Topics from TWO e-mails: 1.) How 'common' retracement levels can anticipate trend reversals; 2.) Trading the VIX options.

#1 MAILBAG QUESTION:

"You put stock in retracement levels for indexes like they were prior lows or something. can you say more on their use?"

MY RESPONSE:

Since we KNOW (don't we!) that the major trend in stocks is up (Dow called it the primary trend), it's also often true that sell offs are going to have certain characteristics; e.g., indexes are not going to give back ALL of prior gains usually and while drops may be scary fast, they aren't usually prolonged.

What with the day to day ups and downs in the Market, it's helpful to look at a LONG-TERM chart periodically to SET in your mind as to the major trend; 6 years now strongly UP. This mental exercise is helpful for me to look at pullbacks not as scary so much but as fairly predictable as to where they might END.

WE GET THAT THE TREND IS UP, SO WHAT DO WE LOOK FOR ON PULLBACKS?

BULL MARKETS: the retracement percentages we pay attention to in bull or bear market trends are 33%, 38%, 50%, 62%, 66% and 100% retracements.

The stocks and indexes having the STRONGEST run ups will typically see a more 'minimal' 1/3 to 38% retracement and then resume their rise.

It's a stronger reversal 'signal' if the index or stock in question is also at an oversold extreme when it gets into an expected retracement/possible reversal situation. In addition to an overbought/oversold indicator extreme such as might be seen in the Relative Strength Index (RSI), another factor is a fall off in bullishness since traders are often the most bearish at lows. I'll discuss further on.

Stocks and stock indexes that are lagging the rate of gain of the strongest indexes; those having a more AVERAGE rate of month over month year or over year increases, will frequently on corrective pullbacks give back around 50% of a prior advance; sometimes a bit more than 50% but less than a 62% retracement.

62 - 66% retracements are seen in stocks and stock indexes that are lagging the pack; sometimes a full 'round-turn' 100% retracement is made back to a prior low and this is how double bottoms might set up.

A MINIMAL RETRACEMENT: 38%

The broad Nasdaq Composite (COMP) saw an exact 38% retracement of its prior advance, then made a 3-day support 'base' in the 4850 area. COMP was not at an oversold RSI extreme but bearishness had risen coming into recent pullback lows.

The NUMBER ONE consideration was the 'minimal' COMP pullback of 38% in the strongest market, tech. Price action thereafter 'confirmed' a potential bottom by multiple lows at 4850; tops may form over many days, even weeks, but bottoms in primary uptrends often develop after lows form in the same area for 1-3 days.

AN AVERAGE RETRACEMENT OF HALF OF THE PRIOR ADVANCE:

The S&P 500 (SPX) retraced a bit over one-half/50% of its prior advance, which is number one in considering a possible bottom.

SPX also saw same subsequent pattern of multiple lows over a 3-4 day period after hitting the 50% mark; same bottoming pattern as seen with the Composite. Moreover, SPX reversed to the upside after its 13-day RSI hit an oversold 'extreme'. Here, we had a common retracement (50%) as a place to look for a bullish turnaround, an oversold Relative Strength Index extreme and bearish 'sentiment' falling.

A TRADING 'GIFT':

The big cap Nasdaq 100 (NDX), in almost a 'gift' for traders in suggesting a reversal about to happen, strongly rebounded after tracing out an exact 50% retracement. That the prior strongest index, NDX, gave back HALF of its prior gains, versus 38% for COMP, was a 'bell ringing' at the recent bottom.

Yet to come is for NDX to sail through its prior top. Stay tuned. Judging by the action in the Nas Composite a new NDX high is coming but maybe NDX 'soaring' through its prior top won't be how it goes initially!

TRADING THE S&P 500 VOLATILITY (VIX) INDEX:

#2 MAILBAG QUERY:

"I love your Index Wraps and have been noting that you are now trading VIX. I could not have timed a better entry and exit between the Wed market lows to Thursday highs if i had a crystal ball (I wish I always had such great timing...perhaps it was beginners luck for the VIX).

Bought Apr VIX 19 PUT @ $2.50 on 3/11/15 - VIX trading around 16.75-16.80. Sold Apr VIX 19 put at $2.80 on 3/13; VIX trading around 15.50

All done on limit orders, not 'market'. At 2.80, I got one of best prices of the day. Highest may have been $2.85 for a split second.

I was extremely disappointed at the returns and very confused at how they trade. My trade should have been in the money by over $3.50, yet it was still trading in the $2's (both the bid and ask!)! I am curious how you can trust trading these when you can't even bank on them at least trading at par with their strike price. Even though it was a successful trade, I would like to learn from this experience."

MY RESPONSE:

First and foremost, like any other option, if VIX moves 3, there's no guarantee that the option will move $3 even if it is in the money.

There are factors that we have to look in addition to how we think your put should move relative to the underlying Index: The market conditions and VIX trend expectations that existed on the days you entered and exited your trade. Also, there was a lot of time, a month, to expiration of your April VIX puts.

The 30-minute VIX chart will help us zero in on the intraday trading over the period you were in and out of VIX puts.

THE CONTEXT: VIX was in a volatile period as seen below. VIX was 'gapping' up and gapping down on overnight news in the market from 3/9 on. You bought your puts on a day when VIX was rallying (3/11). The next day brought a decline in VIX, but by the day after that (3/13) VIX rebounded and volatility looked capable of rising in subsequent days.

It is fair to say that trader expectations were not all that bearish on the 13th, the day you exited your puts. Moreover, the April puts had plenty of time to expiration which would dampen aggressive buying of VIX puts going out to mid-April. You were on right side of what happened with VIX: a short-lived pop up followed by a decline back to low-volatility in the week just ended (3/20/15) with the dip to at and below 13. You just didn't give the trade more time to work in your favor. Good thinking on direction, a little quick to exit.


GOOD TRADING SUCCESS!