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While much of the financial world was anxiously awaiting word on the German Bundestag vote last Thursday, news began appearing about a slowdown in the Chinese property development sector and that the authorities thought cutting off credit to poorly managed developers was desirable as they were intending to encourage consolidation in the sector. More below.   In this Digest Issue, we update our market indicators and offer a VIX arbitrage idea along with a copper hedge just in case we have not yet seen the bottom in commodities.
Market Review S&P 500 Index (SPX) 1131.42. Having made eight reversals since the decline to 1101.54 on August 9, we must acknowledge that the operative technical pattern is a trading range between the low at 1101.54 and the high made on August 31 at 1230.71. Further, we conclude that until some new fundamental information is received, positive or negative, the SPX is likely to remain rangebound.   E-mini S&P 500 Futures (ESZ1) 1126.00. Based upon the preliminary CME report, Friday's volume at just fewer than 3 million contracts, while on the high side it is not comparable in volume to the recent reversals, such as August 9 with 6.3 million, September 12 at 4.8 million, or September 23 with 3.4 million contracts. For a reversal, we would expect to see volume in excess of 3 million and closer to 3.5 million.  S&P 500 Index Implied Volatility (IVXM). Since our last market review, the Implied Volatility Index Mean increased from 27.29 to 38.42, while the CBOE Volatility Index® (VIX) increased from 30.98 to 42.96. 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 applied 60% to the October contract and 40% to November resulting in the average discount of -2.57 or -5.98% shown above. For this short-term indicator the discount to the cash is a SPX buy signal suggesting professional expectations for the cash to decline toward the futures price. Last week it was similar at -6.38% compared to a premium to the cash of 2.86 in our last Digest based upon the closing prices on September 16. Here is a chart showing the recent S&P 500 Index reversals along with the premium and discounts computed on the closest Friday to the reversals.
Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium or discount is always available.     VIX Options With a current 30-day Historical Volatility of 119.24 and 100.70 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 since the options are priced from the futures.
Using the IV Index Mean of 106.29, the IV/HV ratio is .89, using the range method for Historical Volatility the ratio is 1.06. The VIX put-call ratio is .90. The difference between the October and November of 4.40 could make an interesting trade and we have an idea below.    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) 114.83. 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) 78.55. Based upon the recent inverse correlations with both equities and commodities the continuing rise of the dollar against multiple currencies appears to be the single most challenge for the equity market in the fourth quarter. As many have commented the rising dollar is being driven by a "risk-off" safe haven reallocation out of the emerging markets.    iShares Barclays 7-10 Year Treasury (IEF) 105.07. The 10-year note, with a yield of 1.92 % broke the upward slopping trend after trading up as high as 106.66 on September 22 for a yield of 1.69%. It has now reversed and is back up and just under the upward sloping trendline. iShares Barclays 20+ Year Treasury Bond (TLT) 120.86. The long end of the Treasury bond market has already done the work of "operation twist", as the long interest rates closed at 2.92% having been as low as 2.75% on September 23. TLT is still above its well-defined upward sloping trendline and rising once again after a brief correction.  NYSE McClellan Summation Index -340.26. Since our last market review, this NYSE breadth measure lost 135.04 points as this broad market breadth indictor deteriorated with the market decline. iShares Dow Jones Transportation Average Index (IYT) 75.24. In our last market review, the transports were in the same pattern as the other major indexes and near the upper end of range where it was prudent to hedge. That was a timely observation and now IYT is at the lower end of the range where it is prudent to hedge once again, this time for a possible breakdown below support now located at just under 75. iShares S&P GSCI Commodity-Indexed Trust (GSG) 30.19. Our last market review included a GSG chart showing it was up against resistance and we concluded it would probably turn lower. A noteworthy decline came with the breakdown in copper on September 19 that has since been explained by declining activity in the Chinese property sector. As a hedge in the event of a further decline, we offer a copper trade idea below.
Strategy After the successful vote on the European Financial Stability Facility or EFSF by the German Bundestag on Thursday, the markets hardly noticed as attention shifted once again to Greece and the realization that nothing further is likely to be agreed before the G20 summit meeting in Cannes on November 3-4. As for copper, after breaking support at 3.80 on September 19 it quickly declined to 3.07 on September 26. We think this decline is related to the increasing dollar seeking a safe haven and confirmed news that China is in the process of deflating its property market bubble. As long as the bubble had been denied there was some doubt the that monetary measures would continue to be applied, but that changed on Friday as Chinese authorities said they were pleased with their progress in slowing the expensive segment of the housing market and had no intention to stop until there was consolidation the building sector. Reports of half built expensive housing projects now ringing every city would seem to account for the weakness in copper and the materials sector. With considerable commentary on Friday about the historical market record of the fourth quarter after a weak third quarter, along with earnings reports that will be starting with Alcoa next Tuesday, we think it is likely to see an oversold bounce in the next few days, perhaps after retesting 1101.54 on the S&P 500 Index. Our VIX day-weighted measure supports this possibility since it is back in negative territory again as shown in the chart above.    In the meanwhile, as a hedge, we have a copper put spread idea below, but first here is a VIX calendar spread to consider. CBOE Volatility Index® (VIX) 42.96. With a noticeable spread of 4.40 between the October and November futures contracts, consider this calendar spread idea.
The spread has a good volatility edge. The last trade date for the October option is October 18 when the October futures contact will come in line with the VIX cash and the wide spread between the October and November will most likely be diminished. Freeport-McMoRan Copper & Gold Inc. (FCX) 30.45. We last suggested a long call spread with a short put combination in Digest Issue 33. The trade plan called for closing the position on a close below 41.46 and this occurred on September 19 when FCX closed at 40.22 down 1.37 for the day. Since the position was originally booked at a credit of .23 and the put buy back was booked at 3.45 this position lost 3.22. Now we suggest using FCX with its high stock and options trading volume for a copper hedging strategy in the event it does not hold the current 30 level. The current Historical Volatility is 55.82 and 47.62 using the Parkinson's range method, with an Implied Volatility Index Mean of 79.50, up from 73.68 last week. The put-call ratio at .80 is bearish. Friday's option volume was 102,238 contracts compared to the 5-day average of 116,490 contracts.
At 30% of the distance between the strike prices, this is a reasonably priced spread with a decent volatility edge. Use a close back above the previous pivot at 36.24 as the SU (stop/unwind). The suggestions above are 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.   Become a better trader Read Expiring Monthly Subscribe now!   Summary While equities appear oversold at the third quarter end and could see a relief bounce in the next few days we suggest some hedging in the event the decline continues, especially in the commodity sector.

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