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The 2Gs - Goldman and Greece – it took both, but finally the retest of the S&P 500 Index breakout above 1150, has started. Equities were mostly ignoring Greece’s dance around formally asking for a financial bailout, but when the Goldman Sachs news broke, it was all over and in a typical knee jerk reaction equities quickly sold off. After our market review, we offer our strategy spin and some trading thoughts for the correction.
Market Review S&P 500 Index (SPX) 1192.13. Up until Goldman joined Greece on Friday, SPX was continuing higher with only the slightest indication of retesting support at the breakout high of 1150.45 made on January 19, 2010. Now all of that has changed as the focus shifts to the question of how far this correction will go and if 1150.45 will act as support and hold. Since it has yet to reach our Head & Shoulders Bottom upside measuring objective at 1233.29 detailed in Digest Issue 1, dated January 11, 2010, we argue 1150.45 will hold and SPX will resume its uptrend. We have more in the Strategy Section below. E-mini S&P 500 Future (ESM0) 1190.25. With Friday’s decline of 18.25 points on preliminary high volume of 3.6 million contracts as the open interest expanded 34K to 2.5 million the futures are confirming the start of the correction. At 3.6 million contracts, this volume should be considered blowoff volume as the longs rushed to close out positions and new shorts added to the open interest. In general, blowoff volume signals the start of a market correction. The price decline can be expected to continue as long as open interest does not begin to decline. When to shorts decide to take profits it will be reflected in declining open interest and the correction will most likely be near the end.   S&P 500 Index Implied Volatility (IVXM). Since our last market review, based upon April 1, 2010, data, the Implied Volatility Index Mean decreased from 15.13 to 15.12. The VIX increased from 17.47 to 18.36, after declining as low as 15.23, last Monday, April 12, 2010.  The table below shows the VIX Cash compared to the next two futures contracts as well as our calculation of Larry McMillan’s day-weighted average between the first and second months. When there is a premium over cash, it is a sell signal indicating the degree of professional hedging, and this week at 7.90% is lower than last week at 16.89% and lower that our last report at 14.31%. By this measure, selling pressure is diminishing. Some analysts are highlighting the unusually large spread between the VIX cash at 18.36 and the 20-day Historical Volatility of the SPX at 10.20. Here are the comparisons for the last three weeks.   Using the IVolatility Implied Volatility Index Mean and the 30-day Historical Volatility here is a graph showing the past year and the current differential between the implied volatility and the historical volatility.   VIX Options With a current Historical Volatility of 67.60, the next table shows the adjusted Implied Volatility (IV) of the at-the-money (18) VIX calls and puts based upon Friday’s closing options mid prices along with the respective month’s futures prices.   US Dollar Index (DX) 80.82. The net change of +.04 in the last two weeks does not adequately describe the activity taking place in this market nor reflecting the efforts of the euro to rebounded on news that a European solution with International Monetary Fund participation is now under consideration by Greece, although they have not as yet formally asked. On the DX chart, there is a gap below the April 9, 2010 low at 80.87 and the April 10, 2010 high of 80.69, that clearly defines the drop in the DX below its upward sloping trendline from the December 3, 2010 low at 74.33. Unless DX turns up and exceeds this trendline once again, the dollar looks lower and equally the euro looks to be headed higher. The resulting dollar weakness should continue supporting crude oil, raw material and the emerging markets.  iShares Barclays 20+ Year Treasury Bond (TLT) 89.86. After exceeding at the lows of 87.56 and 87.69 made last June 10th and 11th long bonds as measured by TLT recovered somewhat perhaps reflecting a reduction in risk preference as TLT returned to near the 90 support level corresponding to long-term interest rates of 4.67%. NYSE McClellan Summation Index 1241.99. Now turning to equity market breadth, our indicator for the NYSE Composite Index increased 20.56 since out last review, but the shorter-term oscillator is now below zero indicating that it will be declining as the market corrects. Once again, as mentioned in recent previous Digest Issues, the divergence between this indicator and the rising NYSE Composite served well as a warning of a correction, one that is now underway. Baltic Capesize Index (BCI) 3071. Since our last market review, the Baltic dry-bulk shipping rate index for the larger ships declined another 358 reflecting shipping overcapacity. With our next market review in two weeks, we will substitute the iShares Dow Jones Transportation Average Index (IYT) for the Baltic Capesize Index to better reflect actual transportation activity. The Capital Link Tanker Index increased 230.70 points to 2565.99, in part because of the reported chartering of some VLCCs for storage due to the contango in the crude oil futures market.
