« October 2010 »

IVolatility Trading Digest™

Volume 10, Issue 42
Waiting for QE2

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Waiting for QE2

While the QE2 as depicted above has been converted into a hotel in Dubai, its monetary namesake is due to arrive in New York on Wednesday and the financial markets are anxiously waiting to see just how big it is going to be. According to a survey by Jefferies & Co., the consensus is that QE2 will total about $500 billion and this amount is most likely already priced into bonds and equities. We have more in the strategy section below along with four trade suggestions, but first our market review.


Market Review

S&P 500 Index (SPX) 1183.26. Since our last market review, the upward momentum slowed in the last few days and SPX is now just below the upward sloping trendline drawn from the August 31 low of 1040.88 and touching the October 19 low at 1150.71. Since this is a rather steep trendline a minor correction here would not significantly reduce the chances that it will soon challenge the previous April 26 high at 1219.80. Based upon, "buy the rumor sell the news", we would not be surprised to see a minor correction regardless of the QE2 announcement on Wednesday.  

E-mini S&P 500 Futures (ESZ0) 1179.50. Based upon the preliminary CME report open interest was 2,692,418 contracts almost unchanged for the last two weeks when it was reported at 2,696,932 contracts on October 18. Since expanding open interest is a sign of a healthy trend and since there is currently no further sign of expansion it adds support to the slowing momentum view and perhaps the minor correction forecast.  

S&P 500 Index Implied Volatility (IVXM). Since our last review two weeks ago, the Implied Volatility Index Mean increased from 17.50 to 19.13, while the VIX increased from 19.03 to 21.20.  

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.

S&P 500 Index Implied Volatility


For this short-term indicator the premium to the cash is a SPX sell signal indicating professional hedging activity and the expectation that the cash will rise back toward the futures price. Last week, the reading was 14.63%, compared to 25.08% in our market review two weeks ago. Now under 10% we need to go all the way back to Jul 2 to find a comparable reading 8.74%. Accordingly, hedging activity using VIX futures has dropped significantly perhaps reflecting professional near term compliancy and is not consistent with expectations for a near term correction.   

VIX Options

With a current Historical Volatility of 68.87, the table below shows the adjusted 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.


VIX Options


VXX Options

iPath S&P 500 VIX Short-Term Futures ETN (VXX) 13.10, is an exchange traded note based on VIX Short-Term Futures Index offering exposure to a daily rolling long position in the first and second month of the VIX futures contracts and reflects the implied volatility of the S&P 500 Index one month later. The index futures roll continuously from the first month of the VIX futures contract into the second month of the contract.  

The current 20-day Historical Volatility is 43.66 down from 44.37 in our last review, while the 30-day Historical Volatility is 43.60 up from down from 41.88 in the last review two weeks ago. The IV/HV ratio is 1.71 for a positive volatility spread.


iPath S&P 500 VIX Short-Term Futures ETN


The Implied Volatility Index Mean is 74.43 with the calls at 75.34 and the puts at 73.53 skewed to the calls. The put-call ratio is a bearish .70 as call volume decreased suggesting options traders are buying fewer calls for hedging.

US Dollar Index (DX) 77.27. The DX continued to decline finding support at 76 and then rebounded back above 78 on what could have been short covering ahead of the QE2 news. If $500 billion is already in the price then it could remain in the 76-78 range. If the Fed announcement appears larger than expected DX could have another leg down with the next support at the 74 level from last December. In this event, equities, commodities and precious metals could be expected to continue moving higher.

CurrencyShares Euro Trust (FXE) 138.69. For now, it appears resistance at 140 is holding and a 136 – 140, trading range is developing. Of course, if the Fed exceeds expectations on Wednesday it would most like continue up to the next resistance at 145 on more dollar weakness.

iShares Barclays 20+ Year Treasury Bond (TLT) 99.49. Long bonds continued to move lower as long term interest rates have risen back to 4.00% from the low of 3.46% on August 25. From a technical perspective there appears to be good support at 100. If the Fed exceeds market expectations on Wednesday it is not clear if long bonds will turn higher on anticipated Fed purchases or continue to decline on anticipated future inflation. This is the QE2 concern and the Fed has been carefully managing market expectations knowing this is a real risk.

NYSE McClellan Summation Index 859.95. Since our last review, the NYSE Composite Index breadth indicator declined 92.82 points reflecting the loss of upward momentum. This should be a signal to increase equity hedging but so far, the only sign of additional heading appears to be the increase in the put-call ratio of the S&P 500 Index, now above 3.5, compared to 1.10 in our last review and the highest level in the last six months.

iShares Dow Jones Transportation Average Index (IYT) 85.77. IYT continued going higher reaching 86.63 on October 25 and very close to the April high at 86.79, as we said in the last review,

  "...while still below, it is tracking the upward sloping trendline from the March ’09 low. It will take a breakout above the April high to confirm a resumption of the long- term uptrend. Dow theorist will be watching to see if the transports will confirm other major indices as they approach their April highs."



