What does the VIX say about an S&P 500 Bottom?

S&P 500 Bottoming is a Process

The S&P 500 has been searching for a tradable bottom since the sell-off following its September 2, 2020 high. The best way to describe the price action since that point has been “listless.” Without the drivers of stimulus and Federal Reserve policy easing, stocks have failed to find adequate motivation to trend higher.

The lack of motivation led to a 3.53% decline in the SPX. While the prospects for a major move in the market may be delayed until after the election, that doesn’t mean that the groundwork hasn’t been laid for a near-term rally. Here’s what the VIX and other volatility-based indicators are saying.

S&P 500 CBOE Volatility Index (VIX)

The S&P 500 CBOE Volatility Index (VIX) is an average of the out-of-the-money S&P 500 Index options that are for the two expirations closes to 30 days. The VIX value is negatively correlated with the S&P 500 price as put options are bought as a hedge as the S&P 500 Index falls. The use as a hedge gives the VIX a negative correlation with the index.

The chart below shows that the VIX closed on Wednesday at the highest level since June 11. This is significant as it reflects an important change in expectations for future movement. Peaks in the VIX accompany market bottoms.

Applying a Kelter Channel can give some perspective of how extreme the movement is. Using a 2 ATR 20-day Keltner Channel shows the VIX closing above the upper band for the second day in a row. With the exception of February of this year, this has typically signaled a near-term bottom in the market.

The VIX level coupled with a greater than a 1 ATR close lower in the market is a good combination but isn’t all.

S&P 500 CBOE Volatility Index Term Structure

While the S&P 500 CBOE Volatility Index (VIX) is considered mean reverting, it’s not always great at peaking at the same level. Sure, support and resistance levels can be used to help with that and certainly the Keltner Channel, but its just a guide. This is where looking at the term structure can be helpful.

What is term structure you ask? You’re probably acquainted with some ways term structure is referenced in other markets. For example, the yield curve reflects the term structure of the interest rate markets. Looking at the different yields for the varied maturities gives you an idea of market expectations.

The same methodology can be applied to the volatility markets. Looking at the /VX futures, you can get a sense of the market’s expectations by comparing how the price changes with expiration and as compared to the VIX. For example, a normal structure for the /VX is to see rising prices as you move out in time. The chart below is from the same date a year ago. This reflects a normal or contango market for volatility.

During periods of higher volatility, the curve can invert and go into backwardation. That is the current state for the /VX futures market as you can see below. What is important about a falling term structure is that it reflects falling volatility (blue line) in the future.

Another takeaway from the graph above is how the /VX futures price relates to the spot VIX. In this case, if you took a 30-day weighted average of the November and December futures contracts priced at 35.60 and 34.05, respectively, it would be below the spot VIX index at 40.28. This is a bullish indication since the market is pricing in a significant drop in the VIX in the future.

This is one of the strongest take-aways you can have when trying to identify a near-term bottom in the market. There are circumstances, like February and March of this year, where this condition can continue to widen and the market falls. However, that is more of a one-off event. Typically, the price will bottom and begin rising within days.

S&P 500 VIX Capitulation Indication

So you just learned about different ways to look at the S&P 500 CBOE Volatility Index (VIX) and other volatility measures. Here’s a summary of what represents a bullish signal:

• SPX falls greater than 1 ATR
• VIX closes above the upper band of the 20-day exponential, 2 ATR Keltner Channel
• /VX in backwardation
• /VX 30-day weighting is less than the spot VIX

Conclusion

No indicator can predict the future. However, the volatility markets and the use of the S&P 500 CBOE Volatility Index (VIX) reflect what the big money is doing to hedge themselves.  This can be a powerful indicator to tell you when you should start to look for bullish opportunities. Entering at pivotal points following a sell-off can provide one of the best risk/reward opportunities there is in investing.  

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