« November 2010 »

IVolatility Trading Digest™

Volume 10, Issue 44
Bond Market Vigilantes

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Bond Market Vigilantes

There were many developments reported by financial media last week, but not much attention was given to the decline in longer maturity Treasury bond prices as the Federal Reserve implemented the first round of quantative easing. Perhaps the bond vigilantes, those responsible for managing large pension and hedge funds, were front running the Federal Reserve purchases and selling long dated bonds. Perhaps it was short-term bond traders fading the Fed purchases. On the other hand, with all the other important activity in the markets last week the answer could be related to the lack of progress made by the G-20 to resolve the trade imbalance and exchange rate issues. After our market review and brief strategy comment we add a volatility perspective to the equity market analysis.  


Market Review

S&P 500 Index (SPX) 1199.21. After a breaking out the previous week, SPX spent last week correcting the breakout. Although Friday's decline could be attributed to fundamental factors, from a technical perspective, it appears to be a normal correction from an overbought condition. Last week we cautioned the SPX has a tendency to overshoot technical objectives and then reverse. That technical objective was the April 26 high at 1219.80 that put in doubt the previous Head & Shoulders Top described in
Digest Issue 34

Now we have a potential double top in the works and attention should be on support at 1197.96, the November 3 high just 1.25 points lower. A close below this support level suggests the recent decline is more than a correction of the breakout adding weight to the double top interpretation.

E-mini S&P 500 Futures (ESZ0) 1195.50. The support level for the e-mini is the April 3 high of 1198 and Friday’s e-mini close below support raises doubts that the cash will be able to hold its support level. From the open interest numbers, it appears long liquidation began last Tuesday followed by increasing shorting on Wednesday through Friday as the open interest increased.

S&P 500 Index Implied Volatility (IVXM). Since our last review two weeks ago, the Implied Volatility Index Mean declined from 19.13 to 18.01, while the VIX declined from 21.20 to 20.61.  

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 10.13%, compared to 7.31% in our market review two weeks ago and just before the SPX broke out to the upside. This lower weighted premium level supports the view that the current correction from the breakout high will be limited.

VIX Options

With a current Historical Volatility of 73.00, 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


The high November implied volatilities, creating an IV/HV ratio of 1.45, indicates option premiums were bid higher on Friday. Higher call premiums suggest hedging strategies.  

VXX Options

iPath S&P 500 VIX Short-Term Futures ETN (VXX) 47.60. VXX 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.  

After a 1:4 split on Nov 9 VXX turned higher after declining as low as 44.00 on the split. Since the VIX futures are usually in contango this ETN will have a downward bias as it rolls from the first month to the second.

The current 20-day Historical Volatility is 50.12 up from 43.66 in our last review, while the 30-day Historical Volatility is 47.87 up from down from 43.60 in the last review two weeks ago. The IV/HV ratio is 1.34 creating a positive volatility spread.


iPath S&P 500 VIX Short-Term Futures ETN


The Implied Volatility Index Mean is 64.23 with the calls at 65.15 and the puts at 63.32 skewed to the calls. The put-call ratio is .25, normally considered bullish, but in this case bearish for the SPX as call buyers are expecting VXX to rise with a decline in the SPX.  

US Dollar Index (DX) 77.08. Although the Fed's QE2 announcement was larger than expected the 76 support held and then it rebounded back to the 77-78 area for a net change of just .19 since our last review two weeks ago. Since there is a seasonal tendency for the dollar to gain strength going into year-end there is good chance it will remain within the 76 -78 range.

CurrencyShares Euro Trust (FXE) 136.40. After breaking out above 140 on the QE2 announcement it declined back to the lower end of the 136-140 range on more debt default news from Ireland. Now that the current bondholders have been assured they will not suffer a haircut it should rally back up to the top of the range once again and should continue supporting equities, commodities and precious metals.

iShares Barclays 20+ Year Treasury Bond (TLT) 95.81. From a high of 109.34 and a yield of 3.46% on August 25, longs bonds have made a substantial move in a short time and are now yielding 4.26%.

