Trading the VXN Wedge

By: Adam Hamilton | Fri, Feb 14, 2003
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Speculation never ceases to be an intriguing art. Speculators drink in a vast amount of information, try to sort the wheat from the chaff, make a decision based upon this imperfect and incomplete information, and deploy their capital accordingly.

It is the last step that makes speculation so fascinating. Most professions require their practitioners to make decisions based on imperfect and incomplete information, but speculation goes much farther and requires the speculator to put his money where his mouth is. Once his capital is deployed, a speculator can't hide. The markets will either prove him right or wrong and he will win or lose real capital before his trade is closed.

I am very impressed by the speculators who are always alert, even after their trades have been executed. They digest, analyze, and deploy like all speculators, but even after their capital is thrown to the wolves in the markets and placed at risk they continue to calmly and coldly scan the scene, sans dangerous emotions, for any new information that may affect their open positions.

As you well know the markets can move blindingly fast these days and chaos often reigns supreme, so maintaining the information edge that can lead to superior real-world trades is crucial. One speculator I respect who epitomizes this awesome alertness and financial situation awareness is my friend Dan Basch.

If you have been reading these weekly Zeal essays for awhile now you may remember Mr. Basch. In early October his brilliant proprietary work with the SPX/VIX ratio strongly suggested that a major bear rally was imminent. I wrote about Basch's fascinating technical findings in "Trading Volatility Ratios" published on October 4th, 2002.

The essay closed with, "If the SPX/VIX ratio proves true to its golden historical track-record, we are in for a spectacular bear market rally that will knock the socks off those not expecting it and yield legendary profits for those who are." Sure enough, Dan Basch's innovative technical work proved right on the money as one of the greatest bear rallies in the entire bust to date erupted a few days later on October 10th.

This week Mr. Basch told me about a new anomaly in the charts that had piqued his interest. I looked it over with him and found it fascinating as well. Basch's latest technical explorations have been into the VXN, pronounced "Vixen", which is the implied volatility index for the NASDAQ 100 stock index. For all you fellow VIX fans out there, the VXN is to the NASDAQ 100 what the venerable VIX is to the S&P 100.

To summarize before we get into the meat of Basch's technical discoveries, he has noted a colossal falling wedge forming in the VXN. A large falling wedge in a chart is often a very reliable technical indicator for an imminent breakout to the upside. We used this same type of formation way back in mid-2000 in "Gold Boiling in Oil" to help anticipate the coming gold bull.

Like us at Zeal, Mr. Basch is heavily short at the moment and expecting the current US equity downleg to accelerate dramatically. A massive falling VXN wedge breaking out to the upside implies great fear rapidly approaching in the NASDAQ 100. As selling and general fear multiply, the VXN rises as the powerful emotion vastly ramps up volatility. A VXN breakout approaching strongly suggests that the next sharp V-downleg in the NASDAQ is probably less than a couple months away.

For our Zeal Intelligence subscribers riding our various index puts with us, this means the moment of truth just discussed in the current February issue of ZI is relentlessly approaching. We want to sell near the bottom of the V-bounce to reap an enormous harvest of profits from our open puts positions. If the massive VXN falling wedge behaves as expected, the next V-bounce interim bottom will probably arrive in March or April, relatively soon.

If you are still stubbornly long even after the now obvious total failure of the latest major bear-market rally, get out now. It is infinitely better to be in cash earning 1% than suffering through another 30%+ NASDAQ drop from here in the next month or two. If you are already short, count your blessings and get ready for a king's feast of profits!

Now that you understand the important strategic message gleaned from Dan Basch's latest technical research, we can walk through the analysis to flesh out the details. We'll start with a long-term graph to grant us the crucial perspective we need before we zoom in to investigate the colossal VXN falling wedge.

Speculators often ask me why I prefer using the S&P 100's VIX to actively trade the QQQs rather than the NASDAQ 100's VXN or the QQQ's own QQV. The graph above offers one of the primary answers. While the VIX is seasoned and has a long and distinctive track record through much of a boom and bust, the two newer and more direct VXN and QQV implied volatility indices were both freshly born in January 2001.

