Looking for the downside

March 11th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Shot of adrenaline for the markets

* Trading the VIX: approach with extreme caution

* S&P 500 breaking down?

* Monetary freight train

After a couple of weeks of fairly docile trading the market was given a shot of adrenaline this week, once again demonstrating the market’s ability to turn on a dime and catch out all but the most nimble of traders.

Tuesday’s sharp sell-off in equities (driven by a combination of ‘fear-factors’ which I wrote about here) reversed on Wednesday and Thursday, with the S&P 500 up 1.6% and recovering all of Tuesday’s losses as markets priced in the expectation of a positive outcome from the largest sovereign default in history. Friday’s trading saw the index up a further 0.4% up on Friday.

Additionally, the VIX ‘fear index’ has taken a beating, giving up all its Tuesday gains and suggesting that I may have been too soon in identifying a possible breakout here.

Last week is a perfect example of how dangerous it can be trading for the short-term if you don’t adequately manage your risk. This is even more to important to remember in the case of the VIX, as it essentially acts like a leveraged inverse bet on the S&P 500 – hence it can be useful as a hedge but timing it wrong will not look pretty. Case in point, during the past 5 trading days the VIX spiked 21% and then swiftly tanked 19%. Get caught on the wrong side of that trade and you are liable to have “your face ripped off” as the saying goes. (The VIX is now about 1% lower than when I first wrote about it in on February 24th)

The possible VIX breakout I identified was premature, and turns out to have been a so-called ‘head fake’. This is a good lesson – with hindsight I underestimated the significance of the 20.5-21 level on the VIX, which has been an area of significant support and resistance during the past 3 months. Had the index broken through this range then a break-out could have had legs. Chart below:

Despite last week’s trading, I am still watching for a concerted move higher by the VIX. One reason for this is something called ‘negative divergence’ and I’ve highlighted this in the lower section of the chart above. The RSI (or Relative Strength Index) is a measure of momentum, comparing the number and strength of ‘up days’ against the number and strength of ‘down days’ for any given stock or index during the previous ‘X’ number of days. It’s not rocket science.

Traders often watch for ‘divergence’ between the stock’s pricing movements and the RSI – that is to say if the stock is moving in one direction but the RSI is moving in the other. Some take this as an indicator that the market may be about to turn. If a stock or index is moving up but the RSI is moving down, this can be seen as evidence that the rally is running out of steam - this is called ‘negative divergence’. Conversely, if a stock is trending down but the RSI is heading up, it can be an indicator that the sell off may be overdone and is approaching a turning point. This is called – can you guess – ‘positive divergence’.

The VIX has been showing fairly strong positive divergence since December 2011, indicating that we could be reaching an inflection point at which the VIX makes a sustained move higher. (Note: the RSI is just one indicator - it’s very important not to rely on any single indicator, but to use multiple indicators to help you trade. I’ll be writing about other indicators as I come to them in later posts.)

While on the topic of the RSI, the S&P 500 is also showing a good example of divergence and this is one reason I’ll be watching this chart closely in the coming weeks, and keeping an eye out for possible pull-backs. Chart below:

  

As you can see from the above chart, since late December the S&P 500 has been trading upwards in a fairly obvious channel, as shown by the green lines. This channel has provided strong support and resistance at various points which I’ve indicated on the chart with the green and red arrows. (The non-filled arrows I’ve indicated are less convincing as support and resistance, because they do not quite touch the trend lines).

Two observations on the S&P: firstly, recent trading has seen the S&P break down below the support level of the trend line, eventually finding support at the 1340 level, a price which also held up the S&P on two earlier occasions in mid-February (shown by the thick red line).

Secondly, since the back end of January the RSI (bottom part of chart) has been trending downwards- this is an example of negative divergence and suggests the S&P rally may be getting old.

However as mentioned it's vital to use multiple indicators against which to test your theory. Another indicator I'm watching suggests some caution before betting on a decline in the S&P. Below is a chart of minute-by-minute S&P 500 data during the past 10 trading days, showing the correction from the intra-day high on Wednesday 29^th February to the low on Tuesday 6^th March:

The dotted red lines overlayed on the chart show the key Fibonacci retracement levels of 23.6%, 38.2%, 50.0% and 61.8%. More on Fibonacci in a later post but suffice to say many traders view these levels to be highly significant and closely watch how the market responds at these potential resistance and support lines.

As you can see in the above chart, the index encountered some resistance at Fibonacci retracement levels 38.2% and 61.8% (shown in the arrows above) but has since cleared these key levels with some ease. To me this suggests we should be very cautious before entering into any aggressive ‘short’ positions at this stage.

Monetary Freight Train

There's plenty of risk out there - as highlighted here and here - and signs that we could be overdue a more protracted correction.  I’ll be watching the S&P 500 for resistance at the 100% Fibonacci level of 1378. Above that, the lower band of the green trading channel I identified could become the next significant point of resistance.

However it pays to remain flexible and never become fixated on one point of view. This market continues to surprise on the upside and betting against the trend is dangerous. It’s become fashionable of late to question the current rally, and much of the financial media is calling for a correction – this in itself makes the contrarian in me cautious about betting on a sell-off.

It's important to understand that in large part the current rally is a product of the huge amounts of liquidity and ‘free money’ that is being injected into the banking system by the Fed, ECB, BoE et al. The scale of what is going on right now in central banks around the western world is absolutely unprecedented and getting on the wrong side of this monetary freight train could be extremely hazardous to your health.