Price and Volatility Divergences

Comparing signals on a relative basis often can lead to a better feel for future market structure. One of the most well known of these relationships is a component of Dow Theory, in which a breakout or breakdown in the Dow Jones Industrial Average (DJIA) confirmed by a move in the Dow Jones Transportation average will often have a higher chance of continuation than if the Transports diverge from the market.

When comparing the Volatility Index with its underlying index, it’s important to note that this is not an apples to apples comparison. Remember, the supply and demand for option premiums acts differently than supply and demand of a capital market.

With divergences, it is often more important to use these signals as a series of contextual clues rather than a set in stone indicator. For example, if the NDX breaks a clear support level but there is no accompanying spike in the VXN, it tells us that there is reduced demand or an oversupply in NDX option premiums. In other words, traders are selling volatility into the move lower or not buying protection. The options market is skeptical of further downside.