Stock traders are really detectives, always looking for clues as to what might happen next on Wall Street.
Right now, traders are trying to determine whether the S&P 500 is going to:
- Climb back up to its all-time high of 3,588.11;
- Consolidate at current levels for a while; or
- Fall back down below 3,300.
We think there are clues in the VIX.
The CBOE S&P 500 Volatility Index (VIX) is known as the “Fear Index” because it serves as a reliable gauge of how worried traders are that the S&P 500 might suddenly drop over the coming 30 days.
When the VIX moves higher, it’s telling you that traders are getting nervous. When the VIX starts moving lower, it says traders are gaining confidence.
Looking at the daily chart of the VIX in Fig. 1, you can see that the index has been in a down-trend since April, a bullish signal for the stock market.
However, the VIX appears to be at an inflection point.
While the index has been creating lower monthly highs — the September high was lower than the June high, which was lower than the April high — and lower monthly lows — the August low was lower than the June low — it may be setting up to create a higher low. That would be unwelcome news for bulls on Wall Street.
Here’s what we’re watching in Fig. 1:
- If the VIX breaks through the current horizontal support level and starts dropping down toward number 1 on the chart, look for the S&P 500 to climb back up toward its all-time high of 3,588.11.
- If the VIX continues to bounce up off the current horizontal support level at number 2 on the chart, look for the S&P 500 to consolidate for a while.
- If the VIX breaks above down-trending resistance at number 3 on the chart, look for the S&P 500 to fall back down below 3,300.
We’re confident in this analysis because we’re seeing a similar setup on the VIX/VIX3M relative-strength chart.
VIX/VIX3M Relative Strength Chart
Most traders tend to focus solely on the VIX, which measures anticipated volatility in the next 30 days, when they think about measuring trader sentiment.
However, as we’ve covered in the past, sometimes focusing only on the next 30 days isn’t a long enough view. Sometimes it’s helpful to expand your horizons out to the next three months, or 90 days.
When traders need a longer-term outlook, they can look at the CBOE S&P 500 3-Month Volatility Index (VIX3M), which is a measurement of the anticipated volatility being priced into S&P 500 options for the next 90 days.
By comparing the value of the VIX to the value of the VIX3M, you can identify periods when trader sentiment has turned extremely bearish and when it has normalized.
Because these volatility indexes measure the magnitude of the price movement traders believe the S&P 500 may make during the measured time frame, the value of the VIX3M is usually higher than the value of the VIX.
After all, if you give the market three months to make a move — like the VIX3M measures — instead of just one month — like the VIX measures — it has a greater chance of making a larger move.
Interestingly, there are times when traders will price in a greater chance of a larger move in the short term than in the long term because they are nervous the market is about to drop. This pushes the value of the VIX up higher than the value of the VIX3M.
The easiest way to compare the value of the VIX to the value of the VIX3M is to create a relative strength chart of the indexes where you divide the value of the VIX by the value of the VIX3M.
Typically, the VIX/VIX3M relative strength chart will have a value less than one because the value of the VIX is usually less than the value of the VIX3M.
During periods of high market stress, the relative strength chart will often have a value greater than one because traders are pushing the value of the VIX higher than the value of the VIX3M.
So, where is the VIX/VIX3M now?
According to Fig. 2, the VIX/VIX3M is in a down-trending channel — just like the VIX — and still well below one. But it too, is at an inflection point.
We’re seeing a setup on this chart that is similar to the setup we’re seeing on the VIX chart.
Here’s what we’re watching in Fig. 2:
- If the VIX/VIX3M continues dropping down toward number 1 on the chart, look for the S&P 500 to climb back up toward its all-time high of 3,588.11.
- If the VIX/VIX3M remains at its current level at number 2 on the chart, or drifts higher, look for the S&P 500 to consolidate for a while.
- If the VIX/VIX3M breaks above down-trending resistance at number 3 on the chart, look for the S&P 500 to fall back down below 3,300.
The Bottom Line for Next Week
So, what do we expect the S&P 500 to do this week?
We think option 2 is going to play out, meaning we will see more consolidation in the S&P 500.
The reason we’re confident in this assessment is found in Fig. 2. You’ll notice we put a number 4 in Fig. 2 that doesn’t have a counterpart in Fig. 1. That’s because the VIX/VIX3M relative strength chart provides additional information that the VIX chart simply can’t because it’s not a relative strength chart.
Currently, this chart is below one. More importantly, it’s significantly below one. That tells us traders aren’t worried about a dramatic pullback anytime soon.
Since traders are still a little shell-shocked from the profit-taking we saw in the technology sector two weeks ago, we think the S&P 500 is going to consolidate for a bit while traders regroup and figure out where they want to go next.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it.