Volatility Trading Digest – Ben Delivers Again
For the third time we feature Ben delivering the goods.Once again Ben and the Federal Open Market Committee deliver a package that exceeded market expectations. While there are better sources for the details of this unusual open-ended monetary stimulus program, we think the critics of more monetary expansion should keep in mind this part of their statement. “Consistent with its statutory mandate the Committee seeks to foster maximum employment and stability. The Committee is concerned that without further policy accommodation economic growth might not be strong enough to generate sustained improvement in labor market conditions.”
In this issue, we update our market indicators followed by a brief strategy comment and then a broad based directional suggestion along with a new short-term earnings report trading idea.
S&P 500 Index (SPX)
Last week we said, “the usual September seasonal weakness is now just a dim memory in the rear view mirror.” Now after QE3, we are expecting 2012 to resemble 2010 when it trended higher from August until February 2011, especially since there is no near term overhead resistance, the fundamentals are more important than technical analysis.
E-mini S&P 500 Future (ESU2)
Thursday’s volume at just under 4 million contracts seems like a lot relative the recent low summer volume, but compared to the volume of 4.3 million on June 11 before the June expiration it appears less noteworthy especially when it closed up 17.75 points on Thursday after the QE3 announcement. Open interest is expanding for the quarterly rollover so unless there is an unexpected decline it appears normal and comparable to June’s level, although there are still four trading days remaining for further expansion before the September contract expires.
S&P 500 Index Implied Volatility (IVXM)
At the end of last week, the Implied Volatility Index Mean increased from 12.35 to 12.69, while the CBOE Volatility Index? (VIX) increased from 14.38 14.51.
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 10% to September and 90% to October resulting in the average premium of 2.66 or 18.35% shown above. Our alternative volume weighting between September and October calculates to be a 14.83% premium. Last week the day-weighted premium was 15.90% and the volume weighted was 12.99%. Thursday’s volume was 190K contracts while the open interest expanded to 427K contracts, on Friday the volume declined somewhat to 165K contracts and the open interest continue to expand reaching 429K contracts compared to 404K contracts reached on August 21, the key reversal day. Although the premiums are still in the normal range, hedging activity has increased substantially.
VIX Options
With a current 30-day Historical Volatility of 97.38 and 74.54 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.
Using the IV Index Mean of 72.20 the IV/HV ratio is .74, using the range method for Historical Volatility the ratio is .97 while the VIX put-call ratio at .73, up from .54 last week is now less bullish for the VIX, but more bullish for the SPX since they move in opposite directions. Friday’s options volume was 604,856 contacts compared to the 5-day average of 726,160 contracts, down substantially from 1,040,935 contracts the previous Friday.
CBOE S&P 500 Skew Index (SKEW)
Designed to measure the purchase of out-of-the-money S&P 500 Index puts that would require a very large downside move to profit from long put positions, an increase of this index indicates a higher expectation of an extreme down move. After fluctuating within the 114-126 range for several months, it made an unusual spike to 129.99 on August 21, the day SPX made the key reversal, before returning to the middle of the range. Then on the QE3 announcement, it declined again toward the lower part of the range. See the chart below.
CurrencyShares Euro Trust (FXE)
Contrary to expectations, the euro did not sell off after the German Federal Constitutional Court ruling on September 12, but it attempted to trade lower on the QE3 news before reversing higher followed by a gap opening to the upside on Friday.
From the perspective of the US Dollar Index (DX)
According to Robert Prechter, President of Elliott Wave International speaking at the Forex & Options Expo last Friday, DX made a classical fifth wave top at 84.10 on July 24. If so, then apparently the rush into US Treasury notes for safe haven purposes is no longer required and the dollar could go substantially lower. This would be consistent with higher equity and commodity prices.? ?
NYSE McClellan Summation Index
Since we last reported, the NYSE Composite breadth index, our favorite early trend change indicator, advanced 262.32 points and 204.05 points of the advance occurred last week. However, it would need to be above the February high of 1325.47 to resolve the divergence as the NYSE Composite is in new high territory while the summation index lags. We expect it will accelerate as more issues begin participating in the advance. ?
iShares Dow Jones Transportation Average Index (IYT)
While the NYSE Composite and the S&P 500 Indexes are in new high territory this is not the case for the transports as they remain in an 86-95 range. Indeed, it is difficult to see how this group can join the party until crude oil declines and provides some additional cost pressure relief for this important group.
SPDR Homebuilders (XHB)
This top ranked group is almost 4 points above our upward sloping trendline, overbought and vulnerable to a near term correction. However, since the Federal Reserve is targeting housing construction employment with its open-ended mortgage buying plan, we think it will continue higher for some time as new building accelerates.
iShares S&P GSCI Commodity-Indexed Trust (GSG)
Although this is the time of year that crude oil usually declines prices are remaining high, as risk premiums due to Middle East tensions are citied as the cause. In addition, the gold advance helped as this index is now in a well-defined multi-point uptrend using our upward sloping trendline.