« September 2010 »

IVolatility Trading Digest™

Volume 10, Issue 34
Head & Shoulders Top

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Head & Shoulders Top

Here at the end of the low-volume trading season it is time to update the working Head & Shoulders Top pattern first outlined in Digest Issue 26. An updated chart with supporting data is in the Strategy section below. In addition, we have an update for two working deals in the Takeover File and then two stocks with big changes in implied volatility. First, the market review.


Market Review

S&P 500 Index (SPX) 1104.51. Last week we noted the outside range day, a minor trend change indicator, made the previous Friday, implied the next trading day’s high will be higher. The expected new high did not come last Monday, but was delayed until Wednesday when it made a 30.96-point gain. Perhaps the light volume summer trading was responsible for the delay. Some commentators suggest it had been driven lower by long Treasury bond/short equity strategies taking advantage of the thin markets and they were being unwound Wednesday before more liquidity returns next week. A look at the Treasury bond chart adds some credibility to this feasible scenario.

As noted in Digest Issue 30, we think there is a good change for the development of a 1025 – 1125 trading range as long as it remains above the July 1 low of 1011.40. An updated version of the large Head & Shoulders Top, originally described in Digest Issue 26, is below in the Strategy section. However, we still think the range alternative appears the most likely.

E-mini S&P 500 Futures (ESMO) 1103.50. Confirming or perhaps even creating the change in trend on Wednesday was the 59K decline in open interest as e-mini rose 33.50 points. When open interest declines as price increases two forces are at work, first the longs are selling out positions established at lower levels, taking profits; second, the shorts are anxiously buying back their positions, taking losses.   

S&P 500 Index Implied Volatility (IVXM). Since our last review, the Implied Volatility Index Mean declined from 22.68 to 18.12, while the VIX declined from 25.49 to 21.31 confirming the change in trend that began last Wednesday. 

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.


VIX Cash


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 18.16%, compared to 17.68% in our market review two weeks ago. This indicator at 23.71, one of the highest readings seen recently, suggests expectations the current rally could be short lived, but it is consistent with the trading range view.

VIX Options

With a current Historical Volatility of 86.39, 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) 19.08 is based on the cash VIX not the futures. The current 20-day Historical Volatility is 56.04 up from 45.88 in our last review, while the 30-day Historical Volatility is 49.69 up from 49.46 in the last review two weeks ago.


VXX Options


The Implied Volatility Index Mean is 64.13 with the calls at 65.15 and the puts at 63.10. With a put call ratio of .9 options traders are still biased to the upside expecting, and/or hedging an increasing VXX corresponding with a declining S&P 500 Index.

US Dollar Index (DX) 83.10. For the past two weeks, the dollar has traded in a narrow range around 83 closing up just .04. The dearth of activity and the narrow trading range is most probably due to seasonal factors that are now ending. We expect greater volatility in the next few weeks.

CurrencyShares Euro Trust (FXE) 128.47. Since our last review, FXE found support at 125 and turned higher once again. The next upside target appears to be at the round number 130, with support at 125.  

iShares Barclays 20+ Year Treasury Bond (TLT) 103.58. Like a light switch, now it is "risk on" once again, as reflected in the long bonds, which have declined 5.76 points since the high on August 25 at 109.34, a decline of 5.27%. Bond buyers at the top when the yield was 3.57% now have a substantial loss created by the long bond/short equity trade unwinding. Since there now appears to be a Head & Shoulders Top in both TLT and the Dec Treasury bond futures, long bonds are expected to decline somewhat further.

The 90-day TED spread our substitute for the often-quoted Libor – OIS spread, is now 16.81, having declined another 1.61 basis points since our last review. As an interbank liquidity measure, TED's decline back into a more normal range confirms the improved interbank lending environment adding some support for "risk on" trades. 

NYSE McClellan Summation Index 376.23. Since our last review, the NYSE Composite Index breadth indicator declined 231.64 points, but improved 5.02 in the last week as the equity rebound began. If the trading range proves to be the dominant pattern then any further advance could be cut short at the upper end of the trading range.

iShares Dow Jones Transportation Average Index (IYT) 79.42. Consistent with the trading range interpretation IYT turned higher with the market and now faces the upper end of its range at 82.50. If the trading range proves to be the near-term future for equities then expect IYT to have trouble above 82.50.

Baltic Capesize Index 3937. The improvement in Baltic dry-bulk shipping rate index for the larger ships carrying iron ore and coal continued higher once again with another 359-point gain in the last two weeks since our last review. Increased iron ore and grain shipments have been cited despite concerns about increasing lift supply.

Capital Link Container Index  2084.06. Since our last review, the important container sector improved modestly adding 15.17 points to the index despite low activity levels in August.

Capital Link Tanker Index 2176.42. Despite the index improving by 8.45 points since our last review, the tanker sector is now operating below breakeven based upon spot charter rates. In the last two weeks, the rates for the smaller Aframax size ships decline by almost one half. New scheduled ship deliveries are said to be responsible for the dismal rates. For example, in the very large crude carrier sector 180 new ships, or about one-third the size of the existing fleet, are scheduled for delivery in the next two years.



