How Can We Escape the Overbought VIX Cycle?

We interrupt this VIX-plosion to give you a few factoids about said VIX-plosion. The series of swings and triple-digit Dow moves up and back (mostly back) help feed the impression that realized volatility has hit the stratosphere. And it has surely lifted, but not really all that high just yet.

Ten-day realized volatility in the SPDR S&P 500 ETF Trust (SPY) is in the 17s. It was as low as 3 in November, so it sure feels like a surge. But this is the same principle as a 50-degree day in January in the Northeast: It feels very warm in the context of a frigid stretch. But it's historically unexceptional, in the context of an average temperature of any random day. In fact, 17 isn't even exceptional in terms of recent months. The same measure hit 21 in October.

On the other hand, it's a lagging indicator -- it only considers the last 10 trading days, and it's trending higher. So, another day or two of this kind of action and we'll take out the October volatility highs. But again, it still won't hit exceptional highs, barring a crash; 16 volatility equates to about a 1% move or less on two-thirds of days.

If that's of little consolation, that's because it should be of little consolation. There's really no such thing as "resistance" in volatility. It's just a calculation we use to gauge action going backward and, in the case of something like the CBOE Volatility Index (VIX), anticipation of future events. Realized volatility can go to literally any level. Implied volatility on an index does have some sort of cap -- no one's paying infinite volatility for an index, or even 200 volatility for that matter, or 100 volatility? Well, it's extraordinarily rare, but it has happened a few times in history.

I don't believe that's close to being in the cards now. But the sheer frequency of these VIX spikes remains rather jarring. We are on the cusp of a third overbought VIX within one month, and that's very tough to do, by my methodology. If VIX closes greater than 20% above its 10-day moving average and then closes below the 10-day at a later time, I count that as one incident. It takes about five to six trading days, on average, for that to play out. So, for VIX to go overbought three times within about 20 trading days is almost impossible. It has to get overbought, then back off a bit, do that again very quickly, and then get overbought a third time. And the bar for overbought is rising and rising. The 10-day simple moving average (SMA) in VIX is in the mid-19s now, versus 17 back in mid-December.

It's far more common to see the volatility pop play itself out in one shot, especially the larger volatility pops. We've seen VIX stay overbought for 12 trading days at times. So the odd aspect this go-around isn't the persistence of panic, but rather the degree to which it keeps switching on and off and on again.

Bottom line: we clearly need some sort of capitulation to get out of this cycle. VIX nudged into the 30s back in October. Not saying we need to go there, but the stair-step we see now will likely keep on keeping on until we get something out of the ordinary.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.