From the June 01, 2012 issue of Futures Magazine • Subscribe!

Market jumps and the discontinuity phenomenon

Analyzing the VIX

There are several expert systems in the industry that use a wide variety of statistical and fundamental tools; however, we can search for the discontinuity phenomenon using a simplified model of a 10- and 24-period exponential moving average crossover. We will apply it to the VIX, considered a so-called contrarian indicator, meaning it moves opposite of market prices. (Other contrarian indexes also are good candidates for this analysis.) We will use multiple time frames to increase the reliability of the forecast. 

As seen in “Cross-time signals,” the highlighted ellipses on the six-day, one-day, four-hour and 30-minute charts identify key concepts. In the six-day chart, the moving average crossover pattern gives way to a sustained and aggressive rally of the VIX, which is concurrent with the fall in late July 2011 of the major equity indexes. At the same time, we see some important activity on the one-day chart. There are two highlighted areas, the first coinciding with the bullish pattern in the six-day chart. This implies a double convergence and, thus, a stronger reinforcement of the original bullish forecast.

On the other hand, the second and more recent ellipse in the one-day chart reveals a sell crossover signal that is complemented further in the four-hour and 30-minute charts. This triple convergence in different time frames is a powerful indication of the robustness of the sell signal. It also is significant because it constitutes the first discontinuity in the original trend and could have enough momentum to overcome the earlier signal in the six- and one-day charts.

The 30-minute chart shows a second ellipse that occurred two days prior and constituted a buy crossover signal, which preceded a significant rally in the VIX and a plummeting of equity indexes the subsequent two days. 

Despite this price action, however, the VIX subsequently showed a strong bearish correction through three coinciding patterns, which explains the stock market rally since Oct. 4. The more recent spike in the VIX, as shown in the 30-minute chart, clearly marked the discontinuation of the trend of the previous one-day, four-hour and 30-minute patterns, at least in the short term. What remained to be seen was whether the development had enough momentum to serve as a follow-up pattern of the six-day chart, which had its original trend intact.

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