« March 2012 »

IVolatility Trading Digest™

Volume 12, Issue 11
Ides of March

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Julius Caesar's assassination on March 15, 44 BC, forever marked March 15, as the Ides of March, a day of infamy. The Ides of March assumed a completely new identity after the events of 44 BC as the phrase came to represent a specific day of abrupt change setting off repercussions throughout Roman society and beyond. In modern times, the term has become a metaphor for impending doom.

In 2012, The Ides of March will be upon us this Thursday. Will it confirm the expected correction or just be another uneventful trading day with low volume? We will use this opportunity to review our market indicators, update our strategy comments and offer another hedging idea just in case.


Market Review

Review Notes Clip ArtS&P 500 Index (SPX) 1370.87. Last week the long anticipated correction began, but by week's end, it had recovered to close up 1.24 for the week. It now confronts the task of challenging the previous high at 1378.04 set on February 29. Keep in mind corrections in the major indexes are a process, not a one or two day event. The take away from last week is the correction is underway.

E-mini S&P 500 Futures (ESH2) 1372.50. Last Tuesday's volume at 2.57 million contracts finally reached our high volume marker set at 2.5 million. Not surprisingly, it was on the 22.50-point decline as the shorts pressed their positions. By the end of the week, the regular quarterly rollover volume began appearing, as the March contract expires Friday.  

S&P 500 Index Implied Volatility (IVXM). Since our last market review, in Digest Issue 9, the Implied Volatility Index Mean declined from 14.20 to 14.16, while the CBOE Volatility Index® (VIX) decreased from 17.31 to 17.11.  

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.



The day weighting applied 28% to the March and 72% to April resulting in the average premium of 4.60 or 26.91% shown above. Our alternative volume weighting between March and April results in a 21.28% premium.

For this short-term indicator the premium to the cash is a SPX sell signal suggesting professional expectations for the cash to increase toward the futures price. While the premiums are less than last week, both remain above our 20% premium cautionary threshold. In the past, premium levels in excess of 20% usually preceded corrections. While we do not suggest it is a precise timing tool, it does appear to be a good way to measure professional hedging sentiment. Further, expanding open interest confirms the increase in hedging activity as shown in the chart below.



As of Thursday, open interest was 277,541contracts, up from 265,366 last week, and 190,249 contracts on February 3 (see the arrow above where it exceeded 200,000 contracts).  

Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium or discount is always available. 

VIX Options

With a current 30-day Historical Volatility of 95.35 and 72.14 using Parkinson's range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon the closing option mid prices on Friday along with their respective month's futures prices, since the options are priced from the futures.



Using the IV Index Mean of 80.96, the IV/HV ratio is .85, using the range method for Historical Volatility the ratio is 1.12 while the VIX put-call ratio was high at 1.30.    

All of the Implied Volatilities along with the Historical Volatilities and Greeks for the VIX options based upon the Futures prices are on our Advanced Options page, found by clicking on the "market close" link shown near the top of the page.

CBOE S&P 500 Skew Index (SKEW) 124.78. When out-of-the money S&P 500 Index puts are being purchased for downside protection, the SKEW is designed to increase. Now back below the previous cautionary high range between 128 and 130 this indicator still suggests puts volume is in the upper half of its range since it began on February 23, 2011.

CurrencyShares Euro Trust (FXE) 130.59. After rebounding to retest the upward sloping trendline on Thursday the euro took a drubbing on Friday, presumably on the declaration of Greek default news, thereby triggering credit default swaps. The momentum is now downward and it appears 126 could be the next downside target.  

NYSE McClellan Summation Index 912.40. Our NYSE advance-decline indicator continued lower giving up another 319.05 points since we last reported it in Digest Issue 9 as the downside momentum is increasing. There is now a clear divergence between the advances and declines compared to the broad market indexes. In the past, this divergence has been good leading indicators of trend changes. We urge using the link above to look at this important divergence.

iShares Dow Jones Transportation Average Index (IYT) 92.21. While the transports increased on Thursday and Friday, they are a long way below the upward sloping trendline from last October's low. In order to regain the uptrend they would need to close above 100 or about 8.5% higher than the current level and this seems unlikely unless they get some help from declining crude oil and gasoline prices, which is also unlikely as this is the seasonally strong time of the year for energy prices. Thus, the divergence from the major equity indexes is clearly a concern from a Dow Theory perspective.

SPDR Homebuilders (XHB) 20.61. In Digest Issue 9, we cautioned a close below 19 would end the uptrend from the October 4 low at 12.21. Last Tuesday it closed below our upward sloping trendline, however by Friday it was back above and had even broken out above resistance at 20 that seemed to have been restraining it since February 3.



StrategyAfter minor corrections last week, the closely followed equity indexes are back testing their previous highs. While it is too soon the to conclude they will fail and turn lower there is evidence against further advances including the important advance-decline divergence, the weak transportation index and the increased level of professional hedging as evidenced by the VIX futures. Based upon this and an excellent cyclical analysis article in the December 2011 Active Trader magazine by Larry Williams suggesting on or about March 16 could be a 10-year cyclical top we continue to suggest implementing hedging strategies. Here is one more.

Hedge Suggestion

Until we have clear evidence that the previous uptrend is resuming and the divergences mentioned above have been favorably resolved, we suggest another hedging strategy with long vega as implied volatility will most likely rise with the expected correction.

SPDR S&P 500 Index (SPY) 137.57

The current Historical Volatility is 9.30 and 7.75 using the Parkinson's range method, with an Implied Volatility Index Mean of 14.05, up from 13.52 last week. The IV/HV ratio is 1.51 and 1.81 using the range method to calculate the HV. Friday's put-call ratio was bearish at 1.60, but within the normal range of 1.50 to 1.60, since it is hedging favorite. The volume was 2,299,827 contracts traded compared to the 5-day average volume of 2,170,560 contracts.

Here is a put ratio backspread to consider.



Each long April put was priced at 1.31 each or 2.62 for 2 as shown above with an individual vega of .1539 for the total shown of .3078. While we are paying more in implied volatility terms for the options bought than the option sold, we expect to gain from a rise in implied volatility since the position has positive net vega.

Use a close above 140 as the SU (stop/unwind).


The suggestion above is based upon last Friday's closing prices using the mid price between the bid and ask. On Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.


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Despite the recovery from the minor correction last week, we conclude from reviewing our indictors there are still good reasons to expect a more substantial equity correction and therefore we suggest more portfolio risk hedging.


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Finding Previous Issues and Our Reader Response Request

All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. Another way to find them is the Table of Contents link in the blog section of our website.

Next week's issue As usual, we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like us to look at a specific stock, ETF or futures contract, let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com




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IVolatility Trading DigestTM Disclaimer
IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.

Our purpose is to offer some ideas that will help you make money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".