I remember it like it was yesterday.
In August of 2015, the S&P 500 sold off 3% in a single day.
400 points to the downside in the Dow.
The next day, we came off another 500 points.
We finished on the lows headed into the weekend, and then the following Monday the markets crashed.
The catalyst that set this all off was a surprise Yuan devaluation by the Chinese. This led to a series of events in the currency market, which triggered all sorts of nasty things in stocks. The market is now about 30% higher off those lows, but at the time it was pretty harrowing to watch.
Could it have been avoided? Could you have sidestepped costly losses in your portfolio or put on hedges that allowed you to safely navigate the market through an ugly period like that?
It can't be guaranteed, but it is possible.
I'm going to step through some of the warning signs you must watch, and what you can do right now to protect your portfolio.
Before we get started, I want to give you a warning.
You're not going to get an easy answer. There is nuance. I won't treat you like a child and try to scare you with end-of-world scenarios. If you're looking for a reason to sell all of your stocks, you won't find it here. Instead I'll show you what I'm looking at right now and the strategies you can use to protect yourself.
Watching The VIX
One of the biggest myths out there is that a low VIX means that it's time to sell stocks.
The usual story is that a high VIX means "fear" and a low VIX means "complacency." Well, that just simply isn't the case. In fact, when we have a low VIX it tends to lead to higher stock prices.
The concern you should have is a low sustained VIX... meaning when we have had complacency that has persisted for longer than a month.
Here's a chart with the price of the VIX removed, and only the 20 and 50 day moving averages. This allows us to look at the average close on the VIX over a 1 and 2.5 month timeframe.
This telsl us, that over the past month the average close on the VIX is right around 12. Since the market crash that has only happened one other time-- Summer of 2014. Back in July of 2014 the VIX had a closing level of 10.32%-- extreme levels.
Is it a warning sign? Yes. But it can take a while for actual selling to come into play. From that low VIX reading in 2014, it took a month to see any kind of selling in the market. It then took another 2 months before any true fear came into the market... and it took an Ebola scare for sellers to come into play.
The other thing to keep in mind is that the VIX is a measure of expected volatility in the future... so we should also look at past volatility to see how rich the premium is.
Here is a chart of the 20 day historical volatility in the S&P 500:
Over the past month we've seen an actual volatility of around 6%. That means if this volatility continues, then the VIX is actually still overvalued.
This means we have some small warning signs in the volatility markets, but it may take a while for them to actually work out.
What other warning signs should we look out for? Here's a simple one...
Bollinger Band Compression
If you want to look at how tight a market's range has been, simply look at the Bollinger Bands. This technical study can tell you how well the market has been trending, and identify powerful inflection points in the market.
Here is what the market currently looks like:
Over the past month, the Bollinger Bands have drastically compressed. This means that we have not seen any kind of trending action and the market has been very quiet.
When we see this kind of "pinch" in the Bollinger Bands, it means we have a high odds of seeing trending action soon.
This does not guarantee that the big move will be a selloff. In fact, it's possible to have a catalyst in the markets and we see volatility expansion to the upside. Yet most of the time... when we see volatility pick up it's because sellers found a reason to sell and the market is selling off.
Here's a better way to look at it. Instead of reading the bands, we can measure the distance between the upper and lower Bollinger Bands.
The Bollinger Band width on the S&P 500 currently sits around 1.7. That's not the lowest we've seen, but it's still quite low.
If you go back and look at other times we have hit these levels, they tend to precede a selloff. Remember, it's not guaranteed... a good example of upside vol expansion was in September o 2012:
The trouble I have with believing that we're due for a new bearish cycle is that we haven't truly seen the euphoria needed to really suck a lot of new people in. Which brings us to...
Watch The Lotto Stocks
There are a handful of names to follow that you can use to gauge how "hot" the market is getting.
When these names start to run it means the speculators are out in full force and feeling really comfortable in the market.
