The stock markets' sharp June selloff
is waking traders from their complacent slumber. The risk of a significant
selloff, long ignored, has surged back to the forefront of market psychology.
These pullbacks and corrections are healthy and necessary within ongoing bull
markets, but they don't end until fear grows great enough to rebalance
sentiment. And today, stock fear is still too low for a bottoming.
Sentiment, the collective greed and
fear of all traders, drives the vast majority of all short-term
financial-market action. Like a great pendulum, it perpetually swings back
and forth between excessive greed and excessive fear. In bull markets,
maturing uplegs generate widespread greed while
maturing corrections spark universal fear. But these emotional extremes are
self-limiting, they soon burn themselves out.
After prices have advanced long
enough and high enough in a major upleg, greed
peaks. All traders interested in buying stocks anytime soon have already
deployed their capital, leaving only sellers. Their selling spawns a
correction. This is self-feeding, as the lower that prices fall the more
traders are frightened into selling. Eventually all traders interested in
selling anytime soon have sold, so fear climaxes, and then this endless cycle
This leads to ongoing bull markets
advancing two steps forward in greed-driven uplegs
before retreating one step back in fear-driven corrections. Trading these upleg-correction cycles is wildly profitable, buying low
when everyone is fearful and selling high when everyone is greedy. But in
order to trade sentiment, we need some way to attempt to quantify this
ethereal construct. Enter the implied-volatility indexes.
Volatility simply measures how much
markets are moving, either within individual trading days or between them. A
day when the flagship S&P 500 stock index (SPX) sees a 3% trading range
is way more volatile than a 1% one. While volatility doesn't measure
sentiment directly, it is closely tied to it. Since fear is a more immediate,
visceral emotion than greed, fearful times witness far-higher volatility than
Implied volatility extends this
concept into the near future. It looks at stock-index options prices, which
reflect what options traders believe about near-future market action. The
prices at which they make their options bets mirror their expectations. And
when they are scared, which only happens after stock prices have
already fallen significantly, ballooning options prices imply higher
So implied volatility is effectively a
fear gauge, with the famous VIX (short for "Volatility IndeX") being the most-popular index. It measures
the implied volatility of a weighted blend of SPX index options expiring over
the coming month. While today's VIX works well, I still prefer its old-school
predecessor for a variety of reasons. It was the original VIX until September
2003, when that classic index's calculation methodology was heavily modified.
This new "VIX" replaced the
original VIX, which was renamed the VXO. The VXO measures implied volatility
of S&P 100 at-the-money index options expiring one month out.
At-the-money options are a purer, less-diluted measure of volatility than the
out-of-the-money ones introduced in the new VIX. And the giant S&P 100
stocks (top 20% of the S&P 500) are much more liquid and hence the first
and fastest to be sold in fear episodes. Thus the classic VXO remains more
responsive to fear spikes than the new VIX.
Whether you prefer the VXO or VIX,
trading stock fear is easy to understand. Speculators should sell their
positions to realize profits after major uplegs
when the VXO is low, indicating no fear and hence widespread greed and
complacency. And then after corrections when the VXO is high, both
speculators and investors can buy stocks at relative-bargain prices. Sell on
a low VXO, buy on a high VXO. Simple!
As always, this principle of selling
greed and buying fear has proven very profitable in the SPX's current cyclical bull
since 2008's stock panic. This first chart superimposes the SPX (blue) over
the VXO (red), with every stock-market pullback (4% to 10%) and correction
(over 10%) labeled. The highest VXO close within the trading week surrounding
each SPX selloff's bottom is noted in red. This comparison reveals what kinds
of VXO levels are associated with major bottoms. Today it is too low, fear
hasn't climaxed yet.
As 2008's once-in-a-century
stock panic was an epic fear event, the biggest of our lifetimes, the
VXO skyrocketed to crazy-high levels in late 2008 and early 2009. So most of
the VXO's trading action in 2009 was anomalous, a gradual post-panic
normalization. Nevertheless, all the major stock-market pullbacks and
corrections still tended to see a tight range of VXO levels marking their
So far in this cyclical bull, the SPX
has weathered seven pullbacks and a single correction. The average high VXO
close marking the fear climax within two trading days before and after these
major SPX bottoms was 28.3. The high reading was 33.8, at the end of last
summer's massive 16.0% SPX correction. The low one was 21.7, after the minor
3.9% SPX pullback seen last November. Exclude these two extremes and the
average fear peak is still 28.5 in VXO closing terms, with a very-tight 1.5
Thus bull-to-date precedent is very
clear in showing a VXO close around 28 is necessary for a
high-probability bottoming following a pullback or correction in the SPX. So
far in our current selloff, the highest VXO close we've seen was merely 20.5.
