Chart of the Day: How to Trade VIX

At the first sign of a market sell off or correction, my eyes leave my well developed focus list and turn to the CBOE Volatility Index, otherwise known as VIX. During market selloffs, it is crucial that you learn how to trade VIX.

Why do I love trading the VIX during sharp selloffs and corrections?
 
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It's because the VIX smells fear and acts accordingly with wild spikes. Okay, so in truth an insane calculation that some Ph.D wrote is used, but I like to think of the VIX like a shark smelling it's prey, attacking with a mad rush, enjoying the spoils of it's victory, then settling down.

In other words, the VIX will spike up when the market sells off, hang out at the high for a short period, then ramp back down as the market settles down.

Study this chart of VXX (VIX ETF) to understand the last few times VIX has made huge moves. We are talking 30-100 percent moves in 1-2 weeks. Notice that they always correspond to SPY selloffs.

Here you can see that when volume spikes, so does VIX. We are currently in the midst of a big volume spike and VXX has ramped up from a low of $17 to $21.35. Studying recent volume spikes, it looks like we still have some room to run.

In the Trade Report, we are currently up 10 percent, as we entered VXX at $19.30 and are still holding. Once the spike is over, we will reverse and "short" VIX using invese ETF XIV.

Watch this short video on trading VIX during volatile markets and using pair trading with VIX as a strategy to profit without knowing which direction the market will move. If you like the video, please hit like on the youtube clip!

https://youtu.be/avpW0l1NhMU

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Monday's Game Plan and Free Trade Report

I am offering today's Trade Report, which features my plan for Monday and the coming week, free to blog readers today. Enjoy!

January 5, 2008

Market Notes

The market is overbought. I'll get back to that, but first let's take a look at the overall picture. The market (via SPY-SSO) is putting in a healthy looking bottom pattern. RSI has broke out over the middle area. Price is putting in a constructive looking price pattern. Depending on how you view it, an argument can be made for a reverse head and shoulders or a bottoming cup and handle. Price has a broke out over the 50 day moving average. Last and probably most important, the volume pattern is strong, which signals underlying accumulation. Underlying accumulation is an important trait when bottoms are put in.

Note that this "bottom" is not a long or intermediate term prediction. However, it does signal a good probability we will see, at the least, a good bear market rally. I don't mean the 3 day variety we just got, but the type that could last a few months.

Short term, the market is overbought. For my trading style, it is not a good time to buy. Stochastics have reached overbought conditions (see chart), and the T2108 indicator has reached extreme levels, currently at 83.

The Trading Plan

The plan right now is to enter short term short positions to take advantage of the overbought conditions. Once overbought conditions are worked off, I will get ready to enter long in focus list stocks that pullback to support on low volume.

I will only enter shorts on strength. If we get good strength Monday or Tuesday, I'll enter positions listed in the focus list. Note that I already took a small position in FAZ on Friday (see intraday alert from Friday and the blog (www.themarketspeculator.blogspot.com).

Focus List

All longs are overbought and require pullbacks to support. Note that strong volume patterns and overbought stochastics on all stocks. Aggressive types can try taking quick shorts on some of these. This requires entry on price strength. A tight stop must be used.

JBLU, CKH, USM, USD, SUN, VMI, SGR, X, STR, DE, FSLR, ACI, TXI

Stocks from last week's focus list:

BKE, TBSI, IOC, GDX, GG, BG, DBA, CPA, ACM, MOS, SLV, SLW, PAAS, AIPC, AET, DRYS, SUN, URE, LVS, JOYG

Shorts: AXYS, CSX

Quick Thought: The Commodity Bounce

Many broken commodity plays, like the ag sector, have made big bounces today (as of 11:35 AM ET). Keep an eye on volume. One of two things is going to happen:

1. A low volume bounce which will be a "dead cat" signal. If this happens I will intitiate shorts in stocks like MON and TRA.

2. The sector comes storming back on strong volume. This will tell us that the recent action was merely a pullback and it's time to get long again.

Distribution patterns give the edge to the "dead cat" prognostication, but I won't enter in either direction until I get a clear signal.

Market Notes and a Trade

There has been some confusion that I would like to clear up. Some of you think that I am bullish on the market because I am making long play on the S&P 500. Nothing could be further from the truth. This is a short term bounce play within a downtrending market. Until the indexes can break resistance, I am a bear who is willing to play situational longs.