An updated SPX chart below shows a simplified version of the existing Head & Shoulders Top, the technical pattern that is currently active. Using a daily chart going back one year the interpretation has become more complicated since now there are four possible left shoulders and three right shoulders in what is now become a complex Head & Shoulders Top.

As side note, J.M. Hurst in his book, The Profit Magic of Stock Transaction Timing, Prentice-Hall, Inc. 1970, makes the case that Head and Shoulder Tops as well as Head & Shoulder Bottoms are simply a combination of changes in trend accompanied by the normal cyclicality of the equity market. For those interested in the Head & Shoulders phenomena this book is a good reference.


Head & Shoulders Top


This chart updates and corrects the one shown in Digest Issue 26, with the downside-measuring objective unchanged at 862 as shown in the earlier version of the chart.

Here are the numbers used in the calculations.


chart updates


Subtracting the vertical height of the pattern of 177 from the point it crossed below the neckline at 1039, produces the downside-measuring objective.

Interestingly, from this one-year daily bar chart three alternative left shoulders and two alternative right shoulders can be identified. In addition, if the current rally extends beyond 1125 before reversing a new right shoulder will be apparent. Without going into the detail and without cluttering the chart with more labels, the alternative downside measuring objectives, all calculated for a close below the July 1 low at 1011.40, are 811, 808 and 803. Further efforts to identify the best-left shoulder, along with the best right shoulder, seem fruitless and could be thought of as rearranging the deckchairs on the Titanic.

For now watch the July1 low at 1011.40, which to further the complicate the analysis, could also be the new Head of a developing Head & Shoulders Bottom pattern.

For the time being, we continue to assume a trading range, especially since the last pivot was on the neckline described in the chart above. While the current upside range assumption is 1125 any further advance would not only challenge the right shoulder assumption, it could also begin to challenge the validity of the entire Head & Shoulders Top, although a close above the April high of 1219.80 would be required to entirely invalidate the pattern.


Previous Trade Suggestion Review & Update

iShares Russell 2000 Index (IWM) 64.33.

In last week’s Digest Issue 33, we suggested a long call spread combination strategy partly financed by a short put. Based upon the closing prices on Monday August 30 the price of the combination short September 58 put and the long October 62/67 call spread was a debit of .78. Since the close on Monday at 60.30, IWM turned higher and closed Friday at 64.33 for a 4.03-point gain.  

Marking the position to market, the combination is valued at 2.63, for a four-day gain of 1.85.

Since we originally expected IWM to turn back up and go to the upper end of the range at 67.50, we suggest unwinding the position on any trading range day that touches 67.50 and based upon the current momentum and the two gaps on the IWM chart it could come quickly.


Takeover File Update

Potash Corp. of Saskatchewan, Inc. (POT) 148.50.

Despite reports that the Chinese government has given the green light to Sinochem to pursue a counter bid for POT, perhaps in combination with a Canadian partner, the options are not yet reflecting this possibility. Both the September and October options series were active Friday, but little activity was noted in the December series. In addition, the Implied Volatility Index Mean at 27.59 is only up slightly from last week at 26.78. Further, the put-call ratio at .55 would most likely be lower if another bid was anticipated by the options. We do not dismiss the possibility of another bid, but so far, it is not showing up in the options data.

Dollar Thrifty Automotive Group Inc. (DTG) 48.35.

Avis Budget raised its bid for DTG to 40.75 in cash and .6543 shares of Avis shares for each DTG share. Based upon Friday’s Avis closing price of 10.41 the new bid price would be 47.56, still below the current DTG price. Hertz believes it is better fit and the options indicate further developments are likely. With a current Historical Volatility of 19.88 and an Implied Volatility Index Mean at 35.69 up from last week’s 34.65 for a IV/HV ratio of 1.80 placing it number 3 on our Top 5 list and with a very bullish put-call ratio of .15 we expect to see a higher bid coming from Hertz.


IV Change Suggestions

Here are numbers 3 and 4 in our Top 5 for increasing Implied Volatility on Friday. Since both have recently reported earnings and appear to have recently made double bottoms other factors could be at work to create the increased implied volatility and may be worthy of more investigation.  

Veeco Instruments Inc. (VECO) 36.55.

With a Historical Volatility of 74.25 and an Implied Volatility Index Mean at 64.65 up 7.37 or 12.86% on Friday with increased volume, the put-call ratio at .80 is marginally bearish.

LSI Corporation (LSI) 4.32.

The Historical Volatility is 62.56 reflecting the recent stock price decline and the Implied Volatility Index Mean is 45.18, up 3.31 or 7.90% on Friday on what can only be increased put buying as the put-call ratio is very bearish at 5 with the put open interest exceeding the call open interest by almost three times.  

The options prices mentioned above are based upon last Friday’s closing prices using the mid price between the bid and ask.



Supported by negative fundamental news the equity markets decline from August 9 abruptly ended last Wednesday in what could have been unwinding of long Treasury bond/short equity trades during the thin trading environment. Watch SPX 1125 for either the confirmation of the continuing trading range or the development of a new pattern.


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