Volatility Signaling that this Rally Is Running Out of Steam?

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The chart above is a chart of the VIX with standard Bollinger Bands around it. Also below the chart is a 10 period RSI of the VIX. I don't know how many people use traditional technical analysis on the VIX, but I have found some basic indicators to give timely warnings.

First, note that the VIX has touched its lower bollinger band. Since the VIX and the markets have strong inverse correlations, low VIX readings tend to correspond with market tops. The RSI is indicating a level of oversold VIX more so than any time since early May before the steady crush lower from mid May to mid July. I have a simple system for looking for VIX extremes that I have posted about before. That system is still a few lower VIX days away from really being in the danger zone, but I would heed the current VIX levels as a warning that this rally is long in the tooth.

Click on Chart to Enlarge

The chart above is a chart of closing VIX/VXV ratios with standard bollinger bands overlaid. Please follow the link below to the VixAndMore blog as that is where this indicator ratio originates.

http://vixandmore.blogspot.com/search/label/VIX%3AVXV

The chart above does not show intraday lows, but I wanted to show a smooth view of the data that is easy to identify extremes. This ratio is nearing the 0.90 level and its lower bollinger band which have proved outstanding warning signals for soon to be market declines.

Taken together these data certainly should tell us to be on the defensive, or start to get aggressive with bearish trades.

Because this data is raising red flags, I may arbitrarily suggest exiting the QLD trade initiated yesterday before any signal comes from the indicator, or I may suggest a stop loss to use to exit the trade if the market turns south. In the past, trusting the indicator has proven the best strategy, but for real life trading, risk management is the most important part of successful trading.

Pete

New QLD Trade

The short-term model of the Nasdaq is just a hair's width from oversold as I type. Based off of a few post-FOMC meeting studies and the gap support from Tuesday, I think this oversold signal has a good chance to work well.

Trade Recommendation:

Buy QLD before the close today or tomorrow morning with a limit order of 27.00. Current price is 26.74 which I will use to track the trade.

Pete

QLD Trade Exit

The short-term model for the S&P 500 just became overbought and I suggest exiting immediately the open QLD trade. The current price is 28.10 which I will use to track results. The was another nice trade.

Pete

New QLD Trade

The short-term model for the Nasdaq hit oversold levels yesterday, and with today's gap down in the markets, a bullish divergence was created. So I am going to recommend bullish ETF trade here.

Trade Recommendation:

Buy QLD today before the close. Current price is 26.75 which I will use to track the track results.

Pete

I Expect a Continued Trading Range Until Dec. Expiration

There are many ways that traders traditionally look at support and resistance in the markets. As I have mentioned in past posts, one of the main things I look at are gaps in the major index ETF's like SPY or QQQQ. As we stand today there are unfilled gap ups at 79.50, 88.00, and 89.50. These gaps I view as a support cushion below current prices. There are unfilled gap downs at 92.50 and 96.00 which are above current market prices and could be viewed as a short-term ceiling on a market advance. There is a large unfilled gap down at 110.00 from back in October in the midst of the dramatic waterfall decline in the first two weeks of that months. That gap did not get filled at all and should act as a longer term ceiling on prices should the market "breakout" of the current trading range.

Another concept that is more advanced in analyzing the market from both a technical and sentiment perspective is evaluating the open interest in option strikes in the index ETF's SPY and QQQQ. Options are typically used as hedging instruments and that will result in many puts held at strike prices below current market prices. Options can also be used for speculation in both directions. Call options above market prices can be a sign of speculation/expectation that prices will advance beyond those levels by expiration. Additionally there are complex option trading strategies that involve the purchase or sale of both put and call options simultaneously and may take advantage of range trading.

That is a very elementary view of options. The open interest is basically the amount of contracts held in that particular option. So how do you use this data? Looking at front month (current month) options can tell a lot, as that is where the heaviest open interest is.

Right now the peak call open interest for Dec 08 is at 90.00 on SPY. Peak put open interest is at 80.00 and a slightly lesser peak at 85.00. I would view these levels as market support for the rest of the month. It gets more interesting with the QQQQ options. Peak call open interest is at 35.00 in Dec 08. The amount of open interest here blows away the amount in any other strike price. Seeing as 35.00 is well above current prices, I view this level as a level of great speculation and anticipation for prices to move quickly higher in the next week and a half. History will tell us that usually these options will expire worthless. I would doubt that we make much progress to or beyond those levels by expiration.

Peak put open interest in Dec 08 QQQQ options is at 27.00, with heavy cumulative open interest from 27.00 to 29.00. According to the "maximum pain theory" areas of heavy open interest are often where the price will end up at expiration. This will make those options worth little or nothing typically and will inflict great pain on the holders.

