« May 2012 »

IVolatility Trading Digest™

Volume 12, Issue 21
How low can it go?

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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By now, it should be clear to anyone paying attention that the equity markets are declining in response to deteriorating fundamental conditions in Europe. Money flows out of various risk asset classes into dollars and liquid dollar denominated Treasury securities are affecting global economic growth expectations as reflected by declining commodity and equity prices.

Since the equity trend is now undeniably down, we will attempt to set some guidelines to measure how low it should go as we review our market indicators followed by a hedging suggestion.


Market Review

Review Notes Clip ArtS&P 500 Index (SPX) 1295.22. On May 9, SPX closed at 1354.58, below the low set on April 10 at 1357.38, our previously identified trigger point, thereby confirming the Head & Shoulder Top with the April 2 high of 1422.38 and the minimum downside-measuring objective at 1300.

Since there appears to be little support at 1300 we are expecting the decline to continue to at least 1225 where there is some support, but more likely to 1200 where there is more support from both August - October 2011 and April 2010 as well as the long-term upward sloping trendline from the March 2009 low at 666.79. This means the entire 2012 advance will have been unwound, which we think it is quite likely.    

E-mini S&P 500 Futures (ESM2) 1290.75. One way to measure trend momentum is to watch open interest since it needs to keep expanding to sustain the move. On May 9 as SPX closed below 1354.58, the e-mini closed at 1351.00 with high volume of 2.53 million contracts and 2.89 million open interest. As of Thursday, the volume was again high at 2.91 million, as the open interest expanded to 2.97 million, an increase of 78,832 since May 9, thereby confirming the downtrend by this criterion. For a gauge as to when the trend may be changing watch for a sustained decline in the open interest indicating existing long liquidation to existing shorts who begin covering. Although there will be some confusion about the open interest numbers around the June contract rollover surge, a sustained decline in open interest could be the first indicator that the downtrend momentum is waning.   

S&P 500 Index Implied Volatility (IVXM). Since last week, the Implied Volatility Index Mean increased from 17.94 to 22.28, while the CBOE Volatility Index® (VIX) increased from 19.89 to 25.10.

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 88% to June and 12% to July resulting in the average premium of 3.09 or 12.33% shown above. Our alternative volume weighting between June and July results in a 12.88% premium. Last week the day-weighted premium was 7.84% and the volume weighted was 5.05%.  

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. On this decline, the VIX premium indicator has been failing miserably, especially since SPX closed below our trigger point on May 9. Perhaps more hedging activity has shifted to the SPX futures, where we see expanding open interest, or to the VIX options.   

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.

VIX Options

With a current 30-day Historical Volatility of 101.67 and 79.87 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 Friday'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 110.07 the IV/HV ratio is 1.08, using the range method for Historical Volatility the ratio is 1.38 while the VIX put-call ratio is .68.

This week there has been a noticeable change in the futures term structure with July, the deferred contract, selling at an unusual slight discount to the near term June contract. Perhaps simply an anomaly attributed to contacts rolling over from May to June that occurred Wednesday, but watch to see if it persists.     

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) 119.28. Along with our VIX futures premium indicator we are also putting this one in the less than useful category at least for the recent decline from May 9 when it was 115.05 at the bottom of the recent range. Since it measures the purchase of out-of-the-money S&P 500 Index puts for downside protection, perhaps it suggests greater enthusiasm for ATM SPX and SPY puts and greater confidence the decline will continue. In March while the SPX was still advancing it spiked as high as 139.25. Alternatively, perhaps it may be a useful as a contrarian indicator. 

CurrencyShares Euro Trust (FXE) 127.09. Our comment in Digest Issue 17 that FXE was not likely retest the January 126 low in the near future was wrong as it closed below previous support at 130 and then retested the January 126 low last Thursday at 126.20. A weaker euro and an equivalent stronger dollar are currently the most important variables representing "flight capital" out of the euro. Further, the US dollar has also been strong against both the Australian and Canadian dollars and is clearly detrimental for equities and commodities. One indicator to look at is the US Dollar trade weighted index, now at 81.29, having just retested the January 13 high of 81.78. This could be the most important variable to watch.  

