4%, and 30.3% could have been earned. 


The average gain in selling the S&P 500 short after the VIX fell to 20 have run 25.6% in the past few years, about twice as high as riding the periodic bear market rallies.  You can certainly earn both sets of profits though, playing the VIX both ways!


Obviously hindsight is 20/20 and it is impossible to know real-time, when the events actually transpired, exactly when the VIX would carve its actual interim high or low.  Interestingly, however, hitting the exact VIX extremes on your trades doesn’t really matter.  Even if you sold short when the VIX hit 25 but it later fell to 18, and then you covered your shorts when the VIX hit 40 even though it later broke 50, you still reaped immense profits.


The game here is not to magically and miraculously catch entire moves foretold by the VIX, but to get your capital deployed so you manage to ride 80%+ of each major VIX swing, either long or short. 


If you scroll back up to the first graph above you will find a small inset box that zooms in on the huge VIX spike marking the 1998 stock market lows spawned by the Long-Term Capital Management derivatives crisis.  Note that the VIX made 20 very high daily closes over a level of 40 in only 33 trading days in late 1998!  VIX tops and bottoms are certainly not always clean and neat. 


Our current super VIX spike of the past two weeks is executing a similar multi-pronged muddy top.  Thankfully, it is not necessary to buy the US markets at the exact VIX tops or sell the US markets at the exact VIX bottoms to earn huge trading profits.


You can easily trade the VIX extremes with whatever form of financial instrument with which you are the most comfortable. 


If you prefer futures trading, buy S&P 500 index futures when the VIX approaches 50 and sell S&P 500 index futures when the VIX approaches 20.  If leveraged options speculation is your game, buy index calls when the VIX spikes to 50 and sell them and then buy puts when the VIX slumps to 20.  If stocks are where your heart lies, go long index tracking stocks (like S&P 500 Spiders (SPY), NASDAQ 100 Cubes (QQQ), or Dow 30 Diamonds (DIA)) when the VIX stalks 50 and sell when the VIX crashes back down to 20.


Regardless of how you play the speculation game, it is easy to use the VIX to ensure that you are almost certainly on the right side of the short-term market trend, whether it portends farther bear market plunges or exciting bear market rallies.


Now the VIX probably won’t be the perfect short-term trading indicator forever, but I believe it will continue to do extremely well at least until the ultimate bear market bottoms are reached, far below current US equity index levels.  As our graphs in an essay I wrote a couple years ago on discerning the actual long-term secular bear-market bottoms in post-bubble environments indicated, volatility tends to continue increasing until the ultimate bottom is reached.


General investor fear rises and rises, pushing volatility ever higher, until a final brutal capitulation panic marks The End.  You can examine the actual graphs of famous past bubble busts and volatility in “Volatility Squared.”  A Great Bear does not even think of retiring to his comfy cave until investors have bled so much capital, suffered such excruciating pain, that most vow to never buy another stock again as long as they live.  The ultimate long-term bottom won’t arrive until no one cares anymore.


While we all await better days ahead, when the gross speculative excesses of the 1999-2000 US equity bubbles are finally vanquished, trading the VIX in the interim will almost certainly prove to be very profitable.  With current volatility readings in the VIX spiking to enormous extremes even exceeding the perfect 50 buy level, a massive bear market rally is probably already underway or poised to begin shortly.


Prudent contrarian speculators ought to consider trading accordingly.


Adam Hamilton, CPA     August 9, 2002     Subscribe