Interesting about today is that while the S&P dropped well over 2%, the VIX (and VXO) also dropped. Often traders will interpret this as bearish. The thought process is that when the VXO doesn’t drop with the market it suggests a possible complacency among traders. The theory is that this complacency may lead to further selling until participants become somewhat fearful again. At that point a rally will become more probable.
I looked at this theory last month when considering action over the course of several days. At the time I found no evidence to support the bearish case. For testing I looked at a 5-day divergence to measure the return in the VXO and S&P prior to triggering. Tonight I looked at a 1-day divergence.
Not only is there a lack of bearish evidence but these results could be considered borderline bullish. I also looked at more extreme 2% SPX drops:
If the number of instances wasn’t so small then I’d certainly consider the results strongly bullish.
A sensible sounding theory is just that – theory. This is an example of why I make every effort to test all of my trading and market bias ideas.
Note: Apologies for the sporadic posts this week. Things should return to normal next week.