Strategy The long overdue correction from the breakout above the S&P 500 Index at 1150.45 has arrived courtesy of Goldman Sachs. This controversy will be leading the financial market news for a long time giving SPX ample time to retest 1150. Since the markets will also be fixated on whether or not this is the first of more charges to come against other Wall Street banks implied volatility is likely to rise due not only because of declining prices but also due to the added uncertainty of more SEC actions. Here are some indicators to be watching. VIX Spike Theory This short-term indicator says the market is a buy on a reversal of the VIX after is has spiked at least 35%. From Friday’s low of 16.19 to the high of 19.87, the spike was 21.68% so one or two more days and this indicator could give a buy signal. Watch for the reversal. VIX Futures Premium The declining futures premium indicates less VIX futures hedging pressure. The front month with only two trading days until expiration is currently at a discount. If the May future declines below the cash and trades at a discount it will be giving a buy signal. Key Reversals Watch for key reversals in the major indexes such as the SPX, for example, a lower low for the correction but a higher close than the previous day. As mentioned above in the e-mini S&P 500 Futures section, pay particular attention to the open interest as “The price decline can be expected to continue as long as open interest does not begin to decline. When to shorts [smart money] decide to take profits it will be reflected in declining open interest and the correction will most likely be near the end.”  Support Levels Watch the important support levels. For the S&P 500 Index watch 1150. For the June e-mini S&P 500 future contract the support is at the January 11, 2010 high of 1143. For the iShares Russell 2000 Index (IWM), support is at the high of 64.88 also made on January 11, 2010. Nimble short-term traders may want to get short for the correction, but remember short positions using  the major indexes would be a counter- trend trade and should be carefully managed using stops. The alternative is to wait for the correction to be completed before opening new positions using indexes or ETFs that have outperformed the S&P 500 Index since the last pivot in February. Here is one idea. iShares Russell 2000 Index (IWM) 71.46. Comparing the IWM to the SPX since the pivot lows on February 5, 2010 to the highs on April 15, 2010 the SPX advanced 16.22% while IWM advanced 25.14%. When the correction is completed we suggest using IWM with better relative strength without sacrificing options volume and open interest.  The current Historical Volatility is 14.43 up from 14.01 last week, with an Implied Volatility Mean Index of 20.39 up from 19.29 last week. Presuming the equity markets stabilize and indicates a resumption of the uptrend near or before the support levels mentioned above, consider a long call spread strategy. If implied volatility is still rising due to added market uncertainty then consider a strategy that has more long options that short, such as a call ratio backspread. If implied volatility has spiked and appears to be heading lower again then short options strategies, such as short puts can also be considered.   IVOLopps™ For those who may want to trade the correction we suggest long put spreads or long call ratio put spreads with long more options than short, using SPY. SPDR S&P 500 Index (SPY) 119.36. The current Historical Volatility is 9.60 up from 7.86 last week, with an Implied Volatility Mean Index of 15.33 up from last week’s 14.41.   Here is one idea.
The 115 put for the short leg is at the breakout support level. The position as some edge since the long put is less expensive in implied volatility terms (16.40) than the put sold (18.75). In addition, it is net long vega, meaning it will benefit from increasing implied volatility. At 1.80, it has a risk reward of 2.8 with a defined and limited risk of the debit that can be further reduced by using a price stop below. Use a close back above 120 as the SU (stop/unwind).
Summary We do not know how far the correction will go, but we have established some indicators to help determine when it may be over. We expect both implied and historical volatility to rise while the correction is in progress so option strategies with more long options or spreads with positive vega will have an advantage.
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In next week’s issue, we will return with a market update and more specific strategy suggestions.

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