By: Costas Bocelli — September 3, 2020
This Major Stock Market Indicator Is Flashing a HUGE Warning Sign
Stocks are on the rise, and in record fashion.
The S&P 500 Index gained +7% in August, its best showing for the month of August in 34 years.
The S&P collected two more all-time closing highs.
But I have to tell you that something quite unusual has occurred over the past 10 trading days.
So much so that a major stock market indicator is flashing a huge warning sign right under the nose of most investors.
First, I’ll reveal this troubling warning sign.
Then, I’ll show you how to take advantage of it.
It’s a technique that allows stock investors to instantly put cash in their pockets today!
Volatility Is Flashing a Huge Warning Sign
Over the past 10 trading days, the S&P has finished higher in all of them but one.
During that period, the S&P is UP +5.5%.
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In a strong trending bull market that’s making a series of record highs, like it is right now, this type of run isn't that unusual.
But what is unusual is that the Volatility Index (VIX) is also on the rise.
The CBOE S&P 500 Volatility Index (VIX), commonly known as the fear gauge, is UP +23% over the same 10 trading days.
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Typically, when the stock market is rising, the volatility index is falling.
But that’s not case here -- and it could be a troubling sign for stocks in the weeks ahead.
You see, when the S&P is UP over +3% and the VIX is up over +20% in the same 10-day period, it's a rare occurrence.
According to research from NASDAQ, it’s only happened five other times since 1990.
The good news is that over the medium to longer term, the S&P 500 generated positive returns in each of the five past instances.
But the not so good news is that over the shorter term, the S&P 500 posted negative returns in four of the past instances.
September tends to be a weak month for stocks historically.
And the stock market also happens to be short-term overbought.
The Relative Strength Index (RSI), a widely followed momentum indicator, is pushing above 80 on the S&P 500.
The red arrow above the price chart highlights the RSI…
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So the current market condition can be characterized as frothy and ripe for a pullback.
Now, here’s the good news…
If we refer back to the NASDAQ research, it also found the short-term weakness over the ensuing month to be modest.
Of the past five instances, the largest pullback was a -3.3% decline.
If you reference the S&P chart once again, you’d find that a similar pullback would take the index down to the vicinity of the 20-day moving average (blue line).
That would be a healthy development to clear the market excess.
And those fearful investors -- the ones bidding up the options and driving the Volatility Index higher -- may be preparing for a major market crash that's not likely to come anytime soon.
The stock market already had a major washout this past winter.
For sure, stocks have made a huge run off of the March lows.
But U.S. Equities is a strong asset class.
It recently regained the top spot in our Broad Asset Class relative strength rankings.
Demand is also in control.
All of our Major Index Breadth Indicators are positive in the medium- to longer-term outlook.
So, can stocks pull back in the short term?
Will there be another market crash?
How to Take Advantage of Rising Stocks and Rising Volatility
If you're one of those investors who owns a basket of stocks, now’s a good time to wring some cash from your positions.
I’m talking about applying an options strategy that will instantly generate a cash payment and provide a limited form of a downside hedge.
It's known as the Covered Call strategy, and with it, you sell Call options against a long stock position you already own.
So, in this strategy, we're going to be a seller of options.
And this type of market environment (rising stocks and rising volatility) is perfectly suited for this strategy. Since option prices are being bid up (the VIX is rising), you’ll get to collect even fatter premiums.
Selling Covered Calls instantly generates cash and the proceeds you collect by selling the options also provides a limited form of downside protection.
That money is yours to keep and to use in any way you want.
Let’s now run through a timely example…
Let’s say that we own 100 shares of Best Buy (BBY), a leading technology retailer in North America.
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In this example, BBY is trading around $113 per share and near its highs.
To get paid and generate instant income, sell nearer-dated out-of-the-money Call options.
In the case of BBY, you could sell the October 120 Call at a $3.50 credit, which means you’ll instantly collect $350 for each contract sold. This option expires in 43 days.
Since each Call option could obligate you to deliver 100 shares of BBY (in the case of an assignment), you’d not want to sell more than ONE options contract -- thus ensuring the position is completely "covered", hence the name of the strategy.
If you happen to own, say, 300 shares of BBY, then you could sell up to three option contracts.
Also, notice that in the example, the option that we're selling is nearly seven points out-of-the-money. So in the event that BBY trades above $120 per share at expiration and our stock gets called away, we can make an additional $7 in capital appreciation.
The instant cash generated on the stock also earns a hefty return.
The $3.50 credit equates to a +3.1% return -- or a +26.3% annualized return.
And this doesn’t include the potential seven points in capital appreciation should the stock be above $120 per share at expiration.
Now, here's where it can get even better...
Let’s say that the stock remains below $120 per share at October expiration.
In this case, the option would expire worthless, relieving you from any obligation to sell the stock.
That means you could look to sell another round of covered calls and collect even more cash.
How great is that?!
When stocks and volatility are rising, selling Covered Calls is a great strategy to generate instant cash while also creating a limited hedge on stocks you own.
This could be the perfect remedy for a strong market that’s short-term overbought.
Wishing you a happy and safe Labor Day holiday.