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Today


IVolatility Trading Digest™


Volume 10, Issue 5
Sovereign Default Risk

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Sovereign Default Risk

While there are no prizes for correctly guessing the theme of this week’s Digest, questions remain to be answered. Are equities experiencing a bull market correction? Perhaps it is the first leg down in a new bear market or maybe just a modest decline to a trading range bottom. In this Digest, we offer some observations and suggestions relating to Sovereign Risk and the market decline. We begin with our Market Review.

Market Review

S&P 500 Index (SPX) 1066.19. Since SPX did not hold the 1080 support level suggested in our last Market Review we would have expected it to test the previous minor low of 1029.38 made on November 2, 2009, however, since Friday was a Key Reversal we are now expecting a short- tem rebound back up to overhead resistance at 1071.59 made on January 29, 2010. If equities are in the process of making a topping formation from the 1150.23 high made on January 19, 2010 then we could expect to see the oversold rebound return up into the 1120 area and begin forming the Right Shoulder of a Head & Shoulder Top. We have more details of this possible formation in a Strategy section chart below

E-mini S&P 500 Future (ESHO) 1059.75. The March E-mini futures contract did not make a Key Reversal on Friday so it did not confirm the Key Reversal in the cash market. It has been confirming the market weakness with high volume and increasing open interest on down days. If an oversold rebound in the SPX cash is to have the support of the futures then we should expect to see confirmation by short covering and declining open interest on Friday when the numbers are released Monday morning. Thursday’s open interest was 2.75 million, so a decline of 50K or more would indicate Friday short covering.

S&P 500 Index Implied Volatility (IVXM). Since the last Market Review, our Implied Volatility Index Mean has increased 1.35 to 23.06. For the two week period the VIX was higher 1.38 points ending the week at 26.11 after reaching 29.22 on Friday before reversing as the SPX turned higher making a Key Reversal.

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

The discount to cash is a buy signal and the second in the past three weeks, while last week was a small 1.1% premium. Based upon this, the market is oversold and due to rebound confirming the SPX cash Key Reversal.

With a current Historical Volatility of 115.03, the next table shows the adjusted Implied Volatility (IV) of the at-the-money (26) VIX calls and puts based upon the Friday closing mid prices for the options and the respective month’s futures prices.

IV

US Dollar Index (DX) 80.44. The two-week DX rise of 2.16 points reflects risk aversion as asset classes inversely correlated to the dollar declined. The real dollar driver has been the declining Euro. From the high of 151.27 on November 25, 2009, it has declined to close down at 136.40 on Friday, or 9.83%. The Euro, like equities appears to be oversold and due for a retracement back up toward 138-140. The Euro story is all about Sovereign Default Risk and the PIGS - Portugal, Italy, Greece and Spain - who all have public sector debt above, or headed for 100% of GDP.

iShares Barclays 20+ Year Treasury Bond (TLT) 91.98. Now trending upward again, the current rise in TLT is related to risk reduction in all the asset classes that have been moving higher against the declining dollar. As risk assets are sold, the proceeds are used to dollar denominated US Treasury securities including the long- dated bonds as reflected by TLT.

NYSE McClellan Summation Index 299.45. The decline in our early warning indicator was another 631.40 points during the past two weeks. The trend of this indicator is clearly downward with no indication that the bottom is near. While this trend is down, we are changing the color of our warning flag. warning flag  

 Investors Intelligence reports a bullish reading at 38.9 while the bearish count is 22.2 for a positive 16.7 spread. For a comparison the reading on March 11, 2009 was 26.4 bullish and 47.2 bearish, a negative spread of 20.8. Based upon this, the current decline has yet to reach a bottom.

Baltic Capesize Index (BCI) 3474. For the past two weeks, our preferred Baltic dry-bulk shipping rate index for the larger ships declined 687 points or 16.5% with no indication of recovery in sight. The Capital Link Tanker Index declined 204.61 points or 8.8% to 2132.17. Weakness in both sectors is reason to continue flying the caution flag. caution flag


Strategy

Why are the markets spooked about sovereign default risk?

One concerning issue relates to the collateral for sovereign loans and bonds portfolios since big banks typically treat contracts with western sovereign entities differently than those of private companies. Most western countries carry triple A credit ratings and the banks usually do not establish reserves since such debt is deemed “zero-risk weighted”, in bank regulatory rules. Now, however, the bankers are starting to get uneasy and concerned about a default. One default could mean they will have to start making reserves for more sovereign debt and it could mean another hit to the bank’s balance sheets and income statements.

More S&P 500 Index

SPX, the Euro and other risk assets appear to be oversold and due for a rebound. On Friday, SPX made a Key Reversal, meaning it can be expected to make a higher high on Monday. In addition, as the SPX was making a Key Reversal the VIX reversed and declined from a high of 29.22. Previously these spikes and reversals have been buying signals. Further, the VIX futures are selling at a discount to the cash, another previously good buying signal. For the near term, the odds favor a rebound for SPX. For the medium term, consider this potential topping pattern.

S&P 500 Index Cash 2-5-10

Watch the overhead resistance at 1071.59 if it can continue above this level, then it could attempt to reach the 1120 area and potentially form the right shoulder of a Head & Shoulder Top. See the area marked red above. Then a retreat from this level to below the upward sloping neckline will set off the pattern with a downside-measuring objective at 934 (not shown). In the event it continues above 1120, reaching a new high, the pattern will be negated. In the current sovereign default risk environment, we assign a 70% probability that it will turn down from 1120 (or lower) and only a 30% chance it will continue higher.

For the short-term rebound, several ETFs should perform well including:

SPDRs (SPY) 106.66

iShares Russell 2000 Index (IWM) 59.27

iShares MSCI Emerging Markets Index (EEM) 37.20

iShares FTSE/Xinhua China 25 Index (FXI) 37.57

CurrencyShares Euro Trust (FXE) 136.40

All of the above have good options volume and open interest which means reasonable bid – ask spreads and the ability to use spread orders.

We suggest using March call spreads and perhaps call ratio backspreads.

If the SPX rebound continues, back above overhead resistance at 1071.59 we suggest unwinding other long positions until we are near delta neutral at the 1120 area. Then if it turns lower, we suggest new shorts. If it continues higher, we suggest waiting for a new high close above 1150.23 is in place before establishing new longs.

In addition, we suggest focusing upon FXI as a leading indicator as it turned higher sooner than the SPX in the spring of last year and turned lower in November 2009 well before the SPX high of 1150.23 in January.

Summary

Expect a near term rebound from oversold conditions in SPX, the Euro, emerging markets and commodities. Use the rebound to reduce exposure in these sectors. Then watch for the next leg down in these markets.


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In next week’s issue, we will review the status of the potential Head & Shoulder Top and offer specific new trading suggestions.

Previous Issues and Reader Response Request

Finding Previous Issues and Our Reader Response Reques

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