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Today


IVolatility Trading Digest™


Volume 13, Issue 43
Running Out of Gas

Running Out of Gas - IVolatility Trading Digest

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

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).

 

Running Out of GasNow that Washington has been temporarily removed from the worry list the equity market refocused on earnings reports selling on some better than expected announcements as well as the disappointments.

The loss of upward momentum suggests equities are running out of gas - increasing the likelihood that last week's decline could well extend to 3% as previously suggested. We have more below followed by or regular biweekly indicator review and a trade idea for the widely followed Facebook Inc. (FB).

 

Review Notes Clip ArtS&P 500 Index (SPX) 1761.64. After reaching 1775.22 last Wednesday, it made a Key Reversal down on unconvincing volume. Nevertheless, it went on to fulfill the objective of a lower next day low on Thursday followed by another lower low and lower high Friday. If this is the beginning a 3% correction, as we suspect, then expect to see it test support at 1725 over the next two weeks as 3Q earnings reports begin winding down.

CBOE Volatility Index® (VIX) 13.28. The VIX has return to the lower part of its recent range signaling "all clear" to those relying exclusively on this one indicator.

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 Closing Cash

 

The day weighting applies 48% to November and 52% to December for an average premium of 13.31% shown above. Our alternative volume-weighted average between November and December, regularly found in the Options Data Analysis section on our homepage, is slightly lower at 12.76%. Both premium measures are in the normal range between 10-15% relative to the cash VIX, confirming the sanguine market outlook.

VIX Options

With a current 30-day Historical Volatility of 127.08 and 78.64 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 tradable futures.

 

 

Since our last review in Digest Issue 41 "Washington Reprieve" the open interest has increased from 6.1 million contracts to 7.3 million as more options are being used for both direction and hedging activity.

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.

US Dollar Index (DX) 80.72. The reversal up from the low of 78.99 on Friday October 25 was last week's notable standout among our indicators advancing every day to end just above the downward sloping trendline from the July 8 high of 84.75. The advance pushed commodities down across the board with the exception of copper. Most noteworthy was the decline in crude oil prices. There is a case supporting the view that crude oil prices are lower due to seasonal weakness and increased US production, boosting the dollar, which in turn turned other commodities lower. While we are not quite ready to declare the dollar downtrend has ended another few days advance will certainly do it.

10-Year Treasury Notes (TNX) now yield 2.62% after reaching as high as 2.98% before the August employment report on September 6. Our operative upward sloping trendline begins at the low of 1.62% made on May 3, touching the August 12 low at 2.60%. For now, the trend remains lower, and while we thought support around 2.65% would hold, the decline continued down to 2.50% before turning higher. Like to US Dollar Index above, it is now challenging the current downward sloping trendline. A few basis points higher and the current downtrend will end.

Keep in mind there is an employment report Friday that will likely affect both interest rates and the dollar.

iShares Dow Jones Transportation Average Index (IYT) 125.92. Dow Theory followers are no doubt encouraged by the continuing advance in the transports that should now be reflecting lower crude oil prices. Although economic activity seems to be softening according to the decline in the Conference Board Consumer Confidence Index to 71.2 as well as the slowing growth rate of ECRI's Weekly Leading Index (WLI) of the US economy now at 1.7% down from 4.9% in early August the transports continue to show relative strength.

NYSE McClellan Summation Index 570.08. Since our last update in Digest Issue 41 "Washington Reprieve", our market breadth indicator gained 312.43 points, but only 56.36 last week as momentum slowed after Wednesday's Key Reversal down in what could be the start of a 3% correction.

CBOE S&P 500 Skew Index (SKEW) 129.84. SKEW measures the purchase of out-of-the-money S&P 500 Index puts that require a very large downside move to profit from long put positions. An increase of this index indicates greater expectations for an extreme down move.

In Digest Issue 41 "Washington Reprieve", we noted the unusual rise of this index to 131.35 and suggested it could have some value as a contrary indicator when at extremes. The next week it increased to 135.06. Now since SKEW declined somewhat as the S&P 500 Index turned lower last Wednesday out-of-the-money put buyers have slightly reduced their positions, however it remains well above 125 indicating OTM put buyers still expect a further decline.

 

Although we think the current decline could continue to support about 1725, we continue suggesting relative strength stocks such as those in Digest Issue 38 "Options Relative Strength Top 15", since it could end sooner on any favorable news, despite the looming employment report Friday. Since any further decline should be relatively shallow and limited to about 3%, any attempts to hedge or close positions, will likely be costly in terms of commissions and bid/ask spreads when the time comes to get back in. The better strategy is to remain long while extending any long November option expirations out to December in the event the correction lasts a bit longer. When completed as defined by the S&P 500 Index closing back above the October 30 high of 1775.22 chances are good the market advance will continue into year-end.

Relative Strength

Last week we observed several stocks advancing into their 3Q reporting date and then selling off on, or in some cases before, the release despite better than expected earnings including some on our Options Relative Strength Top 15 list in Digest Issue 38 like Facebook, Inc. (FB) 49.75.

After reporting earnings and revenues better than expected as well as an impressive advance in mobile ad revenue last Wednesday, the stock traded up in the afterhours market about 8 points. It then gave the gain back before opening lower the next day, trading in a 5.5-point range to close up 1.20 on 248.8 million shares, second only to 365.9 million shares traded after the 2Q report on July 25 when it gapped up 7.03 on the open. Was this a case selling on the good news or are there real fundamental concerns? Based upon others that sold off after reporting we think the most likely answer was selling on the news.

Friday's close was right on our upward sloping trendline (USTL) from the July 25 breakaway gap that touches the October 9 low at 45.26. Now what to expect?

Presuming the market correction continues FB could also trade lower eventually testing support at 45. However, we then expect it will return to close above the operative USTL defined above.

Many may want to wait and see how it goes, while others may want the use the weakness to establish new long positions in anticipation of further advances. For those confident the advance will continue sooner rather than later here is one long idea to consider.

First the options data,

The current Historical Volatility is 38.76 and 37.31 using the Parkinson's range method, with an Implied Volatility Index Mean of 41.27 down from 71.21 last week and a whopping 77.29 on October 22, with an IV/HV ratio of 1.06 and 1.11 using the range method for historical volatility. Friday's put-call ratio was a bullish .51, not having reached the .7, the bearish line in the last month. The volume was 614,170 contracts traded compared to the 5-day average volume of a massive 906,490 contracts.

 

 

Without implied volatility edge, it has a favorable risk to reward ratio of 1 to 2, risking 1.66 to make 3.34 since the width of the spread is 5 points and it cost 1.66. In the meanwhile, the short call provides a partial hedge against time decay and implied volatility changes. Use a close back below the 45.26 support as the SU (stop/unwind).

The suggestion above uses the Friday closing middle prices between the bid and ask. Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.

 

 

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Summary

Last week's decline along with selected selling on earnings reports suggest a bit more downside for equities as upside momentum wanes. However, any minor correction could be a buying opportunity setting the stage for year-end positioning.

 

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

 

In next week's issue, we will update our Options Relative Strength list.

 

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".