Tuesday, April 26, 2011
I hate referring to the "flash crash." Too many people do it, and it seems a bit inflammatory to keep saying one indicator or another is signaling another dangerous market event. But this one is staring us in the face and begging to be noticed.
The action in the Volatility Index (or "VIX") is eerily similar to what happened last year – just before the flash crash.
The VIX is a measure of fear in the market. It's used as a contrary indicator. So when the VIX is low, it signals investor complacency and warns traders that sentiment is too bullish. When the VIX is high, it indicates traders are fearful and we may have a buying opportunity.
One of the most consistent warnings of an impending correction occurs when the VIX closes below its lower Bollinger band and then rallies back within the bands.
For example, here's how the VIX looked in the early months of 2010...
The blue lines on the chart are Bollinger bands. They outline the most probable trading range for the chart.
Whenever a chart travels outside of its Bollinger bands, it indicates an extreme move – kind of like stretching a giant bungee cord as far as it'll go. When the chart comes back within the bands, it often leads to an extreme move in the other direction – like releasing one end of an outstretched bungee cord and watching it spring the opposite way.
On January 11, 2010, the VIX closed below its lower Bollinger band. When it rallied back within the bands, it made a sharp move higher and busted out to the upside of its trading range. This coincided with a 7% correction in the S&P 500.
In mid-April 2010, the VIX once again closed below its lower Bollinger band. It soon rallied back within the bands. Three weeks later, we got the flash crash and the start of a 20% correction for the stock market.
Here's how the VIX looks so far this year...
Here again, the VIX warned of a correction in mid-January when it closed below its lower Bollinger band. The mild 7% correction that kicked off in February was similar to what we've seen before.
And we got another warning last week.
The timing is almost identical to last April's flash crash... so is the preceding action, the bullish sentiment among investors, the increase in margin debt, the lackluster volume, and any number of other indicators.
Of course, that doesn't necessarily mean the outcome will be the same. But do you really want to take that chance?
Best regards and good trading,
Jeff has been bearish for months now. But by closely monitoring Bollinger bands, the summation index, and even the mother indicator, he's found ways to profit in the face of disaster. Check out more warning signs here…
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