Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Market Review
S&P 500 Index (SPX) closed the week down 46.99 or – 2.21% and just about the same amount of the previous week?s advance as it failed to close above the right shoulder of the already activated Head & Shoulder Top at 2129.87 and then abruptly turned lower failing to renew the uptrend by forming a second right shoulder shown below.
PowerShares QQQ Trust (QQQ) down or – 2.49% went from a gap breakout above the previous resistance at 111 to reach an intraday high of 114.39 on July 20, back to retesting 111 all within seven trading days. For amount of market capitalization involved, this could be a record swing.
CBOE Volatility Index? (VIX) up 1.79 or 14.98% after trading as low as 11.73 just the day before, although seasonal factors alone now favor lower volatility.
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 85% to August and 15% to September as of Friday for a 5.19% premium shown above. Our alternative volume-weighted average between July and August regularly found in the Options Data Analysis section on our homepage was higher at 10.31%.
Premiums for normal term structures 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 the normal zone all week.
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.
S&P 500 Index (SPX) ? adding a cyclical perspective
As a reversal pattern, a Head & Shoulders requires a trend to reverse. Accordingly the current uptrend defined by the upward sloping trendline USTL originates at the October 15 low of 1821.61 (below the left corner of the chart) extending upward to the right closing Friday at 2164.78 at the black arrow in the upper right corner, considerably higher than the current close. Now after two failures to continue trending higher, as indicated by the two right shoulders marked about as RS1 and RS2 chance are increasing it will close once again below the pattern neckline marked NL and continue to the minimum measuring objective at 2007 marked by the red arrow in the lower right corner.
Since the previous uptrend has apparently ended, the usual cyclical patterns are becoming more prominent.
John Murphy provides an excellent cyclical explanation in his book Technical Analysis of the Futures Markets on pages 421- 436. In summary, the common practice is to measure the beginning and end of cycle waves from low points called troughs having tendency to occur about every 28 calendar or 20 trading days. The cycle peaks called crests will vary depending upon the next longer cycle and help determine changing trends by comparing the number of cycle up days to down days.
Presuming the cycle is exactly 20 days; a bullish bias would have more up days than down days while a bearish bias would have more down days and when crests appear at the midpoint it suggest a lack of trend influence.
Comparing up days to down days should help confirm the current trend status while projecting future turning points assuming the cycles continue lacking trend although few if any cycles will be exactly 20 days as other influences override the cyclical tendencies.
Some helpful reference information from Investment Tools.com will help the analysis, saying as of as of July 6, 2015 the average (short term) cycle length, for the last 22 cycles, was 21.77 trading days and 12 cycles have a right hand bullish translation, 8 have a left hand bearish translation, while 2 were centered.
Beginning March 11, 2015 at point 1, on the chart above, here are the cycle counts.
Not surprisingly, the translation turned bearish between points 4 and 5 since this is where the S&P 500 Index first crossed below the upward sloping trendline USTL. Based upon an ideal cycle count of 20 days expect (e) the next cycle low on or about August 4, 2015 in seven trading days. However if the translation remains bearish it could be somewhat longer. If so, it is likely to be below the neckline of the Head & Shoulders Top pattern and heading toward the minimum measuring objective.
Summary
Hopes that earnings reports would help support equities seems to have faded last week along with commodity prices as the S&P 500 Index abruptly turned lower once again after failing to close above the right shoulder of the potential Head & Shoulder Top confirming cyclical crests that have become increasingly more prominent. Interest rates pulled back ahead of the Federal Open Market Committee meeting bolstering expectations they will stay lower longer, but they typically advance or decline ahead of the comments only to reverse a few days later.