In mid-December we were focused on three important contrarian signals that were giving warning signs of a potential market top.
The prevailing theme was the marketplace was complacent and ripe for a selloff, or worse, a rogue wave. We made the point that it was a great time to buy cheap portfolio insurance by going go long volatility.
That mid-December selloff only sent the U.S. stock market (NYSEARCA:IVV) down 4%, but did you see what it did to the VIX? In very short order, the VIX (CHICAGOOPTIONS:^VIX) skyrocketed up over 25%. Is a repeat scenario lining up?
Numerous Opportunities for Cheap Protection
Throughout the last few months the VIX has hovered below 20 and even spent a majority of its time below 15. When it hits these low levels, it often provided a quick profit opportunity.
On 9/21 when the VIX was at 14, we wrote: "The VIX is at five year lows, and most other sentiment indicators are high for the market (NYSEARCA:VTI) right now, which historically marks (market) selling opportunities rather than buying opportunities".
One month later, on 10/19, when the VIX was at 15, we said: "In the money call options with 2013 expirations could be bought as a way to hedge or to protect gains going into next year. We favor VIX options over the VIX ETPs (NYSEARCA:TVIX) as a better way to play intermediate to longer term trends in stock market volatility". These VIX signals in September and October helped point to the near term market top that formed then.
And finally on 12/17 in the ETF Profit Strategy Newsletter with the VIX at 16, it was again a great time to buy protection. We wrote: "The VIX has refused to spend much time below the 15 level providing a solid support and buying area for VIX bulls. As it approaches that level, buying front month in the money calls is a good trade. We like going long the VIX Jan 14 call options at $271 per contract".
Two weeks later the VIX was at 22 and those options were up over 100%, trading for $560. Profits were taken as the technicals warned of the top in the VIX helping us get out before its recent descent. "It (trendline resistance) likely will act as resistance, especially given its steepness, and is a great spot to take profits. Combine this with the channeling technique's target being met, and the odds are increased the VIX will pull back this week. Such a fast move should be considered a gift and there is nothing wrong with taking portions of it off the table".
The Charts Do Help
Below is the chart we have used for the last few months that accompanied our Technical Forecast. In the recent past, when the VIX is below 15, market peaks are usually just around the corner. When the VIX then rises to 19, it is usually an area to start look at taking volatility profits.
However, its latest decline has taken the VIX to six year lows and taken its cousin, the Nasdaq 100 (NASDAQGM:QQQ) Volatility (CHICAGOOPTIONS:^VXN) near all time lows below 14.
A combination of technical indicators such as Relative Strength were used in the examples above to help identify short term bottoms and again are giving us signs of a bottom. As a result we recently suggested again buying VIX longs when it fell below 13 (red arrows in chart). Already those longs are profitable and the potential exists for a whole lot more.
That RSI divergence is one of a few pieces we are watching to complete our VIX bottoming puzzle. The next piece of confirmation of a VIX bottom would be a breakout of a key price level. Finally, the potential also exists for a bullish bottoming pattern to be playing out, but that is not confirmed yet. If it does confirm, our conviction that volatility is bottoming would only increase.
A volatility bottom, would likely imply the market's (NYSEARCA:SPY) rally is over and at a minimum a short-term market selloff (NYSEARCA:SDS) is also likely to occur.
The ETF Profit Strategy Newsletter uses the VIX along with technical analysis and other sentiment measures to identify high probability trading setups for the S&P 500 and other popular asset classes. Buying in the money VIX calls has been a great high probability trade setup when the technicals give us the right signal. Follow us on Twitter @ ETFguide