« June 2012 »

IVolatility Trading Digest™

Volume 12, Issue 23
Flag at Half-Mast

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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From both fundamental and technical perspectives, last week's events were loaded with both doubt and anxiety causing the equity market to swoon while US Treasury interest rates declined to all time lows on safe haven flight capital flows. After a brief consolidation that appears to be a flag continuation pattern equities resumed their downtrend.

We have more on the flag pattern in our market review below along with all of our other indicators followed by a new contrarian idea for those who may think the bottom is near.


Market Review

Review Notes Clip ArtS&P 500 Index (SPX) 1278.04. After closing below our trigger point at 1357.38 on May 9 the decline to the Head & Shoulders Top minimum measuring objective at 1300 was straight down reaching 1291.95 on May 18. It then began forming a consolidation pattern that has the appearance of a classical flag pattern as it rebounded to form a rectangle bound by two parallel lines that slope against the prevailing downtrend. Since flags fly at half-mast, to determine the measuring objective, take distance from breakdown to the bottom of the flag, see A on the chart, or about 68 points and subtract it from the top of the flag to get 1244, marked as MO on the chart. Further supporting this view, Friday's high volume confirmed the breakdown out of the flag.  

In Digest Issue 21 we wrote, it is more likely to decline to 1200 where there 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.

E-mini S&P 500 Futures (ESM2) 1274.00. Based upon the preliminary open interest of 3.14 million contracts, that was up 82,079, the downtrend is still intact. However, since the preliminary open interest number is subject to substantial revision on Monday we remain somewhat cautious, although the volume was also high at 3.3 million contracts. Further uncertainty about the open interest count is added by the soon to expire June contract since open interest will increase as contracts start to be rolled into September.

S&P 500 Index Implied Volatility (IVXM). Since last week, the Implied Volatility Index Mean increased from 19.39 to 24.80, while the CBOE Volatility Index® (VIX) increased from 21.76 to 26.66.   

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 48% to June and 52% to July resulting in the average premium of 1.82 or 6.82% shown above. Our alternative volume weighting between June and July results in a 6.09% premium. Last week the day-weighted premium was 15.10% and the volume weighted was 15.35%.  

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 did appear to be a good way to measure professional hedging sentiment. On this decline, the VIX premium indicator has been has not been increasing as expected. Perhaps more hedging activity has shifted to SPX, SPY and the e-mini S&P 500 futures or 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 118.04 and 81.71 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 108.39 the IV/HV ratio is 1.13, using the range method for Historical Volatility the ratio is 1.33 while the VIX put-call ratio is a bullish .20 for the VIX, but bearish for the SPX since they move in opposite directions.  

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) 116.35. Designed to measure the purchase of out-of-the-money S&P 500 Index puts for downside protection, this index continues to act more like a contrarian indicator since it has been declining as the SPX has been declining.  

CurrencyShares Euro Trust (FXE) 123.55. A weaker euro and an equivalent stronger dollar are currently the most important variables reflecting "flight capital" out of the euro. By the end of last week, the euro was clearly oversold and is now due for a counter-trend bounce that could take the FXE back toward 125. Support for this conclusion comes from key reversal in the June futures contract shown in the chart to the right. A key reversal is a minor trend change indicator made when a contract makes a new low, then reverses and closes higher on increased volume. This implies a higher high the next trading session, but not necessarily a higher close. Unless there is more negative fundamental news from Europe early this week, chances are it will attempt to test 125 where is will likely find sellers once again.

NYSE McClellan Summation Index -507.30. In the past two weeks, the NYSE Composite breadth index, one of the most reliable early trend change indicators, continued declining, but at slightly slower rate, declining another 183.63 points compared to the decline of 419.33 that we reported in Digest Issue 21. As the market nears the bottom, we expect to see a divergence develop between this indicator and the market as defined by the NYSE Composite Index.

iShares Dow Jones Transportation Average Index (IYT) 88.34. After making an impressive counter-trend rally back up above 92, most likely due to declining crude oil prices, the transports succumbed to market selling pressure last Wednesday and turned lower once again closing just above the low at 87.01 made on May 18 leaving intact the well-defined Head & Shoulders Top with its minimum measuring objective of 85. This is the second indictor we expect will diverge from the major indexes as they near the bottom of this downtrend. Lower crude oil prices support this expectation.

