Using an implied volatility-based method to better time the best time to sell the QQQ.
I highlighted some reasons last week why I thought stocks, and QQQ in particular, had finally formed a significant top in my last comment for POWR options. One of the biggest reasons the NASDAQ looks tired and toppy has been complacency, which has manifested itself in the form of option prices.
Most of you are probably very familiar with the VIX—sometimes referred to as the “Fear Index.” The VIX is a general measure of 30-day option prices on the S&P 500. It tends to peak when stock prices fall sharply and usually falls when stock prices rise.
VXN, or Vixen, is a similar measure of 30-day option prices using the NASDAQ 100 (QQQ) rather than the S&P 500 (SPY). Let’s take a look at how using the VXN as a market timing tool can help identify key short-term highs in the market. It’s the equivalent of Warren Buffett’s adage that says, “Be afraid when others are greedy.”
VXN sell signals are generated when VXN pulls back at least 33% from the previous high and then reverses from the lows. In the last 12 months, 6 such sell signals have been generated (highlighted in aqua in the chart below)
Below is the same time period 1-year chart of the QQQ. Notice how the bottoms in VXN exactly match the tops in QQQ (marked in red).
I’ve put together a quick snapshot summary of the VXN-based sell signal methodology over the past year, shown in the table below.
|Selling price||subsequent low||To deserve||% to deserve||Date of low||Days too low|
The average pullback over the past six sell signals was just over 11%. It took about a month (29.83 days on average) for stocks to reach a subsequent bottom after the sell signal was generated.
Just as importantly, the sell signals were never really too early or wrong to call a short-term top. None of the six preceding signals would have caused any subsequent fear of using the VXN methodology as a market timing tool. Indeed, only one of the signals had a small unrealized loss after taking a short position in the QQQ. The other five were pretty much perfect in naming the top.
By using the VXN methodology, the market will tell you when it is time to trade. This can be important because fundamental analysis and technical analysis can often be way too early…making it difficult in this market environment to hold a losing position for too long.
That is not to say that fundamentals and other factors are not important as confirmatory indicators to take a bearish stance.
Both valuations and seasonality also point to opportunities favorable for a pullback.
The two largest market cap stocks in the NASDAQ 100 (QQQ) are Apple (AAPL) and Microsoft (MSFT). Both reached their highest price/sales multiples in the past three months before weakening. Moreover, it seems extreme in itself to have $2 trillion plus market cap companies trading at such high valuations. Further buoyancy seems limited at best.
Seasonality also supports the bearish argument.
In the past twelve years, September has been the only bad month for QQQ. Stocks have made gains less than half the time with an average loss of 1%. Every other month is positive for both performance and number of up months versus down months.
Comparative performance also favors greater pullback for QQQ vs SPY. Normally, QQQ and SPY are highly correlated. However, in recent months, QQQ has outperformed the SPY by a large margin. Look for this correlation to return to the mean, with QQQ starting to underperform to close that gap.
Comparative lows in the VXN also mean that option prices on the QQQ are relatively cheap. This is beneficial for buying puts to take a defined short position with risk. Exactly the type of strategy we use week in and week out in the POWR Options Portfolio.
Traders looking to take a short position in the short term are therefore best served by buying puts versus shorting QQQ. Limited risk with potentially explosive returns. In addition, an increase in implied volatility will generally also benefit the long put position.
What to do?
If you are looking for the best options trading for the current market, check out our latest presentation Trade options with the POWR Ratings. Here we show you how to consistently find the best option trades while minimizing risk.
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All the best!
QQQ shares closed at $322.86 on Friday, down $6.42 (-1.95%). Year-to-date, the QQQ is down -18.59%, compared to a -10.46% rise in the benchmark S&P 500 index over the same period.
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim and 3 years as Market Maker for First Options in Chicago. He appears regularly on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His overriding passion is to make the complex world of options more understandable and therefore more useful to the everyday trader. Tim is the editor of the POWR options newsletter. Read more about Tim’s background, along with links to his most recent articles.
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