It’s almost too funny.
Just one day after the stock market punished the bulls by whacking the S&P 500 below its 9-day exponential moving average (EMA), thereby shifting the short-term momentum to bearish, the market then punished the bears by rallying back above the 9-day EMA and recovering everything it lost on Tuesday.
If the action over the past two days seems kind of déjà vu-ish, it’s because it is. The same thing happened in mid-May when the market suffered a one-day correction. Back then, though, it took the S&P 500 three days to recover the losses.
As I’ve said before, in this environment, the market is doing everything it can to frustrate bulls and bears alike. Tuesday was no doubt frustrating to traders who took on aggressive bullish positions in anticipation of the S&P 500 breaking out to new highs. Wednesday was frustrating to traders who got aggressively bearish.
I have been arguing for the past month or so that the broad stock market is in the process of changing its intermediate-term character from bullish to bearish. But, with the exception of one or two low-risk speculations, I haven’t been shorting stocks. The setup just hasn’t been right to do so.
You see, I like to sell stocks short when technical conditions are extremely overbought – when the proverbial rubber band is stretched to the limit. That’s the type of condition that creates a low-risk/high-reward short trade setup. And we just haven’t gotten that. So I’ve been sitting on the sidelines.
It’s been frustrating – to be leaning bearish and having to watch large downside moves like we saw in mid-May and just this past Tuesday without having any exposure to the short side. But I’d rather be frustrated and sitting on the sidelines with all of my cash than be frustrated and losing money when the market miraculously recovers from even the mildest of selloffs.
One Signal That Says “Go Short”
There’s just one condition I really need to see before I’ll pile into short trades. I’ve written about it before. But we have a lot of new readers here in the Market Minute. So, with the market changing character, it’s worthwhile to write about that condition again.
Before adding intermediate-term short trades to my portfolio, I need to see the Volatility Index (VIX) close below its lower Bollinger Band.
Bollinger Bands measure the most likely trading range for a stock or an index. So, when a chart moves outside of its Bollinger Bands, it indicates an “extreme” move – one that is vulnerable to a reversal.
The Volatility Index is widely accepted as a measure of fear and complacency among investors. It’s a contrary indicator – meaning that when the VIX is high and investors are fearful, it’s usually a good time to be buying stocks, and when the VIX is low and investors are complacent, it’s usually a good time to sell.
When the VIX closes below its lower Bollinger Band, it indicates an extreme move in investor complacency. And that’s what creates a good risk/reward setup for shorting stocks.
As you can tell from the following chart, the VIX has only closed below its lower Bollinger Band one time over the past year…
In early August 2016, the VIX closed just barely below its lower Bollinger Band. That coincided with an intermediate-term peak in the S&P 500 – which went on to lose 5% over the next three months. That was the one and only time over the past year it would have paid to take an intermediate-term short position on the broad stock market.
Yesterday, the VIX closed at 10.03. Its lower Bollinger Band is at 9.58. So we don’t yet have an extreme level of investor complacency. We didn’t have that condition prior to the big, one-day decline in May. Nor did we have that condition before Tuesday’s selloff. The market snapped back immediately following both of those declines.
So, until the VIX closes below its lower Bollinger Band, traders should only nibble on short trades. And they should be quick to take profits on them. The best time to add intermediate-term short positions to your portfolio will be after the VIX closes below its lower Bollinger Band.
Best regards and good trading,
P.S. Have you been shorting stocks this year? Send your stories, along with any questions or concerns, to me right here.