Buy the S&P 500 ETF as Fears Fade

The S&P 500 ETF (NYSEARCA:SPY) just gained 1% for the third day in a row amid hopes the Federal Reserve will succeed in curbing inflation while keeping the economy humming. The million-dollar question is whether this week’s rally will finally put a sustainable bottom in place for the SPY ETF.

the word "etf" spelled out in many yellow cubes against a background of many black cubes
Source: shutterstock.com/Imagentle

Time will tell if the planned pace of rate increases and balance sheet reduction do the trick, but for now, investors are piling back into equities. I’m optimistic for three reasons.

First, previous episodes where the SPY ETF scored three consecutive 1% daily gains have signaled more upside.

Second, the CBOE Volatility Index (CBOEINDEX:VIX) has finally returned to Earth.

Third, after imploding for weeks, Chinese equities finally bottomed.

Let’s take a deeper dive into each. Then, I’ll outline two ways to join bulls using SPY stock options.

The SPY ETF and History

Technicians are always on the hunt for patterns. It’s not that studying the past allows you to predict the future. It’s that knowing history enables you to put today’s action in context. And, sometimes, that gives you an edge.

Take the three consecutive 1% gains in the SPY ETF, for instance. Previous episodes of persistent outsized gains like this are rare. And they’ve been bullish omens. According to Ryan Detrick of LPL Financial, the last three times the S&P 500 scored a similar rally were March 2020, the presidential election of 2020, and November 2018. Each instance saw strong upside follow-through.

It takes significant buying from institutions to generate a large, consistent rally. If they’re wading back into the waters, it should bode well for the market. But it’s not just the size of the move that matters. One thing makes this different from every other recovery attempt of the past six weeks. Fear is fading.

Fear Fades

CBOE Volatility Index (VIX) with sharp drop below 30
Source: The thinkorswim® platform from TD Ameritrade

The CBOE Volatility Index is known as a fear gauge and provides a glimpse into market sentiment. It measures demand for options and rises when anxious investors bid up the cost of insurance. Historically, a push above the 30 level signals extreme market panic. Such spikes usually prove temporary, but the VIX has been sticky this go around.

We saw 11 consecutive sessions with a close above 30 — many of those readings corresponded with intense up days in the S&P 500. The unwillingness of the VIX to recede from its lofty levels signaled investors lacked belief in the rally attempts.

This week was different. While the S&P 500 surged, the VIX finally cracked 30, closing below 26 on Thursday. With that, the persistent fear bid in options has been broken.

Chinese Stocks Stopped Imploding

Chinese stocks have been falling for months, but the decline morphed into an outright panic in recent weeks. A waterfall of selling seized the space causing margin calls and forced liquidations. No doubt the recent debacle with Russian equities becoming untradable accompanied investors to the sell button.

And then, with prices in the depths of the abyss, China issued a statement saying that it would play ball with U.S. regulators and support its public companies listed in America. With that, the selling ended. The iShares Large-Cap ETF (NYSEARCA:FXI) rallied 24% on Thursday in a boom for the ages.

The shift in price and sentiment means there’s one less area weighing on the S&P 500.

A SPY ETF Trade

S&P 500 ETF (SPY) stock chart with double bottom pattern.
Source: The thinkorswim® platform from TD Ameritrade

The improving backdrop has to contend with a price chart that remains messy. Breaking back above the 50-day and 200-day moving averages would go a long way in clearing out overhead resistance and making it easier to justify more aggressive directional trades.

For now, I think selling put spreads is the way to go.

The Trade: Sell the April $410/$405 bull put spread for 65 cents.

Consider this a bet that SPY will stay above $410 for the next month. If it does, you’ll pocket the 65 cent credit. If you want to increase the payday, use higher strike prices.

On the date of publication, Tyler Craig was long SPY.

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