Volatility Trading Digest - Contagion Fears
Volatility Trading Digest - Contagion Fears
Last week the markets once again turned their focus to Europe as Moody's downgraded Portugal's sovereign debt to junk status, along with a sell-off in Italian bonds and bank stocks. Finally, on Friday the short week ended with the U.S. employment report that was described as dismal. With all the headwinds it is amazing equities held up as well as they did. Now since the short-term upside has waned it is time to take a more defensive posture. Following a brief strategy comment including look at the potential Head & Shoulder Top we have two hedge ideas followed by a trend change and takeover idea.
Strategy
On the positive side, our NYSE McClellan Summation Index continued higher adding another 276.69 points as the market breadth continued to improve.
At the end of the week, our day-weighted VIX Futures premium indictor increased to 12.40% from the prior week's reading at 10.08%. For this short-term indicator the premium to the cash is a SPX sell signal indicating professional expectations for the cash to increase toward the futures price. This week at 12.40 is just above the middle of the normal range. Readings above 20% are generally a good indication of increased professional hedging in anticipation of an immediate decline while negative readings suggests complacency about protecting long stock positions by buying VIX futures contracts. Low and especially negative readings in the past have been good leading indicators for short-term market advances.
With the change in momentum on Friday, due to the U.S. Employment report, we will outline the potential Head & Shoulder Top working in the S&P 500 Index (SPX). The Left Shoulder is the February 18 high at 1344.07, the Head is the high at 1370.58 reached on May 2 and the Right Shoulder is last Thursday's high at 1356.48. The neckline from 1250.11 on March 16 to 1258.07 on June 16 has a slight upslope currently crossing at 1261. This means it takes a close below the neckline, now at 1261, but will increase slightly over time, to set off the pattern. Using 1261 implies a downside minimum objective at 1,145. Based upon the yearend earnings estimate of $95.30 this would result in a price-to-earnings ratio of 12 time earnings. However, until we get a close below the neckline of the pattern, we will assume a trading range and plan accordingly.
Since the SPX is and now most likely in the upper part of a trading range and headed lower we suggest implementing some hedge trades, here are two ideas to evaluate.
Hedge Ideas
Direxion Small Cap Bear 3X Shares (TZA)
This ETF seeks daily results, before fees and expenses, of 300% of the inverse (or opposite) of the price performance of the Russell 2000 Index.
From our RT Options Scanner we discovered the unusual activity in this ETF on Friday with five strike prices trading more than 2,000 options contracts each while the call volume exceeded the put volume 6.6 times, as the Implied Volatility Index Mean was 58.81, up from 58.26 last week. The current Historical Volatility is 59.73 for an IV/HV ratio of .98. With good liquidity, Friday's options volume was 31,534 contracts compared to the 5-day average of 31,400 contracts.
Here is a long call spread with good volatility edge for the upside direction along with a short put to reduce the cost.
The increasing price of the ETF corresponds with the expected decrease in the price of the Russell 2000 Index. In the event the market turns higher once again use a close back below Thursdayís low at 30.58 as the SU (stop/unwind).
SPDR S&P Retail (XRT)
This ETF seeks to replicate the S&P Retail Select Industry index.
Using the U.S. employment report as the guide and having broken out to the upside with a gap last week, the retail sector could come under pressure so here is a hedge idea for this possibility.
The current Historical Volatility is 24.22 with an Implied Volatility Index Mean of 21.03 for an IV/HV ratio of .87 and an understandably high put-call ratio of 2.65 since it is used for retail sector hedging. Friday's option volume was 15,230 contracts compared to the 5-day average of 27,620 contracts.
At 17% of the distance between the strike prices this spread provides and attractive risk reward ratio of almost five to one. Use a close back above 56.44 as the SU (stop/unwind).
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