VIX and Other Indicators Signal a Stock Slide

by John Nyaradi | February 22, 2012 3:00 pm

As the major U.S. indexes grind higher into overbought territory, VIX, the CBOE fear index, points to lower stock prices ahead. VIX measures the implied volatility of the S&P 500 and is often viewed as a predictive indicator because as VIX rises, stock prices typically fall, while a falling VIX generally indicates higher stock prices ahead.

Nyaradi VIX 1 VIX and Other Indicators Signal a Stock Slide[1]

Chart courtesy of www.stockcharts.com

Looking at this conventional chart of VIX, we can see that it has recently been in a sustained downtrend until putting in a pivot bottom around Feb. 5. After that, the VIX spiked higher to challenge its 50-day moving average, failed and retraced down to support in the 17 range. It’s now just above long-term support that goes back to before the financial crisis began in 2008, so a break below that would require a wave of positive sentiment unlike anything we’ve seen in the last five years.

Nyaradi VIX 2 VIX and Other Indicators Signal a Stock Slide[2]

Chart courtesy of www.stockcharts.com

The point and figure chart shows VIX on a “buy” signal with a bullish price objective of 30, some 60% above current levels. However, the red column of Os suggests a momentary pause in its climb, while a break below current levels would be bearish and a sell signal for the index.

From here on out, the battle will rage over whether support can hold or if the longer-term bear market will resume. VIX moves inversely to stock prices, so the outcome of this battle will affect equity prices as well.

Taking a look at the S&P 500, which tends to move inversely to VIX, we see that the index is in seriously overbought territory and has been in a nearly unbroken uptrend since mid-December 2011.

Nyaradi VIX 3 VIX and Other Indicators Signal a Stock Slide[3]

Chart courtesy of www.stockcharts.com

Today, RSI is above 70, while MACD is rolling over, and the index is at long-term resistance levels. These conditions would generally point to a pullback of some measurable distance. However, bulls will point to the fact that the index has recently formed the “golden crossover,” a bullish indicator in which the 50-day moving average has moved above the 200-day moving average and generally is thought to portend higher prices ahead.

For investors interested in trading VIX, several exchange-traded funds are suitable vehicles:

iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX[4]). This is one of the most popular “long” VIX ETFs. While the ETF doesn’t exactly track VIX since it has some tracking error, it offers decent exposure to this market and is widely traded and very liquid.

VelocityShares Daily Inverse VIX Short Term ETN (NYSEARCA:XIV[5]) is the ETN to consider if you think VIX is going to decline as it moves opposite to the direction of the underlying index.

VelocityShares Daily 2x VIX Short Term ETN (NYSEARCA:TVIX[6]) is a 2X leveraged ETF that is designed to double the rate of motion in the underlying index. TVIX has become a hugely popular ETN, with volume now topping VXX. But this ETN is likely only suitable for day trading or very short holding periods since its price is readjusted daily and so could generate profits or losses substantially larger than two times the VIX index.

Volatility ETNs tracking the VIX have grown to be hugely popular, widely traded and very volatile vehicles that must be approached with a solid trading and risk-management plan. For the well-prepared, the potential profits can be very rewarding. However, these are fast-moving ETNs, and things can get ugly in a hurry if you wade into these rapids without a plan.

Looking at the big picture and the three charts we’ve just discussed, we see that the indexes are overbought, while VIX is oversold and near multi-year support. The combination of overbought conditions, prices at significant resistance and declining momentum in the stock market, coupled with bullish indicators for VIX, points to the high likelihood of a correction/reversal coming sometime in the near future.

Should that occur, the outcome would be higher prices for VIX and VIX ETNs and lower prices for U.S. equity markets as this combination of overbought/oversold unwinds.

Wall Street Sector Selector holds long positions in VXX and VXX options.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2012/02/Nyaradi-VIX_1.png
  2. [Image]: http://investorplace.com/wp-content/uploads/2012/02/Nyaradi-VIX_2.png
  3. [Image]: http://investorplace.com/wp-content/uploads/2012/02/Nyaradi-VIX_3.png
  4. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX
  5. XIV: http://studio-5.financialcontent.com/investplace/quote?Symbol=XIV
  6. TVIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=TVIX

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