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A Sell Signal To Watch For image

In our last missive entitled A VIX Buy Signal Worth Watching, we reviewed an actionable buy signal using the VIX that is (a) easy to follow and (b) has proved its ability to put the odds in your favor over time. We received quite a few questions and comments on this article, most of which had to do with applying an appropriate/matching sell signal.

So this morning, we thought it would be appropriate to talk about an actionable sell signal that investors might want to watch for in the near-term.

Remember: Most Indicators Don't Go Both Ways

But first, as we've stated a time or two, a great many investors incorrectly believe that stock market indicators are able produce both buy AND sell signals. This is simply not true. Some indicators provide excellent buy signals but lousy sell signals, and vice versa. So, again, please don't think that any single indicator can provide you with accurate signals to move in and out of the markets.

For example, the VIX Buy Signal we reviewed has proven to be pretty reliable in terms of producing short- to intermediate-term buy signals. However, as a sell signal, it leaves a lot to be desired.

In case the point has not been made clearly here, the real key to success in this game is to understand your tools and when to apply them. In short, you've got to use the right tool for the job at hand. Thus, investors should fill their quiver with indicators that provide good buy signals AND indicators that provide good sell signals. Simple, right?

Let's Assume You Followed the VIX Buy...

Let's assume you decided to jump on the VIX buy signal that was given a couple of weeks ago. Since then, the market has moved sideways in a tight range, albeit violently so on an intraday basis. If you bought on 3/17, your current position is flat to slightly down, depending on your entry point. Thus, the key question now becomes, where do you exit?

While I do run the risk of beating a dead horse here, the key is to use the right indicator for the environment. Here's what I mean. We start with the big-picture environment, which can help us determine which type of indicator to use. Currently, our daily market environment model, which is designed to tell us which team is in control of the game is neutral. Thus, we are inclined to take less risk at this stage and remain flexible - because the bottom line is things could go either way right about now.

The Plan For THIS Environment

In English, the neutral reading of our market environment model tells us that the most important thing to do in the near-term is to be ready for the next big move. Again, getting the big moves right is the real key to long-term success.

Generally speaking, stocks tend to exit a sideways, consolidation phase heading in the same direction they were moving before the consolidation began. As such, discretionary traders may want to bet that the current range will be resolved with an upside breakout.

However, we prefer to avoid conjecture because our dang crystal ball is currently in the shop. Therefore, we need to have a game plan for both possible scenarios relating to how the current range will end.

With our environment model neutral and price doing next-to nothing, experience has taught us that this is the time to let price be your guide. In other words, don't try to argue with Ms. Market. No, this is the time to keep your eyes and ears open and do as you are told.

A Sell Signal to Watch For

Anyone who has been at this game a while knows that letting price be your guide is easier said than done. Technical analysis can be tricky and very subjective. In fact, many of the really strong chart watchers will tell you that it is more art than science.

The key is to have some sort of quantifiable indicator to tell you when it is time to head to the sidelines. Enter something called the Donchian Channel.

The Donchian Channel

According to Investopedia, a Donchian Channel is "a moving average indicator developed by Richard Donchian. It plots the highest high and the lowest low over the last period time intervals."

In common terms, the Donchian Channel is a breakout indicator. When price closes above the channel, a buy signal is given. And conversely, when prices closes below the lower channel line, a sell signal is flashed.

However, as is the case with most indicators, the trick is to know when to use them and when not to. In our shop, we like to look at the Donchian Channels only when the market is in a sideways trading range - and has been for some time.

And the bottom line is this is one of those times.

S&P 500 Daily with Adapted 14-Day Donchian Channel

As the blue lines on the chart of the S&P 500 clearly indicate, the market is currently in a well-defined trading range. Thus, the idea is to "do nothing, absolutely nothing, until there is something to do." In other words, if you are long here, you should hold until/unless, the market closes below the lower band.

The current situation is similar to that seen in January of this year (the area circled on the chart). While selling the big decline on 1/24 was certainly annoying, hindsight shows that this was the right move.

The Trigger Point

Cutting to the chase (I know, now my strong suit), should the S&P 500 close below 1839, this is your signal to exit long positions. And for those that like to "go the other way" with their positions on occasion, a meaningful close below 1839 is also your trigger point to put on short positions.

The only caveat here is that everybody in the game sees the same key level on the chart. As such, the algo's will likely exaggerate any move to the downside if 1839 is breached - just as they did on the 1/24 sell signal. This is just the way the game is played these days.

However, if you like to play the game with the odds on your side, using a Donchian Channel (we like a 14-day Donchian Channel, moved forward 1 day) may be something to keep in your quiver when Ms. Market is in an undecided mode.

Positions in stocks mentioned: none


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