Stretch a rubber band and what does it do? It either pulls back, or snaps back, then your fingers get stung. Because rubber bands move fast. Like the CBOE VIX. The VIX tends to oscillate above and below some average or mean, then spike higher or dip lower for a few days before pulling back again. That’s what traders describe as “mean reversion.”And the VIX does that until, “snap!” it does something unexpected.
You can’t predict when that will happen. You can only prepare for it and act on it. Let’s look at two scenarios.
VIX Trading Below the Mean
This typically indicates overconfidence and expectation of a strong or stable market in the future. Traders let their guard down a bit and aren’t buying SPX puts as a hedge. That lack of buying pressure pushes the VIX lower. In this type of market, a small sell-off can take people by surprise, and lead to a larger sell-off—leading to a spike higher in the VIX. (As it did between June and September ’14 in the chart in Figure 1.) When the VIX is low, consider buying volatility and using VIX options to look at bullish trades like long-call verticals.
VIX Trading Above the Mean
This typically indicates panic during a sharp drop in the market. This is not the time to lose your cool. Think about the spring of ’10 or late summer of ’11. The market was selling off, and traders bought SPX puts as a hedge, driving the VIX higher. But it didn’t last, as the market turned around and the VIX dropped. When the VIX is higher, consider selling volatility since the SPX options premiums are generally higher. You might consider shorting put verticals in stocks or indices whose prices have dropped, or even selling defined risk call verticals in VIX options. You’re collecting that option premium while it—and the VIX—are high. Even if you’re not trading options, savvy traders keep an eye on the VIX.
VIX Outside of Normal
When the VIX fell below 15 in early summer '14, it subsequently shot up to the low 30s three months later. Based on where the mean is, a trader can position herself for certain expected outcomes.