This is way below the fear levels likely necessary to fully rebalance
stock-market sentiment. Stock fear is still too low for a major bottoming in
Without greed and fear, the stock
markets would gradually rally in a nice straight line in an ongoing bull
market. The sentiment pendulum swinging back and forth between collective
greed and fear pushes and pulls this ascent into something like a meandering
sine wave. Greed near the ends of uplegs pushes the
stock markets higher than their linear uptrend, while fear near the ends of
selloffs pulls them lower.
The longer that one of these extreme
emotions persists, the more unbalanced sentiment becomes. Hence the longer
and farther the sentiment pendulum must swing in the opposite direction
to rebalance sentiment. Consider last summer's SPX correction. The SPX had
powered higher for so long without any meaningful selling, driving such low
VXO levels in April 2010 (14s), that it took a major correction to generate
enough fear to eradicate that entrenched greed.
Conversely in most of the SPX's
pullbacks of this bull, the stock markets hadn't rallied as far or as long so
the necessary rebalancing was much smaller. Note that the VXO was also
considerably higher heading into most of those pullbacks compared to how low
it was before last summer's correction. But recently by late April 2011 near
the SPX's latest interim highs, the VXO had slumped down into the 13s! Greed
and complacency were extreme, and fear hardly even existed anymore
just 7 weeks ago.
Back then I warned about the high
risk for an imminent correction, a lonely contrarian voice in a sea of
irrational bullishness. I wrote an essay
then showing how precarious the stock markets looked based on key sentiment
indicators including the VXO. I advised our newsletter subscribers to realize
profits on their short-term positions and remain heavily in cash. Cash is the
best "trade" to own during a correction, as it preserves your
capital to buy the resulting bargains after that rebalancing selloff has run
Like last summer, the VXO reads
heading into this latest selling event were incredibly low. Thus we are
likely to need a lot more stock-market selling to drive the levels of fear
necessary to totally erase the recent greed. This is self-evident in this
latest pullback's interactions between the SPX and VXO. Though this selloff
has already been substantial, fear still remains far too low for a bottoming.
Since the final trading day in April
when the SPX peaked at a new post-panic high of 1364, this flagship stock
index has fallen 7.2% over the past 7 weeks or so. This already makes today's
selloff the second-largest (and longest) pullback (4% to 10%) of this entire
cyclical bull. Similar 7%ish pullbacks drove VXO levels to 30.9 in July 2009
and 27.4 in August 2010. So to see today's latest VXO high of merely 20.5
indicates a lot of sentiment-rebalancing work is still left to be done.
The stock markets essentially ground
sideways in a high consolidation between February and May. And since the SPX
stayed near highs, complacency remained stellar. The only interruption was
that early-March 6.4% pullback that climaxed at a VXO read of 28.9 just after
that terrible Japanese earthquake and tsunami. Other than that, we haven't
seen any meaningful fear since last summer.
In April 2011 the VXO averaged just
15.2 on close, very low. This was even worse than April 2010's average VXO
close of 16.1 just before last summer's massive SPX correction. The longer
that fear is absent from the markets, the more complacent and greedy traders
become. Thus the more selling is necessary to ignite the necessary fear to
create a high-probability bottoming. Prudent traders who can patiently wait
for these fear levels, safe in cash, enjoy an incredible buying opportunity.
So until the VXO shoots up above 28
or so on close, or into the mid-30s if this SPX pullback extends to a
correction-magnitude 10%+ as I expect, I would be very careful here.
Pullbacks and corrections within ongoing bull markets don't end until
sentiment is rebalanced, and it takes well-defined levels of fear to
accomplish this. And so far, even despite June's aggressive selling, we have
yet to see it. This means there is likely more selling to come.
While the VXO (or VIX if you prefer)
is a perfectly-fine fear gauge, there is an alternate approach I've used in past
years. It is based on my Relativity
Trading system, using the VXO's 200-day moving average to establish a
recent volatility baseline. While absolute VXO levels are generally pretty
comparable over time, occasionally baseline volatility is driven higher or lower than normal. In these situations it can be useful to
measure the VXO as a multiple of its 200dma baseline, which highlights
This next chart shows the raw VXO in
blue, along with the Relative VXO (rVXO) in red.
The rVXO is simply the VXO divided by its 200dma.
Charted over time, this creates a horizontal trading range. The time
to buy stocks is when the rVXO is high in
this range, like back in the summer of 2010 after the only SPX correction of
this cyclical bull. And today, the rVXO is still
nowhere close to signaling a high-probability bottoming in the SPX yet.
