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Advanced Technical Analysis - VXO

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Since the March lows in volatility (and price high in the OEX), we have been unable to discern a discreet technical pattern in the widely followed and oft-quoted CBOE volatility index, the VXO. The main reason for this "unclear" technical view has been the highly choppy action between, roughly, 13 and 20 over the last 7 months.

Such overlap and range-trade severely stresses technical analysis tools like Elliott wave and Demark indicators and makes conclusions highly tentative. However, we believe we have enough technical evidence (Elliott wave pattern, Fibonacci projections, Demark indicators, and momentum divergences) to suggest that investors, particularly option investors, be on the lookout for a potentially important bottom in the VXO in the next 1-2 weeks (if last Friday's bottom at 12.43 was not just such an important bottom).

Specifically, from an Elliott wave perspective, the peaks in July 2002 at 56.74 to the recent (10/1) low, a fairly clean "5" wave move down can be counted, where the 3rd wave "extended" (and was 5/3rds the distance of wave 1), and waves 1 and 5 are almost identically equal (they would be exactly equal at 12.18). Very often in impulse waves where wave 3 extends, waves 1 and 5 are equal. Furthermore, what appears to be a 4th wave triangle formed from the lows on March 2nd 2004 at 14.03 to the 20.72 peak on 8/6/04. As regular readers are aware, triangle patterns usually express themselves in the next to last position in patterns of one larger degree. Further, 5th wave thrusts out of triangles tend to travel the same distance as the largest width of the 4th wave triangle. In this case, the 5th wave thrust "points" to 12.09 +/- using this triangle rule. The fact that a triangle seemed to form from March to August 2004 adds even more weight to the Elliott wave conclusion that a potentially very important low has or will shortly take place with this index. And it is all the more impressive from a Fibonacci standpoint that wave 5/wave 1 equality from the 2002 peak "points" to 12.18 while the 5th wave projection using the 4th wave triangle rule "points" to 12.09.

To these important Elliott wave/Fibonacci projections we would add a host of Demark indicators. The weekly chart of the VXO shows a rare 9-13-9 buy setup near completion; this week's price bar will register a valid "8" and next week's will register a "9" IF the VXO ticks at least one tick below the 10/1 low of 12.43. Further, the daily Demark chart shows a valid buy setup "13" as of yesterday's close. Lastly, both the weekly and daily momentum profile (MACD line and histogram) is showing a clear divergence on these new price lows for the VXO against the important lows for the VXO struck during the last 18 months (a large divergence, indicative of a potentially very large magnitude bottom).

The very short term chart (hourly) shows a very clean "5" waves down from the August 6th peak to last Friday's (10/1) low. Clean because a perfect "phi" relationship would exist between all of the 5 waves in the sequence if the VXO were to bottom at 12.23.

In sum: (1) the weekly and daily Elliott wave pattern can be considered a completed impulse pattern as all the pieces are in place for a reversal on both time frames, (2) Fibonacci projections point to the 12.09, 12.18, and 12.27 levels on various degrees of scale (weekly, daily, hourly) for a "perfect" Fibonacci completion of this impulse sequence down from 2002; (3) a very rare weekly "9-13-9" buy setup could register if the VXO ticks at least one tick below 12.43 either this week or next week; (4) a valid daily "13" Demark buy setup registered yesterday (10/4); and (5) both weekly and daily momentum is not confirming this new low in prices for the VXO, signaling that its trend is weak and subject to reversal.

All of these technical indicators strongly suggest a major reversal in the VXO (up toward higher implied volatilities) could be in the offing in the next 2 weeks if last Friday's low did not already produce such an important low. A move above 14.76 would be the first sign that an expected turn was underway in the VXO to potentially much higher levels (25 at a minimum). We'll take it one step at a time and wait to see some evidence on the hourly chart that an "impulsive" move up is underway. Hopefully the VXO will register at least one more new low beneath 12.43 in the next 9 sessions to fulfill the last remaining bottoming indicator, though such a move is not necessary to mark such an important low.

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No positions in stocks mentioned.

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