As the S&P-500 Cash Index (SPX) has become the de-facto benchmark for the US equity markets (DJIA belongs to the abacus era), picking tops and bottoms of the SPX has become a favorite of many market timers.

As we all know, volatility at market tops tend to be relatively low, while at the bottoms it tends to spike. Taking that information and turning it into a time series provides a reasonable quantitative tool with which we can reliably pick bottoms—and perhaps also tops—in SPX within +/- 1 to 2 trading days. This type of insight is very useful for trading SPY, QQQ and IWM options.

Now enter VIX, the CBOE’s volatility index for SPX and its futures contracts (symbol: VX) that trade almost 24/6 on the CBOE Futures Exchange. Currently, VX futures contracts span from August 2015 through March 2016. Due to its construct, there is a significant price discount from the front month to back months in VX futures. For that reason, we like to focus on 3- to 4-month spreads.

Empirically, we have observed that when the market is very “toppy”—meaning it appears to be putting in a near-term top—the spread trades very negative, around -2.5 to -3. When the market bottoms, the spread hits parity(zero).

Let’s go through an example we recently used with TimerDigest, a market timing service that ranks top market timers nationally, to establish a long position in SPX: fh1

As you can observe in the charts above, on June 25, 2015, the VX futures spread (long July, short November) was around -2.50.  Then came the big drop on June 29 as SPX closed near its 200-day moving average at 2057, after which the spread rallied to near -0.9.  With SPX further dropping to 2058 on July 6, the spread touched parity (zero). fh2

Two trading days later, SPX dropped again and this time closing at 2046 which was below its 200-day moving average on July 8, which again triggered the spread to shoot back up to parity. After observing these patterns, we prepared to establish long positions in SPY, QQQ & IWM options the next day, both for our options trading service and for our affiliates. fh3

As the charts above show, we covered most of our long positions as the spread dropped back to -2.50. [Note: On Friday, July 17, we rolled our spread forward (long August, short December) as Monday and Tuesday of the following week were last trading days for July VX futures, and we did not want to be caught watching expiration-related pricing.

After 14 years of market timing (via TimerDigest), I must admit market timing is more an art than science.  However, relying on a number of indicators and using a scoring system to measure “the preponderance of evidence” have been most useful to me, instead of leaning too heavily on one or two indicators.

Within my arsenal of favorite indicators is the VIX Futures Spread.