Preparing For A Potential Spike in Volatility

Yesterday I tweeted that I thought we were getting ready for a fairly decent size move in the Volatility Index ($VIX). As we turn into the bearish six months of the year based on the seasonality studies done by the Stock Trader’s Almanac and with the $VIX sitting near $12 it’s not hard to imagine that we may be “due” for some volatility in the equity market. But there is one chart that is making me think this possibility seems more likely based on past instances.

Below is a chart that will take some explaining. If you’ve been reading my blog or following me on twitter for very long you likely know that I’m constantly looking at relationships between varies markets. Whether it’s different sectors, asset classes, commodities, or bond duration, I’m always looking to see how markets are interacting with one another.

The chart I want to discuss today is the relationship between the Volatility Index ($VIX) and the 10-year Treasury Yield ($TNX). I’m not concerned with the absolute level of this ratio but its respective width of the Bollinger Bands. Bollinger Bands show the standard deviation of a stock’s (or in our case a ratio) price movement. John Bollinger, the creator of the Bollinger Bands, has found that low periods of volatility are often followed by high periods of volatility. This can be shown by the width of the Bands as they widen and contract, which is what’s shown in the top panel of the chart.

Currently the Bollinger Bands for the ratio between the $VIX and the 10-year Yield has fallen to previously historic lows. I’ve marked dotted blue lines to show past instances where the width of the bands has been near the current level. On the bottom panel of the chart we have the price movement of the $VIX itself. As you can see, when the Bands width for the ratio has been this tight, its lead to quick moves to protracted long advances in volatility. For example, we saw the Bands contract in late January of this year before the $VIX spiked nearly 40%.

Like most forms of intermarket analysis, we can use this relationship and the chart below to begin looking for setups in the $VIX; however, this alone does not necessarily pinpoint a low in the Volatility Index. We may still see some downside or choppy action before a potential large move in Volatility takes place. But if history does in fact repeat, or as Mark Twain once said, “history does not repeat itself but it often rhymes” then we may be in for a bout of volatility in the coming days or weeks.


Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.

About Andrew Thrasher, CMT

Andrew Thrasher, CMT is a Portfolio Manager for an asset management firm in Central Indiana. He specializes and writes about technical analysis as well as macro economic developments.