Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Like Brexit in June, to say the Presidential election result was unexpected seems like an understatement based upon early market reactions. However, the S&P 500 Index heavily weighted with US multinationals may not be the best choice in an environment of rising interest rates and a stronger US dollar. Sector rotation last week offered a preview what to expect in the post-election macro environment. There is more in the market review below including suggestions to consider for ProShares UltraShort 20+ Year Treasury (TBT), Financial Select Sector SPDR ETF (XLF), iShares Russell 2000 ETF (IWM), and SPDR S&P Biotech ETF?(XBI).
Market Review
S&P 500 Index (SPX) 2164.45 gained 79.27 points or +3.8% for the week advancing right up to test the upward sloping trendline from the February 11 low. Any further advance will delight the bulls while a close above the August 15 high of 2193.81 will create a new upward sloping trendline, USTL although with the current ?as reported? price to earnings ratio of 24X any further advance will struggle against both rising interest rates and the US dollar.
CBOE Volatility Index? (VIX) 14.17 closed down 8.34 points or – 37.05% for the week. The short -term VXST closed at 12.84 having declined back below the VIX Thursday producing a buy signal using this timing indicator.
With three days before the November futures expire, the premium turned positive last Wednesday one day before the VXST closed back below the VIX and finished the week at 12.99%. The quick unexpected reversal limited the time available to unwind and/or reverse hedges opened before the election.
Strategy Ideas
Although the cautious strategy posture suggested last week would not have resulted in gains after the election it may have preclude losses if the wrong sectors or stocks were involved as rotation into financials that benefit from higher interest rates and cyclical sectors was as swift as it was pronounced. If the rotation continues and become new trends, consider using more sector specific strategies, although there is risk some may now be overbought and due for profit taking.
Rising Interest Rates
ProShares UltraShort 20+ Year Treasury (TBT) 39.43 already in a modest uptrend from the low at 30.87 on September 28, it broke out rocketing higher, adding 5.38 points or +15.8% for the week.
The current Historical Volatility is 28.70 and 17.53 using the Parkinson’s range method, with an Implied Volatility Index Mean of 33.97 up from 28.54 the week before. The 52-week high reached 36.35 on February 11, 2016 while the low was 21.80 on May 27, 2016. The implied volatility/historical volatility ratio using the range method is 1.94 so option prices are high relative to the recent movement of the ETF. Friday?s option volume was 25,948 contracts traded compared to the 5-day average volume of 23,750 with reasonable bid/ask spreads.
Using the ask price for the buy and mid for the sell the call spread debit woud be 1.13, about 28% of the distance between the strike prices with 43% of the long side risk hedged by the short call and with a slight volatility edge. Since the ETF volume at 10.7 million shares was the highest for at least a year, there is good reason to presume the gap created at the open on November 9 is a breakaway with no filling requirement. However in the event it should pull back into the gap below 36.34, use it as the SU (stop/unwind) and then look for a reversal to renew the position.
Financial Select Sector SPDR ETF (XLF) 21.67 broke out above the range made this time last year adding 2.18 points or +11.19% for the week. Volume on Wednesday?s breakout was 269 million shares the highest in the last year.
The current Historical Volatility is 18.79 and 13.57 using the Parkinson’s range method, with an Implied Volatility Index Mean of 19.96 down from 21.10 the week before. The 52-week high reached 36.04 on February 11, 2016 while the low was 13.10 on August 9, 2016. The implied volatility/historical volatility ratio using the range method is 1.47 so option prices are moderate relative to the recent movement of the ETF. Friday?s option volume was 266,054 contracts traded compared to the 5-day average volume of 335,760 with good bid/ask spreads.
Due to a lower ETF price and limited strike prices, this one does not have the benefit of an offsetting short call hedge. However, the implied volatility is near the lower part of the 52-week range limiting this risk and with 70 days to expiration the time decay will initially be low. Use a close back below 20 as the SU (stop).
Sector Rotation
The second category looks for those that gained favor as money flowed from sectors previously favored to those expected to perform better in the new post election environment. Previously the leaders were secular growth stocks that become expensive based on price to earnings ratios. Now the advantage goes to cyclical stocks and sectors that are less expensive but should be able to increase earnings if GDP growth improves. However, large capitalization multinationals will likely find tuff going against rising interest rates and a higher dollar. Accordingly, the advantage should be with smaller domestic companies.
iShares Russell 2000 ETF (IWM) 127.36, up 11.62 points or +10.04% for the week closing above 125, a level that had previously constrained further advances. Friday?s volume was a noteworthy 95.6 million shares the highest in a year. In addition, the new closing high renews the upward sloping trendline, USTL from the February 11 low of 93.64 as the previous USTL was breached prior to the election.
The current Historical Volatility is 18.08 and 14.60 using the Parkinson’s range method, with an Implied Volatility Index Mean of 17.78 down from 23.24 before the election, near lower part of the 52 week range with a high reached 30.65 on February 11, 2016 while the low was 13.35 on August 12, 2016. The implied volatility/historical volatility ratio using the range method is 1.22 so option prices are low relative to the recent movement of the ETF. Friday?s option volume on the breakout was 1,266,037 contracts traded compared to the 5-day average volume of 909,020 with reasonable bid/ask spreads.
Using the ask price for the buy and mid for the sell the call spread debit would be 1.48, about 37% of the distance between the strike prices with 42% of the long side risk hedged by the short call without volatility edge. Use a close back below 125 as the SU (stop/unwind). The next one is sector specific due a reduced threat of future price controls.
SPDR S&P Biotech ETF (XBI) 66.21 advanced 11.34 points or +20.67% for the week after bouncing off on oversold low of 54.87 on November 4. Wednesday?s volume was 28.4 million the highest in a year as it gapped open higher. With a target at the prior high of 69.21 made on September 23, this one may be subject to pulling back to fill the gap.
The current Historical Volatility is 44.15 and 28.83 using the Parkinson’s range method, with an Implied Volatility Index Mean of 37.71 down from 47.27 before the election, near middle part of the 52 week range with a high of 65.06 on February 9, 2016 while the low was 27.55 on August 19, 2016. The implied volatility/historical volatility ratio using the range method is 1.31 so option prices are about right relative to the recent movement of the ETF. Friday?s option volume was 38,621 contracts traded compared to the 5-day average volume of 45,370 with reasonable bid/ask spreads.
Using the ask price for the buy and mid for the sell the call spread debit would be 1.43, about 29% of the distance between the strike prices with 44% of the long side risk hedged by the short call without volatility edge. Use a close back below 61.28 as the SU (stop/unwind) and then look for a reversal to renew the position after filling the gap.
Summary
Although sector rotation will likely be challenging the mood of the market has turned more positive as thoughts turn to possible solutions for the slow growth environment. Based upon the first few days it looks as if the election will become a market “game changer.”