« April 2012 »

IVolatility Trading Digest™

Volume 12, Issue 15
Pain From Spain

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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The markets received a jolt last Wednesday when Spain tried to auction 3.5 billion euros worth of bonds, but came up one billion short as the yield on Spanish 10-year bonds rose to 5.72%. As a further sign of distress, the cost of insuring against a Spanish default by using credit-default swaps (CDS) has doubled since the start of the year. Administration of the pain came from the declining euro, which translates into a rising dollar and thus lower equity and commodity prices. More unease is likely this week after the March US employment report fell far short of expectations.

In this Digest, we update our market indicators and supplement our VIX futures reporting along with another hedge trade suggestion.  


Market Review

Review Notes Clip ArtS&P 500 Index (SPX) 1398.08. The advance last Monday initially appeared to have exceeded the March 27 resistance high of 1419.15, but closer examination reveals it closed just short at 1419.04. The importance of the failure to close above the resistance could be significant since Thursday's close is sitting right on the upward sloping trendline, the one that began with the November 28, 2011 low at 1169.29. In the event it closes below the upward sloping trendline, the next support is 1378.04 from February 29. Should this occur it would begin confirming a developing change of trend in the form of a small Head & Shoulders, or perhaps a double top pattern.

E-mini S&P 500 Futures (ESM2) 1390.25. On Wednesday's 15.50 point decline the futures volume increased to 1.8 million contracts, the highest since the June contract became the front month, as the open interest declined 29,334 contracts suggesting long liquidation and short covering. 

S&P 500 Index Implied Volatility (IVXM). Since last week, the Implied Volatility Index Mean increased from 13.35 to 14.74, while the CBOE Volatility Index® (VIX) increased from 15.50 to 16.70.   

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 applies 35% to April and 65% to May resulting in the average premium of 3.05 or 18.26% shown above. Our alternative volume weighting between April and May results in a 15.89% 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. In the past premiums in excess of 20%, have usually preceded corrections, although not a precise timing tool it does appear to be a good way to measure professional hedging sentiment.  

Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium or discount is always available. In addition, the data is available on our Advanced Futures Options pages, using VX as the Instrument symbol and CF for the exchange. Compare the options Implied Volatility to the Historical Volatility by setting HV chart to 21 days.

Here is a chart of the April VIX futures showing the recent open interest decline in magenta as the futures price appears to be making a bottom.



The decline on open interest suggests liquidation by the longs, who no longer want to continue losing money as the future contract declined, along with short covering. If the futures are in the process of making a bottom in anticipation of a market correction then a long VIX futures strategy could be an effective hedge. We have a suggestion in the strategy section below.

VIX Options

With a current 30-day Historical Volatility of 83.85 and 77.04 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 Thursday's closing option mid prices along with their respective month's futures prices, since the options are priced from the futures.



Using the IV Index Mean of 85.26, the IV/HV ratio is 1.02, using the range method for Historical Volatility the ratio is 1.11 while the VIX put-call ratio was .72.     

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) 120.61. Purchasing of out-of-the-money S&P 500 Index puts for downside protection causes this index to increase in value. Now in the lower half of its recent 115-140 range, this indicator suggests fewer recent out-of-the-money put purchases.

CurrencyShares Euro Trust (FXE) 130.04. With the declines last Wednesday and Thursday, the euro once again found support at 130. In the event it now continues lower, the next support would be a retest of the January 126 low. A weaker euro translates in to a stronger dollar along with weaker equities, and commodities, especially crude oil.  

NYSE McClellan Summation Index 540.29. For the eighth straight week, our NYSE advance-decline indicator continued lower, for a loss of 225.54 additional points since we last reported in Digest Issue 13. We have noted several times the divergence between the NYSE Composite Index and the number of advancing issues compared to the number of declining issues has been a good leading indicator of trend changes. While it is too soon to declare the current correction will turn out to be a change in trend, we continue to urge carefully watching this breadth indicator.

iShares Dow Jones Transportation Average Index (IYT) 94.16. Unless they get some help from declining crude oil and gasoline prices, which appears to be more likely, the transports will continue to be a drag on the major equity indexes, a concern from a Dow Theory perspective.

SPDR Homebuilders (XHB) 20.99. Although the homebuilders made another new high on March 27 reaching 21.99 the index has retreated and is once again about to challenge the upward sloping trendline from the October 4 low at 12.21. Since this group has been one of the recent leaders anticipating an improving US economy, should it continue lower, it will place more drag on the major equity indexes.




The indicators we follow are giving a mixed signals, some have improved while others continue suggesting caution and hedging. Further, there is additional fundamental information to consider.  

After the report that US payrolls grew by only 120,000 in March, far below the expected 203,000 jobs, along with earnings reports starting this week, led by Alcoa, having already announced capacity reductions due to excess inventory and declining demand, this could be a challenging week with pain coming not only from Spain.

"When you begin to doubt, begin to 'get out'." Dickson G. Watts

As an alternative to liquidating positions, consider adding an easy to remove hedge. Here is another idea.

Hedge Suggestion

In Digest Issue 13, we suggested a long April 17 call that we subsequently abandoned in Digest Issue 14. However, with the weaker than expected employment report on Friday we suggest taking the whipsaw risk with another VIX hedge.  

CBOE Volatility Index® (VIX) 16.70. Since the pricing for the VIX options are from the futures and the May futures closed at 20.45, we suggest options on this futures contract since the last day of trading for the April option is April 17. The Historical Volatility for the May future contract is 76.44. 

This time we suggest a synthetic long, a combination of a long call and a short put.



While we recognize we are giving up some edge with this combination we think it is worth having the risk protection against declining implied volatility and time decay. We suggest using an S&P 500 Index close of the above the April 2 high of 1422.38 as the SU (stop/unwind).

If the market makes a substantial decline on Monday use this suggestion as guide and adjust the strike prices accordingly, but remember to price the options from the VIX futures, not the VIX.

The suggestion above is based upon last Thursday'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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We have been suggesting caution and the implementation of hedging strategies for several weeks and now with the disappointing US labor report it looks like the time has come for the correction to begin.


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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".