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Volatility Sits at Six-Year Lows, Now What?

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The VIX has been one of the better performers over the last year. It may be showing signs of a bottom, which usually leads to a quick profit opportunity.

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In mid-December, we were focused on three important contrarian signals that were giving warning signs of a potential market top. The prevailing theme was the marketplace was complacent and ripe for a sell-off, or worse, a rogue wave . We made the point that it was a great time to buy cheap portfolio insurance by going long volatility.

That mid-December sell-off only sent the US stock market down 4%, but did you see what it did to the VIX (^VIX)? In very short order, the VIX skyrocketed up over 25%. Is a repeat scenario lining up?

Numerous Opportunities for Cheap Protection

Throughout the last few months the VIX has hovered below 20 and even spent a majority of its time below 15. When it hits these low levels, it often provided a quick profit opportunity.

On September 21 when the VIX was at 14, we wrote: "The VIX is at five-year lows, and most other sentiment indicators are high for the market right now, which historically marks (market) selling opportunities rather than buying opportunities."

One month later, on October 19, when the VIX was at 15, we said: "In-the-money call options with 2013 expirations could be bought as a way to hedge or to protect gains going into next year. We favor VIX options over the VIX ETPs (NYSEARCA:TVIX) as a better way to play intermediate to longer term trends in stock market volatility." These VIX signals in September and October helped point to the near term market top that formed then.

And finally on December 17 with the VIX at 16, it was again a great time to buy protection. We wrote: "The VIX has refused to spend much time below the 15 level providing a solid support and buying area for VIX bulls. As it approaches that level, buying front month in the money calls is a good trade. We like going long the VIX Jan 14 call options at $271 per contract."

Two weeks later, the VIX was at 22 and those options were up over 100%, trading for $560. Profits were taken as the technicals warned of the top in the VIX helping us get out before its recent descent.

"It (trendline resistance) likely will act as resistance, especially given its steepness, and is a great spot to take profits. Combine this with the channeling technique's target being met, and the odds are increased the VIX will pull back this week. Such a fast move should be considered a gift and there is nothing wrong with taking portions of it off the table."

The Charts Do Help

Below is the chart my firm has used for the last few months. In the recent past, when the VIX is below 15, market peaks are usually just around the corner. When the VIX then rises to 19, it is usually an area to start look at taking volatility profits.

However, its latest decline has taken the VIX to six year lows and taken its cousin, the Nasdaq 100 Volatility (^VXN) near all time lows below 14.

A combination of technical indicators such as relative strength were used in the examples above to help identify short term bottoms and again are giving us signs of a bottom. As a result, we recently suggested again buying VIX longs when it fell below 13 (red arrows in chart). Already those longs are profitable and the potential exists for a whole lot more.

That RSI divergence is one of a few pieces we are watching to complete our VIX bottoming puzzle. The next piece of confirmation of a VIX bottom would be a breakout of a key price level. Finally, the potential also exists for a bullish bottoming pattern to be playing out, but that is not confirmed yet. If it does confirm, our conviction that volatility is bottoming would only increase.

A volatility bottom, would likely imply the market's rally is over and at a minimum a short-term market sell-off is also likely to occur.



Editor's note: This story by Chad Karnes originally appeared on ETFguide.com

To read more from ETFguide, see:

Are Higher Interest Rates the New Normal?

3 Signals That Could be a Turning Point for Stocks

Are Gold and Silver Poised for a Move Higher?
No positions in stocks mentioned.
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