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By Carson Dahlberg, CMT
Special to the TradeTech Blog
The (EEM) iShares MSCI Emerging Index Fund exemplifies the outperformance this sector has had recently over the S&P500 benchmark that many use (3.25% above over the last 21 trading days). Also new products like the CBOE Emerging Markets ETF Volatility Index (VXEEM) make it possible to do things which previously were not. Namely, we can now look at the specific implied volatility of the underlying versus using the VIX for the S&P500. This gives us more accuracy when incorporating volatility analysis into our work, as we try to find not only what to buy but when and at what price to do it.
Let’s take just a few examples from aligning the daily charts of EEM and its Volatility Index. I have circled extreme readings in the Volatility Index, using our volatility-based technical analysis. There are many ways to examine extremes in volatility, but for simplicity’s sake, in this example I’m just using our N Bands (which are designed to give immediate support or resistance). These circled areas represent where volatility and/or price should not be/have gone too far too fast; and definitely out of bounds in terms of support/resistance. I have highlighted the areas of support and resistance that pertain to our discussion. Incidentally, our support and resistance are derived from volatility as well.
These circled examples were on the following dates: 8/5-8/9, 10/3, and 11/25. These all represented peaks in volatility which correspond to troughs in price. You could just have easily focused on the reverse. So what we see is that by combining two sets of data (price and implied volatility) we can confirm high probability inflection points but avoid multi-colinearity. We also achieve a greater level of precision in gauging where a security has hit an extreme.
So, how about some objective analysis? From the volatility chart, we can see that there is a clearly defined range of support and resistance. We can also see that volatility continues to fall toward layered support. However, the volatility chart is not yet extremely extended (oversold as some might say). Simultaneously, the underlying EEM is nearing the first level of volatility-based resistance. One scenario could be that volatility remains low, trapped in said range, and the EEM pauses/slows its advance near this level. You could use this info to combine with your research to come up with other views or strategies. You could then use objective, statistically significant levels to monitor the emerging market.
Bringing it back full circle, let’s take a look at relative strength. From the relative EEM/SPY chart, a few things stand out:
• The Upper N Band, which is immediate volatility-based resistance, is now pointed upwards and the ratio is making a right translation of the trough. This is statistically significant and can mean a pause versus an about face.
• The move has been so strong that the ratio is testing the immediate resistance level – this is also usually a bullish development.
• The level which has served as resistance since mid-December (shaded green) is now serving as support. This makes sense as the EEM itself is now reaching resistance and may pause before continuing its advance.
So all in all, it looks like we have some more clues of the ‘risk-on’ trade picking up steam.
On a side note, we would like to announce that we will be presenting in NYC for the Market Technicians Association’s Annual Symposium – Technical Analysis Applied: Quantitative Investing in a Qualitative World. You can read more about this event at this link. We will be discussing the use of volatility-based technical analysis.
Carson Dahlberg is the Chief Technical Strategist and Partner at Northington Trading, LLC.
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