Extremely oversold conditions, VIX spike buy signal

With so many oversold conditions in the market arising since 2016 started, I wait for signals to show that the market might turn bullish. So far, most signals have not materialized, but the fruit is ripening.

The VIX has closed more than 3 points of its intraday high of Friday, so I entered a very bullish trade with defined risk. I bought the Jan 22 SPX 2000/2005 call spread for 65 cents. If the market gets bullish, it could move quickly, so I want to be a bit ahead of the curve with a bullish call spread.

Besides the VIX signal, the VXST also traded below the long-term volaitility measures. This is a new signal that reinforces the bullishness of the VIX signal.

With the SKEW at 138, and still in this wildly elevated state since September, its hard to see a very long term change in the markets bearishness yet. We need the Skew to come down and the Put/Call ratios to roll over to buy signals before the market attempts a real bullish run. Those signals are still being set up.

A New Year's worst start

So, now its official! This year has begun worse than any year in market history.

Most of the moves have been in the overnight action. You can see this based on where the SPY (and ETF that tracks the SPX) opens every morning. In the first 4 days of trading, the overnight moves have combined for about 100 points drop in the SPX. which is the entire loss from last Friday's close. The media blames China... as most of the move comes when Asian markets open and trade (if even shortly, as China has been closed twice during the week).

Fascinatingly, during US trading hours the market traded positively on Monday and Tuesday, and flat on Wednesday and Thursday. So if we look at the US action, the markets are relatively bullish if viewed from the perspective of intraday trading. The US is basically, fading the overseas move.

So, when will this rout end? We need to look at how oversold the markets are. The VIX is spiking, but still not very high in absolute terms at around 25 today. The SKEW keeps printing numbers above 135, so its not confirming a bottom yet. What is giving a set up that could be interesting soon is the term structure of the volatility indexes. We have short term volatility now trading higher than volatility measures further out. This does not occur that often, as shown by the green arrows in the chart below. When volatility indexes revert back to a normal structure (longer term volatility trading higher than shorter term volatility), markets get bullish very fast. I will be trying to catch that move.

On the same chart, I have marked pink horizontal lines corresponding with the low levels of the volatility indexes. Since the September spike, volatility has remained high. Until we see the volatility break down below this new support area, a new high on the indexes will not come. Trading call verticals looks to be much easier in 2016.

There are two indicators that already show the market is in an very oversold state. The first is the number of stocks trading above their 20 day moving average (chart below). Again, this number is less than 20% of all stocks, which does not last long without the market bouncing higher for a few days.

Finally, market breadth is extremely bad currently. TRIN was above 2 for most of the day yesterday and today 90% of all stocks may have traded down. These can both signal short bounces in the $SPX.

As I write this the futures are spiking higher - up 1% in a flash move - probably China is doing some intervention finally to stop the bloodshed. Lets see if next week's options expiration's week turns out positive.

What a difference 5 mins can make!

If you thought the market started off the day bad, it ended much worse. Its hard to believe but the day after a follow through day (IBD marked it yesterday), the SPX fell 1.5% today, most of that in the first 2 hours, but then brutally in the last 5 minutes.

The TRIN went crazy today showing selling was wide spread and on heavy volume. It closed at 3.17 a level not seen since September 1st, but was even higher intraday.

Again, the SPX sits around this 2040 level, an important level because it acted as support last Wednesday and acted as the gap area last Friday and again Tuesday.

After the 1% loss in the morning, the SPX bounced off its lower Bollinger Band on the 15-min chart and rallied a bit (see arrow in the charts above). At that point I bought some TNA and TQQQ. The rally only extended to the mid-line on the 15 min chart and then slid down with the declining line. Then everything broke loose about 5 mins before the market closed. 

So, instead of picking the bottom, we have an issue of trying to repair a trade that when wrong. This can be handled with options on those ETFs. We need to sell some OTM calls, and, if the market is weak, use them proceeds to collarize the ETFs with some put buys. Hopefully, we can limit the downside further and wait for some rebound. 

