ESTIMATING SHORT-TERM SUPPORT FOR SPY AND IWM -- USING FIBONACCI CLUSTERS FOR CORRECTION TARGETS -- VOLATILITY INDICES SURGE ABOVE RESISTANCE -- MEAN REVERSION STRATEGY FOR THE VIX
ESTIMATING SHORT-TERM SUPPORT LEVELS FOR SPY... Link for todays video. Stocks continued lower for the second day, but bounced off their afternoon lows as short-term support levels came into play for the major index ETFs. Not everyones definition of short-term is the same. I would consider a 6-week 60-minute chart representative of the short-term picture. Further along the timeline, a 6-9 month daily bar chart would represent the medium-term and an 9-24 month weekly chart would cover the long-term picture. Chart 1 shows the S&P 500 ETF (SPY) over a seven week period with 60-minute bars. The ETF advanced around 5% the first three weeks of February. Stocks were already overbought heading into the month and certainly became more overbought by the end of last week. There are two reaction lows around 127-127.5 that mark an important support level. Further up, we can estimate support using the Fibonacci Retracements Tool and basic chart analysis. Broken resistance levels around 129.5 and 130.5 turn into potential support. A 62% retracement of the 4-5 week advance would extend to the 130 area. Also notice that 14-period RSI on the 60-minute chart moved to its lowest level since July 1st. The combination of support and short-term oversold conditions could give way to a bounce or a consolidation. Those wanting to estimate resistance for an oversold bounce can use the same process in reverse. Apply the Fibonacci Retracements Tool to the two day decline and look for broken support levels. Chart 2 shows the Russell 2000 ETF (IWM) with the same analysis tools.
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Chart 1
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Chart 2
USING FIBONACCI CLUSTERS TO ESTIMATE CORRECTION TARGETS... Chart 3 shows a daily candlestick chart for SPY extending back around six months. Using Fibonacci clusters and broken resistance, we can estimate a target for an extended correction. As its name implies, a correction is expected to retrace a portion of the prior advance. But which advance? There are clearly two advances on this chart. One extends from late August to late February and the other from late November to late February. In this case, we can apply the Fibonacci Retracements Tool to both and look for a Fibonacci cluster. This is simply the intersection of two Fibonacci retracement levels. A 61.8% (62%) of the three-month advance marks potential support at 122.73, while a 38.2% (38%) retracement of the six-month advance marks potential support at 123.82. There is also support from broken resistance just above 122. Taken together, we can estimate correction support around 122-124. Keep in mind that these are just estimates and two days of weakness is certainly not enough to reverse the medium-term uptrend. Chart 4 shows the Russell 2000 ETF with the same analysis tools.
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Chart 3
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Chart 4
VOLATILITY INDICES SURGE ABOVE RESISTANCE... The CBOE Volatility Index ($VIX) and the Nasdaq 100 Volatility Index ($VXN) are largely coincident indicators that rise when stocks fall and fall when stocks rise. Volatility indices measure 30-day implied volatility for a basket of near-term put and call options. You can read more on the VIX and VXN from the CBOE website (www.cboe.com/micro/vxn/). The inverse relationship between stocks and volatility makes sense. Fear increases as stocks fall and put option premiums rise as demand for puts increases. Put options offer protection against a decline or a chance to make money on a decline.
Chart 5 shows the CBOE Volatility Index with a series of downtrends interrupted by surges, most of which lasted just a few weeks. The red dotted lines mark reaction high resistance for the VIX. The red arrows mark the S&P 500 when the VIX broke these reaction highs with a surge. The January and April surges foreshadowed corrections that lasted 4 weeks and 8 weeks, respectively. After that, the corrections signaled became shorter. The November pullback was hardly a correction. These short pullbacks are testament to the strength of the uptrend in the S&P 500 the last six months.
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Chart 5
The thick red lines mark the 25 level. This seems to be an important level for volatility (fear). With a surge above 20 this week, the VIX broke its January high, but remains below 25. To avoid getting pulled into a fleeting surge, it seems prudent to wait for follow through above 25. A break above this level would put volatility at a relatively high level, which would indicate a high fear level. Such a move would be negative for stocks and could signal the start of an extended correction. Chart 6 shows the Nasdaq 100 Volatility Index ($VXN) for reference.
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Chart 6
MEAN REVERSION STRATEGY FOR THE VIX... In his book, Short-Term Trading Strategies that Work , Larry Connors advocates a short-term mean reversion strategy using the CBOE Volatility Index ($VIX) to identify short-term oversold situations. According to Coopers strategy, the S&P 500 is oversold when the VIX exceeds its 10-day SMA by more than 5%. Again, this is a short-term mean-reversion strategy that seeks to identify short pullbacks within a bigger uptrend. The bigger uptrend represents the mean. A dip in the S&P 500 and spike in the CBOE Volatility Index suggest that stocks are too far below their short-term mean. A rally back to this mean or above the mean is then expected. Cooper also suggests not buying stocks when the CBOE Volatility Index is below its 10-day SMA by more than 5%.
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Chart 7
So how can be determine when the CBOE Volatility Index is 5% or more above its 10-day SMA? The Percent Price Oscillator (PPO) was built for such endeavors. This indicator measures the percentage difference between two exponential moving averages. PPO(1,10) tells us the percentage difference between the 1-day EMA and 10-day EMA. Yes, a 10-day EMA is not exactly the same as a 10-day SMA, but the differences are negligible. The 1-day EMA is the same as the close. Chart 7 contains shaded areas showing when the PPO (upper window / left scale) is above 5%. I would even go as far to suggest an additional filter. Once the PPO crosses above 5%, we never know how long it will stay above 5%. A strong downtrend could unfold and the PPO could remain above this level. Therefore, traders might consider waiting for the PPO to cross back below 5% to confirm a downturn in the VIX and an upturn in the S&P 500. Connors book, Short-Term Trading Strategies that Work, contains many more strategies and is available in our bookstore. Chart 8 shows the Nasdaq 100 Volatility Index ($VXN).
