VIX Breakout Could Signal Further Market Weakness

01/24/08 08:44:24 AM

by Kevin Hopson

Even though the VIX is finding resistance around last August's high, the recent pattern breakout could act as a catalyst for higher prices.

Security: VIX
Position: N/A

The Chicago Board Options Exchange Volatility Index (VIX) measures investor fear/volatility via options trading for the Standard & Poor's 500. The VIX tends to move in the opposite direction of the S&P 500, which means it can act as a contrarian indicator when volatility reaches extreme levels. Unfortunately for the bulls, the VIX may have higher to go before signaling a bottom in the market.

If you look at the six-month chart (Figure 1), you will see that the VIX has broken out of a symmetrical triangle pattern. By taking the base of the triangle (high point - low point ) and adding this figure (37 - 16 = 21) to the breakout point (25), you come up with a potential price target of 46.

FIGURE 1: VIX, SIX MONTHS. Note that the VIX has broken out of a symmetrical triangle pattern.

Graphic provided by: StockCharts.com.

In addition, it appears that the VIX has broken out of a reverse head & shoulders pattern, which formed within the symmetrical triangle. If this pattern is accurate, it would coincide with the price target I mentioned. For example, if you measure the distance from the completion point of the left shoulder (29) to the bottom of the head (16) and then add this number (29 - 16 = 13) to the neckline breakout point (34), you come up with an estimated price target of 47. In other words, the two patterns indicate a target range of 46–47.

Since the VIX met resistance around last August's high (as illustrated by the red line), the index could pull back in the near term, possibly to the mid-20s. The reason I say this is because broken resistance tends to act as support and the triangle breakout point (prior resistance) comes into play around 25. If a pullback of this magnitude does occur, it could create an attractive trading opportunity. More specifically, to hedge against another market downturn, traders might consider buying inverse S&P 500 exchange traded funds (ETFs). ProShares, ProFunds, and Rydex are just a few companies who offer these investment vehicles.

Kevin Hopson

Kevin has been a technical analyst for roughly 10 years now. Previously, Kevin owned his own business and acted as a registered investment advisor, specializing in energy. He was also a freelance oil analyst for Orient Trading Co., a commodity futures trading firm in Japan. Kevin is currently a freelance writer.