Apparently, as of Friday the Fed still had not yet decided on the size of QE2. Bloomberg News reported Thursday that the New York Fed asked the 18 reporting dealers with which it conducts open-market operations what they expect in QE2 and what they thought the impact would be on the Treasury market.

Since there is a developing divergence in the advance-decline line along with the high SPX put-call ratio mentioned above, we suggest adding some SPX or IWM hedging until the Fed announces its intentions.

Last week we wrote the precious metals sell off was most likely the result of apprehension about an announcement coming from the G20 finance ministers meeting. The more serious alternative was profit taking. Since gold and silver quickly rebounded, we have concluded it was a temporary G20 correction and not profit taking. Accordingly, we suggest adding to precious metals positions as they have seasonal strength as well as the dollar weakness working in their favor.

Our indicators are mixed reflecting the current uncertain market condition. The VIX futures premium has declined, but the SPX put call ratio mentioned above, is at the highest level in six months. Consequently, a carefully chosen combination of shorts and longs appears to be the best match for Monday. 


The Hedge

For those who may want to do some hedging based upon the slowing momentum and possible selling on the Fed announcement here is one hedge suggestion.

iShares Russell 2000 Index (IWM) 70.30.

The current Historical Volatility is 19.19 and the Implied Volatility Index Mean is 27.81 with an IV/HV ratio of 1.45 and a bearish put-call ratio of 1.5. Consider this put vertical spread as a short-term hedge.


iShares Russell 2000 Index


Use a close back above 72 as the SU (stop/unwind).


Trend Continuation

Since the large cap NASDAQ stocks are not showing signs of slowing, here is a trend continuation idea that adds to the earlier suggestion make in Digest Issue 40 and another for sliver adding to Digest Issue 41

PowerShares QQQ (QQQQ) 52.18. This ETF is a unit investment trust designed to correspond to the performance, before fees and expenses, of the Nasdaq-100 index. The fund holds all the stocks in the Nasdaq-100 index, which consists of the largest non-financial securities listed on the Nasdaq Stock Market.

The current Historical Volatility is 13.75 with the Implied Volatility Index Mean at 20.48 for an IV/HV ratio of 1.49 and a bearish put-call ratio of 1.4 indicating considerable hedging activity.


PowerShares QQQ


With good edge use a close below the upward sloping trendline or about 51 as the SU (stop/unwind).

Silver Wheaton Corp. (SLW) 28.75.

With a current Historical Volatility of 38.16 and an Implied Volatility Index Mean of 48.75 for an IV/HV ratio of 1.28 and a bullish put-call ratio of .3, consider adding this short put.


Silver Wheaton Corp.


Use a close back below the last pivot at 25.35 as the SU (stop/unwind).


Quarterly Earnings Report

With still a good number of earnings reports due this week here is one to consider.

American Superconductor Corporation (AMSC) 33.65 is an alternative energy company offering grid interconnection solutions as well as licensed wind energy designs and electrical systems based on power electronic systems and high temperature superconductor wires that dramatically improve the efficiency, reliability and quality of electricity during its generation, transmission and distribution.

The company is scheduled to report earnings on Tuesday before the opening. The consensus estimate is .28 compared to last year at .19. The stock has been declining from 38.88 reached on October 13 in what appears to be selling on the expectation that it will not meet the estimate.

With a current Historical Volatility of 37.46 and an Implied Volatility Index Mean of 57.84 for an IV/HV ratio of 1.54 and a very bearish put-call ratio of 9, or nine times more puts than calls, consider this call credit spread.


American Superconductor Corporation


We suggest unwinding or closing the position after the report is released as the implied volatility is likely to decline. There is some upside risk as the position will be short above 35 so manage the position size accordingly.


All of the suggestions above are 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.



The financial markets are currently reflecting unusual uncertainty while waiting for the QE2 announcement from the Federal Reserve on Wednesday. Since our indicators are mixed, we suggest a strategy using a combination of selected shorts and longs.


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Waiting for QE2


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.

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Thank you

Posted by Robert Robinson on November 01, 2010 at 05:55 AM EDT

Robert, Thanks for taking time to comment. Let us know if you have any questions. Jack

Posted by Jacktrader ( on November 01, 2010 at 03:28 PM EDT

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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".