Since the ?Four Horsemen of the Apocalypse? rode right over the cliff on August 20 the focus has changed from when the S&P 500 Index will turn lower to how far down will it go.
The bounce back from the first down leg forming symmetrical triangle consolidation pattern provides a good downside measuring objective detailed below. The new group to replace the ?Four Horsemen of the Apocalypse,? called the ?Foremost Five? consists of fundamental and technical components that will likely play an important role in determining how low the correction will go. First, a few brief market observations and then downside ideas forProShares UltraShort S&P 500 (SDS) and Facebook, Inc. (FB)
Market Review
S&P 500 Index (SPX) closed the week down 67.65 points or -3.40% after forming what appears to be a symmetrical triangle consolidation pattern after bouncing back as expected from the oversold August 24 low of 1867.01. From a trendline perspective the three-day decline that began August 20 inflicted considerable damage closing below the upward sloping trendline that began all the way back down at the October 4, 2011 low at 1074.77. When adjusted using log scale the upward sloping trendline ended August 19 as it declined 17.31 to close at 2079.61. Details for determining the downside measuring of the symmetrical triangle consolidation pattern using SPY are included with the chart below.
CBOE Volatility Index? (VIX) was up 1.75 from last week.
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 35% to September and 65% to October as of Friday for a – 4.47% premium shown above. Our alternative volume-weighted average between September and October regularly found in the Options Data Analysis section on our homepage was slightly higher at -2.46% making the twelfth day of negative premiums, an unusually long period for premiums to remain negative.
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.
Symmetrical Triangle Consolidation Pattern
SPDR S&P 500 ETF Trust (SPY) 192.59 -2.96
The reason for using SPY instead of SPX is the important Friday gap open lower that does not appear on the SPX chart.
Symmetrical triangles are continuation patterns formed when two minor trendlines one from the highs the other from the lows converge at an acute angle. The expectation is for prices to move in the direction of the major underlying trend, now down. Drawing the triangle requires four reversals of the minor trend defining minor trendlines to form the triangle as shown above at points 1-4. Ideally, during the consolidation, volume should decline.
The gap open lower that occurred Friday and shown above makes the case for a forceful breakdown that is likely to continue to the downside measuring objective determined by taking the height of the triangle between points one and two and subtracting it from the point where price crossed the minor trendline Friday.
Here are details for the reversal points above including the volume.
During the consolidation, volume should decline and then increase on the breakdown but typically not in the first couple of days and Friday?s volume of 207.1 million seems to fit the pattern.
The measuring objective down at 176.42 or another -8.4% lower is marked with the arrow in the lower right corner.
Foremost Five
Replacing the ?The Four Horsemen of the Apocalypse? are five familiar friends repackaged with a somewhat less menacing title.
DBX ETF Trust – Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR) down 2.59 or -7.92% for the week although the China markets were closed Thursday and Friday. With concerns about market supporting activity, along with the recent currency devaluation China deserves top billing in the risk category.
United States Oil (USO) as a proxy for WTI Crude Oil advanced .20 for the week. The importance of crude oil extends beyond their index weighting to include capital equipment and many supporting services.
Market Breadth The McClellan Oscillator Summation Index reported by McClellan Financial Publications, improved slightly last week, adding 90.84 points, but still quite negative at -861.97.
US Dollar Index (DX) returns to the lineup ahead of increasing speculation about a possible interest rate increase announcement after the upcoming September 16-17 Federal Open Market Committee meeting.
ProShares UltraShort 20+ Year Treasury (TBT) also returns to the focus group, like DX above, due to the importance of a possible interest rate announcement at the upcoming FOMC meeting. Perhaps combining with DX would be simpler since they have a tendency to move in the same direction, but for the time being they remain separate.
Although iShares Transportation Average (IYT) down 2.11 or -1.48% for the week, remains an important leading indicator, responding to the economic environment like a dependent variable and will still be closely followed, but not included in the main focus group for the time being.
Strategy Idea
Based upon the breach of the long-term upward sloping trendline by the S&P 500 Index from the October 4, 2011 low at 1074.77 and the subsequent formation of a symmetrical triangle consolidation pattern the odds favor more downside so here are two ideas for consideration. The markets in China were open Monday although US markets were not so the S&P 500 Index futures before the openTuesday should provide an indication as what to expect on the open.
More Downside
ProShares UltraShort S&P500 (SDS) seeks daily investment results that correspond to two times the inverse (-2x) of the daily performance of the S&P 500? Index.
The current Historical Volatility is 51.11 and 35.44 using the Parkinson’s range method, with an Implied Volatility Index Mean of 49.60 up from 47.89 the week before. The 52-week high was 74.37 on August 24, 2015 while the low was 19.11 on September 5, 2014. The implied volatility/historical volatility ratio using the range method is 1.44 so option prices are somewhat high relative to the recent movement of the ETF. Friday?s option volume was 32,052 contracts traded compared to the 5-day average volume of 22,240 with reasonable bid/ask spreads.
Using the ask price for the buy and mid for the sell the call spread debit would be .45, about 23% of the distance between the strike prices with a good implied volatility edge. Use a close back below the last pivot low of just under 22 as the SU(stop/unwind).
Facebook, Inc. (FB)?The reason for considering FB for the downside has little to nothing to do with the fundamentals and everything to do with the current market environment and options liquidity. According to the Analyze tab in My Favorites FB has been 81.84% correlated to the S&P 500 Index for the last 30 days and will likely remain highly correlated. This means while giving up some correlation for option liquidity that could become very important if the market continues lower. In addition, this suggestion has lower implied volatility while allowing more time than SDS above.
The current Historical Volatility is 37.38 and 43.35 using the Parkinson’s range method, with an Implied Volatility Index Mean of 37.96 down from 39.01 the week before. The 52-week high was 53.17 on August 24, 2015 while the low was 19.17 on June 10, 2015. The implied volatility/historical volatility ratio using the range method is .88 so option prices are inexpensive relative to the recent movement of the stock. Friday?s option volume was 196,195 contracts traded compared to the 5-day average volume of 212,460 with good bid/ask spreads.
Using the ask price for the buy and mid for the sell the call spread debit would be 1.39 about 28% of the distance between the strike prices with a slight implied volatility edge. Adjusting for the time decay over the holiday weekend the debit would be 1.37. Use a close back above the last pivot high at 91.48 as the SU (stop/unwind).
The suggestions above are based on Friday?s ask price for the buy and middle price for the sell presuming some price improvement is possible while the put sales is based on the bid price. Tuesday?s option prices will be somewhat different due to the time decay over the weekend and any price change.
Summary
Multiple closes of the long-term upward sloping trendline by the S&P 500 Index combined with uncertainty about slowing growth in China and the recent yuan devaluation as well as weak commodity prices, especially crude oil, the upcoming FOMC meeting and selected technical indicators all suggest additional downside risk ahead.