Volatility Trading Digest - The Cyclical Rotation
Volatility Trading Digest - The Cyclical Rotation
In this Digest along with our regular market indicators, we look at the cyclical status of the equity market, admittedly something we should have done sooner since the cyclical rotation looks to be well underway. First, our market review.
Market Review
S&P 500 Index (SPX)
Since our last review two weeks ago, things have become more complicated. The lower boundary of the large symmetrical triangle described in Digest Issue 19 was broken on Tuesday May17 as it declined to a low of 1318.51. This diminishes the validity of the large symmetrical triangle pattern that was forming with the upside at 1432.50. This now appears unlikely.
Since our last review two weeks ago, things have become more complicated. The lower boundary of the large symmetrical triangle described in Digest Issue 19 was broken on Tuesday May17 as it declined to a low of 1318.51. This diminishes the validity of the large symmetrical triangle pattern that was forming with the upside at 1432.50. This now appears unlikely.
However the low on Tuesday May 17 was a reversal pattern quickly confirmed by Wednesday's 11.70 point advance, but the volume of the SPDR (SPY) was not very impressive. The significance of the reversal was more important from a trendline perspective since the low at 1318.51 became the third point for the upward sloping trendline that began in August of last year, which we call the "Jackson Hole" trendline, since it began when Federal Reserve Chairman Ben Bernanke confirmed plans to implement quantative easing, called QE2. With the failure of the symmetrical triangle described above this is now our best reference point. We have a graph showing the trendline in the strategy section below.
E-mini S&P 500 Futures (ESM1)
For the past two weeks, the futures volume has been moderate and with the exception of Monday May 9, the open interest changes have been moderate as well. At the end of the last two weeks, based upon the preliminary CME report, the net open interest change was 2,767 contracts. Since expanding open interest is required to sustain the uptrend this is slightly positive, unless Fridays' final open interest numbers reported on Monday are significantly less than the preliminary report of up 18,606 contracts.
For the past two weeks, the futures volume has been moderate and with the exception of Monday May 9, the open interest changes have been moderate as well. At the end of the last two weeks, based upon the preliminary CME report, the net open interest change was 2,767 contracts. Since expanding open interest is required to sustain the uptrend this is slightly positive, unless Fridays' final open interest numbers reported on Monday are significantly less than the preliminary report of up 18,606 contracts.
S&P 500 Index Implied Volatility (IVXM)
Since our last review, the Implied Volatility Index Mean declined from 15.82 to 14.42, while the VIX declined from 18.40 to 17.43.
Since our last review, the Implied Volatility Index Mean declined from 15.82 to 14.42, while the VIX declined from 18.40 to 17.43.
The table below shows the VIX Cash compared to the next two Futures contracts as well as our calculation of the day-weighted average between the first and second months.
For this short-term indicator the premium to the cash is a SPX sell signal indicating professional hedging activity and the expectation that the cash will rise back toward the futures price. This week at 5.24% compares with last week's 8.49% and 3.59% in the last Digest Issue two weeks ago. This reading continues to suggest there is not very much enthusiasm for protecting long stock positions by buying futures contracts on the VIX. In the past readings above 20%, were good indications of increased professional hedging.
VIX Options
With a current 30-day Historical Volatility of 94.05 and 84.09 using the Parkinson's range method, the table below shows Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon the closing option mid prices on Friday along with their respective month's futures prices.
Using the IV Index Mean, the IV/HV ratio was .86, with the range method it was .96.
CBOE S&P 500 Skew Index (SKEW)
As out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase. When we last reported the SKEW was 124.61 while the range is from a low of 118.54 on March 3 to a high of 131.70 on April 21. Interestingly as the SPX reversed on May 17, the SKEW had declined to 121.14, but increased with the move above the upward sloping trendline contrary to expectations.
Skew represents the inequality of the distribution or to the extent to which one tail is longer than the other tail. If the distribution is negatively skewed, the left side tail is longer than the right side tail. Friday's 30-day reading was -.0479 compared to -.1004 in our last Digest Issue. A true normal distribution has a skewness of zero. From the Skew & Kurtosis section of our Advanced Historical Data service here is a visual of the current skew distribution.
The relatively low skew distribution of -.0479 along with the Skew Index of 129.15 and the day-weighted VIX futures premium of 5.24% implies once again a low level of professional hedging activity. Taken together, these indicators are not flashing caution signals.
US Dollar Index (DX)
After trading as high as 76 last Monday DX, retreated the rest of the week closing just above 75. It is still above the downward sloping trendline from the January high at 81.31 and now would need to close below 73 Ω for the downtrend to resume. The dollar's advance from the May 2 low of 72.72 is reminiscent of the "risk off" trading we often experienced last year as the euro is sold for dollars. The euro related dollar strength has resulted in lower commodity and raw material prices as well as precious metals.
After trading as high as 76 last Monday DX, retreated the rest of the week closing just above 75. It is still above the downward sloping trendline from the January high at 81.31 and now would need to close below 73 Ω for the downtrend to resume. The dollar's advance from the May 2 low of 72.72 is reminiscent of the "risk off" trading we often experienced last year as the euro is sold for dollars. The euro related dollar strength has resulted in lower commodity and raw material prices as well as precious metals.
iShares Barclays 20+ Year Treasury Bond (TLT)
Long-term interest rates have been declining since February 10 after reaching 4.78%. On Tuesday as SPX tested the upward sloping trendline, rates had declined as low as to 4.23% before increasing slightly to close the week at 4.29%. The rotation out of cyclical stocks along with declining long-term interest rates seems to be confirming the validity of the slowing global economy viewpoint being expressed by some analysts.
Long-term interest rates have been declining since February 10 after reaching 4.78%. On Tuesday as SPX tested the upward sloping trendline, rates had declined as low as to 4.23% before increasing slightly to close the week at 4.29%. The rotation out of cyclical stocks along with declining long-term interest rates seems to be confirming the validity of the slowing global economy viewpoint being expressed by some analysts.
NYSE McClellan Summation Index
For the last two weeks, our market breadth indicator for advancing issues and declining issues on the NYSE once again took a turn for the worse by declining 68.64 points. This may be a further indication of sector rotation out of smaller stocks into the larger capitalization stocks with more liquidity.
For the last two weeks, our market breadth indicator for advancing issues and declining issues on the NYSE once again took a turn for the worse by declining 68.64 points. This may be a further indication of sector rotation out of smaller stocks into the larger capitalization stocks with more liquidity.
iShares Dow Jones Transportation Average Index (IYT)
While briefly trading below the upward sloping trendline starting from the March 15 low at 88.90, the transportation index continues showing good strength, but a second failure of the trendline would further confirm rotation out of the cyclical stocks. Stay tuned as it is currently resting right on the important trendline.
CRB Index (CR)
On Thursday May 5, the CRB Index gapped lower closing down 17.56 and below our 358-stop level. It is now a good way below the upward sloping trendline from the August 25 low at 260.22, providing a clear indication the uptrend is over. The recent evidence of rotation into consumer staples from the industrial, commodity and raw materials sectors suggests money is coming out of the cyclical stocks and ETFs.
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