Volatility Trading Digest - Greek Theater

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Volatility Trading Digest - Greek Theater

According to Wikipedia, Western theater originated in Athens and its drama has had a significant and sustained impact on Western culture as a whole.  With the exception of a few odd takeovers, last week's financial news was all about the theater going on in Europe and assessing the probability of a Greek debt default.  So far, the markets seem to think it will be manageable, but what if they are being too optimistic.  From a risk management perspective, we think some additional hedging is in order.  We have two ideas to consider right after our market review.
 
Market Review

S&P 500 Index (SPX)
Now in an unmistakable well-defined downtrend the challenge is to find an area where it might stop declining.  From the high on May 2 at 1370.58, to last Thursday's low at 1258.07, the decline was 8.2%.  While we are not suggesting they are necessarily comparable, the decline last summer from the April 26 high to the July 1 low was 17.1%.  Although there are no clear near term support levels referring to the long-term upward sloping trendline from the March 2009 low may offer some possibilities. 

E-mini S&P 500 Futures (ESU1)
The June Futures have now expired so the current front month contract is now September.  Fridayís volume was back into the moderate range at 2.4 million contracts after 5 days of high volume as positions were being rolled over from June to September.  The preliminary open interest report does not yet reflect the decline attributable to closed June contracts.

S&P 500 Index Implied Volatility (IVXM) 
Since our last review, the Implied Volatility Index Mean increased from 16.02 to 18.89, while the VIX increased from 17.95 to 21.85.  

The table below shows the VIX Cash compared to the next two Futures contracts as well as our calculation of Larry McMillanís day-weighted average between the first and second months.



For this short-term indicator the discount to the cash is a SPX buy signal indicating professional expectations for the cash to decline back toward the futures price.  This week at -1.53% compares with last week's 3.55% and 5.43% in the last Digest Issue two weeks ago.  The negative reading suggests complacency about protecting long stock positions by buying VIX futures contracts.  Negative readings in the past have been good indicators for short-term market advances.  Readings above 20% are generally a good indication of increased professional hedging in anticipation of an immediate decline.  The current level suggests SPX is oversold and likely to rebound.

Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium is always available.  

VIX Options
With a current 30-day Historical Volatility of  107.19 and 94.40 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 of 93.70, the IV/HV ratio was .874, with the range method it was .993. The VIX put-call ratio was .25 indicating an expansion of hedging call volume.  

CBOE S&P 500 Skew Index (SKEW)
When out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase.  The SKEW continue to act like a contrary indicator.
Perhaps a better way to view it is to look at the skew distribution as 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 distribution reading was -.6619, compared to -.8743 in our last Digest Issue, suggesting less put activity.  A true normal distribution has a skewness of zero.

US Dollar Index (DX)
After rising for 6 days, DX made a substantial decline Friday on news that Germany and France have agreed to a plan for a voluntary rollover of Greek debt by private creditors.  While the details had yet to be finalized, the plan was said to fall well short of the requirement to extend bond maturities.  The decline added support for the US equity markets, but not very much for commodities.  For a higher DX, or lower euro hedge, we have a suggestion in the Strategy section below. 

iShares Barclays 7-10 Year Treasury (IEF)
As the best indicator of the new "risk-off" environment, the 10-year Treasury bond closed the week once again with a yield below 3% at 2.94%.  

NYSE McClellan Summation Index
For those who are looking for the emergence of some support for equities around the 1250 level on the S&P 500 Index our market breadth indicator of advancing issues to declining issues on the NYSE will be a real disappointment as it continues  declining, losing another 499.67 points since our last Digest review.  With last summer's decline, this index reached a low of -420 on June 8 and we expect it will need to turn higher once again this year before the major indexes make a turn.

iShares Dow Jones Transportation Average Index (IYT)
Now in a defined downtrend the best that can be said about the transports is they are relatively stronger than the major equity indexes, but the chances are still good they will be under the March lows below 90 before this decline is over.  

iShares S&P GSCI Commodity-Indexed Trust (GSG)
Using the GSG as a proxy for the CRB Index, we note it received no support from the DX decline and euro reversal on Friday.  Checking the long-term chart, we see some support at 33 from last October, another 3.2% lower.
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