NYSE McClellan Summation Index -323.67. As we cautioned in Digest Issue 17 breadth needed to start improving before the previous market uptrend could resume. However, breadth continued declining after a short, but unsustainable advance we optimistically noted in Digest Issue 18. Last week's decline of 419.33 points was the largest since last August 5 when it declined 447.07 to reach -620.99, a level that seems likely to be tested again soon.

iShares Dow Jones Transportation Average Index (IYT) 87.27. Although crude oil has recently declined, it has not helped the transports as they accelerated their decline on Thursday closing down 2.83 at 88.37 and below the neckline of a well defined Head & Shoulders Top with a minimum measuring objective of 85.

SPDR Homebuilders (XHB) 19.73. With the close at 22.43 on May 2, the homebuilders established a new and somewhat flatter upward sloping trendline from the October 4 low at 12.21, however with Thursday's decline of 1.09 it is now below the new trendline and below support at 20, which is not encouraging. Since this group has recently been demonstrating relative strength, watch for a quick rebound when the major indexes bottom. 

iShares S&P GSCI Commodity-Indexed Trust (GSG) 31.59. Since energy represents approximately 70% of the weighting, of which petroleum is the most significant component, any continuing decline in crude oil prices and GSG could retest the low made last December at 31.31, which is just .28 away. Interestingly Goldman Sachs reduced their commodity outlook to neutral on March 27 when it was 35.73, just as it closed below the upward sloping trendline from December's low.




Interrupted only a few times like the brief flash of optimism in Digest Issue 18 on a short-lived improvement in market breadth, we have been documenting the divergence between this important indicator and the NYSE Composite Index since Digest Issue 9 on February 27. The second important divergence occurred on April 2 as the SPX made a high of 1422.38, but was unconfirmed by the DJ Transportation Index, using IYT that only reached 93.66 after making a high of 96.13 on March 16. In combination, these two divergences were good early warning signs that were the basis for several hedging suggestions in subsequent Digest Issues. "Sell in May and go away" is clearly the current mood of the markets and until we begin to see a sustained improvement in market breadth, we continue to suggest hedging and/or short positions.

Hedging Suggestion

While the primary driving force for the market decline since early April has been the fundamental deterioration in Europe and the declining euro along with the associated decline in global growth expectations equities are probably better to use for hedging than the euro since it could stabilize on central bank support long before equities reach the bottom. Accordingly, here is another hedge suggestion to add to the crude oil suggestion made in Digest Issue 14 and adjusted in Digest Issue 20 last week.

Along with market breadth, the euro and the US dollar index, we also suggest watching 10-year Treasury note interest rates as any further decline from the current level of 1.70% will continue indicating global economic weakness and even the fear of currency devaluations in the euro zone.

SPDR S&P 500 Index (SPY) 129.74.

Since we made the case for a SPX decline to 1200 in the section above we will use this objective as the basis for our hedge position. However, because the decline is now obvious to most everyone in the market the stage could be set for short counter-trend rally so we suggest using a put spread instead of the put ratio backspread with the extra long put that could incur time decay in the event a rally occurs.   

The current Historical Volatility is 13.57 and 11.33 using the Parkinson's range method, with an Implied Volatility Index Mean of 22.22, up from 17.83 last week. The IV/HV ratio is 1.64 and 1.96 using the range method to calculate the HV. Friday's put-call ratio was bearish at 1.95, in the upper portion of 1.5 - 2.5 range since January where occasional spikes above 2.5 are quick and infrequent. Friday's volume was 4,896,765 contracts traded compared to the 5-day average volume of 3,537,270 contracts.

Here is a put spread to consider for this plan.



With a decent volatility edge and slightly long vega of .0315 with enough time to expiration to allow for a possible counter trend rally this spread has a good risk reward ratio of almost 3 since the risk is 1.30 and the maximum gain is 3.70.

Use a close back above 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.


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With last week's decline, the equity market could be oversold and due for short-term bounce, but depending upon actions taken to stabilize Europe, the evidence suggests there is more downside yet to come.  


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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".