The market’s recent gains have given investors a much needed shot in the arm and are taking the sting out of losses suffered in the first half of 2022.

But while the bounce has rebuilt battered trading accounts, investors must be wary now more than ever.

Because this market can quickly change. Meaning, we can’t let winning trades turn into losers. Or blindly bet on old winners that have previously performed well.

When things start picking up after a rocky patch, it’s too easy for undisciplined investors to take their eye off the ball.

And that means losing money.

That’s why I always keep an eye on the CBOE Volatility Index (VIX) no matter what the market is doing. It’s often called the “fear gauge” for investors.

And the VIX’s recent activity has me watching it more closely than ever…

Changing Direction

Right now, the VIX is warning me of a potential change in direction.

Below is a chart that shows the action in both the S&P 500 Index (SPX) and VIX since the start of 2022.

The top half of the chart is the SPX and the VIX is directly below it…

S&P 500 (SPX) with CBOE Volatility Index (VIX)

Source: eSignal

The VIX is useful because it’s forward-looking. It’s calculated using options on the S&P 500 index with 30 days until expiry.

Traders buy call options when they think the index is going to rise and put options when they think it will fall.

The more nervous they become about a fall, the more they will pay for those put options. That drives volatility (and the VIX) higher.

On the chart, as the VIX rose from January through early March (A to B), the S&P 500 index (in the upper half of the chart) fell steadily.

S&P 500 (SPX) with CBOE Volatility Index (VIX)

Source: eSignal

When the VIX started to fall after ‘B,’ we saw the index rally into late March. As the VIX climbed and remained high in April and May, that coincided with further falls in the S&P 500.

It’s not always an exact science. But watching the VIX can clue you in on what the market will do in the future – and help you trade off it.

That’s why the VIX’s action since June has caught my eye…

The S&P 500’s lows in June coincided with the VIX topping out at ‘C.’

As the S&P 500 rallied strongly these past couple of months, the VIX has been steadily trending down to ‘D.’ That puts the VIX now only slightly above where it was when the main selling began at the start of 2022.

And that’s why this pattern in the VIX is making me extra cautious right now…

The Odds Are Growing

As we have seen in multiple examples this past week, stocks like Financial Select Sector SPDR Fund (XLF) and Industrial Select Sector SPDR ETF (XLI) are on or near overbought territory.

And although we can’t see it in the chart above, the S&P 500 is now also in overbought territory.

That doesn’t mean an imminent reversal is guaranteed. But it shows us that we must be cautious.

Because with the VIX trading near yearly lows and the S&P 500 in overbought territory, the odds of a reversal are increasing by the day.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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