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Today


IVolatility Trading Digest™


Volume 19 Issue 17
3 Caution Signs [Charts]

3 Caution Signs [Charts] - IVolatility Trading Digest™

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As popularized at mid-20th century fairgrounds, "Close, but no cigar" characterizes last week's S&P 500 Index action, since in really technical terms, in order to get the bulls excited it needed to close above the September 21 intraday high of 2940.91, not just above the previous closing high.

Review NotesS&P 500 Index (SPX) 2939.88 added 34.85 or +1.20% last week making a closing high on Tuesday and then again on Friday. The next challenge is to close above 2940.91 the September 21, 2018 intraday high. Three indicators below suggest it may struggle to go much higher.

VIXCBOE Volatility Index® (VIX) 12.73 nudged up .64 points or +5.29% last week . Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, added just .02 points or +.21% to close at 9.69.

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Back at the top of the range before the correction began last October, this gauge remains bullish.

VIX Futures Premium

The chart below shows as our calculation of Larry McMillan’s day-weighted average between the first and second month futures contracts.

With 17 trading days until May expiration, the day-weighted premium between May and June allocated 68% to May and 32% to June for a 16.21% premium vs. 20.98% for the week ending April 18, still in the green zone between 10% to 20% associated with S&P 500 Index uptrends. Another bullish indicator although less than the previous week.

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The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month future converges with the VIX at expiration. Previously, declines below 10 % and advances above 30% were unsustainable.

For daily updates, follow our end-of- day volume weighted premium version located about half-way down the home page in the Options Data Analysis section on our website.


Big Data? In options we are Big Data!
For a comprehensive review and reminder check this out
Options: Observations of a Proprietary Trader  


Caution Signs

As of April 18, our Foremost Indicators all confirmed the bullish view, however last week some caution signs began to appear.

VIX 10-day Correlation Indicator.

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Usually the VIX and the SPX are negatively correlated, as the SPX rises, VIX declines. When VIX rises along with SPX the correlation turns positive. The blue dotted vertical lines above show four times in the last year when the correlation turned positive as SPX began pulling back. While it entirely missed the correction that began last October, the current level is the highest in a year. Caution sign number 1.

SPX Skew and Kurtosis

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Skew -1.3546 (52-week low -3.2621 October 10, 2018, 52-week high 1.1618 February 7, 2019)

Kurtosis 4.8114 (52-week high 14.7255 October 10, 2018, 52 week low -1.0938 August 14, 2018)

Skew and Kurtosis are statistical measures used to quantify the differences between actual current frequency distributions and normal distributions.

The significance of these numbers is their relationship to those used by options pricing models that assume frequency distributions of price changes are log normally distributed with a slight positive skew. For reference the commonly pictured “bell-shaped” distribution curve has a normal symmetric distribution with zero skew, meaning up-and-down movements have the same probability.

Skew measures the amount a curve has shifted from the center, marked 0 on the X axis in the Skew Distribution chart below.

Used in conjunction with the current implied volatility, Skew suggests how options are being priced considering implied volatility is being determined by option models using lognormal distribution assumptions. If the current price changes of the underlying are not log normally distributed then options prices may not reflect their current true value.

A distribution is positively skewed when the peak is shifted to the left and the tails on the right side are longer with a greater number of large positive spikes that lengthen the positive tail. A negative skew is shifted to the right with longer tails on the left caused by a numerous large negative spikes. Negatively skewed distributions have what statisticians call a long left tail meaning a greater chance of extremely negative outcomes for investors.

Along with implied volatility, skew can be used to measures when options are relatively expensive or inexpensive. A negative skew means the density of a return's distribution is asymmetric with a sharper decline on the right tail meaning put options are more expensive than call options.

The chart below displays the distribution on Friday April 26, when the 30- day Skew was -1.3546. Notice the sharp decline on the right of center marked 0 and the long left tail.

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Now look at the Skew and Kurtosis vs Price chart for the last year at the top that includes a SPX line chart.

