How to Play a Short-Term Top in the S&P 500 (SPY)

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It was a risk-on type of week for investors as the SPDR S&P 500 ETF (SPY) zipped higher by nearly 2.5% on the week, all but erasing prior fears and bearish behavior tied to China, Greece and Iran.

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Whether those stories come back to haunt investors isn’t certain, but the SPY ETF is ripe for profit-taking.

For active traders, we’ve got a short-term strategy on the SPY ETF to share.

The VIX

When the differential between the spot CBOE Volatility Index (or VIX) price and its 10-day simple moving average reaches 15% or higher, generally the SPY will reverse direction and allow for a profitable short-term trade. This occurs more regularly than not when the signal triggers because the VIX is a mean-reverting instrument.

At the end of the day, month or year, the VIX is not going to trade to 0%, nor will it trade perpetually higher.

Because of this mean-reversion attribute, the short-term 10-day SMA works well as a gauge for determining excessive behavior in the spot price in VIX because prices, regardless of whether they are high or low nominally on a historic basis, shouldn’t spread too far above or below the short-term moving average.

And when it does, the SPY ETF is a very suitable way to fade the move.

The 10-day SMA differential of 15% or greater is the favored canary in the coalmine for alerting bulls and bears when it’s time to exit. However, trendlines, nominal/historic highs and lows and other moving averages can also be considered useful at times as support for a pending reversal in the SPY due to extreme short-term behavior in the VIX.

That said, let’s take a look at the chart.

The VIX Daily Price Chart

VIX chart
Click to Enlarge
Source: Charts by TradingView

What the VIX chart also shows — and what bodes well for the SPY reversing lower in the near-term — is that the 10-day SMA relative to the VIX spot is over 22% and above the watched 15% threshold. Also, at less than 12, the VIX is historically cheap on an absolute basis.

In 2014, the index got down to a low near 10.5%, which hadn’t been seen since early 2007 after the VIX had hit an all-time-low around 8.50% in late 2006. As much, nominally, we can determine the VIX is cheap on a historical basis, which as the SPY nears its all-time-highs, has the effect of making bulls appear complacent.

Lastly, a horizontal line drawn on the chart shows the 12% area to be a spot where VIX has bounced from on a couple other occasions in 2015. And incidentally, the SPY sold off each time and enough so, to generate a nice, profit for short-term traders.

SPY Weeklys Bear Put Spread

Checking the SPY ETF options board for position ideas that fit in with our technical outlook of an extreme near-term top in SPY given multiple confirmations from the VIX to support a bearish stance, I like the weekly July 31 $213/$210 put spread for 95 cents or better. This would result in a gain of $2.05 below $210 at expiration on a share move of just more than 1%.

The max risk of 95 cents for this vertical can be reduced further by using a stop-loss, such as the SPY moving higher by 1%. That would put it through its recent all-time-highs but by a wide enough amount to not fall prey (hopefully) to a simple failed breakout that narrowly takes out the prior highs before reversing.

Given the strong evidence discussed, traders might look at longer-dated options, especially if one is inclined to see the bigger picture as one of the SPY and other market indices trading at historically rich valuations. However, because the 10-day SMA VIX differential relative to the spot is a short-term signal, we wanted to go with a spread that works to expand quickly and maximize profits based on this trading tool.

Also, given volatility is priced cheaply as we’ve shown, an outright long put in SPY could be considered. But, with short-term options, time decay is still a serious threat and justifies using a vertical as we’ve done here.

As of this publishing, investment accounts under Christopher Tyler’s management do not own positions in any of the securities or their derivatives mentioned in this article, but may initiate in the future at their discretion. The information offered is based upon Christopher Tyler’s observations and strictly intended for educational purposes only; the use of which is the responsibility of the individual. For additional market insights and related musings, follow Chris on Twitter @Options_CAT.

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The information offered is based upon Christopher Tyler’s observations and strictly intended for educational purposes only; the use of which is the responsibility of the individual. For additional market insights and related musings, follow Chris on Twitter @Options_CAT and StockTwits.


Article printed from InvestorPlace Media, https://investorplace.com/2015/07/sp-500-spy-etf-vix/.

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