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Today


IVolatility Trading Digest™


Volume 10, Issue 46
Divergence Warning

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

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Divergence Warning

With a least two important divergences working in the equity market we are going to take a further look to see what these cautionary signals may foretell going into the last month of the year. Then we offer a gold hedging strategy. We begin with a review of our market indicators.

 

Market Review

S&P 500 Index (SPX) 1189.40. After correcting the November 4-upside breakout SPX traded down to 1173 and then began what appears to be right triangle consolidation pattern. If so, we would expect it to complete this continuation pattern by continuing lower adding further support to the potential double top formation from the April 26 high at 1219.80. Further, while the shoulders are not well defined there could also be a new developing Head & Shoulders Top with the November 5 high of 1227.08. 

As we mentioned in Digest Issue 45 last week caution was still justified due to the lagging advance-decline line and the resulting divergence. Since the advance-decline line as measured by the NYSE Summation Index continued lower last week, the current condition has further deteriorated. 

E-mini S&P 500 Futures (ESZ0) 1183.25. The volume was low or moderate all week and open interest has remained at about the same level for the last three weeks. If increasing open interest is required to support the current trend then the uptrend that began from the August 31 low of 1032.75 is in further doubt since open interest is not expanding.

S&P 500 Index Implied Volatility (IVXM). Since our last review two weeks ago, the Implied Volatility Index Mean increased from 18.01 to 19.17, while the VIX increased from 20.61 to 22.22.  

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 16.65%, compared to 7.04% in our market review two weeks ago. Now the premium to cash is at the lowest level since April 30 and the previous market high. As the market declined through May, the weighted average was negative for five weeks as the cash was bid up above the futures. Based upon the current technical outlook it will be interesting to see if the discount returns with the expected market decline.

VIX Options

With a current Historical Volatility of 98.83, 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 low IV/HV ratio of .89 indicates the movement of the underlying VIX is exceeding the implied volatility of the options.

VXX Options

iPath S&P 500 VIX Short-Term Futures ETN (VXX) 45.76. 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 59.38 up from 50.12 in our last review, while the 30-day Historical Volatility is 54.09 up from 47.87 in the last review two weeks ago. The IV/HV ratio is 1.20 creating a positive volatility spread.

 

iPath S&P 500 VIX Short-Term Futures ETN

 

The Implied Volatility Index Mean is 66.04 with the calls at 64.25 and the puts at 65.84 skewed to the puts. The put-call ratio is 1.30, normally a bearish reading, but in this case, it is bullish for the SPX since put buyers are expecting VXX to decline with a rising SPX. Alternatively, put buyers could be working the contango roll loss from the December futures contract to the January contract.

US Dollar Index (DX) 80.36. The dramatic change in the currency market occurred last Tuesday November 23 when DX closed up almost a full point and then continued higher for the balance of the week closing above the well-established 80-resistance level. According to the financial media, the boost was attributed to the ongoing debt problems in the euro area and renewed tensions in Korea creating another "risk off" rush to the exits for equities and commodities.

CurrencyShares Euro Trust (FXE) 131.98. If "risk off" means a higher dollar then it also means a lower euro. Apparently, euro bondholders were rushing to sell positions on renewed default risk concerns, converting bond sale proceeds into dollars driving the euro lower and pushing up the dollar. The euro ended the week below the 132.50 support level.

iShares Barclays 20+ Year Treasury Bond (TLT) 97.07. If the recent decline in long bonds, that ended last week, was from the selling Treasuries and investing the proceeds in "risk on" assets, including equities, commodities and precious metals, then it all ended last week as "risk off" returned once again. Now the focus shifted from QE2 to Eurobond risk and renewed tensions in Korea, as the long bond yields declined from 4.26% to 4.20%.  

NYSE McClellan Summation Index 501.71. Since our last review, the NYSE Composite Index breadth indicator decreased 366.94 points. 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 indicating equities were being sold into the breakout or focus shifted to fewer larger names with greater liquidity. Breadth divergence is one of the most reliable early warning signals of a trend change.

iShares Dow Jones Transportation Average Index (IYT) 88.34. Up 1.41 since our last review, IYT is showing relative strength that will be hard to maintain if SPX breaks down below the consolidation pattern and continues lower. So far, it is holding up well and not yet confirming the decline.

Ben Delivered QE2

 

 

Continuing fundamental issues in Europe have taken their toll on the "risk on" trades. As mentioned in Digest Issue 44 gold broke the upward sloping trendline closing at 1329 on November 16 before turning higher and then retreating once again to form a well defined Head & Shoulders Top pattern that would be set off on a close below the neckline at about 1335. If so, the downside-measuring objective for gold is back down to 1238.

In addition to gold, potential Head & Shoulders Tops can be seen in Copper, the iShares MSCI Emerging Markets Index (EEM), iShares FTSE/Xinhua China 25 Index (FXI) and numerous "risk on" individual stocks.

Due to the recent developments in the markets, especially the divergences in two important indicators and the potential Head & Shoulders Tops in many indexes and ETFs we suggest reducing long positions, and or hedging strategies be implemented with the expectation that equities, commodities and precious metals likely continue lower for the near term. More on the divergence issue follows.

 

Divergence Warning

Returning to the divergence issue, we noted in Digest Issue 44 a breadth divergence was created when the McClellan Summation Index turned lower while the NYSE Composite and the S&P 500 Index broke out to new highs on November 5. 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.

Divergences exist when an index makes a new high (or low) but the oscillator does not. This is often seen ahead of short-term changes in trend. Below is an example of a divergence and a bearish failure swing.

 

Divergence Warning

 

Fitting the current SPX divergence into the illustration above, the 9 week RSI Indicator was 79.12 on April 23 and was not taken out by the Nov 5 reading of 76.74. The closing price on November 5 at 1225.85 was higher than the April 23 close at 1217.28 creating the bearish failure swing.  

 

IVOLopps™

Gold Hedge

Since gold prices often make large down moves here is one suggestion for hedging long gold and other precious metals that follow gold prices.

SPDR Gold Shares (GLD) 133.11.

The current Historical Volatility is 20.90 with an Implied Volatility Index Mean at 18.32 with the calls at 17.38 and the puts at 19.26, skewed to the puts. The IV/HV ratio is .88 and the put-call ratio is moderately bearish at .85. Consider this January bear put spread with enough time to expiration to cover the seasonal December high.

 

SPDR Gold Shares

 

Use a close back up above the left and right shoulders of the Head & Shoulders Top at 135 as the SU (stop/unwind).

The suggestion above is 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.

 

Summary

The combination of bearish diversions along with potential Head & Shoulders Top patterns in many "risk on" categories suggests equities, materials and commodities have either changed or are changing trend and most likely heading lower. 

 

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Divergence Warning

 

Finding Previous Issues and Our Reader Response Request

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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".