SPDR Homebuilders (XHB) 19.54. The optimism we cautiously expressed in Digest Issue 21 is now gone as this the index for this group that had previously been demonstrating some relative strength, morphed into a Head & Shoulder Top pattern, with the Head at the May 2 high of 22.43, the neckline at 19.25 and with a minimum downside measuring objective at 16.57.  

iShares S&P GSCI Commodity-Indexed Trust (GSG) 29.32. As we noted in Digest Issue 21, energy heavy GSG was just .28 away from testing the low made last December at 31.11. Not only did it surpass this low, but it continued lower closing just .30 above the low make last October 4 at 29.02, which means the entire gain in commodity prices as reflected by this index has been reversed. While this is not good news for the oil and gas industry, it will help the consumer staple sector, since less money will be going into gasoline tanks. Eventually it will also help the transports.




Until we begin to see a sustained improvement in market breadth, we continue to suggest hedging and/or short positions. For now, the active pattern is a bear flag flying at half-mast implying the decline will continue to at least 1244, and perhaps lower.

In the meanwhile, we realize there are still opportunities available for those who are prepared to take the risk. As for bear markets here is a quote worth mulling over.

"For those properly prepared in advance, a bear market in stocks is not a calamity but  an opportunity." John Templeton


Strange as it Seems

This is our contrarian idea section, and here is one from our complementary Top 5 ranker scan that presented as a regular feature in the "Rankers and Scanner" section of our home page. On Friday, this one ranked number three in the high IV/HV ratio scan at 2.00. High IV/HV ratios are the first alert that something unusual is happening as the options prices are being bid up to abnormal levels.

InterOil Corp. (IOC) 66.21. IOC is an integrated oil and gas company in Papua New Guinea, engaged in the exploration, and development of crude oil and natural gas. It has three onshore exploration licenses covering approximately 3.9 million acres in the Eastern Papuan Basin, northwest of Port Moresby, Papua New Guinea. The company also engages in the refining, and retailing petroleum products. In addition, they are attempting to build an LNG export terminal.

With the recent confirmation of a large gas discovery along with a better than expected earnings report on May 14, the stock has since gained 12.48 points. News that the company is making deals with Korean and Japanese importers of LNG, currently priced around $18 per mcf compared to Friday's New York Mercantile Exchange closing price of $2.43 per mcf, is also supporting the stock price.

We have featured this one in past, most recently last December in Digest Issue 47 when we suggested an iron condor to take advantage of the then high IV/HV ratio when the Implied Volatility Index Mean was 133.19.  

The current Historical Volatility is 43.98 and 54.71 using the Parkinson's range method, with an Implied Volatility Index Mean of 87.91 down from 95.15 last week. The IV/HV ratio is 2.00 and 1.61 using the range method to calculate the HV. The put-call ratio is extremely bullish at .30 with Friday's volume of 16,404 contracts traded compared to the 5-day average volume of 25,480 contracts.

While there appears to be good support at 60 going back more than a year, it did trade as low as 34.05 last October 4 when the market declined, so there is certainly some risk along with the long-term fundamental opportunity.

Here are three put sale ideas with various degrees of risk depending upon the distance from to the current stock price.



Unless the plan is to take the stock by assignment in the event it closes below the strike prices shown above use a close below the support price of 60 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.


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The equity markets are responding to deteriorating fundamentals in the US as well as the continuing torrent of negative news from Greece and Spain creating speculation about what a breakup of the euro currency would mean for the global economy. US equity markets appear headed lower, perhaps as low as 1200 for the S&P 500 Index.


IVolatility.com Bookstore  In addition to the vast number of articles and other information on our web site, take a browse through our bookstore for more reference information and material.


Twitter Follow us on twitter for more ideas from our scanners and other developments.


In next week's issue, we will run our rankers and scanners looking for more interesting trading ideas.


Finding Previous Issues and Our Reader Response Request

All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. Another way to find them is the Table of Contents link in the blog section of our website.

Next week's issue As usual, we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like us to look at a specific stock, ETF or futures contract, let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com




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IVolatility Trading DigestTM Disclaimer
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".