I bet you probably thought this was going to be another “buy VIX future or options to prepare for a market crash” article.
Sorry to disappoint you but I am not going to recommend that in this article. What I will discuss though, is provide some examples of how using VIX, VIX9D, VIX3M, and VIX6M could help you foresee a market crash.
What are VIX, VIX9D, VIX3M, and VIX6M?
VIX as you might know is the 30-day forward projection of volatility by calculating the changes in SPX index options.
The other three as their name suggests, VIX9D is the 9-day forward projection, VIX3M is the 3-month forward projection, and VIX6M is the 6-month forward projection.
The reason to monitor these other VIX-related indices in addition to VIX itself is to gain insights into what the market is expecting to happen in those time frames.
A lot of times, VIX would jump substantially but it reverses immediately because the nature of the volatility is not long-lasting. In other words, watching VIX only is very difficult to tell if there are larger concerns that are boiling beneath the surface.
If an event is likely to be long-lasting, that potential volatility will more likely be present in VIX3M and VIX6M.
Why Use Ratio and Percentile Rank (PR) to Monitor these VIX Indices?
Why use ratio (relative strength)?
To make the changes that are taking place in these indices really stand out, it is better to monitor the ratio between VIX and these VIX-related indices rather than just the value of these indices themselves.
Essentially, the idea is similar to commonly used valuation tools such as Price to Earnings ratio.
One company might have a Price of 100 and Earnings of 10 (=PE 10), whereas another might have a Price of 50 and Earnings of 5 (=PE 10).
The ratio will essentially allow us to compare them side by side.
Why use Percentile Rank?
Depending on the market conditions, the value of these VIX-related indices varies substantially.
For example, the first 2 months of the year could have a super calm market condition, then the market tanks, then recover significantly by the end of the year (something similar to 2020 when COVID-19 happened).
In such a condition, it would be difficult to tell if the VIX 25 that we see at the end of the year is relatively high or low based on the recent market condition.
In case you are not familiar with VIX, historically speaking, VIX 25 is pretty high.
So to make the comparisons easier, calculating the Percentile Rank using the previous 252 trading days’ data, will allow us to see if the current value that we see is relatively high or low when compared to a one-year data set (252 trading days).
How VIX Indices Could Provide Market Insights?
Example 1: January 2020, COVID-19 early warning #1
Before the large drop that took place in late February 2020 (red arrow in the graph below), there was a small dip that started on January 27 (yellow arrow).
Percentile Rank for VIX/VIX3M (59%) and VIX/VIX6M (61%) were giving early warning signs on January 24th (first red box in the table below).
Both jumped from around PR 30% the day prior (an almost 100% increase), whereas looking at the value of VIX3M (16.07) and VIX 6M (16.78), the increase was not as significant as the Percentile Rank.
This is why combining the ratio of VIX and VIX-related indices plus the Percentage Rank calculation can really make it easier to spot the warning signs.
Takeaway: The Percentile Rank for VIX/VIX3M (59%) and VIX/VIX6M (61%) were giving early warning signs
Example 2: Early February 2020, COVID-19 early warning #2
After the small dip in January 2020, SPX continued to climb and reached an all-time high at the time.
While SPX continued its climb, the Percentile Rank for VIX/VIX3M and VIX/VIX6M stayed at around PR 50% (the small red box on the right in the table below).
It would be very difficult to just look at VIX3M and VIX6M values to see this warning sign (the small red box on the left in the table below).
When looking at these values, one should ask if the market is continuing to climb, yet, why people are hedging and worrying about something in 3 months and 6 months’ time?
Takeaway: While SPX continued its climb, the Percentile Rank for VIX/VIX3M and VIX/VIX6M stayed at around PR 50%. Something big might be coming.
Example 3: Thanksgiving November 2021, Omicron News
Let’s use the Omicron news that broke out back in November 2021 as an example of how VIX indices were giving some early warning signs.
- The news came out on the night of Thanksgiving day (November 25th) and the market tanked the day after (November 26th).
- Looking at the PR of VIX/VIX3M, it was already spiking up to PR 50% a few days earlier since November 22nd. (Red box in the 1st image below)
- The market would recover but started to go down again on December 16, ultimately reaching the bottom on December 20th. (2nd image below)
- While SPX was going down starting on December 16th, only the PR of VIX9D/VIX increased significantly. The other three, especially VIX/VVIX did not move much even though SPX dropped significantly on December 20th.
As you can see, using these PR values could be very useful in understanding what the market is thinking. The market, after all, is consist of people.
Takeaway: The Percentile Rank of VIX/VIX3M was already spiking up to PR 50% a few days earlier from PR 28%.
Example 4: January 2022, Inflation Fear
The tone of the stock market changed substantially in early January 2022. While SPX was still hovering close to the all-time high of 4800 level (red arrow in the SPX graph below), the VIX-related indices were showing some early warning signs (the small red box in the table below).
Both VIX/VIX3M and VIX/VIX6M jumped close to PR 50%, indicating people are hedging and worried about something long-term.
Takeaway: Both VIX/VIX3M and VIX/VIX6M jumped close to PR 50% from PR 12% and PR 11% respectively the day before.
Example 5: January 2022, Short-Lived Counter Rally
A counter rally that happened at the end of January never took the market back to the all-time high (the yellow arrow and the yellow box in the graph below).
Looking at the PR of VIX / VIX-related indices, all remained above PR 80% despite the fact that SPX rallied close to 400 pints in 4 days.
It’s also interesting to see VIX itself dropped from 27.66 to around 22 in 4 days, which might have given a wrong indication of this market rally might be sustainable (the small yellow box in the table below).
Takeaway: The Percentile Rank of VIX / VIX-related indices, all remained above PR 80% despite the fact that SPX rallied close to 400 pints in 4 days.
I have been trading volatility-related products (VXX, UVXY, etc) for a while and was familiar with some of the VIX-related indices. However, I have never really incorporated them into my day-to-day trades until I started calculating Percentile Rank and realized how powerful this tool could be.
By coupling this tool with simple technical analysis, I could now tell which way the market might move in the short term with higher accuracy, which allows me to set up profitable trades.
I have previously relied on trading strategies that incorporate probability such as selling Iron Condor, Selling Strangle, the Wheel Strategy, etc. These kinds of trade strategies tend to work well only in certain market conditions and not the others. While just keep trading in all market conditions the same way and the probability might work itself out, it’s really hard to continue the same trade strategy when it clearly is not working for a prolonged time.
I now understand that the key to becoming successful in trading is not finding the right trading strategy, but rather acquiring the ability to read the market.
My plan is to share more of what I have learned in the coming months so if you are interested, make sure to subscribe.
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