Volatility Trading Digest - Flag at Half-Mast
Volatility Trading Digest - Flag at Half-Mast
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
S&P 500 Index (SPX)
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.
Two weeks ago we wrote that 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)
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.
CBOE S&P 500 Skew Index (SKEW)
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)
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
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 two weeks ago. 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)
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)
The optimism we cautiously expressed two weeks ago 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.
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