This is the time to play a few bounces and get ready to reload shorts. For short plays, I am looking for broken stocks on my short list (stocks that have topped and now downtrending) that are making feeble bounce attempts.

This morning I added some to my DECK short, 50 shares at $107.35. If we continue to bounce on low volume tomorrow, you can bet I will add some more shorts.

Trading SPY and Stochastics in a Bear Market

If recent history is any indication, the next time the stochastic indicator hits an extreme oversold reading of less than 20, it will be time to buy the S&P 500. Since October the SPY has hit this level 6 times and made at least a three point gain in 5 of those trades. That amounts to an 83 percent win rate. Not bad.

Study the chart below and device an entry plan. Blue arrows show winning entries and the orange arrow points to the sole loss. Note that this chart is from from Friday's close. Today's stochastic reading is 32.68, which is still way to early for entry.

I will likely enter on an extremely low reading, and use a 1.5 point stop. My target will likely be three points. This is how I play longs during bear markets. I become more precise with my entries (something I've advocated against in the past) and take quick profits.

Classic Bear Market Action

While I try to stay away from the chatter of market pundits, I do like to keep an eye on what a few select bloggers and "market gurus" that I respect have to say. What surprises me today is that I am hearing, even from those who I respect, that a bottom has been made. I disagree.

What I see are signs of a classic bear market, and today is a great example. We had wonderful news that Warren Buffet, our modern day Stanely Morgan, is coming to the rescue of at risk insurers. The market goes nuts. Everybody is buying. SPY trades up over $136. The Q's trade up to $44.68. The bear market is over . . . not.

We end the day with the Q's in negative terriroty and SPY making a modest gain way off the highs. My friends, this is what happens in a classic bear market. We may still get a bit more bounce, but I have a strong feeling we will come back down.

What would make me change my bear market thesis? If the S&P can breakout over the 50 day moving average (currently 1416) on strong volume, I'll change my tune.

Classic Distrubtion Phase Price and Volume Action

As I expected, last week's bounce was prone to failure and it looks like we are going to test the late January lows. I am weighted to the short side, so you can bet I am giddy about price acton over the past two days.

As we move towards the lows, I will likely start to lighten up on my short positions. Volume patterns don't predict a breakdown, at least not yet. While price and breadth were horrid today, volume wasn't all that heavy. Until we see more distribution, I won't go with a "breakdown of January lows" thesis.



From a technical perspective, this chart is a good example of a classic "dead cat bounce." We had a significant decline followed by a bounce that reached resistance on volume that was lower than during the distrubution phase, finalized by a sharp move down that completely wiped out the bounce gains in less than half the amount time. This is classic distribtuion phase action.

If we get early long side relief tomorrow, I will probably initiate more shorts based on the "retest January lows" thesis.

Weekly Spy Chart

Analysis of the weekly SPY chart leads me to believe the market still has room for a bounce before the next downturn.

Key factors in support of bounce:
1. Bounce at major price support
2. Stochastic oversold crossover developing
3. More room to move until resistance reached.

Note that each time stochastic has reached oversold levels and crossed we've seen a decent sized bounce.

Key factors in support of continued downtrend post bounce:
1. Topping price action pattern
2. Major volume distribution
3. Major resistance

If volume stays low, I will likely unload long positions once resistance is reached and deploy some shorts.

Quick Trade Update

I was stopped out of SKF and bought UWM and DDM, which are ultra long the Dow 30 and Russell 2000.

Looks like this might be the capitulation bounce we've been waiting for.



Update: A few readers have asked how I timed the DDM trade so perfectly. I should have posted my entry prices. I did not buy at the bottom. I ain't that good . . .I bought toward the end of the day at an average price of $70.57.

Another Trade Update

I have decided to take on two more small long positions, BVN and HWAY. Both have handled the bad market well. HWAY is in the medical lab sector, which has been somewhat of a safe haven in recent times.

While badly beaten stocks are usually the best short term bounce plays, I don't have the stomach to go after these types of stocks at the moment. Therefore, I've decided to play the bounce thesis with two strong stocks and one index play (QLD). All are small position sizes with logical stops that wouldn't lose me more than about $800 combined if the market continues to tank. Unless you have supreme confidence, I would not make any big bets at the moment.

