« September 2011 »

IVolatility Trading Digest™

Volume 11, Issue 34
Return to Work

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Opportunities GaloreSince the summer holiday season has ended we now look forward to the schedule of events that is surely to keep volatility well supported for the next few weeks. Although September has a reputation for being a seasonally weak month, for the last two years the market has been up. Wednesday and Thursday should be lively due to a court ruling from Germany followed by speeches by both Ben Bernanke and President Obama. Then near the end of the month, the German Bundestag will vote on the European Financial Stability Facility.

In this Digest, we review of our market indicators and offer some brief strategy comments along with a hedge idea for the financial sector.




Market Review

S&P 500 Index (SPX) 1173.97. After testing the August 9 low at 1101.54, SPX formed a symmetrical triangle consolidation pattern that became an unusual reversal with the upside breakout on August 29. We estimated the upside objective to be the resistance from June 16 at 1258.07 and unless Friday's decline continues below the lower boundary of the consolidation pattern at 1138 the upside resistance remains the current objective.   

E-mini S&P 500 Futures (ESU1) 1169.25. Along with the upside breakout from the symmetrical triangle consolidation pattern open interest has continued to increase over the past two weeks and with the exception of last Monday, volume has been higher than expected for the last two weeks of August. Since the September contract will expire on the 16th open interest will start expanding faster as contracts are rolled into December.

S&P 500 Index Implied Volatility (IVXM). Since our last market review, the Implied Volatility Index Mean decreased from 36.63 to 30.69, while the VIX decreased from 43.05 to 33.92.

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.



For this short-term indicator the discount to the cash is a SPX buying signal indicating professional expectations for the cash to decrease back toward the futures price. This week at -2.05 is less than last week's -7.16 and substantially less than -18.93% in our last market review. It is also noteworthy that the premium in the front month is the first premium to cash we have seen since July 22 just before the big decline in the SPX, however then the day-weighted premium was 5.58 compared to the current discount to cash.

Readings above 20% are generally a good indication of increased professional hedging in anticipation of an immediate decline while negative readings suggests complacency about protecting long stock positions by buying VIX futures contracts. Low and especially negative readings, like the current one, have been good leading indicators for short-term market advances in the past.

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

VIX Options

With a current 30- day Historical Volatility of 230.81 and 153.42 using Parkinson's range method, the table below shows 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.



Using the IV Index Mean of 92.29, the IV/HV ratio is .40, using the range method for Historical Volatility the ratio is .60. The VIX put-call ratio was .90.

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

CBOE S&P 500 Skew Index (SKEW) 119.33. When out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase. From our perspective, the SKEW continues to act more like a contrary indicator.

US Dollar Index (DX) 74.76. The dollar index remains near the middle of its current 73.50 to 76.50 trading range having tested 73.50 four more times since June 7. As money flows into Treasury Notes and Bonds, the dollar has remained relatively stable.  

iShares Barclays 7-10 Year Treasury (IEF) 104.54. As an economic indicator the 10-year note, with a yield of 1.99% is not painting a bright picture for the US economy. On Friday it reached a new high gaining .92%, even more remarkable was the 3.25% gain in the iShares Barclays 20+ Year Treasury Bond (TLT) 112.51, now yielding 3.31%.

NYSE McClellan Summation Index -290.12. Since our last market review, this NYSE breadth measure advanced 328.17 points, with 301.63 points of the gain in the last week as breadth continues to show signs of improvement despite the renewed decline of the bank stocks.

iShares Dow Jones Transportation Average Index (IYT) 80.22. Although the transports recovered along with the broad market as it broke out above the triangle consolidation pattern, on Friday the IYT declined more on a percentage basis as economic slowdown concerns reemerged. Further, the Association of American Railroads reported a slight dip in weekly rail traffic, which is not surprising since most of it was attributed to hurricane Irene. 

iShares S&P GSCI Commodity-Indexed Trust (GSG) 33.84. GSG our proxy for the CRB Index declined once again after reaching the downward sloping trend line from the April high. Energy makes up 70% and crude oil is the largest of the 24 commodities included based upon a world production weighting all priced from the near term futures contracts. High Grade Copper at 4.12, basis December futures, continues to show relative strength, having declined from 4.50, it is still within the recent 3.90 – 4.50 range.



StrategyReturn To Work

Further to our comments in the introduction above here is a bit more detail on the events that should continue to support volatility for the next few weeks.

As for the September record, while the S&P 500 Index declined 9.2% in 2008, it advanced 3.6% in 2009 and 8.8% last year. This year we think the fundamentals events will most likely prevail over any seasonal influence.

On Wednesday before the markets in the US open, we will know the decision of Germany's top court, the Karlsruhe-based Federal Constitutional Court, on whether the government broke the law with last year's bailouts of debt-stricken European countries.

Next the FT reports on Thursday the US Federal Reserve chairman, Ben Bernanke is scheduled to give a speech on the economic outlook five and a half hours before President Obama addresses a joint session of Congress on the employment situation and what his administration proposes to do about it.

Finally back to Europe, on September 29 the German Bundestag or Parliament will vote on the European Financial Stability Facility and presumably, the rules and conditions Germany will impose for further debt support for European countries.

With all of the above and other developments not yet known, it should be enough excitement to support market volatility, although we note the trend is currently lower as shown in volatility charts of both the S&P 500 Index and the CBOE Volatility Index® (VIX®) below.



Without the fundamental developments scheduled for the next few weeks, we would expect the implied volatility shown in orange above to decline back toward 20%. However, the events outlined above are likely to keep it elevated.



The implied volatility of the VIX Index has already declined substantially, but could rise again due to fundamental developments and increased hedging activity.


Hedge the Financials

After the news on Friday, that the Federal Housing Finance Agency (FHFA) sued 17 large banks for alleged mortgage misdeeds it could be too late for a meaningful financial sector hedge. However, we are once again reminded what Jessie Livermore said,

"Remember that stocks are never too high for you to begin buying or too low to begin selling."

Financial Select Sector SPDR Fund (XLF) 12.54.

Although XLF declined almost twice the amount in percentage terms as the S&P 500 Index on Friday, no doubt anticipating the FHFA legal action, it is hard to say if all the negative news is now in the price. In the event it opens substantially lower on Tuesday then adjust the strike prices of the spread lower. Here is the trade suggestion based upon Friday’s numbers.

The current Historical Volatility is 56.90 with an Implied Volatility Index Mean of 44.97, down from 46.01 last week. The IV/HV ratio is.79 while the put-call ratio is very high at 5.0. However, keep in mind, this ETF is used for hedging long stock bank positions. Friday's option volume was 392,766 contracts compared to the 5-day average of 280,850 contracts.



With a debit only 21% of the distance between the strike prices and with good volatility edge, use a close back above the last pivot at 13.50 as the SU (stop/unwind).

All of the suggestions above are based upon last Friday's closing prices using the mid price between the bid and ask. On Tuesday, the option prices will be somewhat different due to the time decay over the weekend and any price change.


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Until Friday, implied volatility had been declining as the equity market worked its way higher. However, with the weak employment report and the legal action against the banks as well as other important fundamental developments scheduled this week, volatility is likely to remain high.


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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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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".