The VXST:VIX Ratio – Knowing when a VIX spike is out of steam

November 9, 2017 – Today was a terrific day for trading volatility. Plenty of money could be made on both sides of the trade, and unless you got greedy, everyone left happy. Today was also a textbook example of an indicator I like to use to identify VIX tops: the VXST:VIX ratio.

I mentioned it briefly in my last entry, but I'll expand on it a little today. Without going into mathematical definitions, VXST is VIX's jumpier, angrier baby brother. If you know the simple definition that VIX is the expected volatility over the upcoming 30 days, VXST is the equivalent for the upcoming 9 days. Think of it as volatility with an even shorter time horizon than VIX – kind of like zooming in on the next few days. It tends to rise faster than VIX, and drops faster than VIX.

The VXST:VIX ratio is just a simple way of telling us which value is greater, and by how much – VXST or VIX. The normal state of a healthy, up-trending market is that VXST is lower than VIX, similar to the way that the VIX futures curve usually slopes up. Traders expect volatility to be greater in a month than they do over the next few days. So the VXST:VIX ratio is typically less than 1.

When the VXST:VIX ratio starts rising (especially if it starts rising aggressively), and and VXST overtakes VIX, traders are starting to believe that short-term volatility is outpacing longer-term volatility. This coincides with a very jittery or strongly down-trending market, as was the case today when the S&P 500 was down about 1% at its worst levels of the day. A VXST value greater than VIX is generally a warning sign to traders with a short VIX position because VXST often continues pulling VIX higher, and there is real risk of a runaway VIX event. How this scenario is handled by VIX traders varies – some reduce or cover their positions, some go long, some hedge. But you can't simply ignore this indicator if you are short volatility.

Taking the analysis just one step further, it would make sense that if VXST stops outpacing VIX and begins to retreat relative to VIX, it might signal a top to the ongoing VIX spike. This is exactly what happened today, as seen on the 5 minute chart. The spot VIX peaked at 12.19 just as VXST:VIX hit a high of 1.0686 (lower chart, red arrow). Traders with a high risk tolerance may have been able to use the next bar as an initial sell signal on the VIX, when VXST dropped just a bit. Traders who were still long volatility into the move should definitely have heeded this warning and taken profits.

Of course, any single indicator can be used in hindsight to justify a move, and I would never recommend relying simply on this one indicator to trade an entire position. In fact, I was watching SPX futures while VIX was peaking and I had a slightly lower target for SPX futures, but it was coming up fast so the VIX spike was definitely on my radar. If I hadn't already been slightly short the VIX into this spike, I might have been more aggressive and added to my short position right there.

The confirmation came about half an hour later when VXST crossed back under VIX and the ratio dropped back under 1.0 (green arrow). At this point SVXY, which follows the inverse of VIX futures, was already 3% off its low, but it became “safer” to add to a short VIX position and follow the index back down. By the end of the day SVXY rallied and finished up another 2% after VXST:VIX dropped below 1. Any traders who were still long the VIX from the morning definitely should have sold by then as there was no longer any reason to stay long with VXST dropping so quickly relative to VIX. The move was, in essence, out of steam.

Of course, everything needs to be traded with context. VXST could have taken another leg up and VIX could have surged the rest of the afternoon. Other indicators need to be watched for clues that this is a possible scenario, such as market internals (breadth indicators, the A/D line, volume profiles and so on). Today was a textbook example of an intraday reversal. One day we will have a multi-day VIX move which will play out differently. When that happens, I'll be happy to post a comparison.

Happy VIX trading!