Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.

Until recently ad hoc reviews of various indicators seems adequate since the markets were in bull mode after the election. However, since the week of March 6, that’s no longer true as first noted in Digest Issue 11 “Consider Planting Hedges [Charts]” There were several important examples of “Buy buy the rumor sell the news” activity going into the nonfarm payroll report on Friday March 10. Then last week the S&P 500 Index closed below the upward sloping trendline ending the “Trump” trade. A more extensive indictor review follows including crude oil from the perspective of the latest Commitments of Traders report from the CFTC.

Market Review

S&P 500 Index (SPX) rebounded 18.74 points or +.80% for the week after testing support at the 50 day moving average near 2331 but still below the upward sloping trendline, USTL from the November 4 low. Should it turn lower again the next support is down at 2300 and then 2275 going all the way back to December 13.

CBOE Volatility Index® (VIX) declined .59 or – 4.55% for the week. The comparable IVolatility implied volatility index mean, IVXM 9.51 fell 1.04 points or – 9.86% for the week after they both turned slightly higher Friday.

VIX Futures Premium

The chart below shows as our calculation of Larry McMillan’s day-weighted average between the first and second months.

With 12 trading days until the April expiration, the day-weighted premium between April and May allocated 48% to April and 52% to May for a 8.62% premium vs. 8.65% last week reflecting a slightly higher VIX on Friday.

The premium measures the amount the futures currently trade above or below the cash VIX, (contango or backwardation) until front month future converges with the VIX at expiration. Depending on the time to expiration, premiums for normal term structures during uptrends are 10% to 20% and decline when the VIX advances faster than the nearest future as the market declines and/or the futures decline as the front month expiration approaches. Premiums less than 10% suggest caution and negative premiums indicate oversold conditions when the VIX is higher than the futures and are usually associated with reversals.

In the past premiums below 10% usually preceded further declines as the VIX advances faster than the futures.

Uptrends Continue

Last week we included a chart for The US Dollar Index (DX) & (DXY) .91 points or +.92%. Last Monday it traded down to the neckline of a potential Head & Shoulders Top pattern, found support there and turned higher. Since the advance appears to have been an oversold bounce it could turn lower once again to retest the neckline.

Using our Stock Sentiment Ranker on the ETF group here is number 3, one that has been trending higher since December 22, 2106 as the dollar declined from the January 3 high at 103.82.

iShares MSCI Emerging Markets (EEM) 39.39 off .42 or -1.06% for the week as DXY bounced off the potential neckline. Should DXY turn lower again EEM will likely continue trending higher.

The current Historical Volatility is 14.96 and 8.36 using the Parkinson’s range method, with an Implied Volatility Index Mean of 14.74 down from 16.07 the previous week. The 52-week high was 26.88 on June 24, 2016 while the low was 13.80 on February 17, 2017. The implied volatility/historical volatility ratio using the range method is 1.76 so option prices are somewhat expensive relative to the recent movement of the ETF.

While the current implied volatility is near the 52-week low, the 52 week mean appears to be about 17.5%.

Friday’s option volume was 303,314 contracts with a 5-day average of 217,110 contracts and 7.2 million contracts open interest with favorable bid/ask spreads.

With defined and limited risk, consider this May 19 long call spread that allows enough time for the uptrend to resume after current pullback ends assuming DXY turns lower again.

Success is dependent on DXY so watch for it to resuming declining before reaching 101 since any further advance will question the ability for EEM to continue higher. Using the ask price for the buy and mid for the sell, the debit would be .33 and 33% of the distance between the strike prices with 48% of the long call hedged by the short call. Use a close below 38.50 at the upward sloping trendline USTL as the SU (sell/unwind).

Here is one more that has been trending higher, now in the number 4 position by our Stock Sentiment Ranker.

PowerShares QQQ ETF (QQQ) advanced 1.75 points or +1.34% for the week compared to +.80% for the S&P 500 Index. The current uptrend began from the December 2 low of 115.22. As with EEM the declining dollar helps along with good earnings reports by the large capitalization NASDAQ stocks.

The current Historical Volatility is 7.44 and 7.23 using the Parkinson’s range method, with an Implied Volatility Index Mean of 11.10 down from 11.54 the previous week. The 52-week high was 22.78 on June 27, 2016 while the low was 8.81 March 20, 2017. The implied volatility/historical volatility ratio using the range method is 1.54 so option prices are slightly expensive relative to the recent movement of the ETF. While the current implied volatility is still near the 52-week low, the 52 week mean appears to be about 12.5%.


Friday’s option volume was 632,014 contracts with a 5-day average of 431,160 contracts and 4.2 million contracts open interest with narrow bid/ask spreads.

With defined and limited risk, consider this May 19 long call spread

Using the ask price for the buy and mid for the sell, the debit would be .76 about 38% of the distance between the strike prices with 49% of the long call hedged by the short call. Since the dollar has been declining all quarter earnings reports will likely receive some extra currency translation help as 1Q reporting begins. Use a close below 130 at the upward sloping trendline USTL as the SU (sell/unwind).

The spread suggestions above are based on the ask price for the buy and middle price for the sell presuming some price improvement is possible. Monday’s option prices will be somewhat different due to the time decay over the weekend and any price change.

Strategy

While the SPX turned higher last week it remains under the upward sloping trendline, but tracking it higher. For an all clear signal it needs to close above 2400. However, improving breadth and a relatively strong NASDAQ suggests it will likely continue higher.

Summary

The recent S&P 500 Index pullback apparently ended last Tuesday and while it may be early to conclude the uptrend has resumed improving breadth and NASDAQ outperformance is encouraging enough to return to the long side with limited and defined risk call positions.