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When do divergences matter?

Hey Market Pilots,

As the market climbs higher and higher, we continue to wonder just how long this can be sustained. Many of us have been proven wrong in the recent past when we tried to short the market but it just kept going up despite our indicators. Since then, I have directed our subscribers to be careful on the short side; To really only expect a short trade to be a reversion to the mean from an overbought rally. While this has been the case for quite some time, I would like to build the case that could be changing in the foreseeable future and we need to be aware of it.

Let me first start with a chart of the put/call ratio. This chart indicates the ratio of the of puts versus calls which basically tells us how many traders are long versus how many are short. When the put/call ratio gets too low, that tells us that too many people are long the market and there aren’t many more traders able to go long and keep bidding the market up. At this point, the market typically starts to roll over and reset the balance between longs and shorts.

Right now, we are at low levels that have historically prepped the market for a decline. As also seen by the chart above, this condition can persist for some time so it’s more of a heads up to keep in the back of your mind when looking at the landscape of charts.

The next chart I present is of the SPY and the VIX. The interaction of these two is typically inverse to one another; When the SPY goes up, the VIX should go down in a corresponding manner. Clues arise when we start to see divergences from that relationship. In the chart below the red lines demonstrate the proper inverse correlation of SPY up and VIX down. Then we have the yellow lines which are not properly correlated. Notice that the SPY has been trending up, making new highs but the VIX has been holding flat. If things were all fine and normal, the VIX right now should be trending lower but it’s not and that is making me take note.

Often times this kind of divergence can be a clue as traders are building a hedging position in the VIX in preparation of a down move with the SPY.  This divergence is usually more precise and can be executed in a timelier manner. The fact that this divergence has been persisting for a relatively long time is making me wonder if something more drastic is on the horizon. We can’t say for sure, especially with how much influence the Fed has had, but between these two clues I present, I think we need to be on watch and trade accordingly.

Over and Out,

Your Profit Pilot

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