Humor me for a moment, what does the following look like?

volatility chart for SPX

My first thought was that this looks like the Cyclone roller coaster at Coney Island, or one of the other well-known roller coasters around the country. I decided to find a description of roller coasters and came upon this presentation from an engineering class on the design of roller coasters.

rollercoaster diagram

That looks familiar, doesn’t it? So maybe roller coaster is an appropriate term for this current stock market. But how do we ride this roller coaster?

This is where TradeSmith’s tools can help guide you through the noise so you can make intelligent decisions.

Let’s take a look at the first chart again and add a couple of the TradeStops Stock State Indicator (SSI) lines. By the way, this is a six-month chart of the S&P 500.

Position card for SPX

Adding the SSI Yellow Zone and Red Zone lines didn’t change the movement of the index, but it certainly gives a lot more clarity as to the current condition of the index. Right now, the S&P 500 (SPX) is in the SSI Green Zone. That means the index is in a healthy state and is behaving normally. It’s easy to see that during the last six months, the SPX entered the SSI Yellow Zone four times, but each time, it bounced back into the SSI Green Zone.

Another positive aspect of the chart is that since the end of June, the SSI Stop Loss line has been creeping higher. That means the index itself has made new highs along the way and the risk we took in late April when the new SSI Entry Signal was triggered has been lessened.

Speaking of risk, our Customer Success team has received a large number of questions about risk. Many of these questions focus on the CBOE Volatility Index, commonly known as the VIX, which is a short-term measure (30 days) of volatility based on a formula using call and put options on the S&P 500. To be perfectly clear, the VIX has nothing to do with what we follow at TradeSmith.

The VIX is a nice number to follow, but it doesn’t tell us what we should do with our investments. Unless you’re a day trader or very short-term trader, the VIX is not going to help you with making any buy or sell decisions.

So what numbers are helpful to know, especially right now? The first number I like to focus on for any ticker I’m following is the Volatility Quotient (VQ). The VQ is a measure of a stock’s normal volatility; for the S&P 500, the VQ is currently 9.3%. Remember, this means that normal noise in the market can move the SPX down (or up) by as much as 9.3% without us getting too excited. This is normal and our charts show that expected volatility for the SPX and every stock and ETF.

health and risk for SPX

In addition to the stock’s VQ, I like to focus on its historical trend line to help me manage my personal portfolios. This is the same number I just described, but is it increasing over time or decreasing over time when compared against itself? We can set up our TradeStops charts to follow the historical VQ of each stock. Here’s the historical VQ of the SPX.

Historical VQ of SPX

You can see that over the past six months, the current VQ of 9.3% is the highest it’s been in recent history. But the lowest VQ in the six-month timeframe is 9.0% so the current VQ is not at a worrisome level. During the financial crisis in 2007-2009 and afterwards, the VQ for the SPX moved above 20%, so its current VQ is quite low. Still, I want to keep an eye on it and see if it increases over time.

The second number I want to follow is the percentage of stocks in the SPX that are in the SSI Red Zone. This number is at a level that is concerning. As you can see, more than 48% of the stocks that make up the S&P 500 are currently in the SSI Red Zone.

SSI distribution for SPX

Why is this number important? In a general sense, as a larger percentage of stocks move into the SSI Red Zone, it becomes more difficult for the markets to increase. Of course, as an extreme number of stocks move into the SSI Red Zone, that’s more than likely the precursor to a bear market.

But I don’t want to just follow the raw number. As with the VQ, I want to see where the number is trending. For that, we go to Ideas by TradeSmith. Here’s the six-month graph showing the percentage of stocks in each of the SSI Zones.

SPX SSI distribution trend line

At first glance, it’s just a jumble of three colors, but as you look closely, you can begin to see what’s happening. Six months ago, in March, at the far left-hand side of the chart, the percentage of stocks in the SPX that were in the SSI Red Zone was at 62%! Since that time, the percentage has been mostly declining, which coincided with the market moving higher.

However, since the middle of August, the number of stocks in the SSI Red Zone has been increasing slightly. That doesn’t guarantee a move lower for the SPX ticker or even an upcoming bear market, but it’s something to watch. If this number continues to increase, it’s a potential warning of another move to the downside. This is one chart I watch very closely! If you haven’t given Ideas a try, give our Customer Success team a call, and they’ll tell you how you can add Ideas to your toolbox.

Marina Stroud and I will be talking about these numbers and others during our webinar on Wednesday, Sept. 18 at 1 p.m. Eastern. You can register for the presentation by clicking here.


Tom Meyer
Research and Education Specialist, TradeSmith