Volatility is Back; Things to look for in a topping pattern

VIX jumps 10% today after dipping into the 20s earlier this week.  The game is changing.  Whenever the VIX gains volatility in itself, this usually leads to a bottoming or topping process in the broad market a few weeks later.   One more thing I would monitor are the inverse ETFs, like SRS and SKF .  Both of them trade near the lows of the year, so we are looking for a reversal with huge volume in them, which usually occurs before the market moves down. I bought puts in 2 strikes on FAS on Tuesday, just so that on my screen I can see how much people are willing to bid up and down the 3x ETFs.  I usually get a good sense of investor sentiment there.

What does this mean for today’s tape?  At this point it is not a good idea to add to longs, in fact you should be trimming them.  On the short side, you should not be getting aggressive just yet.  What is happening is just more news that is shaking out the weak and late longs.  In other words, the foundations are being shaken but the building has yet to fall.  What we do have is a ton of stocks, hundreds of them, that have rallied up to or slightly above their 200 MA (remember, for swing traders, the best stocks to short are the ones that have fallen under the 200 MA), and now the more bad news you have near this resistance point, the more easier it is for longs to rationalize a sale.  Not exactly the best reason to short this sell-off.

Instead of rushing into shorting everything, or trying to buy the dip, what you should be doing here is screening for the stocks that have rallied to the 200ma on low volume and wait for a confirmation drop below it.  Some stocks do breakout of that resistance area, but many will not.  Try to keep a list of these stocks that are getting shutdown at the 200ma; you should see an increase in volume as they sell-off.  It’s almost like a bear’s playground out there with all these ugly stocks rallying up to resistance, but you have to know how to play it.

On the other hand, what I do like about this whole relief-rally, is that even though everyone is looking at the stellar movement in the ugly stocks that have bounced, there actually has been some (very very few) nice and fresh new leaders that have risen from that capitulation period.  These stocks have small caps, so they are in their growth stages.  Money can be made shorting retarded tapes, but the real money comes from these smaller cap stocks that are born from the fire.  They are “the next” APPL, MSFT, GRMN, SBUX, GOOG.  When our economy gets everything fixed and this whole bank debacle becomes a memory, then these “the next” stocks will be the leaders of a “true rally.”  Until then, this is a traders market.  Trade accordingly.