Stock Market Volatility - Big Pop or Big Drop Ahead? 10-11-18

I have spent considerable time today comparing current market conditions with past data in order to guide expectation and strategies for trading.

MOST of the extremes in VIX, put/call ratios, multiple gaps downs and back to back down days or down streaks have in the past led to strong short term rebounds with peak gains coming at 4-8 days later.  So I think it is possible and reasonably probable that stocks rally 2-6% over the next couple weeks on a closing basis from today's low.

However, and few of the conditions I looked at which indicate very extreme readings, like 3+ standard deviation from the norm, suggest there is also a real possibility of a short term "wipeout" move which will occur before any rally attempt materializes.

Currently, I would estimate the probability of a 5% or greater decline, over the next 3 days or less, to be around 40%.

There is currently no bullish divergence on the hourly MACD chart of SPY, and given the strength of the decline, I would expect for that to develop before the low is in. 

If there is a gap down tomorrow, then from past similar instances I would estimate that from tomorrow's open there is a 2:1 or greater MAX gain versus MAX loss after the open, with a high probability of a close above the open. 

This data is useful in particular for a Friday where if tomorrow gaps down, we could write an option credit spread ATM or slightly OTM with the expiration at tomorrow's weekly option.

Since volatility is very high, and the odds of a close above the open are well above 50% from past stats (more like 75% from what I am looking at), then this could be a nice time to SELL premium with the limited risk of a bull put credit spread.

I may update tomorrow.


Pete

Projections for SPY Based Upon Recent Price Action

Click on Chart to Enlarge

My post earlier today appear to have been timely for the short term trade, as stocks reversed most of the day's losses after this morning's sell off.  It likely will prove to be a short term low that holds for a little while.

However, the current explosion in volatility and persistent downside price action that has repeatedly closed below the lower bands, with sharply increasing volatility, has led to rather predictable price action in the past.  I would encourage you to go back through this post I made in August 2011 during that waterfall decline, because I accurately forecasted price action based upon prior instances of similar action.  And that forecast being spot on just adds further weight to the likely outcomes here, with history as a guide.  So the implication here is that if today's is a bottom of this initial plunge, but the correction does make a lower low, then we may see prices rally back to the region of Monday's high and find resistance there.  Interestingly that area is exactly 61.8% of the retracement of the last 5 days action since the high of point "d" as I have labeled it on recent charts - the 10-8-14 high.

This post shows the trade set-up I mentioned at that time as the initial rebound unfolded.

Here is a follow up post from the action as it unfolded in August 2011 and led to a new low for the correction which ended up being a major buy signal.

The chart above shows a projection similar to the ones linked here, and is based upon a rally to the high of the second candlestick before today's reversal.  In the past when no divergence is present, the market has routinely retested the low before rallying again.  So in this case we may expect a similar outcome.  Each rally here would be a short-term short trade set-up.  And if the bull market has topped, then the next break of support may be significant and lead to much further losses.  But the technical indicators and underlying sentiment will be our guide as we move forward assuming this forecast is roughly accurate again.

The initial rebounds after a sharp decline like this tend to be swift.  I would expect a short-term short sale opportunity to develop by next week.

As a side note, there is perfect hourly time frame bullish divergence on IWM currently and a bearish engulfing pattern on the daily chart just below support.  So it would be logical to go long IWM if one were to believe the bull case here.  You can always treat it like a short term trade and exit part at the first sign of hourly time frame overbought levels.  Then maintain a portion of the trade for a potentially larger advance if the market does put in a lasting low here today.  In these scenarios I go in with the expectation that I may only breakeven most times, but I will be in the market for the times when it does put in a lasting low,

Again, comment or question below if you need further assistance in navigating here based upon your trading time frame, etc.

Pete

Major Stock Index Selling By Smart Money

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The commercial "smart money" traders increased their selling in stock futures this past reporting period making them the most net short in over a year.  The last times they were this heavily short were at the July 2011 and May 2011 tops.  While a signal like this can fail to lead to a major correction, in the context of a double top/failed breakout I wouldn't bet on it.  At a bare minimum I suggest having in the market trailing stops on long positions or growth stocks.  Remember, our goal as individual traders is to observe what the big players are doing, anticipate what they are likely to do next, and to position ourselves with them.  So they are more bearish than in the last year or so.  Are you?

Combined with a failed breakout of the April 2012 high, this reinforces that a correction is likely from these levels.  But as noted in the recent video, it would be out of character for the market to push above the recent August high and then make a correction.  A new high would likely be a continuation point.

Click on Chart to Enlarge

Click on Chart to Enlarge

Notice that the bollinger bands are squeezed tightly on SPY.  Not shown is the ADX/DMI which shows that the daily DMI has been below 20 for 2.5 months.  As it approached 20 two weeks ago, it turned down as the market failed to breakout.  Recall several posts talking about this explosive set up in the past.  Most recently it occurred in gold resulting in an upside breakout.  But the key is the watch for a close OUTSIDE the bands with both bands expanding.  When that happens in this situation it typically leads to a sharp price movement, though it may only last 1-2 weeks.

Click on Chart to Enlarge

The VIX/VXV ratio recent spiked lower again similar to what occurred in March of this year.  What this mean is that short term volatility is out of balance with longer term volatility expectations.  As you can see on the chart, that has often led to substantial corrections in stocks with on overall increase in volatility and a rebalancing of the VIX/VXV.  The other possibility is for volatility to remain low and the longer term volatility shrinks to rebalance the ratio.  If that happens it would likely be in the context of a continuing low volatility market advance.

As an additional note, the VIX has been running high relative to historical volatility.  This also often happens prior to market corrections.  The option market does not believe the current low volatility trade is sustainable.

At this point the US dollar looks set to make a continuation of its advance, and commodities have run very hot for several weeks and are likely to correct.  So I think we are likely to see a deflationary theme type sell off here again with most assets down and the US dollar up.