With QE2 specifically targeted at 1 year to less than 10-year maturities, the decline in long Treasury prices and even Treasuries at the 10-year maturity seems curious. Could it be bond market vigilantes selling positions acquired when there was fear of deflation? If so, that means they believe QE2 will have its desired stimulus effect. Another plausible explanation is bond traders and short-term hedge funds are selling Treasuries and investing the proceeds in "risk on" assets, including equities, commodities and precious metals. Since the Seoul G20 meeting resolved very little relating to the fundamental issues there is no reason to believe the current trends will be reversed anytime soon.   

NYSE McClellan Summation Index 868.65. Since our last review, the NYSE Composite Index breadth indicator increased 8.70 points, but is now declining once again. As the NYSE Composite Index and the S&P 500 Index broke out above their April highs, the McClellan Summation Index turned lower creating a noticeable divergence. A further divergence was created when the 9 week Relative Strength Index (RSI) failed to make a new high on the breakout creating a bearish failure swing. Both divergences suggest the current correction is not finished. 

iShares Dow Jones Transportation Average Index (IYT) 86.93. As a confirming indicator, IYT also broke out above its April high and up to 89.57 on November 5 before retreating last week. On a weekly chart, with the breakout to the new high, a new three point upward sloping trendline from the March 2009 low was created. It would now take a close back down below 80 to change this uptrend. Perhaps this is more evidence of positive QE2 expectations.

Ben Delivered QE2

In last week's Digest Issue 43 we suggested many stock indices along with some commodities, gold and silver were overbought and due for a correction and indeed we did see the beginning of the correction last week. However, for the S&P 500 Index it will still need to close below 1197.96, the November 3 high to reverse the breakout on the QE2 news. While gold based on the December futures contract is now approaching its upward sloping trendline from the July 28 low at 1159.30 that touches the November low at 1325.50. Now at 1365.50 it will take a close below 1349 to breach this trendline.  

Further assurances from the euro area on the Irish bond default issue could take the selling pressure off the euro creating a weaker dollar while further supporting equities, commodities and precious metals.

Short-term traders may want to try the downside in the event the S&P 500 Index closes below 1197.96 this week. Since the Digest is limited to weekly suggestions, we think the risk of a quick reversal at the support for both equities and gold makes the short side unattractive since counter trend corrections have a tendency to reverse quickly to the upside. For our weekly strategy suggestions, we think the better strategy is waiting for the correction to be completed before adding more longs.

Since there have been no real fundamental changes from the G20 meeting we are inclined to think the equity uptrend will resume shortly and last week’s sell off will have be declared a correction of the recent breakout. This also includes commodities and precious metals. However, we do acknowledge rising long- term interest rates are a concern and could become an issue it they continue their ascent.

Volatility Update

S&P 500 Index (SPX) 1199.21. Here is the one-year volatility and price chart.


 S&P 500 Index


The Implied Volatility Index Mean is currently 18.01 with the current 30-day Historical Volatility at 12.11, up from last week at 11.26. The IV/HV ratio is 1.49.

In the chart above notice how the IV Index Mean declined down to about 15 on two prior occasions, first in January and then in April, before turning higher with the increase of the underlying Historical Volatility as the index declined. Both times the IV/HV ratio widened crating a positive volatility spread as the IV Index Mean failed to follow the Historical Volatility lower. Then they both turned as SPX declined. Currently we have the same situation as both volatility measures appear to be turning higher and this is consistent with the two previous market declines. While not predicative, it is certainly instructive and in conjunction with divergences in both the McClellan Summation Index and the RSI it suggests the breakout correction is likely to continue going lower.     


The equity market along with commodities and precious metals began correcting last week, but so far, the decline has been limited while there have been no real fundamental changes, with the possible exception of rising long-term interest rates. If equities continue declining this week, consider the possibility of a developing double top.

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Bond Market Vigilantes


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