Volatility Trading Digest - Watching the Bounce

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Volatility Trading Digest - Watching the Bounce

The never-ending search for clues about market direction continues despite the turmoil in Europe that will ultimately determine the outcome. In the short-term the stage is set for the bounce that began last Wednesday to continue after the Euro zone finance ministers agreed on Saturday, to lend Spain up to Ä100 billion, from an undetermined source, to recapitalize its banks.

We will wait and watch cautiously to see how high this news carries the euro, the S&P 500 Index, and other risk assets along with a few select indicators. After a brief strategy comment, we have a new long suggestion for the bounce and then update a previous crude oil suggestion followed by a high-implied volatility trade idea.
 
Strategy

S&P 500 Index (SPX)
The flag pattern highlighted last week was completely destroyed last Wednesday when SPX gained 29.63 to close at 1315.13, considerably above the crucial pattern low of 1291.98, made on May 18.  

Now with expectations that it will continue higher on the weekend news from Europe watch 1334.93 from May 29 where it could encounter some "sell the bounce" pressure.

NYSE McClellan Summation Index
Further validity supporting the bounce comes from an improving NYSE Composite breadth ratio, gaining 56.77 points last week, for the first improvement in the last four weeks.
S&P 500 Index Implied Volatility (IVXM). Since last week, the Implied Volatility Index Mean decreased 24.80 to 18.75, while the CBOE Volatility Index (VIX) decreased 26.66 to 21.23.     

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 28% to June and 72% to July resulting in the average premium of 2.00 or 9.44% shown above. Our alternative volume weighting between June and July results in a 7.36% premium. Last week the day-weighted premium was 6.82% and the volume weighted was 6.09%.  

For this short-term indicator the premium to the cash is a SPX sell signal suggesting professional expectations for the cash to increase toward the futures price. In the past premiums in excess of 20%, have usually preceded corrections, although not a precise timing tool it did appear to be a good way to measure professional hedging sentiment. Along with the slightly lower VIX, we consider the current futures premium reading to be neutral to slightly positive.  

Using a cyclical rotation indicator as another measure to help evaluate the strength of the bounce, we compare the Consumer Discretionary Select Sector SPDR (XLY) , divided by the Consumer Staples Select Sector SPDR (XLP) creating the ratio index from last December shown below.



The downward sloping trendline labeled DSTL in blue above from the May 2 peak at 1.34 shows the Consumer Discretionary SPDR, XLY has already reversed the downtrend and appears headed higher once again adding support for "risk on" cyclical trading ideas.

Consumer Discretionary Select Sector SPDR (XLY)
While there are many ways to increase risk exposure, this one keeps us focused on the ratio in the event the current bounce momentum falters.

The current Historical Volatility is 19.17 and 14.73 using the Parkinson's range method, with an Implied Volatility Index Mean of 20.48 down from 26.45 last week. The IV/HV ratio is 1.07 and 1.39 using the range method to calculate the HV. The put-call ratio at a whopping 17 reflects considerable hedging activity with Friday's volume of 6,717 contracts traded compared to the 5-day average volume of 14,550 contracts. The bid/ask spreads appear wide so use limit orders and consider legging into the position. Here is one long call short put directional idea.



There is some implied volatility edge in the short put. Use a close back below the downward sloping trendline shown above or alternatively the most recent pivot at 42 as the SU (stop/unwind).  

If the bounce continues and money flow returns to the cyclicals then we should close our crude oil put spread from May when USO was 36.26. Here are the trades need to close the position.

United States Oil (USO)
The totals shown above are for 2 options at each strike price, the July 33s were 2.17 each, while the July 35s were 3.63 each. After the adjustment made in May, the current position has a credit of .21


 
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