Watch out for this “sell” signal

If you took our advice to buy stocks last week, you're up a solid amount.

Last Tuesday, stocks looked like they were heading over the cliff. The S&P 500 traded as low as 1,815. Many investors thought the long-awaited correction was finally here.

But we said this old bull market still had one more kick left in it. So the selloff had us looking to buy stocks in anticipation of a rally going into the end of the month.

On Thursday, the S&P 500 closed at about 1,865 – up 2.7% from Tuesday's low. That's a solid return for two trading days. And there's more to come. But there's also trouble brewing around the corner...

With more than a week to go before the end of this seasonal bullish period, there's a good chance the S&P 500 will make a run at the 1,900 level.

But there's a reason Wall Street veterans "sell in May and go away." Historically, the first day of May kicks off a seasonally weak period for stock prices.

Of course, it's not as simple as just waiting until May 1 to exit our short-term trade. Sometimes, weakness sets in a few days before the start of the month, sometimes a few days afterward. Traders need to use another indicator to know when it's time to take profits.

That's where the Volatility Index (the "VIX") comes in.

The VIX is commonly referred to as Wall Street's fear detector. Extreme moves in the VIX are excellent contrary indicators. We buy when the VIX makes an extreme move to the upside, and we sell when the VIX makes and extreme move lower.

Take a look at this chart of the VIX plotted along with its Bollinger Bands...

Bollinger Bands measure the most probable trading range for a stock or an index. Whenever a chart moves outside of its Bollinger Bands, it indicates an extreme condition – either extremely overbought or extremely oversold. Since the VIX is a contrary indicator, it's best to buy stocks when the VIX is extremely overbought. It's best to sell stocks when the VIX is extremely oversold.

The blue arrows on the chart point to the times when the VIX traded above its upper Bollinger Band and then fell back below it. Those are "buy" signals. We got one early last week.

The red arrows point to times when the VIX fell below its lower Bollinger Band and then closed back above it. Those are "sell" signals. There have only been two over the past year. Each one was followed by a modest decline of between 2% and 5% in the S&P 500.

If the market continues higher from now until the end of the month, the VIX should continue lower. It won't take much more of a drop to get the VIX below its lower Bollinger Band. When that happens, the VIX will be on the verge of generating another broad stock market sell signal.