Is $VIX “Too Low” (Preview)

By Lawrence G. McMillan

As a general rule, I am not in favor of shorting the market when $VIX is “too low.”  That is usually a loser’s game, as the market doesn’t turn downward until $VIX begins to trend upward.  However, there is a combination of factors that we researched a long time ago (at least 10 years) that is now coming up again.

Background

$VIX was invented by Professor Whaley for the CBOE and first published in 1993.  That version of $VIX used only 4 series of $OEX options.  It used the two front month options, and the two nearest strikes that surrounded $OEX’s price.  It was backdated to 1986 so that the Crash of ‘87 could be in the data.

In 2003, Goldman Sachs and others came to the CBOE with another plan to calculate $VIX – one that would take into account the expensive out-of-the-money puts.  This process involved all of the strikes on $SPX options that had both a bid an offer (note the change of underlying index).  It retained the concept of using the two front months.  This new calculation was called $VIX, and the “old”($OEX-based) calculation was renamed $VXO, as far as its symbol goes.

In 2014, there was another change because of weekly and end-of-the-month $SPX options.  The definition was changed to include the two series of either weekly, monthly, or end-of-the-money $SPX options that most closely surrounded a 30-day expiration window, looking forward.  So this became $VIX, and the 2003 calculation became $VIXMO, as far as the symbols are concerned.

The “System”

When we first researched this system in late 2006 and early 2007, we noted the following:

If $VXO closes below 10.00 and $VIX closes below 10.30, 
$SPX will experience a sharp drop within the next week.

It doesn’t occur often, but this system had produced some decent results  in our research.  When we put in into effect in on Feb 13th, 2007 (or at any time over the next 5 trading days, for the condition continued to exist through that time), it was a tremendous winner.  For, on February 27th, $SPX dropped 50 points in one day when China raised margin rates, completely upsetting what had become a rather frail environment...

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