Volatility Trading Digest: Monday Market Review

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Market Review
 
S&P 500 Index (SPX)
The equity strength displayed on April 23 was an illusion since the next trading day SPX made a key reversal, a higher high for the uptrend from the February correction, but a lower close on the day. Then on Tuesday April 27, the picture changed with a 28.34-point decline, confirming the key reversal and setting up a potential small Head & Shoulders Top pattern. We now have solid evidence that a retest of support, at the breakout high of 1150.45, made on January 19, is underway, helped by a new small Head & Shoulders Top.

We compute the height of the pattern to be 38.18 points and estimate a cross below the neckline at 1180 would produce a downside minimum measuring objective at 1, 141.82. We now think the test of support will need to be completed before SPX can reach our Head & Shoulders Bottom upside measuring objective at 1233.29. A close below the new neckline would put SPX over the edge.

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From a weekly perspective, the retest is important since it appears a close below 1150 would mean the upward sloping trendline from the March 2009 low would be broken going over the second edge.
 
E-mini S&P 500 Future (ESM0)
The down-day 3.6 million contract blowoff volume on April 16, was the first indicator the trend was about to change. Confirmation was provided Tuesday April 27, with a second 3.6 million-contract blowoff volume day and a further 27.25-point down day. Now expanding open interest means the shorts are pressing their bets while declining open interest suggests short covering.   

S&P 500 Index Implied Volatility (IVXM)
Since our last market review, the Implied Volatility Index Mean increased from 15.12 to 18.61. The VIX increased from 18.36 to 22.05, after spiking, retracing and then rebounding once again.  

The table below shows the VIX Cash compared to the next two futures contracts as well as our calculation of the day-weighted average between the first and second months.



For this short-term indicator premium over cash is a sell signal indicating the degree of professional hedging, and this week at .50% is lower than last week at 13.34% and lower that our last market review at 7.90%. By itself, this indicator is suggesting an oversold market.

Some analysts are highlighting the unusually large spread between the VIX cash at 22.05 and the 20-day Historical Volatility of the SPX at 15.25. Here are the comparisons for the last five weeks.



The declining differential reflects the acceleration of the Historical Volatility relative to the Implied Volatility.
 
VIX Options
With a current Historical Volatility of 125.86, the table below shows the adjusted Implied Volatility (IV) of the at-the-money (22.5) VIX calls and puts based upon Friday’s closing options mid prices along with the respective month’s futures prices.



US Dollar Index (DX)
As SPX began topping as described above, DX moved higher contrary to its previous inverse correlation due to the abnormally weak and oversold euro. However, a rebound in the euro may not be enough to support equities, if the SPX retest gains momentum as expected.

iShares Barclays 20+ Year Treasury Bond (TLT)
It should come as no surprise that talks of European debt contagion would reduce the market risk preference as reflected in higher long-term bond prices and lower yields. Now at the previous January resistance at 92 higher prices will reflect continued reduction in risk preference and would be consistent with the correction in equities that appears to be in progress.

NYSE McClellan Summation Index
Our preferred breadth indicator for the NYSE Composite Index declined 108.72 points since our last market review and now the declining breadth is consistent with the declining broad market indicators. The divergence has been a good leading indicator of the expected correction since it stopped rising on March 19 as the NYSE Composite continue to going higher.

iShares Dow Jones Transportation Average Index (IYT)
From the perspective of a daily chart the upward sloping trendline from the February low crosses at approximately 82 ?, for the weekly going back to the March 2009 low the upward sloping trendline crosses at about 77. For the equity correction currently underway, we expect to see the daily trendline broken, but the chances are the weekly level will hold. 

The Capital Link Tanker Index increased 39.45 points to 2605.44 for the two-week period and since the crude oil futures market contango continues to increase, we suspect the market is being supported by VLCCs chartered for storage.
 
Strategy

Until the correction is complete, we suggest hedging strategies with long vega as implied volatility is likely to rise as the correction continues. Here is one example.

SPDR S&P 500 Index (SPY)
The current Historical Volatility is 13.38 up from 9.25 last week, with an Implied Volatility Mean Index of 19.54 up from last week’s 14.27.

Here is a put ratio backspread idea to consider.


Each long Jun 13 put was priced at 1.70 each or 3.40 as shown above with an individual vega of .1466 for the total as shown of .2930. While we are paying more in implied volatility terms for the options bought than the option sold, we expect to gain from a rise in implied volatility since the position has a positive vega of .1176.  

Summary
The retest of the 1150.45 support of S&P 500 Index has begun as the equity market turned lower. The support level is likely to hold and then we may yet reach the minimum upside objective at 1233.29. In the meanwhile, the correction offers an opportunity to make trades that benefit as implied volatility increases.



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