Tuesday, March 1, 2011
There's no such thing as the "perfect trade setup." But this is as close as it gets...
This is a chart of the iPath VIX Short-Term Futures Fund (VXX). A tradable proxy for the Volatility Index (VIX) – an indicator we've covered in Growth Stock Wire many times. As you can see from the chart, VXX spent the past 10 months forming a falling wedge pattern with positive divergence on the MACD momentum indicator.
These patterns most often break out to the upside. The longer it takes for the pattern to form, the more violent the breakout. For example, a chart showing a one-month falling wedge will have limited upside compared to a chart showing a six-month long falling wedge.
You rarely see wedges as long as 10 months. So when a breakout occurs in this pattern, it's likely to lead to a sustainable move higher. It doesn't move in a straight line, though. Often, we get a breakout in the chart pattern followed by a quick retest of the former resistance line. If that former resistance now holds as support, it should be off to the races.
Take another look at the VXX chart. The stock broke above the resistance line of the wedge last week, and it's coming back down to test the line – which should now hold as support. This sets up a terrific low-risk opportunity to trade volatility.
If support holds and the breakout is genuine, VXX should turn higher within the next day or two and kick off an intermediate-term rally in volatility lasting at least a few weeks. On the other hand, if VXX falls back into the wedge, the pattern is violated, and traders can exit the stock with a small loss.
This is the epitome of a low-risk/high-reward trade.
The operative word here is "trade." VXX is not a buy and hold vehicle. Volatility expands and contracts. Then it expands and contracts again. It has been contracting for the past 10 months, so I expect it'll expand now for at least the next several weeks.
Buying VXX right here as it retests the breakout point of the falling wedge pattern is one of the best-looking trades you'll find this week.
Best regards and good trading,
As Jeff said in January, "Periods of low volatility in the stock market are always followed by periods of high volatility." Back then, a special indicator showed volatility was at its lowest level since the flash crash... leaving nowhere to go but up. Read more about this indicator here: When This Stock Market Signal Flashes, It's Time to Get Short.
Following last week's 40-point drop in the S&P, the Fed is telling people to "buy on the dips" in the market. But according to Jeff, nothing could be more dangerous. See what he recommends to keep your head above water here: Don't Buy the Dip.