Wednesday, December 31, 2008

VIX Analysis…

Today the VIX is down another 4%, and has broken down out of its latest consolidation range. This is further confirmation of a bullish trend in stocks for now.

The VIX is a derivative that measures certain option buying activities (a good site to learn more about the VIX is: VIX and More, start by looking at their top 10 articles of the year post). It measures “volatility” and is indirectly a measurement of fear (the VIX is only 1 volatility measurement, there are many such as the VXO, VXN. Plus, there are many other fear gauges as well).

I use the VIX/VXO as one gauge to help me decide where the market is psychologically. There are three components which must be considered in any market; fundamentals, technicals, and psychological.

Since the VIX is a derivative (it indirectly measures an underlying), some believe that technical analysis (TA) on the VIX is utter nonsense. I say they are mistaken big time. I’ve used TA on the VIX for years and have seen it work consistently. But yes, you do have to keep how it works in mind and give it a little more leeway than you would TA on a direct asset.

Let’s start with a 20 day, 20 minute chart. Note that today’s action just broke down out of a sideways consolidation channel. Also note that the stochastic is oversold in the short run, but if you look back a few days you can see that it can stay in oversold for quite some time.

Next, let’s look at a 3 month daily. Here you can see that we broke down out of the large triangle and are printing a red candlestick under that channel. Here, too, we are deeply oversold on the daily stochastic (also oversold on the weekly). We are approaching the lower Bollinger band again, and also the 200 day moving average which is in the 34 region. That would be my guess for the next area of support as it also coincides with support areas further back in time. Also note that the target on that large triangle would be 45 from the triangle break at 55, which would equal a target of just 10! Will we get there? I don’t think so, but there’s another target producer that says we’re going to 20…

That 20 target comes from this computer generated Point & Figure chart (courtesy of In order for us to reach that target, the VIX will first have to break pretty strong support in the mid 30’s.

Now let’s look at a 60 day, 60 minute chart and apply a little basic Elliott Wave analysis. From the peak at 90, you see a precipitous 50% decline all the way to 45 that I am labeling as wave 1 down. Next is a very large retrace back up to more than 80. Deep retraces are a hallmark of wave 2’s, and that’s how I have labeled that move. Next you can see a decline to my smaller red number 1, and if you count the movement inside of that move, you will find 5 smaller waves. Then a nearly perfect 50% Fibonacci retrace to the red #2, followed by a wave 3 movement down, which again contains a very clean 5 wave pattern inside that.

From that red #3, we moved sideways over the past few days which is typical of a wave 4 movement and it now looks as if wave 5 down is underway. When wave 5 down finishes, that will finish the larger wave 3 down, and I’ll bet it ends in the mid 30’s.

If this is a 5 wave movement, I would then expect sideways consolidation in the mid 30’s to produce a larger wave 4, which would be followed by a 5th wave to the eventual low. It’s also possible that this is not a 5 wave move and is only a 3 wave A-B-C… don’t know.

What does this analysis tell us? That it would appear lower volatility is going to be with us for a while and that portends interim higher prices for equities. That is consistent with Elliott Wave work in the equity indices which place us in the larger wave ‘B’ up/sideways which should be followed by the very destructive wave ‘C’ down to the eventual bear market lows.

This also coincides with Martin Armstrong’s work in waves which calls for a rally through about March of 2009. I’m not certain of that timing, I’ll be looking for other technical indicators to decide when wave ‘B’ is ending.

Remember that if you are using options, the volatility is a large component of the intrinsic value (IV) of options. As the VIX falls the intrinsic value of all options will decline, the further out-of-the-money (otm), the larger the decline. The reason for this is simple; low volatility means that the odds of reaching targets far away go down. In a high volatility environment one expects the likelihood of reaching far away targets to be higher, thus the sellers of options want more money from the buyers as their risk is greater. That means that as the VIX moves down, the price of otm PUTS will drop dramatically, while the price of way otm CALLS will not gain in value as quickly as you might expect when the market goes up. Thus, if you are playing long with options here, my advice is to buy in-the-money calls or use another vehicle entirely like the 2x or 3x ETFs (caution: I do not consider the leveraged ETFs to be “buy & hold” instruments for any significant length of time – they are good for short term trades only).

Hope this analysis is helpful, comments are always welcome.


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