Rob at Quantifiable Edges takes a look at the old "stretched VIX" rule, namely, what happens when the VIX (well, he uses VXO, but same idea) moves beyond 10% below it's 10 Day MA. A basic rule states that this means the VXO is oversold, and hence the market is overbought,. And thus is bearish.
Rob studies it and doesn't see much there there, stating.
The system as designed shows a slight edge when there is a mild VXO stretch. As the stretch gets larger the edge disappears. To understand why this occurs, consider what would cause the VXO to get extremely stretched, as opposed to slightly stretched. A mild stretch might be the result of a typical move higher in the market. An extreme stretch is more likely to be the results of a strong thrust higher in the market. If the market is truly strong, then the result will be more upside – not downside.
I would agree and disagree by my anecdotal experience. I agree in that over the course of time, oversold volatility is not a great signal. Complacency can reign for an eternity, whereas overbought VIX and fear tends to resolve faster. Well except for the past couple month's (handling an outlier is another topic). Not to mention that Rob makes a good point that an extreme move is likely part of a strong trend, and there's no odds in guessing when such a trend will end.
I would disagree in that I have found this particular VIX methodology works decently IF it's a countertrend move. In other words, in this environment with an ugly market and roaring volatility, an oversold VIX can provide a decent signal that a market rally/volatility melt has run it's course. As it did this week.
Of course the key to all these rules in the Fall of 2008 is that all bets are off. We're living in an outlier environment. So it's fine to look for guidelines, just so long as we keep them all within the context of this particular wild market.