Notice how Skew (blue line) has been gently declining since the middle of March. Then compare it to the sharp decline to the 52-week low of -3.2621 on October 10, 2018 the day when the SPX declined 94.66 points setting off the correction that ended December 26,2109.

Kurtosis measures the relative peakedness or flatness of distributions compared to a normal distribution (a normal distribution has a zero kurtosis). Distributions are said to be leptokurtic when their tails are wider than those of a normal distribution and said to be platykurtic when their tails are thinner. Markets for stocks tend to be slightly leptokurtic (log normal). This means large market moves occur with greater frequency than is predicted by a normal distribution. Applied to options models, a Kurtosis greater than zero means fatter tails and option models under price both out-of-the-money and in-the-money puts and call. A Kurtosis less than zero means thinner tails so options are overpriced.

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Currently 4.8114, see the Skew and Kurtosis vs Price chart above. Markets typically have slight positive Kurtosis reflecting a large number of small spikes less than 1 standard deviation accompanied by a large number of spikes greater than 3 standard deviations.

The purpose of considering Skew and Kurtosis is to compare option prices, determined by an option model assuming a log normal distribution, to the current actual frequency distribution to decide if option prices need adjusting until Skew and Kurtosis return to normal. In addition, they may also contain some additional information about increasing risk when Skew declines below zero accompanied advancing Kurtosis as shown in the Skew and Kurtosis vs Price chart at the top. Notice how Skew declined and Kurtosis spiked higher last October just as SPX began the correction that ended in late December. Currently a similar pattern could be underway as Skew declines and Kurtosis advances.

While not intended as a timing indicator, a declining Skew along with rising Kurtosis may be useful as an early warning indicator. The example above is one of many seen during the long advance of the S&P 500 Index from the March 2009 low. Maybe coincidence or perhaps something more? Some were mentioned in early Digest issues. Caution sign number 2.

Skew & Kurtosis are included in our Advanced Historical Data service, calculated for eight time periods along with the charts above and more.

VIXMarket Breadth as measured by our preferred gauge, the NYSE ratio adjusted Summation Index that considers the number of issues traded, and reported by McClellan Financial Publications, declined 76.38 points, or -7.30% last week to 970.53. Now below the 50-day Moving Average. Caution sign number 3.

Strategy

PreviousIssuesAlthough the S&P 500 Index made two closing highs last week it has yet to close above the September 21 intraday high at 2940.91 and caution signs are beginning to appear. Until it breaks out and continues higher, perhaps some hedges such a put spreads and collars should be considered while option prices are still relatively inexpensive.

Summary

Last week the S&P 500 Index continued higher making two new closing highs but still short of the previous September 21 high at 2940.91. A few selected caution signs suggest it may have some trouble pushing higher as it encounters resistance from profit taking near the previous high. While option prices are relatively inexpensive, traders, strategists and hedgers may want to consider some put spreads.

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This week the plan was to feature the XLP/XLY ratio as a rotation gage, but since 3 Foremost Indicators began flashing yellow things changed. Presuming the S&P 500 Index remains stable, perhaps the XLP/XLY ratio rotation indicator can be included next week.

Finding Previous Issues and Our Reader Response Request

PreviousIssuesAll 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 source is the Table of Contents link found in the lower right side of the IVolatility Trading Digest section on our website homepage.

CommentAs always, 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 at Support@IVolatility.com or use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com website. To receive the Digest by e-mail let us know at Support@IVolatility.com

 

 

Comments:

That is one of the best real world explanations of Skew and Kurtosis I’ve ever read..Thank You

Posted by Jay on May 01, 2019 at 01:16 PM EDT
Website: http://capitalirondata@yahoo.com

Jay,

Thanks for your kind comment. While other Skew measures, like to differences between the implied volatility for calls compared to puts, this one focuses on movement of the underlying compared to assumptions used in options pricing models.

Jack

Posted by 52.6.122.109 on May 06, 2019 at 05:15 PM EDT


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