Timing A Shift In Volatility

2016-08-16 | Henry Gambell

As we head toward Friday’s monthly expiration, I’ve watched, read, and discussed more opinions of the market than I care to rehash. To some degree I think that’s because we’re trading at such an extended range and “reversion to the mean” traders continue to argue a pullback while those that are riding the trend continue to push for S&P 500 Index (SPX) at 2200.

At the end of the day I can’t say that I have much of an opinion either way, at least not into Friday. I *think* we’re going to get more of the noise that we’ve seen for the past several weeks, but of course there is no guarantee. The big caveat to that, the “thinking” part, is recognizing that the VIX is suggesting a substantial shift in trend and that shift could be right around the corner. Why now? Why is this the turning point as opposed to the most recent high, or the one prior to that? My primary reasoning comes from the VIX.

The chart shown here shows a daily aggregation of the VIX and allows us to get into some detail of this thought process. The first part of the puzzle is the Bollinger Bands shown in blue. This is one of the most tried and trusted indicators in trading and at its most basic level shows us contractions and expansions in volatility. The Keltner channels are the other indicator layered over price and give us an idea of the most recent range of an underlying security.

$VIX Squeeze

When the Bollinger Bands are showing a point in time where volatility is so quiet that these levels have shrunk down inside the most recent range defined by the Keltner channels, we know the market has reached a point where a break from consolidation is imminent. The direction of the break isn’t always easy to determine, but the momentum indicator shown in the lower subgraph is a helpful place to start.

In each of these examples you can see momentum either crossing above or below zero, helping signal the direction of the move. With this indicator it’s always more important to recognize which direction the signal is moving, as opposed to an exact reading at a single point in time.

Another factor I’ll add is what’s typically referred to as pot-odds. The current 5-year range on the VIX quotes a high of 53.29 and a low of 10.28. Is the current reading of 12.58 closer to the bottom of the range, or the upper end of the range? It doesn’t take long to see we’re trading much closer to the bottom part of that range. With momentum also trying to turn higher I’m looking for a substantial move higher from the VIX over the course of the next 2-3 weeks.