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Is VIX Pointing to a Market Correction?

Thursday, 14 Oct 2010 | 5:23 PM ET

The rally that added 15 percent to the S&P 500 Indexsince early July may be under threat. At least that's what the VIX may be signaling.

AP

The Chicago Board Option Exchange's Volatility Index, or VIX, measures near-term volatility as expressed by S&P 500 stock index option prices. A rising VIX, implying more volatility and fear in the marketplace, is bearish for stocks, while a falling a VIX is bullish.

For the year-to-date, the VIX has averaged 23.6, and for the last seven years it has averaged 21, according to Randy Frederick, director of trading and derivatives for Charles Schwab.

The index has traded below 20 most of this week—with the exception of Thursday, when it regained some ground. Still, the index remains below its 2010 average.

But according to Frederick, "it won't stay there for long."

That's because the VIX has a tendency to revert to the mean, which in this case would lead to a spike in volatility.

Secondly, more traders are buying calls on the VIX now than are selling puts, indicating these traders believe "a spike in the VIX is much more likely than a continued slide in the VIX," he added.

Frederick keeps track of the "implied volatility gap" between puts and calls. When that gap gets to more than 200 percentage points — which it was on Monday — there's a good chance the market is heading lower, he said.

"Two of the last three times that happened (mid-January and mid-April of this year) the market went into a correction phase within a couple of weeks," Frederick said in a note to clients.

One other technical sign on Frederick's watch list: the S&P 500is likely to hit the Golden Cross sometime next week.* That's when the index's 50-day moving average crosses above the 200-day moving average. Typically, the Golden Crossis a bullish sign for stocks. But Frederick noted the S&P 500 Index had actually rise instead of fell, which it should have done, after it reached the bearish Death Crossmilestone on July 2.

"I’m not a huge believer in technicals in the equity markets," said Frederick, who pays more attention to options and futures. "If this indicator was completely wrong in July, would it be right to the upside or completely wrong this time."

* (The Dow hit its Golden Cross last week.)

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Disclosures:

Disclosure information was not available for Frederick or his firm.

Disclaimer

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