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VIX at 46-month Low - Sell Signal or Momentum Thrust?

It was a close call, but the S&P seems to be on its way towards our upside target. It didn't look like it when we identified a potential head and shoulders bottom eight trading days ago.

As the S&P has broken out of the head and shoulders neckline at 1,340, the VIX (NYSEArca: VXX) has closed at its lowest level in 46-months. In addition the VIX triggered a sell signal for stocks, the same signal that foreshadowed the April 2010 decline (more about that in a moment).

Open Chart Gaps - Unfinished Business

The first order of business after breaking above the 1,340 neckline was to close the vexing open chart gap at S&P 1,343. Already, back on President's Day (February 21), when overnight futures fell hard, the ETF Profit Strategy Newsletter noted the following:

'As of 11pm EST the S&P futures are down 15 points. Since there's a good chance of a gap down open, it would be timely to mention that the S&P has a strong tendency of closing open chart gaps sooner or later. If an early morning gap isn't closed right away, it might be closed sometime later this week, month or year.'

The following morning the S&P opened four points lower than the previous Friday's closing price, leaving a vacuum between 1,339 - 1,443. Over the past two years all such vacuums have been filled.

This little chart gap was one of the reasons the ETF Profit Strategy Newsletter speculated on March 20 - with the S&P at 1,279 - that: '1,249 was the low of a 7% correction that will result in new highs around 1,3XX (target level reserved for subscribers) as discussed in the March ETF Profit Strategy Newsletter, page 3.'

The VIX Sell Signal - How Accurate?

As the S&P is moving towards the ideal target level, the VIX (Chicago Options: ^VIX) is not only at a 46-month low, it has also triggered a sell signal for stocks.

The set up for this sell signal occurs when the VIX drops below the lower Bollinger Band, which occurred on April 20 and 21. A subsequent close back above the lower Bollinger Band triggers a sell signal for stocks. This happened on April 25.

There have been five such VIX sell signals since the March 2009 bottom. June 30, 2009 - January 12, 2010 - April 13, 2010 - September 4, 2010 - October 13, 2010.

Discerning eyes will see that the market corrected sharply after the first three sell signals triggered. Following the April 13, 2010 sell signal, stocks held up for nine trading days before succumbing to severe selling pressure.

The S&P (SNP: ^GSPC), Dow Jones (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC), small caps (NYSEArca: IWM) and mid caps (NYSEArca: MDY) tumbled 15 - 20% from April - June 2010. Previously high-flying sectors like financials (NYSEArca: XLF), technology (NYSEArca: XLK) and materials (NYSEArca: XLB) fared even worse.

The April 2010 VIX sell signal was compounded by a 10-year low in the CBOE equity put/call ratio. A low put/call ratio means that only a minority of equity positions are equipped with a put option safety net.

On April 16, 2010 the ETF Profit Strategy Newsletter warned that: 'Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling, results in more selling. This negative feedback loop usually results in rapidly falling prices.'

The market peaked six trading days later. The 'Flash Crash,' which temporarily reduced the Dow by 1,000 points, happened 14 trading days later.

As accurate as the June, January, and April VIX signals were, the two sell signals that occurred since QE2 was announced (September and October 2010) failed miserably.

In Dangerous Territory

On one hand, the S&P broke above prior resistance and the head and shoulders neckline around 1,340; on the other hand, the VIX has triggered a sell signal. Conflicting indicators aren't investors' best friend and investing or trading 'right here, right now' requires delicate money management.

The Sunday, April 3, ETF Profit Strategy update stated that: 'Bullish bets should be watched very carefully, especially once stocks move above 1,356.' The S&P closed at 1,360 on Thursday, which is right in the danger zone but below the ideal up side target.

One Step at a Time

In the current environment, it pays to be nimble, watch support and resistance levels carefully and don't stay married to any positions. Traders/investors may stay long until either the up side target is reached or support is broken.

The same applies to going short. Small short positions can be established once the upside target has been fulfilled or support has been broken.

The ETF Profit Strategy Newsletter reveals the target level for this advance, along with the support level that, once broken, would point towards lower prices, potentially much lower. The Newsletter also includes our Sunday night Technical Forecast for the week ahead, followed up by a Wednesday night mid-week update and the accompanying trading strategy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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