Earlier this morning, I discussed the VIX and volatility with my traders in our Live Room. We talked about how so much of the algorithm and machine-led trading has a lot to do with volatility.
Until we make lower lows on stocks and until the VIX breaks out and starts to make higher highs, I don’t believe we will see the machines change their pattern of aggressively buying the dips in these markets. In other words, this pattern will continue until it stops working. So where does it stop working and what will that look like?
Whether the Dow, the S&P 500, or another US index, the pattern we have been witnessing thus far is a pullback to a higher low followed by a bounce. This is eventually followed by another pullback to a higher low and the pattern is repeated. In order to break this pattern, we would need to see a pullback to a higher low with a bounce that fails to make a new high, but creates a lower high instead. From there, we would need to see the market make a series of lower lows. I’ve underlined these higher lows on the chart of the Dow below, and traced out in green what a bounce to a lower high would look like.
At the same time that US indices make a series of lower lows, we should also see the VIX turn up and start to make a series of higher highs. To that end, I have been measuring and mapping where that change would occur with VIX futures. Specifically, I’ve been using the 4 hour chart below to analyze the intermediate term. It clearly shows a series of lower highs, with the most recent one defining our TMS, around 17.50 (horizontal red line). If there is a break above that level, I think that will change a lot of the structure in the market and will influence the algo behavior we talked about earlier.
In the chart above, you can also see that each time we’ve been trading contrarian via VIX calls or we bought some futures well, we’ve taken profits on tops pretty well (denoted by the red arrows). The red X shows where I played some defense on the core long VIX position and took some risk off, but bought back in much lower on the next green arrow. That ended up being the right move and we took our gains on the next subsequent move higher, right in front of Pi on the hourly timeframe. Our most recent buy was bang-on right near the low on the VIX before the front month rolled
Speaking of the hourly chart, with this last higher low an inverse head and shoulders reversal pattern has formed. Typically, this pattern has a horizontal neckline but, in our case, it is descending – I often call it a “mutated” head and shoulders pattern – but the concept remains the same and you can see how that dashed red line at 17.50 is pretty key.
We’ll see if a break of that key level also lines up with a break of last week’s lows or below Pi on the Dow. Here is that chart again where you can see these corresponding levels marked with red horizontal lines.
The way I want to play it is to first see if the VIX opens up this morning. On the potential strength of the VIX, we can either take profits on Calls that we bought and/or re-short some Calls on a rally so that if we get another pullback, those Calls will start to go in your favor.
For more on this, check out the video that I recorded below.