Ask any floor trader or armchair trading enthusiast if bottoms can be called in the stock market and the responses will range from an enthusiastic “Yes!” to a look as if you just had escaped from a padded room.
This debate is heated between both academics and seasoned practitioners. Careers have been spent studying whether the market can be timed properly and quantitatively to correctly identify a price bottom. Those who endorse holding a diversified portfolio of investments over the long term, like traditional mutual funds, claim market timing doesn’t work. However, seasoned stock traders claim, and demonstrate, that the market can be timed. Well-known pundit Jim Cramer is one. He explains in his book “Real Money” how he calculates a number of variables and, using that data, gains a sense of when price action is about to turn.
The problem for the novice is deciphering how these veterans time the stock market. The inability to quantify this intuition provides naysayers with all the ammunition they need to shoot down market timing; they brand those who practice it — as many see Cramer — as foolish. Our goal is not to debate the track record of pundits, but to provide valuable timing tools. Of course, we know that objective tools do exist. Some of the most popular are oscillators, such as stochastics. However, these tools are not perfect. They only work a portion of the time and only depending on the context of the market.
Using oscillators exclusively and blindly is ineffective because they do not take into account times when the market has a massive selloff. As accelerated selling leads to exaggerated levels in price action, these oscillators show oversold readings for prolonged periods but offer no practical instruction as to when price has reached a point where it will snap back.
The bottom line is that everyone entering or exiting the market is timing it, so one should look to do so at an optimal point. Decades of audited results from professional money managers show it can be done well. The logical foundation for this position can be summed up by three elements: Markets are dynamic because they are made up of individuals, trends form when one crowd takes control and crowds are often wrong.
Markets are made of traders buying and selling. Those who think the market is undervalued, buy; while those who think the market is overvalued, sell. If you get enough traders on either side, they form a crowd that likely will create a trend.
Trends happen when one side takes control of the market. At some point, the crowd that has control will take the market too far in a given direction and this will form extremes in price. When price becomes out-of-balance, it is likely to snap back in the short-term to form a counter-trend.
Finally, most crowds are wrong. This is the paradoxical nature of the markets that is hard to grasp. Professional traders realize that when everyone is buying, that is the time to consider cashing out. Understanding these key concepts is important to timing the market successfully.
Enter the VIX
Larry Connors, head of the Connors Research Group and author of the book “How The Stock Market Really Works,” determined that when the Chicago Board Options Exchange’s Volatility Index (VIX) reached extreme levels over several consecutive days, then the likelihood for a sharp reversal could be quantified with high accuracy, giving the trader a huge edge in trading the market (see “Revealing reversals”).
VIX is a measure of the level of implied volatility of a wide range of options on the S&P 500. This indicator reflects investors’ best assessment of risk as measured by short-term market volatility. The VIX will rise when fear is gathering in the market and fall as investors become euphoric, making it ideal as a predictor of short-term market volatility.
If implied volatility is high, the premium on options will rise and vice versa. As a result, rising option premiums reflect the rising expectation of future volatility of the underlying stock index, corresponding to higher implied volatility levels.
The VIX’s price movement is inverse of the S&P 500’s price action, so you want to watch and observe for extreme levels reached by the VIX. Because the market is dynamic, however, using the VIX alone, at best, would be incomplete. Due to its dynamic nature, it is essential to have another indicator that complements the VIX’s volatility, revealing when and where extreme levels are reached to help you prepare for entering the market.
Bollinger bands were popularized in the 1980s by John Bollinger. They are simply a standard statistical volatility measure applied to the market. Bollinger plotted them as bands placed above and below a moving average of price.
Volatility, in the case of Bollinger bands, is measured by the standard deviation. This measure changes as volatility increases and decreases. Therefore, the bands widen when volatility increases and narrow when volatility decreases. It is this dynamic nature of Bollinger bands that complements the VIX when they are used together.
The reason for this is the trader doesn’t have to be dependent on some arbitrary reading of the VIX alone. By overlaying Bollinger bands on top of price action, you can see the extreme price levels in relation to the Bollinger bands’ upper or lower band (see “S&P turning points”).
To identify a bottom forming in the S&P 500, you will want to look for times when the VIX’s price action is trading beyond the upper level of the Bollinger bands’ trading channel. This is critical because it shows an extreme level in the price action where a high-probability reversal lies waiting.
Once the VIX has traded through the upper trading band, the result would be that a bottom has formed in the market and is likely to reverse sharply. The trigger to signal the reversal is a price bar reversal off the upper trading band, closing lower (see “In the zone”).
This technique is based on the price action of the market itself. It gives a true representation of what is happening in the present, which is the only true measure of success when trading the market.
The ability to spot a bottom being formed — long term or short term, as a pullback in an established trend or as a major turning point — allows you to trade when the market is turning the corner, shifting momentum back in the opposite direction like a rubber band that has been stretched too far, then released suddenly.
Using this as a basis to help make trading decisions allows you to trade with confidence. You can enter a stock when the larger market shifts strength back in the direction of the primary trend. You can see where the turns are occurring as a chart pattern is forming, enter a breakout move as an inert stock explodes upward, or use short-term option trades to lock in consistent profits while further controlling your risk exposure.
More important, while others argue the merits of market timing or flounder to offer piecemeal explanations that only vaguely can detail timing the market, you can begin using these tools to make more profitable trades.
Billy Williams is a 20-year veteran trader specializing in momentum trading both stocks and options. Read his market commentary at www.StockOptionSystem.com or his newsletter on ETF trading at www.FinanceBanter.com.