Here is Why You Need to Watch XIV at 40

My guess is you are familiar with the appearance of charts of the CBOE Volatility Index (VIX) over the past year or two. "Ugly" would be a common way technical analysts (including this observer) steeped in charts of equities would describe them -- the endless, directionless chop; the declines that inevitably (and usually abruptly) terminate in the 10-12 area; the sharp rallies that seem to end as quickly as they begin (rarely lasting for more than three weeks, give or take).

Of course, there is a very plausible explanation for these VIX chart characteristics, in the sense that in charting a volatility measure we are, by definition, tracking the fluctuations in a mean-reverting series whose "perturbations" are (quite naturally) often quite extreme and simultaneously quite brief. (The fact that volatility behaves in this manner would seem to be a deterrent to the widespread use of volatility derivatives to "protect" portfolios, but that's a separate discussion.)

But the folks at Credit Suisse seem to have created some order out of chaos in designing and structuring their VelocityShares Daily Inverse VIX Short-Term ETN (XIV). This may be due in no small measure to the fact that equity volatility has had a bias to the low side in recent years. When this is superimposed upon the daily adjustments that characterize the calculation of the XIV (and the fact that the XIV -- as an inverse ETN -- increases in price over periods in which the VIX declines), it often translates into upward XIV price movement that can be rather smooth and steady (as illustrated by the XIV rally from February through July 2014, as depicted on the accompanying chart). And such equity-like price action also creates opportunities to identify price levels that may be of particular significance from a volatility perspective, such as the 40 level for XIV on which our chart is focused.

Note how XIV sliced through the 40 level in early June and, after a brief re-test, went on to what was then (and still remains) an all-time high at 47.66 on July 3. And except for a brief period in early August, XIV traded above 40 from early July through most of September. What turned out to be a decent warning signal for trouble ahead (in the form of the mid-October market correction) was the dip by XIV below 40 in late September, followed by an unsuccessful re-test on Oct. 6 (and further confirmed by the close on Oct. 9 below support at 36). To recap: We had a pretty clear indication that XIV -- which moves in the direction opposite that of the VIX -- was breaking down technically. And by straightforward extension, this was therefore an indication that the VIX may have been headed for an upside pop, which by now we all know strongly implied that the market was about to take a hit.

And right here and now, it looks like the XIV is at an inflection point, though none is apparent from the charts of the major equity indices, which have all been registering all-time highs with almost boring regularity. Because after rallying sharply from its low of 24.67 on Oct. 18 (in conjunction with the sharp decline in the VIX and the concurrent sharp rally in equities), the XIV's upside progress over the past week or so has been stalled in the 40 area. In fact, this past Friday was the first trading day since Oct. 6 that the XIV had traded above 40, and after its early peak at 40.74, the XIV barely managed to remain above the 40 level -- closing at 40.07 after dipping as low as 39.70 late in the session.

So -- as I pointed out in the discussion on the XIV chart -- we are at a juncture in which further upside progress by XIV above 40 would be consistent with further upside for the market. But if this assault by XIV on the 40 level is repelled, things could begin to get pretty dicey for the market pretty quickly, especially if we once again dip below XIV support at 36. Would this decline resemble October's crash-like (but thankfully, brief) market plunge? It is impossible to say at this point, and by this I mean anything would be possible -- including a pullback that inflicts greater damage over a longer time frame. But my strong inclination would be that if we are destined for major market damage, this would not occur until after the first of the year.

This "Chart of the Week" commentary originally appeared in the Dec. 7, 2014 edition of Weekend Player.