While this chart encompasses the past
couple years or so, in Relativity trading we consider the past 5 to 6 years
to define relative trading ranges. The rVXO's
current range runs from 0.75x on the low side to
1.75x on the high side. Our subscribers can log in to our website
and see the large high-resolution long-term rVXO
chart from which this range was derived, which is updated weekly.
When the rVXO
gets low in this range, around its 0.75x support zone, volatility is too low.
This means greed and complacency are too high and an imminent SPX selloff is
likely. This only happens after stock-market uplegs.
Conversely when the rVXO gets high in its range,
around its 1.75x resistance zone, volatility is too high. This means fear is
excessive and an imminent sharp SPX rally is likely. This only happens
after stock-market pullbacks and corrections.
Like sentiment forever oscillates
between greed and fear, so does volatility perpetually meander between low
and high states. Whenever it gets too low or too
high, the smart contrarian bet to make is the mean-reversion one. Any
extremes in the financial markets, no matter where they occur, almost always
eventually revert back to their long-term averages. Mean reversion is
a critical principle for success in speculating and investing alike, always
be aware of it whenever something is out of whack.
Note today that despite the recent
sharp SPX selloff, the rVXO has merely climbed to 1.14x at best. This is still well below the midpoint
in this indicator's secular trading range! Last summer's SPX correction saw
an rVXO peak near its end of 1.53x, and the last
pullback in March 2011 went as high as 1.39x in the trading week surrounding
the SPX's bottoming. So just like in absolute terms, also in relative
terms the VXO remains too darned low to signal the end of this selloff.
Fear just isn't high enough yet.
Stock-market corrections are
exceedingly-crafty devils. They often advance two steps lower before
rebounding one step back to keep fear from building too rapidly. These
countertrend rallies within corrections keep traders fully deployed as long
as possible. Big up days in between the selling stretches convince traders
that the selloff must be ending, so they keep their capital in harm's way. By
the time the correction is truly finally maturing, it is too late and they've
already suffered big losses in their positions. Nothing generates fear like
watching your own trades hemorrhage your capital!
So buying again just because the
stock markets start rallying and sentiment feels a little better is a fool's
errand. Speculators and investors alike are far better off watching the VXO,
VIX, or some other well-established sentiment gauge. Selloffs should only be
aggressively bought once fear is high enough, as measured by the precedent
from the ends of previous pullbacks and corrections, to mark a
high-probability bottoming. And the VXO remains far from that metric in our
Trading stock fear is wildly-profitable,
but demands iron discipline and emotional self-control. Traders have to learn
to totally ignore their own fear, because the best time to buy is
right when it looks like the stock markets are ready to plunge over a cliff.
When everyone else's fear peaks, when all hope seems lost, that is
when the relatively-cheap post-selloff stocks should be bought. And the VXO
is an excellent non-subjective metric for traders to gauge popular fear.
Always watch it carefully.
At Zeal we've long traded stock fear
with great success. I wrote my first essay on the VIX way back in August
2002, and in the many years since we've greatly
refined our knowledge and timing of trading stock fear. And this critical
tool in our trading arsenal has certainly helped generate our spectacular
trading results. Since 2001, all 583 stock trades recommended in our
subscription newsletters have averaged annualized realized gains of +52%! Such
rapid appreciation really multiplies wealth.
And since greed and fear are the
biggest drivers of short-term price movements by far, sentiment is always a
key focus in our acclaimed weekly and monthly subscription newsletters. In them
I weave together our vast research, knowledge, and wisdom to help speculators
and investors better understand what the markets are doing, why, and where
they are likely heading. When high-probability-for-success trading
opportunities arise, we recommend specific trades you can mirror. Subscribe today and start thriving!
The bottom line is trading stock fear
yields the best buying opportunities within any ongoing bull market. Traders
can only expect to buy low when everyone else is scared and selling, driving
down stock prices to bargain levels. The implied-volatility indexes,
particularly the classic VXO, offer the best way to objectively measure
collective fear. Waiting for levels where past selloffs bottomed leads to
great buying ops.
And today's stock-market selloff,
though substantial, has yet to get anywhere close to the fear levels seen
after the rest of this bull's pullbacks and corrections. This means sentiment
is not rebalanced yet, hence more selling is highly
likely to spark the necessary fear levels to eradicate residual greed. So be
careful here, don't get suckered in to the countertrend rallies until the VXO
signals fear is high enough to buy.
So how can you
profit from this information? We publish an acclaimed monthly
newsletter, Zeal Intelligence,
that details exactly what we are doing in terms of actual stock and options
trading based on all the lessons we have learned in our market
research. Please consider joining us each month for tactical trading
details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm
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