Since the VXN and QQV are barely even 2 years old, and all the experience that traders have with them today is in the current NASDAQ bust, I am very hesitant to place heavy reliance on them. The red VXN line shown above superimposed over the blue QQQ NASDAQ 100 tracking stock is the entire history of the VXN!

In comparison the VIX data, also shown above in yellow as a familiar implied volatility anchor point, runs back to 1986 so speculators have a much better understanding of how this index registers extreme fear and greed over time. We plotted the VIX data in these graphs as well this week merely as a visual reference for our fellow speculators who usually traffic in it, so it is easy to compare the VXN activity with the much-more well understood VIX.

In the entire history of the VXN there have only been 3 major tops and 3 major bottoms, all circled above and noted with letters. What is a very high fear-laden VXN reading? Is it 80? 85? 70? How about a major low VXN reading? Should we call it 45? 35? 40? Because the VXN's major highs and lows have thus far refused to match up well across the small stretch of its history, caution should be exercised in interpreting this particular implied volatility index. Eventually we will have enough back data to know what a truly noteworthy VXN high or low is, but for now it remains somewhat ambiguous.

Even though the VXN is much younger than its spiritual ancestor the VIX, it is still valuable to monitor today, especially as a secondary trading indicator. It captured Dan Basch's attention lately not because of a new low or new high, but because a powerful technical pattern was emerging, the mighty falling wedge. Our next graph zooms in a bit to highlight this fascinating development.

Since about the middle of last year the VXN has interestingly been winding itself tighter and tighter in a colossal falling wedge (or descending triangle), highlighted above in red. With multiple VXN bounces off both the bottom support line and top resistance line of this falling wedge, this technical formation is remarkably well-defined. The implications of this development are stunning and bear careful consideration by all active index speculators.

Falling wedge technical formations are interesting because they usually almost always precede a significant event, a sharp and aggressive breakout to the upside out of the falling wedge formation. When Mr. Basch and I were talking about this development earlier this week, he shared various historical stock charts with me of falling wedges leading to huge upside breakouts. At Zeal we are familiar with this pattern as well, and as I mentioned above we have used this technical formation in the past in analyzing gold and oil and have been blessed with much success.

This colossal VXN falling wedge apparent above has a high probability of exhibiting similar behavior. As the current NASDAQ downleg already in progress accelerates, fear will continue to grow among general investors, slowly at first and then exponentially as we near the next fabled V-bounce. As I have discussed in many past essays on volatility, it is always spawned by the selling and fear that perpetually mark interim bottoms. As fear in the current NASDAQ downleg gathers steam, the VXN will break out of its falling wedge to the upside with all the fury of a runaway freight train.

When an upside breakout from a massive falling wedge occurs, a high technical probability exists that the item breaking out will rocket up to challenge its recent highs in a relatively short period of time. For the VXN, as noted in the first graph above, high levels so far in the game appear to cluster around a 70-85 range. Dan Basch's own highly mathematical and precise technical analysis points to a post-wedge-breakout VXN target of 78, right in the middle of the visual range from the first graph above.

Naturally the volatility-based VXN and the QQQs have an inverse relationship, so a rapid upside breakout in the VXN is almost certainly going to coincide with vicious selling on the NASDAQ as we head into the V-bounce consummation of this current brutal Great Bear Bust downleg. Indeed, in a causal sense it is the NASDAQ selling that spawns the VXN spike, not the other way around.

As you know I have a speculator's addiction to volatility and am perpetually fascinated by it. My first thought after initially witnessing Basch's VXN falling wedge was how unnatural it is in a Great Bear Bust. As I outlined a few weeks ago in "The Bust and the VIX", volatility should generally increase throughout an ongoing bust, not wither away. The VXN wedge's behavior is unnatural and not sustainable.

