Technical Analysis: The One Certainty of the Markets

If you want strong returns when markets are on another wild ride, always keep an eye on the VIX, or the Volatility Index, which measures implied volatility of S&P 500 options.  Always… It’ll tell you exactly when to go long.

In fact, look at what’s happened to VIX pricing in times of excessive panic in the last year.  It’s spiked on the UK vote to exit the European Union.  It spiked on fears of war over Syria and North Korea.  It spiked on uncertainty over U.S. elections.

But each and every time, it signaled a buying opportunity on the S&P 500.

That’s because at such extremes, the herd is so busy panicking that they forget to pay attention.  In short, the VIX is a contrarian indicator, incredibly useful in determining when the markets have gone too far off the rails. 

The second that signal is seen it’s time to buy the dip and let it rip.

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But how can we tell with high certainty that the VIX is about to pull back after a panic-stricken run?  Actually, the herd tells us that by stretching the “rubber band” too far too fast with overreactions.

We all know what happens when you pull a rubber band too far.  It snaps back.  The very same thing happens with stocks, ETFs, indexes and even the Volatility Index.  To spot such moves, we look back at our pivot point indicators, such as relative strength (RSI), MACD and Williams’ %R (W%R).

All three will tell us when panic has reached excessive heights.

However, we also want to watch the Bollinger Bands (2,20).  This will tell us with obscene certainty when the rubber band has really been pulled too far.

Let’s start with RSI, MACD and Williams over the last two years.  Each time RSI moves to or above its 70-line, we have an overbought situation.  Fear has run amok.  Now look at MACD.  When it spikes, fear has run amok.  And when Williams moves to or above its 20-line, confirming what RSI and MACD told us, fear is too high.

We’re not done, though.

Now we bring in the Bollinger Bands (2,20) – our rubber band indicator.  Look at what happens about 100% of the time when the VIX stretches to the upper limits of the Bands.  It lets us know the rubber band has been pulled too tight.  It’s ready to snap back.  We can also tell how well it works by looking at the buying activity on the S&P 500 following such extremes.

One way to trade such moves is with an ETN like the Velocity Shares Daily Inverse VIX Short Term ETN (XIV), which has a tendency to run higher, as fear subsides.  While we’re not issuing a recommendation on the trade, we simply wanted to point out one of the many ways people trade such extreme opportunities.

If there’s one thing we can always depend on, it’s that traders will overreact.  Spot it in time, though, and you stand to do very well.

Be well.  We’ll speak again soon.

Learn to Trade with Bollinger Bands Side-By-Side with Seasoned Pros. Apply Your Knowledge
and Skills and Get Paid To Trade! Learn How Here