The Tycoon Report

How To Pick the Next Bottom in this Bloody Market

Tuesday, July 1, 2008 | Chris Rowe

First I want to thank you again for the nice e-mails.  I have to quickly answer one common question and then I'll get into my article.

Many readers are asking about the S&P put options I recommended as a hedge against a likely decline in the stock market.  (Click to read the article).  On May 27th I said, "With Crude gunning through $135.00/barrel last week, and the stock market running into resistance right around the old support level (below), you should consider hedging your account with deep in-the-money puts on the S&P 500."  The puts I told you to use are up about 35% since I wrote that article about 1 month ago.


People are asking when they should sell out of the put option.  Well I stated in the May 27th article that I would think about getting out when you see the CBOE volatility index (Symbol: VIX) in the 26 - 30 level.  But that was a general statement and you should always consider what other indicators are telling you.

To clarify, I would be reluctant to sell the S&P puts when VIX only moves above 26, but happier to exit the hedge when VIX is somewhere above 30.  Click to read the article.

That leads me to today's article. 

Let's take a quick look at the Chicago Board Options Exchange Volatility Index and compare it to market lows. 

As you can see below, when the VIX (lower chart) is above the 30 level, it usually corresponds to near lows in the stock market (upper chart).  The VIX helps us find bottoms in both bull and bear markets.

But if you look carefully, you can see that the VIX generally tends to reach higher levels in a declining market than in an advancing market.  You can see that from 2004 - July of 2007 the VIX usually remained below 20 and if it came anywhere near 20, it would correspond to the bottom of a correction in the bull market.


This is a great example of one of the most important trading concepts I find myself teaching on a regular basis: You must be willing to evolve with, and adapt to, the current stock market.  You may have heard what sounded like static rules saying the market is near a bottom when VIX is above 30 or 35.  That worked well before 2004, but not at all from mid-2003 to mid-2007.

But since the abolishment of "the uptick rule" and the sub-prime meltdown/credit crisis/hedge-fund blow ups, the VIX has nearly hit 40 on 3 occasions. Over the last year, the market has once again changed. So when you look for spots to exit your bearish positions, watch for the VIX to move up near 35. 

At the Trend Rider, I have bearish positions that are extremely profitable, and I look very carefully for the absolute best time to exit each position.  Like I said, it's hard to be very precise when using just one indicator so I use lots of them in conjunction with one another.  But if one were forced to only use VIX to find intermediate-term bottoms in this long-term down trend, the way to play it is as follows: 

When VIX is above 30, be on alert for an intermediate bottom.  It will likely (but not definitely) move above 35 before the market hits a bottom.

The first time you notice the VIX starting to reverse lower (significantly), that is when you would exit half or all of your S&P 500 puts (for example) that I recommended in my May 27 article.  As you can see in the chart above, I drew a red line from a time in late 2001 when VIX moved above 30 and close to 35.  If you tried to call a bottom at that point (S&P 500 was at about 1,100) you might have been disappointed by the additional 12% decline!  So you should wait for the VIX to start to reverse down.

Let's zoom in.  While the chart above is a 10-year chart, the one below is a 4-month chart.  After moving above 30 and then 35, there was a point when it opened at about 37 and closed at about 34 (blue arrow).  That may have caused some to falsely call exact the intermediate bottom.  As you can see the VIX charged even higher to about 57 and the S&P500 dropped 11%!  That's why I say you might exit HALF of the bearish positions - to avoid a head fake.


Either way, you'll have a pretty close estimate of when the actual bottom has been made.  After opening at 57, VIX closed at about 47.  That, to me, is an obvious market bottom.

These day's things may be different (remember, the market's rules are always changing as the market evolves).  But the point is, after moving near 35 look for a swift decline in the VIX to spot the bottom.  It may be at 35, 40, or even 57 again.  But when that happens, everyone will seem to think the world is coming to an end.  Tensions will be high, and almost nobody will believe it's a bottom.  That is what actually causes the VIX to move higher.  Long story short, VIX reflects the price of options on the S&P 500.  When investors are fearful, options become expensive. So of course no one will think it's the bottom.  That's the whole point in using indicators - to tell us when it's okay to be the minority.  And as an investor, it almost always pays to be in the minority.

One quick note: You may notice the chart above shows VIX symbols to be "VXO".  That's the old version of the VIX which relates to the S&P 100 options.  That's what I used to get a chart that dates back 10 years.  The newest VIX with the symbols "VIX" dates back only to 2004.  Both work well.

Okay, here's a quick plug: My options trading service has been closed to new members for a long time.  But if you want an invite to join us, click here because we are opening the doors to newcomers until a small number of slots are filled.  But if you want to learn how to trade like I do, with a system that has helped me to be profitable on approximately 80% of my trades over the last 3 years you should take advantage of a July 4th special where we're offering my "Internal Strength System" by clicking here.

If you are strapped right now, or just not ready, that's cool.  We'll be making you money here in the free Tycoon Report for a little while longer


“Profit from the Trend”

Chris Rowe
Chief Investment Officer
The Trend Rider