Taking the front month data together, I believe it indicates a continued trading range until expiration. Also, I would place my bet on prices of SPY and QQQQ being near the current level or probably a bit lower at expiration. After expiration, when all those contracts are history, I think we will be likely (or more likely) to see a price breakout of the range.

One last interesting point comes up when looking at Jan 09 SPY open interest. There is huge call open interest at the 100.00 strike and is greater than corresponding put open interest by a 6 to 1 ratio. It seems that options players have an optimistic expectation for the beginning of the new year as SPY would have to rise well above 100 to really cash in on those options.

While I don't want to read too much into a single piece of data like that, I believe history would tell us to bet against points of optimistic or pessimistic extreme like that.

Pete

Stocks to Watch -- Bearish Trades

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Today's post is really an educational post that will cover a number of concepts relating to the kinds of patterns to look for in bear markets that will provide excellent short sale candidates or put option trades allowing you to make money as stocks decline in value.

The chart above is Verizon, ticker VZ.

The long term view is that the stock is below its 200 day moving average (MA), and the 200 day MA (red line) is pointed down. Also, the 50 day MA (green line) is below the 200 day MA. Since the October low, the stock has touched or crossed above the 50 day MA only to fall back below it 4 times. Now in the most recent advance the stock has moved back above the 50 day MA. Multiple failed rallies at the 50 day MA are classic for bear market rallies. A high volume close back below the 50 day MA would be very bearish.

Another key to look for on rally attempts is the volume. Notice how the peak volume on up days (the black bars at the bottom of the chart) was highest in October after the lows, then lower at the last week in November, and lower yet the last few days. Also today marked a new high coming off the October low, yet volume is not impressive. These are signs of waning demand at higher prices.

The stock has been somewhat range bound forming a rising wedge/triangle type pattern since the October lows. The bollinger bands overlaying the chart are the blue lines, and they provide a statistical range around price and should contain about 95% of all price on a closing basis. These bands tend to be a ceiling on rangebound market rallies. Price is pennies below the upper band right now, and the 200 day MA hovers in the same area. The 200 day MA is a typical resistance point for bear market rallies. A downtrendline is present at that level also.

An advanced concept to understand in technical analysis, particularly pertaining to short-selling is the idea of overhead supply. Basically, areas of previous consolidation or support that the stock has moved below provide a point where many shares were aquired by institutional investors (large funds, etc.). Since these investors are now at a loss, they will want to sell and "breakeven" when the stock comes back to that level from lower prices. Such is human nature. So any advance into prior consolidation levels will meet a plethora of sellers and keep pushing prices down. In reference to this chart, VZ traded in an extremely tight range from mid-June to mid September of this year. It is not often you see such a tight range. This occurred almost entirely between 33.00 and 35.00. Not totally visible on the chart is that there is a horizontal support line around 32.00 from prior significant lows. Price finally broke that level in September and is now coming back to that level. There is a saying that old support will become new resistance, and I have found that to be very true in a situation like this. Price is now just above 33.00 and should be meeting anxious sellers soon.

I did not include any technical indicators on this chart, but there is a major bearish divergence in momentum on this advance compared to the November advance. Also, the %K slow stochastics is overbought which tends to occur at significant price peaks both shorter and longer term.

Now the last and most key ingredient for a successful short sale is the state of the stock market in general. The market will need to show further declines to really drive this stock down. I believe that this will occur over the next several months, but any move below the November 20 market low will be good confirmation that the bear's appetite has not been fulfilled.

Now, I won't go into any detail on other stocks now, but I want to give a few stocks from different sectors that I think are going to go down for people to check out on their own.

The oil refiner group (XOM, CVX, SUN, SNP) look ripe to short-sell. Other stocks are GG (gold stock), WMT and PG (refer to prior posts).

If anyone wants more analysis on any of those stocks, please post a question or comment.

Pete

Levels to Watch on SPY

In the shortened week last week, the short-term model became extremely overbought. I was away visiting family and did not make any posts. I did not feel in a huge rush to suggest a bearish trade at that overbought signal because the market was able to hold up for a day or two after it became overbought. That can be a sign of underlying strength. We were also far enough off the lows of the previous week, that the market could become oversold above those lows. That is one thing I look for to determine what direction to trade--Is the market above or below the prices that it was at when the last signal registered? So I think the next signal here will be the one to act on.

Right now there is a large unfilled gap down overhead at 90.00ish on SPY. I view that as a major area of resistance. If the market is able to push through that level, then I think there is a good shot it makes it up to the 96.00ish level where there is another gap left unfilled.

If the market fails the next day or so, and goes below Monday's lows, then the next area of major support is an unfilled gap up at 79.65. If we get down to that level this week, then I think that would be a good short-term bullish trade entry point. If accompanied by an oversold reading, I would definitely consider recommending a trade there on SSO.

Pete