As the VXN falling wedge indicates, NASDAQ 100 volatility is not behaving properly and will have to explode to the upside soon to maintain an overall uptrend. This kind of glaringly obvious anomaly, a deviation from what the overwhelming weight of probability declares as expected behavior, is the kind of thing speculators dream of discovering and trading!

Interestingly, when Mr. Basch first contacted me earlier this week his expected colossal VXN wedge breakout hadn't occurred yet. As I was writing the rough draft of this essay on Thursday though, the first signs of the expected breakout were confirmed by the markets. And so it begins! We updated all the graphs in this essay to include Thursday's exciting data documenting the breakout he told me about before it actually happened. Three cheers for Dan Basch!

All speculators including Mr. Basch and myself are eager to gain an idea of how low this current downleg might batter the QQQs and NASDAQ before the next major bear-market rally erupts from the next interim bottom. Only time will tell what the real answer will be, but it is possible to make some simple calculations to get an order-of-magnitude idea of where we may be able to close our puts and shorts for enormous downleg profits.

Back in early December when we officially threw short for this downleg and recommended the same to our dear subscribers to our Zeal Intelligence newsletter, I offered a rough-guess downleg target based on the most recent three major downlegs of this horrific bust. Our active target at Zeal for this QQQ downleg hasn't changed since early December. It is at a QQQ level of $15 or so, a new all-time QQQ low that is almost unimaginable to most market players today. Here's how we arrived at this dismal target.

If you scroll down to the last graph of "QQQ Options Trading 101", you can see the total QQQ performance during its last 3 major downlegs. In early 2001 the Cubes plunged 50% in a brutal downleg. In late 2001 they plunged again by 45% in their next vicious downleg. In mid-2002 a third ugly downleg ensued, and the QQQs fell a gut-wrenching 53%. Yikes! I bet some of the remaining tech bulls are reaching the point where they would rather be Mike Tyson's punching dummy than bear any more NASDAQ torture!

If you take a simple average of the percentage fall in the last 3 major QQQ downlegs, you arrive at 49%. This average is even nice and tight without the skewing influence of outlying data, since the last 3 downlegs were conveniently so similar in raw magnitude. Even though this current downleg probably won't come in at exactly 49%, I am betting it will be reasonably close.

The latest interim high, the bear-rally top after the massive October-November bear-market rally, was carved out at a QQQ close of $28.00 even on December 2nd. Incidentally, we were very blessed at Zeal as this fortunately proved to be the very day the December 2002 issue of Zeal Intelligence was published when we officially closed all our index calls and threw short with puts and recommended that our subscribers do the same.

If today's current major QQQ downleg is merely average, we can expect about a 49%ish loss from the latest interim QQQ highs of $28.00. Believe it or not, this simple math leads to a current probable QQQ downleg target of $14.28, which we rounded up to $15 to be conservative in the December ZI as we ran the optimization table to decide on our specific QQQ puts deployments for this downleg. QQQ $15?!?

My office manager and I had a good laugh after we published this QQQ target in early December for our subscribers as one gentleman wrote in and said, "Holy [bleep]! QQQ $15?!? Now THAT is bearish!"

Indeed it is. Supercycle busts are not fun events and the Great Bears they spawn know few limits to their horrific carnage.

The same simple average recent downleg approach can be applied to the NASDAQ Composite to get an idea of where it may fall to in this downleg. If you visit our famous giant "NASDAQ 2000 vs. DJIA 1929" graph at www.ZealLLC.com/2002/1929.htm, which we just updated this week, you can see all the recent downlegs in the NASDAQ measured in percentage terms. The last 3 major NASDAQ downlegs weighed in at 43%, 38%, and 46%.

The simple average of these gives us a 42% downside magnitude estimate for the NASDAQ in this current downleg. The latest interim top on the NASDAQ after its awesome October/November bear rally was 1487.94 on November 27th, the day before Thanksgiving. If you take an average 42% downleg loss from here, it gives us a current strategic NASDAQ Composite downleg target of 863, which we rounded up to 865. NASDAQ Comp 865?!? Ouch.

