The Volatility Index And The Anomaly At The 26 Level – “The line must drawn here! No further!”

By | July 14, 2020

The market got a scare in the last two hours of trading on Monday. There was a sharp drop in equity prices on news that some businesses in California were being closed again and of renewed US/China tensions in the East China sea. The broader market dropped sharply and the Volatility Index jumped closing the session with a nearly 18% gain. This correlation is normal: as investor fear levels rise stock prices fall and the Volatility Index moves higher. But here’s a interesting anomaly that can been seen on Monday’s 10 minute VIX chart.

Earlier in the Monday session when the DJIA had been up over 500 points the VIX was also slightly higher on the day. Note the first hours of trading that are framed in green. The DJIA goes into rally mode and the VIX also moves higher, of course on a more shallow trajectory. The correlation indicator during this intra-day period shows a high degree of correlation. In the last two hours of trading when the DOW started to go into a waterfall decline the VIX rallied sharply. The correlation between the two readjusted and realigned into a normal inverse correlation.

Anomalies like this have occurred this month because of the formation of the strong zone of support that we have been highlighting on the VIX daily chart, between the 26.50 to 25 levels. When the VIX returns to that area it is more likely to bounce than to break through. This thesis has been confirmed a number of times going back to June. At this point, it looks like the only event that will take the VIX down through the support zone is some very positive news on the virus. I’m all for that. But what has been holding the Volatility Index above the support zone despite the higher equity prices?

It’s fear. It looks like traders have their speculative limit and they see the VIX at a certain level as a good level to buy puts. More profits equals more puts. Apparently that has been the case since the beginning of June. The chart below is the 10 day average of the CBOE put/call ratio. It shows the monthly increase in put buying. For those that trade the $VIX or the VXX, rebounds off the 26.50/25 area have been profitable. While for traders booking big equity gains, hedging those positions is a good idea.

In the immortal words of Jean-Luc Picard, “The line must drawn here! No further!”

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