This Volatility Tool Says More Gains Are Coming…

I’m cautiously bullish in the short run…

And my opinion is based on something I’m not seeing other analysts mention — volatility of volatility.

I realize that may sound a little confusing at first. But this tool indicates we could see additional gains in the stock market, so bear with me while I explain…

In this case, I am measuring volatility with the Cboe Volatility Index, or VIX.

VIX is a real-time market index that is calculated from the prices of option on S&P 500 futures. VIX is a market-based measure of how much volatility traders expect to experience in the next 30 days. VIX is often called the “Fear Index” because it tends to rise as the S&P 500 falls.

The reason for that rise is because traders often try to add put options to their portfolios when the index falls. The puts are intended to offset losses in stocks they own since put options tend to increase in value when prices fall. The surge in put buying pushes their price up and based on option pricing models, that increased demand results in higher volatility that shows up in VIX.

What My Award-Winning Indicator Is Saying

For the volatility of VIX, I am using my Income Trader Volatility (ITV) indicator.

ITV measures the volatility of a stock or ETF. It is an indicator for individual stocks that is similar to the VIX index for the overall market. ITV tends to move higher as the price of the stock or ETF falls. When prices bottom, we usually see ITV fall.

I created ITV to address some of the problems I saw with the VIX.

One problem is that VIX only applies to the broad stock market. VIX won’t help us find individual stocks that are likely to be bottoming.

A second problem is that there is really no way to know when the VIX is high enough to signal a bottom. In hindsight, days or weeks after the bottom is in place, it’s easy to spot the spike in VIX that signaled the bottom. To overcome this issue, I added a moving average (MA) to provide a real-time trade signal from volatility.

ITV gives a clear buy signal when volatility breaks below its MA. That’s a buy signal that can only occur after volatility peaks. This buy signal quantifies what so many analysts are looking for which is a way to use volatility to time trades.

The chart below shows ITV applied to VIX. The dashed line at the bottom of the chart is the MA of volatility. The vertical dashed lines show the previous signals based on ITV.

Right now, ITV is giving a “sell” signal by breaking above its MA. Remember that ITV moves opposite to price so when ITV is rising, we expect price to be falling. In this chart, with ITV crossing above its moving average we expect VIX to decline. Declines in volatility are generally bullish for the stock market.

Five prior signals are shown. Two were whipsaw trades that were quickly reversed. The other three came before significant declines in VIX.

I’ll be watching for a whipsaw, but the volatility of volatility is bullish for stocks.

Gains Ahead

This signal coincides with a bullish chart pattern. After a strong rally, SPDR S&P 500 ETF (NYSE: SPY) pulled back and consolidated for about 12 weeks. Highlights of that price action are marked in the chart below.

A throwback occurs after an upside breakout from a chart pattern. Throwbacks occur almost 60% of the time after a breakout. When a throwback occurs, the subsequent price move tends to be stronger than breakouts that are not followed by a brief pullback.

Based on the pattern, the price target for SPY is about $389, more than 7% above Friday’s close.

This analysis is based purely on technicals. There is no fundamental reason to expect SPY to rally. But the technicals are clear. And for that reason, I am cautiously bullish for now.

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