What Flips The VIX Light Switch?

Hey Traders,

For a low volume trading day …

We certainly saw a lot of action to finish out the holiday-shortened week.

In particular, I took note of the VIX, which was quick to spike up to 28 (that’s Zone 4 for those of you that know your Vol Zones).

What is interesting is that before Friday’s trading session, my Option Pit VIX Traffic Light – a proprietary indicator built by yours truly – was shining yellow …

Telling me the VIX was getting ready to make a big move.

How did it know?

Let’s take a look at how the Option Pit VIX Traffic Light works.

Red Light, Green Light

As you would expect, the Option Pit VIX Traffic Light has three “colors” that tell us what to look for out of volatility in the near future:

      • Red: Volatility is falling, or staying stable. You can trade and use your normal approach to risk management. 
      • Yellow: Volatility is going to make a move, but it could go either way. Think of this as a “caution” sign. Tap the brakes, and make sure you’re trading like “anything could happen.”
      • Green: It’s time to get ready for some excitement … and opportunity! Volatility is on the move. If you’re a confident volatility trader, it’s a great time to make your move, as long as you practice strict risk management, and are intentional with your trading.

Now, on Wednesday, the Option Pit VIX Traffic Light was yellow, which means volatility was setting up to make a move.

But I do want to emphasize that the “move” anticipated by a yellow light can be either up OR down.

So a yellow light does not necessarily signal an impending switch to green … it could mean that volatility is getting ready to tank.

However, as it turns out, Wednesday’s light just so happened to precede Friday’s big VIX pop.

These Traffic Light readings aren’t just arbitrary …

They aren’t just my “best guess” at where the VIX is going.

The Option Pit VIX Traffic Light is actually based on several indicators that alert me to any unusual changes in the vol landscape that could signal a change in trend …

      • VIX Futures Curve
      • VIX and S&P 500 (Ticker: SPX) Correlation
      • VIX of VIX (VVIX)
      • VIX Realized Volatility

First, and perhaps the most important indicator, is the VIX futures curve.

The VIX futures curve plots out where VIX futures are trading relative to VIX spot/cash price.

About 80% of the time, the VIX futures curve is in contango – meaning VIX futures are trading progressively higher than cash VIX.

VIX futures must equal VIX cash by expiration, so when the futures curve is in contango, we expect to see VIX futures falling into expiration.

A VIX futures curve in contango usually tells me things are “normal,” and therefore we can expect to see the VIX behave within its usual parameters … and usually head lower.

Now, when the VIX spikes above futures, the VIX curve enters a backwardation pattern.

Backwardation refers to the VIX futures trading progressively lower beneath spot VIX.

Here is the VIX curve on Friday It is more of a flat curve rather than a “picture perfect” backwardation pattern (as the curve is not totally inverted), but it is still trading under VIX cash:

This tells me that fear has quickly entered the marketplace, and I know that traders are nervous RIGHT NOW.

Backwardation is a “green light” indicator, while a flat curve (still trading above the VIX) would be a “yellow light” indicator.

You can find out more about the VIX curve in this video right here.

Correlation … Might Equal Causation

The second VIX Light indicator is S&P 500 (Ticker: SPX) and VIX correlation.

In other words, I am looking to see if volatility and the SPX are headed in the same direction.

Usually, SPX and VIX have an inverse correlation, so if SPX is going higher, VIX is falling, and vice versa.

If I see the S&P 500 going higher, and the VIX going higher, this signals me that it might be time to change the light.

You can see how the SPX and VIX are typically inversely-correlated on this 30-day chart. The S&P 500 is on the top, and the VIX is on the bottom.

Notice how before Friday, the VIX was heading higher as the S&P 500 remained mostly flat, or gained a little.

This was one of the reasons I turned my light yellow earlier in the week.

VIX of VIX, Vol of VIX

The third indicator is the VIX of the VIX, or VVIX.

VVIX tells me the appetite for volatility options, and how expensive it is to buy or sell VIX options right now.

If the VVIX is low, or falling, that is a red light indicator.

If traders are loading up on vol options and spiking VVIX, this can signal that there is anxiety in the market.

Typically, assuming a sub-20 VIX (which is most of the time, even if it doesn’t feel like it lately!) I look for the VVIX to remain below 100.

A move above 100 warrants a closer look.

However, since the COVID pandemic, with the VIX elevated, VVIX has tended to also remain high.

But this is not telling me traders are looking for volatility to spike …

Rather, often they are snapping up VIX puts, looking for a vol drop.

But look at VVIX on Friday; it shot up more than 35%!

Finally, the fourth indicator is realized volatility in the VIX – vol of VIX.

I look at the 10-day and 20-day realized (historical) volatility in VIX to see how they are moving.

If I see realized vol heading higher, this is something to keep an eye on.

Here is a look at 10-day (dark blue) and 20-day (light blue) realized volatility for VIX over the last 30 days:

VIX realized vol was more or less flat on Friday … as it has been for the last few days.

Typically, the VIX futures curve has the strongest effect on the VIX Traffic Light. If all other indicators are red, but the VIX curve goes flat and hits “yellow” territory, the light will usually change.

VVIX and VIX volatility are more sub-indicators that I use to help me interpret changes in the VIX curve and SPX/VIX correlation.

However, that is not to say that movement in VVIX or VIX volatility will never cause me to change the traffic light; they can and do.

If you want to get the latest VIX Traffic Light updates, there are two things you can do:

      1. Sign up for my VIX Edge newsletter, where I’ll email you regular updates on what’s happening with volatility.
      2. Join my Volatility Edge program, where you’ll get exclusive access to VIX Traffic Light updates in your Member Portal, PLUS trade recommendations to help you profit by trading vol! Right now is the CHEAPEST you will ever be able to get in – so make your move!

Your Only Option,

Mark Sebastian

 

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