« February 2013 »

IVolatility Trading Digest™

Volume 13, Issue 7
When the Tide Turns

January Barometer 2013 - 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).


When the Tide TurnsLike a broken clock that is right twice a day those who have been calling this market overextended and due for a correction will eventually be right. The tide will turn the question is when.

In this issue we look at our indicators and conclude a corrective retest of the breakout is about to begin and those who have been warning are about to be proven correct. We then offer an iShares Russell 2000 Index (IWM) conditional hedge idea for the occasion. We begin with our market review.



Review Notes Clip ArtS&P 500 Index (SPX) 1519.79. The current uptrend, measured from the November 16 low at 1343.35, with the December 31 reversal low of 1398.11 making the second trendline point, continues higher as noted in Digest Issue 4. However, like one of the new electric cars, the batteries are running low so the momentum is waning. Last week, as the trading ranges narrowed the volume declined dramatically until Friday when it accelerated on a down day. While options expiration could explain the volume increase, it is just as likely bidders lost interest at the higher prices.

S&P 500 Index Implied Volatility (IVXM). Since our last review, the Implied Volatility Index Mean declined from 10.50 to 10.28, returning toward the noteworthy low of 10.20 made on January 24, while the CBOE Volatility Index® (VIX) declined from 12.90 to 12.46.

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 88% to March and 12% to April for an average premium of 17.45% shown above. Our alternative volume weighting between March and April is 19.42%. Compared to our last review the premiums are up again, but still under the 20% where they suggest extensive professional hedging and foretold price declines in the past. Some argue higher premiums are contrary indicators, but we are not sure at what level they become reliable.

iPath S&P 500 VIX Short Term Futures ETN (VXX) 21.97. The five-day average volume was 31.54 million shares without a noticeable increase Friday as it declined .19 points.

VelocityShares Daily Inverse VIX Short Term ETN (XIV) 23.12. The 5-day average volume for the inverse was 10.38 million shares along with a .18 increase Friday.

When the term structure is in contango, or it slopes upward over time, the advantage goes to a long XIV position since it represents a short futures position and VXX continuously sells the near term contract and buys the next longer term contract at a higher price. The spread between March and April is -1.12 compared to the week before when it was -1.21 and -1.09 in our last market review.

VIX Options

With a current 30-day Historical Volatility of 69.03 and 50.13 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.



Using the IV Index Mean of 56.64, again near the 52-week low of 54.23 made January 18, the IV/HV ratio is .82, using the range method for Historical Volatility the ratio is 1.13. The VIX put-call ratio at .35 is bullish for VIX, but not for the SPX with a put-call ratio of 2.05, up .45 for the week, since they move in opposite directions. Friday's options volume was 428,197 contracts compared to the 5-day average of 550,780.

The equity only put-call ratio was .59 making the spread between the SPX put-call ratio and the VIX put-call ratio .24. As the SPX put-call ratio increases it becomes more bearish while the VIX put-call ratio is more bearish (for the SPX) as the ratio declines making the spread between them wider.

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) 130.46. We are returning SKEW to the lineup again as it 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 a greater expectation for an extreme down move. Now near the upper end of the 114-130 range it confirms increased interest in OTM put buying. The last close above 130 was September 21, 2012 about two weeks before the market decline that ended in the middle of November 2012. Although it lacks timing precision, SKEW seems to be sending a cautionary signal.

iShares Barclays 7-10 Year Treasury (IEF) 106.04. IEF is right on support at 106 with interest rates at 2.00%. The next important support to watch (resistance for 10-year rates) is the March 19 low at 101.83 or 2.39%

US Dollar Index (DX) 80.58. The dollar index is just above the 80.08 midpoint of its 5-year range between the March 17, 2008 low at 70.70 and the March 9, 2009 high of 89.46. On any further decline, watch the 74 level where it found support from April to September 2011. For now, the short-term trend is higher undermining support for equities.

iShares Dow Jones Transportation Average Index (IYT) 105.77. Advancing in a narrow channel without any sign of hesitation, if there is a fearless flyer, it is the transports. In addition to being an important Dow Theory confirming indicator, they deserve close attention as a leading indicator as they continue trending higher having surpassed the previous high of 101.60 that defined the 10-year trading range from the March 2009 low at 38.28. While the transports imply the equity uptrend will likely continue, they are still vulnerable to a market correction.

NYSE McClellan Summation Index 1048.95. Confirming the loss of momentum noted above in the SPX volume, the market breadth indictor declined 34.25 points since our last market review two weeks ago. On February 10, 2012, this index was 1325.47 when the SPX was 1342.64 or 177.15 points lower. Ideally, the market breadth should confirm the major indexes highs and since it has been a reliable precursor of corrections in the past, the divergence is a concern.



StrategyIn Digest Issue 5, we wrote, "Although the market appears extended until an unbalancing force triggers a correction it should keep trending higher." Now with the chatter beginning about the US Government spending sequester, due on March 1 we think the balance is tipping in favor of a more cautious stance since the unbalancing force could be set in motion with the sequester that some political pundits think is now very likely.

As for volatility, both implied volatility and historical, we know from experience they revert to their means and both are now well below their mean values. Therefore, when the correction gets underway volatility will increase so think in terms of option strategies that benefit from increasing volatility such as put ratio backspreads with more long options than short or long straddles and strangles. Since the VIX implied and historical volatilities are also quite low, a long VIX call is another alternative. However, keep in mind, counter-trend trades need close attention since the corrections are usually brief.


Correction Hedge

With the preface that previous counter-trend hedge trades suggested since November have not been necessary and reduced portfolio returns, here is a contingent April put spread to consider in the event the correction is about to begin.

iShares Russell 2000 Index (IWM) 91.74.

We begin with the option data.

The current Historical Volatility is 8.60 and 7.99 using the Parkinson's range method, with an Implied Volatility Index Mean of 13.63, down from 14.40 last week. The IV/HV ratio is 1.59 and 1.71 using the range method to calculate the HV. The put-call ratio is bearish at 2.0, but it is a hedging favorite so high ratios are normal, in fact, 2.0 is in the lower part of the range. Friday's volume was 812,233 contracts traded compared to the 5-day average volume of 596,730.

On the correction, as volatility increases, we estimate the implied volatility could return the 20 area.



With decent volatility edge and enough time to expiration, the cost is 25% of the distance between the strike prices giving a risk to reward ratio of almost 3 to 1. However, this is a contingent suggestion deferred until IWM closes with a lower high and lower low, which it has not done since February 4.

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


The powerful IVolatility Advanced Ranker

Just $19.95 per month

E-mail Support@IVolatility.com for a free two-week trial.



Increasing talk about a US Government spending sequester along with declining momentum suggests a correction from the breakout above 1460 on the S&P 500 Index that according to some market commentary is long overdue, could be triggered by extensive media coverage of the sequester.


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 return to our ranker and scanner tools to find more interesting trade 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.




Comments are closed for this entry.

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".