Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
As it turned out, the Santa Claus rally no show correctly foretold the arrival of the bears on Wall Street. Now to explore the question how low the S&P 500 Index can go, we use some charts to help establish alternative downside measuring objectives. First, a brief market review.
Market Review
S&P 500 Index (SPX) declined 121.91 points or -5.96% for the week, closing below the 2000 level that had defined a trading range since October. See the chart below.
CBOE Volatility Index? (VIX) up 8.80 for the week, based on real-time prices of options on the S&P 500? Index, constructed to reflect investors’ consensus view of future (30-day) expected stock market volatility. See the IVXM chart below.
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.
With 7 trading days until the January monthly expiration, the day weighting applied 28% to January and 72% to February for a -12.31% premium shown above. Our alternative volume-weighted average between January and February regularly found in the Options Data Analysis section on our homepage was slightly higher at -9.94%.
While day-to-day VIX changes offer little forecasting insight following the VIX futures premium helps since it measures expectations of tactical professional traders and money managers using VIX futures and options for hedging long portfolio risk.
Premiums for normal term structures during uptrends are 10% to 20% while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging often occurring around market highs suggesting overbought conditions associated with pullbacks. Alternatively, premiums less than 10% suggest caution and negative premiums indicate oversold conditions. Last week the volume-weighted premiums were in negative oversold zone all week except Tuesday at .16%, closing Friday at -9.94%.
VIX Options
With a current 30-day Historical Volatility of 164.82 and 128.14 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.
For the week the implied volatility of the near month at-the-money call gained 41.86 percent advancing from 102.43 to 144.29 with 7,805 contracts traded Friday while the out-of-the-money January 29 call traded 29,475 contracts with a closing implied volatility of 164.35.
Downside Objectives
S&P 500 Index (SPX) declined 121.91 points or -5.96% for the week, closing below the 2000 level defining a 100 point trading range that held previous declines. A close above the November 3 high at 2116.48 was needed for an upside breakout anticipated by those expecting a traditional Santa Claus rally, but it failed to develop as every advance encountered selling while market breadth continued to narrow. To define the measuring objective of a trading range subtract the height from the breakdown, or 2000 less 100 or 1900 marked MO on the chart below. However, since MO is the minimum and the August 25 low at 1867.30 makes a tempting target it will likely test this lower level.
Since a picture is worth a thousand words, here are some charts.
At or near the August low watch for a key reversal on increased volume as a reversal sign.
Here is the long-term upward sloping trendline from the March 2009 low suggesting the current decline could reach 1750 and find support at the trendline meaning the uptrend would still be intact and the current decline would be a correction not the start of a bear market from this perspective
The often-heard overvaluation issue based upon the price-to-earnings ratio at the 1750 level becomes less compelling. Using Goldman Sachs? recent 2016 earnings forecast of 106 the P/E ratio would be 16.5 and 18.4 based upon the Crestmont Research?earnings estimate of 95 while the long-term historical norm is 17.5 according to Crestmont. Although periods of undervaluation often follow periods of overvaluation, a 1750 target seems like the place to test the longer-term uptrend thesis. Note LT USTL in the right corner of the top chart, 8.95% lower.
Implied Volatility Perspective
From a volatility perspective, the S&P 500 Index decline could continue as the implied volatility spikes higher when compared to the advance that occurred last August, provoked in part by a widening of the Chinese yuan trading band and rumors of further devaluations much like the one occurring last week that contributed to the market decline.
Using the Implied Volatility Index Mean, here is the S&P 500 Index volatility chart from our complimentary Basic Options service showing the August spike along with the options volume below.
Summary
Although currently oversold, until crude oil prices stabilize to provide some support, the direction for the S&P 500 Index appears lower as markets go back into ?risk off? mode. After the traditional Santa Claus rally fizzled and while a few large capitalization favorites held up the S&P 500 Index, with a few exceptions, the selling underway gives the appearance a race for the exit is underway.