When I coached Little League baseball, the process of trying to figure out the strengths and challenges of the individual players always fascinated me. 

One year, we had this tiny guy with a great big throwing arm.  This kid could really hum the ball, and on top of his throwing skills, he was very good at fielding ground balls.  This made him a great candidate for playing the most important position in the infield—shortstop. 

In baseball, the shortstop plays between second and third base.  Most batters are right handed so they hit more balls to the shortstop than to any other position.  In addition to getting a lot of balls hit their way, shortstops have to make a long throw to first base in order to get the hitter out. 

So our strong-armed, little guy seemed ideal for shortstop.  Until I hit a ground ball to his right.  He missed it.  And another.  Then another.  If I hit a ball directly to him or to his left, he gobbled it up.  But hit one to his right and there was little chance he would make the play.

Fortunately, we had an ideal solution for this player.  We put him at third base where the foul line protected his right side.  His strong arm was still a great asset at this position, since it’s a long throw from third base to first. 

Once we assessed this player’s abilities, we could put him in a position where he could excel.  And he thrived at third base all season.

The VIX volatility index indicator is much like our little ball player.  It has some amazing strengths (as we’ve discussed in recent articles), but it also has a glaring weakness.  Let’s investigate where it is useful and where it’s not.

The VIX: Gold for Oversold, Not So Hot for Overbought

Several weeks ago, I wrote about VIX as a tool that works.  We looked at a chart that showed how well VIX has described market fear points—basically times when VIX has traveled above 30.  As way of review, here’s that monthly chart of the S&P 500 on top and the VIX below.

The traditional level of concern is 30 (shown by the horizontal blue line). Every trip the VIX takes above that blue line tells a story.

In short, VIX does a great job of alerting us to an oversold market.  A move above 30 indicates the options writers require a greater premium to sell options, especially puts.  VIX “just works” when used to indicate short-term, oversold markets because it describes a relative level of fear or skittishness in the markets.

However, like our little baseball player who didn’t do so well with ground balls hit to his right, VIX does a lousy job alerting us to overbought periods.  In fact, if we use the traditional level of 18 for an overbought reading on the VIX, it really is fairly useless for any market in an uptrend.  Let’s take a look.

We could argue that there are a few useful signals, but the vast majority of time that the VIX has been less than 18 has not signaled overbought conditions or a valid reason to sell.  The VIX overbought “signals” have been early or just false.

So here’s the bottom line: the VIX does a great job of telling there is short term fear / oversold situation in the market (spikes above 30) and longer term fear/downtrend (stays above the 30), but a poor job of predicting overbought markets.

Great Trading,
D. R.

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