Condor Options

We have our internal debates here at Condor Options (after all, group-think is a sign of an unhealthy organization), and one of them is about how much in the field of technical analysis is useful and how much is just haruspicy. Nowhere is this question more controversial than in the case of the VIX. As an index of options premium, it’s a derivative of a derivative—and despite the fact that you can trade the VIX, indirectly, with index options, surely it trades absolutely unlike any instrument you’ve ever seen, right?

Not quite. There’s no disputing the fact that VIX options don’t behave like equity options, and earlier this year we posted the case against applying technical analysis to the VIX. But there’s another side to this coin: anyone who trades options for a living, and has any hope of doing it well, is conscious of the fact that he or she is trading implied volatility. Ideally, we want to sell more implied volatility (by selling iron condors, for example) when it’s high and to buy more IV (e.g., by buying calendar spreads) when it’s low. Therefore, it’s arguable that supply and demand actually do affect implied volatility, and that should be reflected in a chart of the VIX.

Now, we haven’t done any quantitative backtesting on this, but it’s hard to ignore how well a daily chart of the VIX for the past year (below) does, in fact, appear to conform to some basic principles of technical support and resistance. Most significant are the major support and resistance levels. Three times in 2008, the VIX bounced off resistance when it crossed into the 30s (points A, B and C), and on its way into the current, post-credit-crisis trading range (A’ to B’), it formed a pennant in that same 30 – 37.5 zone (point D) before rocketing higher. Since October, the market appears to have viewed anything below about 50 as a buying opportunity, and seen spikes into the 80+ range as extremely overbought.

In addition, the way volatility seems to have responded to major moving averages on the VIX chart makes it look like a better subject for technical analysis than most stocks. There was support at the 200-day simple moving average three times during the initial bear-market consolidation last winter into early spring (points a, b and c). Once that support failed in April, the 20-day SMA became the key support/resistance line. Implied volatility met with resistance at the VIX’s 20 SMA between the end of March and mid-May (point c to point d), found support there and at the 50-day from Memorial Day through mid-July (point d to point e), and then consistently ran into resistance at the 20-day line again from mid-July through August (point e to point f). Since then, extreme volatility (historical) in the VIX has made things a bit blurry, but it looks like the 20-day and 50-day moving averages continue to hold significance. We’ve had a major reversal (point a’) and congestion (points c’ and d’) at the 20-day, and a major reversal at the 50-day (point b’).

If we’re willing to take this exercise one step further, there’s the matter of that big symmetrical triangle that’s been forming in the VIX since mid-October. Yeah, a handful of data points don’t prove anything, but it does look a lot like that bottom trend line has functioned as support since last Wednesday. We don’t want to get too carried away, though—maybe it’s just coincidental that the VIX happened to reach the trend line a week ahead of the December FOMC policy statement—and we’re looking to the post-crisis range bottom at VIX 45 to be the more significant support level.

It’s certainly arguable that all this is merely a Rorschach test. (The same could be, and has been, said about technical analysis in general.) Nevertheless, if we accept that options traders are “trading” volatility all the time, and, therefore, some of the same forces affect its “price” as influence the price action of any stock or commodity, then it’s not that far-fetched to think that basic technical analysis (we’re not talking about head-and-shoulders patterns and MACDs, here, folks) just might yield some valid clues about when it’s a good time to be a net buyer of volatility and when it’s better to lean short.