Dan Basch's technical work leads him to believe the VXN will soar to 78. Our far-less sophisticated and primitive Zeal estimate is 70-85 for the next interim VXN high. I believe traders have a better than 67% chance of seeing the QQQs bounce near $15 and the NASDAQ near 865 when this next V-bounce in our Great Bear Bust is reached. If the VXN falling wedge behaves as individual stock falling wedges usually do, odds are we will see this next fear-laden interim bottom before the end of April.

Rubbish you say? You believe our discussion thus far is worthless bearish drivel and nonsense? You hear the Wall-Street-paid shills on CNBC every day telling you how the October 9th all-time QQQ lows of $20.06 will definitely hold in a retest? You believe the NASDAQ has already fallen far enough in this Great Bear and The Bottom is now in?

I understand, perhaps you are right. Both you and I are blessed to think however we want and trade however our hearts desire. I respect your bullish convictions and know I can't change your mind but please allow me a few more minutes to offer you some food for thought anyway. I believe this current downleg will slice through the latest $20 QQQ interim lows like a razor-sharp machete through a pineapple. Here's why.

Post-bubble Great Bear Busts exist for only one reason. Stock prices must be mercilessly driven down far enough to squeeze out the outrageous speculative excesses of the preceding massive bubble. In every post-bubble bust in history, the respective Great Bears haven't stopped mauling stocks at fair-value, but have driven them down even farther to classically undervalued levels as measured by both P/E ratios and dividend yields.

Our current Great Bear Bust will not end until stocks are undervalued. Period. Is the NASDAQ now undervalued? Our final graph, a small version of our famous and now newly updated "NASDAQ 2000 vs. DJIA 1929" graph, sadly lays out the evidence that the NASDAQ remains incredibly overvalued today with a lot farther left to plunge. Please don't get mad at me! I don't make the rules, I just strive to speculate correctly in whatever the markets may bring.

Dear tech-bull friends, in early 2000 Wall Street told you it was fine that companies were trading at their highest valuations in history, over 100x earnings, because it was a brave "New Era". They lied, it wasn't fine. In both April 2001 and September 2001 at the V-bounces Wall Street told you The Ultimate Bottom was laid in and the bear market was over. They lied again.

Now Wall Street brazenly claims that the October 9th lows at the most recent V-bounce are The Ultimate Bottom and the bear is over. They are still lying!

Every single Great Bear Bust in history ends when stocks are really undervalued. Not a moment sooner. That is well under 10x earnings for the elite mature companies that command most of the market capitalization of any given stock market. As of the end of January the NASDAQ 100 was still trading at 33x earnings. As hard as it is to believe, this is still above the classic bubble-top level of 28x earnings!

The NASDAQ is not going to quit falling, is not going to carve out its Ultimate Bottom, until it is undervalued. My best guess is this is around 10x earnings, but even if you still somehow believe that mature technology companies mysteriously deserve higher valuations than mature non-technology companies, even an amazingly high and generous bottoming P/E of 20 is still vastly, vastly lower from here.

Like every other major bust in history, the current NASDAQ bust will not end until the index is fundamentally-undervalued in terms of its all-important trailing price-to-earnings ratio. Wall Street has zealously claimed that P/Es are irrelevant in a "New Era" for almost a decade now, and they have been catastrophically wrong and cost investors trillions by foolishly ignoring history.

The massive late-stage divergence between the current NASDAQ bust and the classic Dow Jones Industrial Average 1929 bust is readily apparent in the graph above. This current downleg, which is already well in progress with the first tentative signs of the colossal VXN falling wedge breakout, is far from over. The NASDAQ and QQQs will plummet fast and far before we hit our next V-bounce interim bottom. And it ain't going to be pretty!

The writing is on the wall. The VXN falling wedge breakout confirms the many other indicators speculators have been using to go short. If you remain long the US equity markets now, you really ought to get out and take refuge in gold or cash or get short and harvest some fat profits on the current downleg.

Those who choose to foolishly ignore the warning signs and remain long are sadly marching headlong into a classic Great Bear ambush and slaughter. God help them.


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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