Mean Reversion And The Volatility Index

The equity markets are at an interesting crossroads right now. Many of the short-term charts I watch are giving some hints of an oversold market while longer-dated price action is showing some breaking down in equities that could take us lower. However, we still must contend with end-of-the-year window dressing and the fiscal cliff nonsense.

With the weakness in stocks over the past few weeks we’ve seen the VIX start to tick higher. Today I want to look at an interesting way to find mean-reversion opportunities in the Volatility index. The current level in the VIX is still under 20, so we aren’t quite to a price extreme, but it has still enjoyed a nice run and may be due for some kind of pull back.

The chart we are going to look at has the Volatility index in the top panel with the Rate of Change (ROC) indicator in the bottom panel. The absolute level of the ROC indicator doesn’t tell us much. For that reason I’ve overlapped the Bollinger Bands on top of the ROC. This helps us get a sense of when Rate of Change might be ‘out of bounds’ in relation to the two bands.

As you can see, when the black ROC indicator breaks above the top Bollinger Band we often see a period of weakness in the VIX. Now that's not always the case, as not every indicator works all the time. But it is a great example of how we can use two different indicators -- the Rate of Change and Bollinger Bands -- to get a better idea of what a security or index is doing.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.