VIX Rate Of Change More Important Than Its Level

Back in February 2010, I introduced Chart In Focus readers to the 7-day rate of change (ROC) for the VIX.  It is a fun little indicator, and offers us a nice simple way to see the VIX in a different form than just looking at what the raw values say. 

The maths is very simple: We just compare the VIX today with the VIX of 7 trading days ago, and find the percentage difference between those two numbers.  It ignores all of the values between, which might seem like we are unnecessarily ignoring important data.  But the result does a couple of magical things which make it worth looking at. 

The first magical indication is that any reading above around +20% is a pretty good sign of an oversold bottom for stock prices, one that is worthy of a bounce.  It does not seem to work the same way when we look at extreme negative readings for this indicator.  Remember that the VIX is a fear indicator, and so the sudden development of fear which produces a high reading on the 7ROC is not the same phenomenon as a sudden abandonment of fear.  Deeply negative readings for this indicator are usually seen at the kickoff of a strong up move, and not at the end of one. 

VIX Chart 2011

Photo: McClellan Financial Products

The other magical insight that this indicator gives us occurs when it passes upward through zero.  An upward crossing through zero often (but not always) marks an important top for stock prices.  These seem to be better top signals when the upward crossing through zero occurs after a longer period below zero.  The red vertical lines highlight some good examples of this sort of indication.

The stock market selloff during May and June 2011 unfolded without any big spikes upward in the VIX, which was confusing for a lot of people.  If the market was in a downtrend (they wondered), why was the VIX staying so low?  We now have the answer, with the sudden jump upward in the 7ROC indicator to a high of 25.8% on June 16.  Fear reaches a climax at the end of a decline, not in the middle of one.

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