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Educational Article

Complacency Reigns!

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I've been writing about the Volatility Index (VIX.X) so much lately that I feel like a bit of a one-trick pony, but I keep coming back to it because the action is so compelling and I feel it is sending us some big warning signals that we can't afford to ignore. Despite continued volatile action in the broad market, the VIX has continued to drill to new multi-month lows, very clearly telegraphing that option writers are becoming less and less nervous.

The big question is "why"? The economy is not in good shape, and while this earnings season probably won't be a disaster, neither will it provide any evidence of the much-ballyhooed second half recovery. While I touch on the topic of the VIX every week in the LEAPS column, the strange behavior of this indicator has prompted me to write a couple of lengthy articles on the topic in recent months. For those of you just tuning in, here are the links to what I think are the pertinent issues related to the VIX.

Best of Intentions
http://www.optioninvestor.com/page/oin/education/opt101/2003/02-26.html

Consolidation
http://www.optioninvestor.com/page/oin/education/opt101/2003/03-26.html

Let's summarize what we were looking for, so that we can put the recent action in the VIX into the proper context. Stepping backward in time just a couple weeks, I was looking at some potential support levels in the VIX, first at the ascending trendline (just below 29) and then at the November/January double bottom near 26.20. Well the trendline was violated late last week, and yesterday's close of 26.04 fractionally broke the double bottom support. With last night's bullish reception of the MSFT/INTC earnings results, a strong move at the open (and hence more weakness in the VIX) seemed to be a certainty.

While we did get a slight gap up at the open, it isn't the price action in the major indices that I think was important. It was the weakness in the VIX, which traded down to 25.10 this morning, its lowest level since June 11th, 2002. There was one other, more esoteric support floor that I came up with for the VIX and it came from a historical calculation I did with respect to the VIX and its 200-dma. This study demonstrated that over the past several years, there has been a floor under the VIX at a level 30-32% below the 200-dma. Based on the 200-dma at 35.82 this morning, that pegged the practical floor for the VIX in the 24.36-25.07 area. So isn't it interesting how the VIX bottomed right at the top of this range today? We've looked at this chart before, but I think an updated picture as of today will prove most enlightening.

Daily Chart of the CBOE Volatility Index (VIX.X)

Those two potential support levels near 29 and 26 didn't hold, but the calculated floor for the VIX based on the 200-dma was spot on! And I like the way the VIX drifted up to close just over 26 this afternoon.

On several occasions in recent months (specifically in the Best of Intentions article), I've noted the strange divergence between the VIX and the S&P 100 (OEX.X). Over the past several months, there has been a consistent draining of fear out of the market, and that phenomenon caught my attention big time. Today I want to take a different look at this relationship, in a way that I think will better demonstrate what I'm seeing.

Relative Strength Chart of the VIX vs. OEX

Those two charts may look the same, but take a closer look and you'll notice some subtle, but I believe very important differences. See that island candle that was entirely above the upper trendline in the first chart? In the relative strength chart, the close was back below the trendline. And look at the action over the past week. While the past five days have been below the lower trendline on the first chart, when we look at the VIX in this relative strength format, we see that the lower trendline has been respected on both of the past 2 days. In addition, look at the horizontal support produced by the November/January double bottom. That level of support also held today, whereas it has been violated on the standard VIX chart.

Alright, I know I've probably already made my case, but I want to present one more perspective of the inter-relationship between the VIX and the OEX that shows how fear has been draining out of the market.

OEX Daily Chart with VIX Overlay

Normally, the VIX and OEX should move opposite of one another, but that is clearly not what has been happening lately. Even though the OEX is actually below its 10/21/02 level, the VIX is also lower, by 34%!! The aberration from the normal VIX/OEX relationship was further highlighted today, as the OEX fell back to $446 while the VIX essentially ended the day unchanged. Let's go back in time a mere 10 trading days, and we can see the OEX came to rest on 4/02 at $447. Where was the VIX at the time? 31.29. The OEX is marking time, while the VIX continues to show a shocking lack of fear.

This strangeness is not confined to the OEX/VIX relationship though. Have you taken a look at the NASDAQ-100 Volatility index (VXN.X) lately? Yesterday, the VXN hit a new all-time low of 35.98. Now I realize there isn't as much historical data for the VXN as there is for the VIX, but the last time the VXN was in the area of 36 was at the end of March 2002. Do you remember what happened to the NASDAQ for the next four months? It got clobbered to the tune of a 38% loss. Here's a fun exercise for those of you that use Qcharts. Pull up your own relative strength chart of the VXN vs. the NASDAQ-100. The actual entry for the symbol field is "index:vxn.x /index:ndx.x" Don't forget the space between the first symbol and the "/". Do you see anything there that looks vaguely familiar?

So what does it all mean? Is the market ready to fall apart again? Well, yes and no. I've made no secret of my opinion that the equity market is still headed lower -- much lower. And this blatant display of complacency being demonstrated by the volatility indices only solidifies that belief. As traders, determining direction is only one part of our daily struggle. Perhaps more important is timing. While I think this bear market rally is getting a bit long in the tooth right now, I keep coming back to the bullish percent readings and they tell me that I'm still a bit too early to start getting aggressive to the downside.

Based on the discussion above, I think we are very close to a bottom in the VIX. But at the same time, I am holding off on entering bearish position trades on the major indices because of my expectation for further upside due to the position of the bullish percents. My ideal situation is to see the VIX fall near the 24 level, the OEX climb up to the site of its descending trendline (on the exponential chart shown in the Consolidation article referenced above), which is currently at $468 and for the bullish percents to work their way closer to overbought territory. Currently the OEX bullish percent is only 45%, so clearly there is further upside POTENTIAL. But I'll also point out that I have no conviction in seeing further upside. The bullish percents could halt their advance right where they are and the markets could proceed south from here. That's why I'm not trading the major indices (even on a short-term basis) from the bullish direction. My attention is focused on the bearish setups now and I'm just hoping the stars line up for the entries I want. As you can see, there are still several factors that need to line up for that great shorting opportunity, but if my analysis on the VIX is accurate, I certainly wouldn't rule out a repeat of what transpired between May and July of 2002.

No matter how you slice it, we're likely to see some excitement in the weeks and months ahead!

Mark

Note: I'm taking a brief respite from the markets next week, so I won't be doing my normal Monday and Wednesday articles. So rest up in my absence and we'll get back to educating as usual on April 28th.



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