Market Notes: Are We Oversold?

I am still finding this market tough to trade. I have no problem trading in bear markets, but my issue right now is that we are oversold, but not that oversold. So it's tough to initiate longs or shorts. If I do decide to trade, it will most likely be with an even distribution of longs and shorts.

Take a look at the chart below. It shows the percentage of S & P 500 stocks above their 50 day moving averages (I usually use Telechart's T2108 indicator, but I am away from my laptop), and is currently hitting oversold territory at 20. However, the last selloff reached all the way down to around 5. While it might be prudent to take on a few small pilot long positions, I wouldn't make any big plays just yet.

Market Notes

We are in a tough spot with regards to initiating short positions, and I'm in no mood to add longs. I was hoping for more of a bounce before short entry, but today's move ruined my plans. Amazingly, we are still above last week's low of 1378 (by two points). I'll probably let things play out a bit before making any new entries.

Time to enjoy today's profits (see last post), do some reading and sort through my watchlists.

Ain't No Egg on My Face . . .Yet

Many were quick to get on me after the market failed to rocket up after my capitulation call last week. While I conceded that I could be wrong, I also pointed out that it is not invalidated until a breach of 1378 on the S&P 500. Capitulation bounces rarely go straight up. As long as the low of the capitulation day holds, the thesis holds.

So far so good. Volume is showing accumulation (more volume on up days than down days).

Be advised that my capitulation thesis is *short term.* I believe we are in a downtrend with more room for downside. This is not a long or even intermediate reversal call. Rather, it was just a call to play a quick bounce. Nothing more. I still am more willing to short than buy this market, but will make long plays in strong sectors and when I see a bounce coming.

This Bounce and Trade Update

I have received a few e-mails asking whether the bounce is over. I honestly don't know. However, in my mind, it's not officially over unless we breach 1378 on the S&P chart. There is still a ways to go down before that happens.

I think what we are seeing today is based on: some skittishness about the financials and exits/profit taking at the first sign of strength. Bounces rarely go straight up. As Rob Hanna points out, reversals usually pullback before making there move up.



Trade Update: I went short DSX (another shipper) at $26 and am still holding my few longs until they hit there stops or targets.

Short Term Capitulation?

I have a feeling we might be in the midst of short term capitulation. Things look really bad, many former leaders are getting abused and it is really tough to buy right now.

Note that does not mean we are going to see the uptrend resume. If we get a post capiutlation bounce, I think it will be of the "dead cat" variety, and we we resume the downtrend later this month. A bounce might be a good place to add shorts.

I have exited most shorts and made two buys.

I took a pilot position in RICK at $24.90. My stop is just under $24, with the recent high at $28. Low risk, decent reward. If the market continues to tank and I get stopped out, no big deal.

My other buy was MON at average price $115.23. This one got dicey when it dropped below $110, but it has recoved and his back up over $117.

I likely won't do anymore buying. I don't like to go all in on up bounces in downtrending markets. I'll make a few small long plays, but that's it. I do still like gold and oil related stocks on the long side.

High Flyers Have Lost Their Wings

My focus list, which is mostly comprised of momentum stocks, looked ugly today. Not only was there a lot of red, but many stocks have broken major support levels. Because of this, I cannot play a bounce in these stocks. I never play bounces when support has broken. Many of my favorites have now made it to my short term shorts list.

For example, LFC, BHP, FXI, AAPL, RIMM, DE, RIO, FLR, VMW, FCX, DRYS and many others now look like short candidates on a near term bounce towards old support levels. Only a few stocks are on my long list. These stocks are mostly recent breakouts that are still acting strong, such as DCO and HMSY.

Looking at today's sector action, the bottom performing sectors have been the darlings of the market the past few months (and in some cases, much longer). Industrial Metals, Gold, Silver, Copper, Tech, Ag, Chemicals, Energy, Industrials, they all got hit hard. What does that mean? There are two theories. The first is we had our capitulation move and can expect a resumption of trend. The second is that now that the high flyers have also broke down, we can officially expect a bear market.

I can't make a prediction, other than to say I am now more inclined to add a few shorts. I added a few today, and may add more if we get a weak bounce.