S&P500 and VIX Consensus at Extremes
While catching up on my nightly reading I noticed the following post by Frank of Trading the Odds: http://www.tradingtheodds.com/2010/02/vix-surges-20-as-fear-returns/ In this post, Frank presents his standard approach to measuring the edge of a given setup. He does a very good job of crunching the numbers for all to see on a daily basis. In this case, the VIX surging over 20% in one day was the setup described. In general the analysis is very thorough, and the new additions to the setup evaluation framework that Frank recently built in are definitely a good improvement. That said, long-time readers know that I prefer not to use fixed percentage trading rules etc since they are not normalized within the context of a particular environment.
Another concern, was whether looking at the VIX vs the S&P500 directly was redundant. Generally speaking, I have found little value in using the VIX as an overbought/oversold indicator to trade the S&P500 in lieu of using the S&P500 directly (however the divergences between the two are very valuable). In this case, my central question was whether there was information that could be derived from a consensus between the S&P500 and VIX at extremes. Could looking at both together produce superior information concerning a short-term bottom than either in isolation? To run this test I used the last 5000 bars of data on both the S&P500 index and the VIX from Yahoo Finance. I took the one day returns for the VIX and normalized them using a 50-day percentile ranking, I did the same for the S&P500–only I subtracted the final number from 1 to account for the negative correlation between the two. Thus the worst days in the S&P500 were 90th percentile and higher using this method. Similarly, the biggest up days for the VIX were also represented by high percentile values. Lets look at the numbers:
|Next Day||max tail loss|
|Return||W%||(worst next day ret)|
As you can clearly see, consensus indeed helps to confirm temporary market bottoms (at least for a 1-day hold). Combining both screens produced higher next day returns, higher winning percentages and lower risk of an adverse loss. However, while not shown, this “consensus” method does not help add any value outside of the extremes. Apparently, bottoms require BOTH a major spike in the fear gauge and a major loss for the S&P500 which in hindsight makes sense.