With the TRIN so high, I cannot see much more than 1 day selling. but that maybe a pretty dismal day! 

The SKEW came down today, but still remains above 130. Tomorrow is option expiration. For the major players the options expired today, and tomorrow is just clean up with settlement prices. It can be a bit of a mess in the morning! 

IBD calls a Follow Through Day

Today markets rose on strong volume across all sectors. Investors' Business Daily labeled it a Follow Through Day. This designation creates the basis for a bull run that would need several down days on high volume to stop. Based on a trading program worked out over many years, an entrance into leveraged ETFs for Russell 2000 and Nasdaq stocks is warranted on the open tomorrow.

In addition, my trading friend Erin pointed out that a statistic she watches signified a intermediate bottom was in place on Monday also. She looks at the percentage of stocks that trade above their 20 day simple moving average. When less than 20% of stocks are trading above that moving average a possible market bottom has occurred. On Monday, only 16% were trading above their 20 day SMA.


Major news stations pointed to how traders took the FOMC meeting decision as a bullish signal. However, the VIX signal and Erin's research showed that the bullishness started long before this afternoon's rate hike decision. Lets watch to see how bullish the markets can get. SPX 2100 is the first number to break through.

VIX signal works magic

The VIX buy signal worked so well, there was really no time to trade it. The market got so bullish so fast, moving 20 points in the first 3 minutes of trade, that I would have had to make the trade yesterday for a reasonable fill. In hindsight, that was the obvious trade to make!

After the initial thrust the market created a trading range between the low of last Wednesday (around 2040) and the close of last Thursday around 2055, from which the markets gapped lower last Friday. This 2040 area on the SPX is interesting as it remains a pivot between bullish and bearish sentiment.



With tomorrow's FOMC meeting on the deck, put buying continued in an excessive manner. The SKEW traded up again, holding above 140 for the 3rd consecutive day. High SKEW readings can signal a coming pullback in the SPX, but usually when the market is already in a strong uptrend. A two day bounce does not qualify. I would expect the SKEW to give us a more normal reading after the FOMC.

VIX gives buy signal

Over the last few days, the VIX has been running up. It went from around 17.5 last Tuesday to an intraday high today of 26.8. This 9+ point move qualifies as a VIX spike (a +3 point move happening over 3 days or less).

The spike itself does not give a reason to buy SPX. However, today's closing print of 22.7 does! As the SPX made a solid move off its lower Bollinger Band line on a 15-minute chart around 8:30 AM (not shown), the VIX just crumbled. The VIX closed more than 3 points from its intraday high giving us a buy signal on the SPX.

In similar fashion the VIX Friday closed above the VXV (a longer term measure of the volatility of the SPX). This is a set up for a bullish move in the SPX if the VIX then closes below the VXV, which it did today!

Today's SKEW, however, is far from supportive of this bullish sentiment.  The VIX did close down sharply from the crazed levels of Friday, but still printed a stratospheric number at almost 141. This is hardly a place to launch a bullish run from. However, with the FOMC getting out of the way as early as tomorrow, the SKEW could fall dramatically and let the market take off into the Santa Claus rally that everyone expects.

Further, I find the RUT's lack of ability to close in positive territory as somewhat disturbing. The RUT really needs to start moving up if the bulls want us to believe that the lower highs and lower lows of this pullback are over.

SPX whacked at 2100

Today we had a rather rare situation for bull markets: a complete reversal of a major move up move from the prior day.

The Stochastics are saying this can go much further lower as we just pulled out of the upper region (second graph on the picture below) and even more damning is the RSI graph below. In Early November, the SPX failed to get into the upper overbought area, and on this move back to those highs on the SPX, its RSI is posting a lower high.



The RUT looks most concerning as it took out its support levels of late. Its Stochastics are falling sharply from overbought levels and the RSI never made a new high to support the price high in the index.

 

VXST is now above VIX which is short term bearish for the market also. I think some bearish positions are warranted here, as the SKEW is still above 130 and the SPX cannot get traction above 2100. We may see a move to 2040 on the SPX.