For a stock to get on this list, it needs to be a "brand name" stock that doesn't have a huge capitalization, or is a new issue.
A good example is BABA. When it ran from 82 to 120 in a month after it's IPO... that's how you know the market is starting to run hot.
Past "Lotto" stocks I've used in the past are GPRO, TWLO, BABA, DRYS, GMCR, CREE and a few others. Most of these names aren't on the list anymore because the market participants changed.
One of the reasons why I'm not super bearish here is that we really haven't had a new crop of runners pop up yet. One space I'm watching is the resurgence in the ag space-- stocks like POT and MOS.
So with this in mind let's talk about what I think will happen in the near term.
My Prediction On the Markets
A low VIX and low actual vol don't necessarily lead to market selloffs. I think it will, eventually, because stocks go up and down. That's just the normal cycle.
The market looks ready to be setting up for a breakout. So I don't think it makes sense to get aggressively bearish here... instead you want to start layering on hedges into that breakout.
So far, earnings season hasn't been a disaster. We are starting to see separation in the market, with large cap financials seeing some profit taking, while names like NFLX and TXN start to see breakouts.
My bet here is that we will rally into earnings season, and then investor psychology starts to anchor onto the next big Fed meeting, which is in the middle of March. We'll probably see profit taking and maybe a little fear into that event as we don't know what the Fed will do. We may get a little shakeout as the animal spirits in the market try to convince the Fed that another near term hike would be a bad idea.
Start looking for story stocks. NFLX is probably on there, so is POT. If they start running hard, that means we're close to a pivot high. From there you want to start looking at some smart long vol exposure.
How to Trade It
There are a handful of strategies to consider with this scenario.
Buy VIX Calls
Before I get started with this, remember that the VIX is a statistic. The actual numbers you're trading against are in the VIX futures.
So while the VIX is sitting at 12, the March VIX future is at 15.
The trade to look at is to buy the VIX Mar 15 Call for 1.50. This is not something you want to hold to expiration. Instead, you want to wait for the pre-Fed scare to come into play and then take profits into that.
The other reason I like VIX calls is that they are cheap.
Here is a chart of VVIX, which shows how expensive the premium is on VIX Options:
With any reading sub 80%, and you want to look to buy VIX protection simply because it's the best deal you can get right now.
Buy SPX Put Spreads
Look, buying puts straight up is fine if you absolutely nail the top, but if the selling comes a month later, then you're screwed because the time decay losses are larger than the gains you made from the selloff.
Instead, consider put spreads. They take advantage of another anomaly in the market right now.
This is a chart of the SKEW. It shows how expensive out of the money puts are compared to at the money.
What this means is you can buy put spreads and reduce your overall cost and risk through this.
Consider this trade: Buy to Open SPX Mar 2260/2200 put spread at 13.80... you can also do a similar trade in the SPY options.
With this spread, you're buying the 2260 at a vol of 11.42%, and selling the 2200 at a vol of 13.44%.
All you'd need is a 30 point move to the downside and you're in the money.
Now at this point, I wouldn't consider this trade... but if the SPX ran to 2300 on a clear breakout, then I'd start layering into these spreads.
Sell Spreads in Individual Stocks
One more edge we can pull out of the market...
Stock correlations have, and continue to be incredibly low in the markets.
That means stock picking continues to be a form of risk management.
Here are some of my recent trade ideas:
If you want to have trade setups "done for you," consider this:
Twice a week, I send Proactive Spreads clients a newsletter giving 2-3 trade setups.
Each trade setup has:
- A chart of the stock to see where I'm finding tradeable levels.
- Descriptions of the setup so you fully understand the reason behind the trade
- A price level that will let you be Proactive about the trade
- The exact option spread to take
- The prices to execute based on our key price levels
- Further risk management instructions
Selling spreads is the best way to play stocks consistently.
Ready to be a consistent trader? Want to see exactly how we do it?