I love to be right as much as the next guy… but sometimes it’s no fun.
Since the end of August – weeks now – I’ve been pounding the volatility drum as October got closer and closer.
That was the topic on the table this week, when I sat in with Suzanne Sena for a Fast Profits video trade.
We focused our discussion on the seasonal volatility that’s as closely associated with this time of year as yellow leaves and jack-o’-lanterns. (If you haven’t seen this Fast Profits, you can click here to watch it at any time… and e-mail to thank me when your stake doubles).
Anyway, the CBOE Volatility Index (VIX) was sitting just below 16 while Suzanne was interviewing me. During that chat, I pointed out that a break above 16 would swing the market into selling mode and subsequently shoot the VIX toward readings around 20, where we would likely see a break in the selling.
And that’s more or less exactly what we saw as markets try, with mixed results, to pare their losses as I write this.
We’re moving into a period where keeping an eye on the rearview mirror will give us vital intel for going forward…
It’s Scary, but We’ve Been Here Before
The VIX is pulling back from its intraday high of 24.52, the highest reading of the “fear index” since April.
Hey – remember April?
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Let’s reminisce for a moment because it feels like a lot of people have forgotten about the market’s early spring performance…
April was U-G-L-Y. So was March, and of course, February was a mess.
Over that three-month stretch, the S&P 500 dropped about 12% from its January high. As bad as that sounds, in the end, it was only a healthy correction. After all, stocks always take a breather during strong bull markets. And that’s exactly what happened in February.
Regarding this latest pullback, the media and everyone else will likely tap tariffs, trade wars, and interest rates as the reasons for this reversal, but I don’t care about any of that – not right now.
As long as the pullback remains healthy, I really couldn’t care less that we’re seeing the market take a breather. But it’s important that I stress that I’m not concerned with the “whys” and “hows” right now only because the pullback is healthy.
Here’s what I’m looking at.
- S&P 500 Technical Support: I recently mentioned the S&P 500’s historical performance after breaking its 50-day moving average. And more often than not, the trend has been positive. That said, we need the index to grab support at its 200-day (which it closed below today) and climb back above the 50-day within the next week.
- Rising Volatility: The Fear Index tends to make spikes like we’ve seen over the last few days, then retrace to lower levels quickly as traders step in to “buy on the dip.” If the VIX encounters strong resistance at 25 and then pulls back below 20, we’ll see short-term buyers take control of the tape again. After 20, a dip to 16 will really get market bulls excited. That appears to be the way the market is headed now. I’ll have a little bit more on this, including a killer chart, tomorrow.
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Now, critical to all this, whether we go higher from Friday’s rally or fall through the floor, is…
- A Risk-On Trade Resurgence: Long before this bearish slide, we had been talking about small-cap stocks lagging the broader market. It was a key indicator that this selling spree was approaching. Clearly, I want to see some buying in this sector as well because markets do not recover from corrections like this unless investors are willing to take risks, to see the dip as a value opportunity. If they won’t take the risk for that value, then the market is doomed to drop another 10% from here.
For now, we’re still looking at a healthy correction, but I’m watching the three aforementioned points very carefully. The second the market tips its hand a little for a rebound, play the short-term rally that develops, riding the wave of buying with short-term bullish positons.
However, more than 60% of the initial rallies following a pullback like this wind up failing. Those are called “dead cat bounces.” If that looks likely, be ready to pounce on the market with some hedged positions to take quick bearish profits.
Bottom line: Get good and hedged, with a mix of calls to leverage a move higher and puts to capitalize on a move lower. Stay nimble, and be ready to “cut bait” the instant the near-term trend is confirmed.
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