Panic Sign: 3 Point VIX Reversal

In this article we will focus on the third panic sign, the “3 Point VIX Reversal”. This is my favorite of the 5 panic signs because the reversal often signals the unwinding of hedges by major players, providing astute traders with valuable insight into the underlying market dynamics.

It is consistent with the adage of buying when others are fearful, and offers a favorable risk-reward ratio for those seeking long-term positions amid market dislocations.

Understanding the VIX and Its Origins

The VIX, or Volatility Index, plays an important role in options trading, and its origins can be traced back to the ingenuity of Goldman Sachs traders over two decades ago.

The calculation of the VIX involves intricate processes that occur every ten seconds. It is calculated from the implied volatilities of S&P 500 index options with an average remaining maturity of 30 days, and includes a wide range of available options, including at-the-money, in-the-money, and out-of-the-money calls and puts.

Goldman Sachs’ development of the VIX was made possible by the introduction of advanced computer technology. This allowed the VIX to be calculated with remarkable speed, precisely every ten seconds. The index takes into account the implied volatilities of S&P 500 index options, creating an intraday picture that traders can analyze.

The VIX is often considered the “fear gauge” of the market, with a natural floor around 10. Although there were brief periods in 2005 and 2017 when it dipped just below 10, it typically stays above that threshold. The average VIX over the past 10-20 years is around 16, providing a benchmark for market conditions.

This volatility index plays a crucial role in indicating the presence of panic in the market. When the VIX exceeds 20, it serves as a red signal, indicating the onset of panic. Traders must monitor the VIX on a daily basis, as a red alert is triggered when the VIX crosses the 20 level.

Understanding the VIX involves not only its historical average, but also recognizing that sustained VIX readings below 20 indicate that panic is not imminent. Only when the VIX exceeds 20 does it indicate the potential for panic in the market. If you want to learn more about the VIX, check out my comprehensive article on the VIX.

VIX as a Key Indicator of Market Dynamics

This fear gauge operates on a scale with a natural low of around 10 and a historical high of around 80, which was only reached during the 2008 global financial crisis and the 2020 market sell-off.

The VIX has certain levels that are important to traders as they signal different types of market environments. Below a VIX of 20, the market is bullish and generally on an upward trajectory. From 20 to 30 is a level of moderate concern and uncertainty about the future. Traders and investors alike are more cautious. A VIX around 30 is considered high and signals increased fear and sometimes even panic.

Traders looking for panic signals turn to the VIX, as a breach of the 20 level triggers a red alert. This signals the onset of panic and prompts traders to exercise heightened vigilance and adjust their strategies accordingly.

The VIX as a Panic Indicator

The VIX, or volatility index, plays a crucial role as a panic indicator. When the VIX crosses the 20 threshold from below, it becomes a strong red signal that panic is building in the market. This pivotal level serves as a trigger for traders to exercise caution and adjust their strategies in response to increased volatility.

But for now, we are not interested in identifying the onset of panic, but rather a signal for maximum panic. It is clear that we cannot wait for the VIX to drop below 20 again, as that could take weeks or even months. Right after the 2020 market bottom, the VIX took more than a year to cross the magic 20 and close below it.

This is where the panic signal of the 3 point VIX reversal comes into play.

3 Point VIX Reversal

Now let’s dive into the heart of the matter – the VIX 3-point reversal. Picture this: the VIX is above 20. This is condition 1 of our panic signal. And then the following must happen: the VIX must make a new high, relative to the previous day, and then the VIX must fall from that new high to the close by at least 3 points.

So it does not matter how this happens. If the VIX is higher or lower than the day before. What is important is the new intraday high followed by the 3 point reversal to the close, all above the crucial 20 level in the VIX.

1. VIX above 20
2. New intraday high
3. A reversal of at least 3 points

Here are some charts where you can see this. These VIX 3 point reversals are marked with a red arrow.

The VIX 3-point reversal is not just a theoretical concept; it has real implications for your trading strategy. If this reversal occurs, it could mean that institutional players are unwinding their hedges, as S&P 500 options are primarily traded by very large players. For short-term traders, this insight offers valuable opportunities for quick profits when market dynamics shift.

Options traders, you’re not left out either. The VIX 3-Point Reversal provides a strategic advantage for making informed decisions. Whether you’re considering selling puts, creating bull put spreads, or exploring other options strategies, this signal offers a roadmap with favorable risk-reward ratios.

Even long-term investors can benefit from this sign of panic. After all, when is the best time to buy for the long term? When there’s blood in the streets and others are fearful.

Summary

The VIX serves as a panic indicator, especially when it crosses the 20 threshold from below. The 3 Point VIX Reversal adds depth to this understanding and provides a practical strategy for traders. This reversal, in which the VIX makes a new intraday high at least three points higher than the previous day and closes above 20, signals a potential unwinding of institutional hedges. This insight provides opportunities for short-term profits and strategic advantages for options traders, creating a roadmap for navigating market shifts.

If you find this helpful, you may also be interested in other signs of market panic. In this article you will find 4 more panic signals like this one.