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Again, we established a position here that looked something like a bottom. There was a support point here, and the market rallied up, and a continuation of prices in which the flag patterns began to develop again. This was a very short pattern here. They don’t all have to be long patterns. Some of them can be extremely short.
Here’s a short pattern. That’s a short pattern. Now we’re starting to establish rounding tops again. In these cases, if you were establishing a rounding top, you would take a look at prices after they increased. It’s possible to have established short positions right underneath this low. This one would have been a false signal, but this one would not have been, because it broke this low, and it broke through dramatically to the down-side, after a rounding top.
Even though it’s not 100% perfect, it is a good way to determine the probability of future market direction – when used in conjunction with the VIX. Let’s take a look at the VIX. Before I really do anything in the market, I always take a look at the relationship between the VIX and current prices. When the VIX is relatively low, it is generally a clue that prices in the stock market will begin to decline, and sometimes decline rapidly.
The VIX actually has a historic basis going back to 2003. The VXO was the original volatility index, which was based on the OEX Index. That goes much farther back. They started establishing data back in 2003. Actually, the OEX Volatility Index, or the current VIX, goes back for quite a long time. It looks like they didn’t actually keep data on that.
There is also the VXN, which is the volatility index for the NASDAQ. They just started to establish data back in 2001, for the NASDAQÂ volatility index. You can see at what levels these were, back during the market decline in 2001. Some of these volatility levels were as high as 82-83. They were extremely high.
That’s an unbelievable level. Since then, of course, we’ve had a tremendous rally. Prices have gradually started coming down on the VXN. I take a look at the VXN and the VIX itself, which is the volatility index of the Chicago Board Options Exchange, to determine where the probability of prices will go.
You can think of volatility in this way. When volatility is extremely low, people are very comfortable in their positions. They are very comfortable with stocks. They don’t see the risk in holding stocks. They believe that everything is right with the world. Interest rates are low. Business is great. Stock prices are going up. They get complacent.
That’s what happened, back in December of 07. It was actually a low. There was some volatility. The volatility index started moving up. They established another low. Volatility index moved up. It never broke this 12.5 level, which was somewhat of a resistance point.
Prices moved up again. The volatility index moved low. Right around the middle of February, prices just fell apart, and the volatility index increased dramatically. When the volatility index increases dramatically in a single day, like it did right here, it’s generally a sign that volatility will continue to increase over time, because of the large movement of the volatility index.
It did become extremely volatile. The prices went up and down. Eventually, this resistance point for the volatility index became support. Prices on the stock market generally started to decline, and get to the point where volatility was high. They were high, relative to its recent past.
In order to really determine the historical perspective that you need, you need to use these long-term charts. You can see, going back to 1998, 1999, and 2000, the volatility index was anywhere between 17.50 to 37.50. At times, it got up to the 55 level, in which there was an extreme amount of fear in the markets.
What does the VIX do, anyway? The VIX is a sentiment indicator of investors’ bearishness or bullishness. It’s an indicator based on the SMP 500. It’s a measurement of the implied volatility of the SMP 500. What it really measures is how bearish or bullish people are on the SMP 500. It’s a sentiment indicator. In other words, when people are feeling very good about stocks, it’s very low. When people are very bearish about stocks, it’s very high.
When you take a look at the VIX itself, you can almost determine whether or not things are going to get better or worse in the market. You can predict short-term price movements in the market, with some degree of regularity, just based on the type of technical analysis we already do on stocks.
In other words, resistance points work very well on the VIX. Flags look very well. You might have noticed that I’ve drawn a couple lines here, which are flags. These indicate that, from this point here, the volatility has started to decrease. It broke through this resistance point, which actually was the support line here. It created a gradual increasing of prices here.
The thing about flags is that they are not dramatically increasing the prices, after a price decline like this. It’s a gradual increasing of price. That’s an important distinction to make for flags.
It established a flag here. What happens? Well, we know that on the establishment of a flag, a gradual increase of prices after a severe decrease like this, that it’s likely to continue that trend. The probability is that it will continue that trend. That is exactly what happened.
Here, again, we had a small little flag. These 3 little bars are a flag, which is a continuation of a prior trend. When we see these 3 little graduations in prices here, we know that the trend will probably continue. It did.
Again, we had another gradual increase on prices here on the VIX. That is another sign that it will probably reverse itself and continue this down trend, which it did again. We had another little flag, and a decrease in prices.
We had a pretty strong reversal. We actually had a resistance point here, a support point for the VIX, that went a little while back here. It went all the way to October 8. Remember, I talked about resistance and support points – this support point right here was significant, because prices rose dramatically after touching it.
It becomes a support point, at that point, because of the way prices react to it. It turns out that it is support again here. When that support was hit, prices reversed dramatically and started going back up again, which means the prices of the stock market declined.
We’re going to take a look at the Dow Jones, as this VIX was unraveling here. Let me do the 3-month chart on here, and I’ll do the 3-month chart here as well, so we’re looking at the same time frame.