Outside the Box: Brace yourself for the coming spike in the VIX
Here we go again. The great volatility crushing of stock markets that happens when markets levitate relentlessly and everyone gets bullish. But don’t let the calm waters during this options expiry week fool you — the calm won’t last.
We’ve seen such periods of volatility compression many times before in the last few years, especially during the historic volatility crush of 2017. What invariably happens is that things get too calm, energy builds up, and we get a big launch in volatility out of the blue.
In our technical view, markets are setting up for yet another spike of size and perhaps a larger spike than most people expect.
And yes, one can identify patterns ahead of time that even suggest specific targets (see Mella’s piece on charting volatility).
Here’s the big volatility picture of the last few years:
What’s the main message here? Big structural patterns of compression interrupted by short-term spikes resulting in the building of bullish descending wedges that eventually produce a much larger spike (purple patterns). The big spikes then result in an aggressive crush of the VIX VIX, -2.37% in an extreme tight falling wedge pattern.
We saw one in 2015 following the August 2015 correction, and another big one in early 2018 following the February correction and, we just witnessed one again following the December lows, a pattern that produced a quick spike from 13.5 to 18 last week prior to this current options expiry week.
All of these tight wedges produce an eventual counterspike of size coming from overly compressed conditions.
One notable feature: When VIX gets crushed following spikes any gaps on the way down eventually get filled. All of them.
And so here we find ourselves with Thursday seeing the lowest VIX print of 2019:
Several key observations:
VIX has already broken out of its recent wedge pattern. This week’s compression, while producing lower prices, appears to simply retest its broken trend line. Note also that VIX has a glaring open gap in the 24/25 area. The year is young still, and there is plenty of room to eventually fill this gap.
Another feature of this rally: Currently six open gaps on the S&P 500. SPX, -0.09% “All gaps will fill, if ever” Art Cashin once famously quipped.
While some gaps can stay open and unfilled for years this large number of open gaps are unlikely to remain unfilled for an extended period. Indeed the rally of January 2018 also was riddled with open gaps. All of them filled in February 2018.
But there’s a larger volatility structure looming that suggests a much more sinister picture to unfold sometime in 2019.
A chart from Mella:
Her charts excel in their simplicity but clarity. This shows relative strength in VIX despite lower prices while forming a bullish pattern. It supports not only the notion of a VIX gap fill at 24/25, but perhaps a spike into the 30s. She also still has a pattern that suggests a potential run to VIX 50 coming.
Volatility compression can extend as we’ve seen before, and this pattern can suggest prints in the 12 range being possible. But it also strongly suggests that the next big move in VIX is not lower, but rather a launch higher. A lot higher.
Sven Henrich is founder and the lead market strategist of NorthmanTrader.com. He has been a frequent contributor to CNBC and MarketWatch, and is well-known for his technical, directional and macro analysis of global equity markets. Follow him on Twitter at @NorthmanTrader.