Has VIX/VXX Finally Turned the Corner?

Includes: DIA, KBE, SPY, VXX, XLF
by: Investment Underground

By Chopthis777, Guest Editor

Last Friday's action increased the premiums (price between VIX futures and the spot VIX). This is very bearish for VIX/VXX in the “normal” market. Since we haven't seen a “normal” market since the beginning of QE1, it wouldn't necessarily mean much unless “confirmed” by today's market action in one way or another. However, for the sake of keeping the convention consistent, I will still go with the Long Term Sentiment Disclosure of “Strong Sell” for now. (Please note that this LTSD can and will change very quickly due to the day's market activities, for it is a lagging “confirmation” rather than a leading “indicator.")

Last week's market overall was consistent with the “usual” option and futures contract expiration activities in VIX/VXX. Monday started out with VIX and VXX going in opposite direction -- “divergence” -- which has happened about 85% of the time for each VIX futures contract expiration since the inception of VXX in January 2009. And for every case there was a “divergence," there also came what I call “convergence," or both VIX and VXX moving in tandem with relatively stronger force.

Of course, the real question will be which one – the VIX or VXX, which have gone in opposite directions – will be found to be the “correct” one. Unfortunately, there is really no way to predict this with any meaningful accuracy. However, one can still collect valuable insight for clues on how the market will behave. I will list the three possible scenarios for this “convergence” coming together for today (2/22/2011) and the rest of the week in the order of what I believe is the more likely scenario.

  1. VIX will move up sharply while VXX will also rise up in a sizable move. This action will make VXX quite bullish, at least for the short term, and will result from both VIX and VIX futures moving up in tandem.
  2. VIX will move up while VXX will move down in relative terms. This action will paradoxically make VXX less bearish (not necessarily bullish) even though VXX actually went down in price. The reason for this action will be the VIX moving up in a relatively calm fashion while VIX futures come down – again, relative to VIX – also in a relatively calm fashion.
  3. VIX will stay about the same or even go down a little, while VXX goes down in a sizable move. This action will show up when VIX futures' relatively high negative premium becomes less negative due to the reduction in the implied volatility in the nearer-term VIX futures, while the further-away VIX futures' implied volatility stays the same or even goes higher.

Additional consideration for the entire market's direction may be found in the late actions of XLF and KBE. Since the downturn of the market in Oct. 2008, these key ETFs have tried to rebound once already -- only to be taken down again in 2010. They are making a run for the upside this time again, very “quietly.” Every visible sign seems to indicate that they are indeed making new higher highs. However, these signs once again must be considered with the back drop of the “not normal” or “new normal” market condition that is QE2, etc.

It is very tricky and dangerous to rely on the “old faithful” indicators and ideas since we are not in Kansas anymore. Therefore, it would be very prudent to have a relatively shorter term “outlook” of the market with an “itch” finger on “exit” strategy for the time being unless of course one's money management strategy dictates otherwise.

The S&P 500 (NYSEARCA:SPY) again seemed to have broken above the recent resistance level as well as DJIA (NYSEARCA:DIA); however, with the continuing backdrop of geopolitical uncertainty coming from Africa and the Middle East, the real test of these levels getting broken seem still to come. It will be very interesting to see what the corporate earnings that are being reported this week do against this backdrop of negativity.

Market correction has been forecasted/expected for over three months now by some pundits; for the time being, it seems like at least some type of correction is ready. VXX has closed down for four straight days in a row as of last Friday. It isn't as clear cut as it seems, though, because of the extra long weekend as well as the fact that VIX didn't confirm that negativity. However, there have only been two times in history that VXX went up for five straight days, and one time it did so for six straight days. All three times came at or around the market top/VIX bottom. Again, it will be interesting to see how the market will play out this shortened week.

Last Friday's MRP (Minimum Reversal Price) for VIX was 22.70; that's 38.16% above the same day's VIX close price of 16.43. I will be worried about VIX/VXX reversion to upside beginning around 20%.

2/10/11 Sell: Same as yesterday's except more likelihood of intraday turbulence.

2/11/11 Strong Sell: The premiums got more negative and there's a sign that confirmation to the market up move for several months has happened. Watch out for the monthly contract expiration divergences between VIX and VXX.

2/14/11 Sell: The premiums got less negative and there's divergence between VIX and VXX. As we enter monthly VIX futures expiration windows, there is likely more turbulence and a sense of uncertainty in the market. Political/economical backdrops also add more to this scenario. Short term trading opportunities may arise allowing nimble traders to benefit both directions.

2/15/11 Sell: The premiums got less negative again. We are waiting for the confirmation of the divergence moves from 2/14/11. Short term trading opportunities may emerge and disappear very quickly as we move through the Feb. VIX futures expiration week.

2/16/11 Sell: Basically the same, except the Feb. VIX futures contract is off the board. We are still waiting for meaningful confirmation of the divergence which happened on Monday. It is still possible that Tuesday's action was indeed the convergence; both days' actions were very weak. Short term churning action in the market continues.

2/17/11 Strong Sell: The premiums got more negative as the Feb. VIX roll off completes. Convergence seemed to be confirmed as well. Still looking for short term churning action in the market looks to continue at least until the end of the trading day. This might be a good time for short term intraday tradings.

2/18/11 Strong Sell: The premiums got more negative. There is still additional sign of divergence between VIX and VXX; we may have to wait for another convergence in the market. This may also create additional short term turbulence, which may be a good opportunity for shorter term traders. Decision time may be at hand.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in VXX over the next 72 hours.