Volatility Trading Digest - Strategy Ideas
Strategy
In the past week, there has been a noteworthy improvement in the equity indexes with both the S&P 500 Index and the Dow Jones Industrial Index both making Head & Shoulder Bottom patterns while the confirming Dow Jones Transportation Index is very close. In addition, many other individual issues have already made Head & Shoulders Bottoms or are also very close. However, before coming overly enthused, we note several other important indexes has not yet crossed above their necklines, including the E-mini S&P 500 September futures contract above, the Powershares (QQQ) and the Russell 2000 ETF (IWM) but we are anticipating they will continue higher in the next few days.
Although there is considerable uncertainty about the outcome in Greece the equity markets seem less concerned about the never-ending elections in Greece and more focused on other events scheduled this week.
Since it appears equities are about to continue higher, this seems like this is a good time to check the contrarian sentiment indexes.
The American Association of Individual Investors Sentiment Survey for the week ending Wednesday June 13 reports the bulls at 34% with the bears at 35.8% for a net bear reading of -1.8%, but for the prior week ending June 6, the bulls were 27.4% and the bears at 45.8, making the bear spread -18.4%. The long-term average is 39% bullish and 30% bearish for a spread of +9%. As a contrarian indicator, this one seems to confirm the June 6 bottom as sentiment is improving.
Another indicator we occasionally check to determine their bullish or bearish bias is the weekly Investors' Intelligence survey of financial newsletter writers. Although backward looking, it is considered contrarian since at the extremes it has signaled changes in trend. As of June 13, the reading was 37.2% bullish and 26.6% bearish for a bull/bear spread of 10.60%. For the week of June 6, the readings were 34 bullish and 26.6% bearish for a spread of 8.40%. This one also indicates improving sentiment from the low made the week before.
Our friends at Leavitt Brothers have a number of interesting timing indicators including one for the Nasdaq Composite Bullish % Index using a 5-day EMA that looks quite timely. Click on the link and have a look.
While there is still some uncertainty and downside risk if there is no QE3 announcement, the weight of evidence suggests closing any remaining long put positions and begin looking for opportunities to sell puts on selected individual issues while the implied volatility remains favorable since it will decline when they start trending upward again.
A Walk on the Long Side
SPDR S&P 500 Index (SPY)
While acknowledging there could be a good bit of downside in the event there is no QE3 announcement from the FOMC meeting next week here is a long combination idea with a well defined stop included just in case it's needed.
First, the relevant options data.
The current Historical Volatility is 16.57 and 14.31 using the Parkinson's range method, with an Implied Volatility Index Mean of 18.77, up from 18.29 last week. The IV/HV ratio is 1.13 and 1.31 using the range method to calculate the HV. Friday's put-call ratio was bearish at 1.50, but within the normal range of 1.50 to 1.60, since it is hedging favorite. The volume was 3,557,807 contracts traded compared to the 5-day average volume of 3,429,840 contracts.
Consider this long combination idea.
While there is a decent volatility edge in the short put, use a close below the pivot that forms the right shoulder of the Head & Shoulder Bottom pattern at 131 as the SU (stop/unwind).
The suggestion above uses the closing middle price between the bid and ask on Friday. On Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.
Summary
The improvement in equities last week was most likely due to QE3 expectations despite continuing uncertainty from Greece as most of the major indexes are making an important technical bottoming pattern providing an overall positive tone for equities.
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