Volatility Crushed - Rare Signal On Watch

By Lawrence G. McMillan

...Volatility indices ($VXST, $VIX, and $VXV) literally collapsed yesterday.  They were down in the morning after Tuesday’s somewhat surprising strength, but on Wednesday afternoon, they were really crushed. Short-term vol ($VXST) was down 16.7%, while $VIX was down 12% – pretty big moves. This has several implications. The first is that our “bearish demarcation” line of 13 for $VIX was pretty good. A couple of days ago, $VIX neared that point, but never exceeded it, and now the market has rallied again. Secondly, with these indices so low (new all-time lows in $VXV; lowest $VIX since February 2007), they are certainly in overbought territory.

Third, $VIX rarely falls below 10. In fact it has only done so nine times in the past (not necessarily nine days, but nine groups of days). We had designed a trading system based on $VIX moving below 10, way back in 2006. That system is now potentially coming into play again. Simply stated, if $VIX closes below 10 and $VXO closes below 10.30, one should short the market. The short is covered on the first double-digit down day for $SPX. That system hasn’t set up since February 2007 (when it caught a 50-point $SPX drop), and it still hasn’t set up yet (since $VIX hasn’t closed below 10), but it’s certainly a potential setup soon...

This commentary was excerpted from this morning's edition of The Daily Strategist newsletter.