Volatility Trading Digest - Speculating on the Fed
Volatility Trading Digest - Speculating on the Fed
While most of us like to think equity prices are a function of logical fundamental valuations, the reality is something else. For now, the markets are moving based upon speculation the Federal Reserve will implement another round of Quantative Easing, QE3 among other things detailed below.
After updating our market indicators, including an updated S&P 500 Index chart in the Strategy section below, we offer some thoughts to consider over the next two weeks along with an updated gold idea.
S&P 500 Index (SPX)
Last week we said, "After reaching the Head and Shoulders minimum measuring objective at 1404, SPX continued working higher toward the April 2 resistance high at 1422.38. Then last Tuesday [August 21], it advanced to 1426.68 before closing lower at 1413.17 making a key reversal, unable to close above the April 2 resistance. Since it is considerably higher than the active upward sloping trendline from the June 4 low at 1266.74 the failure would not seem significant, but at end of August, it is another story."
On the key reversal, it has yet to close above the April 2 high so it remains the resistance level. As expected, the volume during the last holiday week was very low so we are reluctant to draw many conclusions, however since we are now in September, seasonally the weakest month of the year, the likely direction is lower, unless there is some unexpected good news from Europe or the Federal Open Market Committee.
E-mini S&P 500 Future (ESU2)
Open interest continued increasing to reach 3.1 million contracts based upon Friday's preliminary report with volume in excess of 2 million contracts, the first day volume exceeded 2 million, (moderate volume) since August 2. Two days last week volume was extremely low at less than 1 million before Fridays' increase, no doubt related to speculation about possible comments from Federal Reserve Chairman Ben Bernanke at Jackson Hole. This week open interest should start expanding rapidly for the regular September rollover surge.
S&P 500 Index Implied Volatility (IVXM)
At the end of last week, the Implied Volatility Index Mean increased from 13.10 to 15.37, while the CBOE Volatility Index (VIX) increased from 15.18 to 17.47.
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 60% to September and 40% to October resulting in the average premium of 2.36 or 13.53% shown above. Our alternative volume weighting between September and October calculates to be a 13.60% premium. Last week the day-weighted premium was 24.82% and the volume weighted was 28.49%. The premiums declined considerably last week while the volume declined somewhat, as the open interest increased to 365,620 contracts, but still less than 403,608 contracts reached on August 21, the key reversal day.
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 appears to be a good way to measure professional hedging sentiment, which is now back into the normal range.
VIX Options
With a current 30-day Historical Volatility of 98.11 and 68.17 using Parkinson's range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday's closing option mid prices along with their respective month's futures prices, since the options are priced from the tradable futures.
Using the IV Index Mean of 80.32 the IV/HV ratio is .82, using the range method for Historical Volatility the ratio is 1.18 while the VIX put-call ratio at .90, up from .21 last week, is now in bearish territory for the VIX, but more bullish for the SPX since they move in opposite directions. Friday's options volume was 242,733 contracts, up slightly from the 5-day average of 231,900 contracts.
CBOE S&P 500 Skew Index (SKEW)
Designed to measure the purchase of out-of-the-money S&P 500 Index puts that would require a very large downside move to profit from long put positions, an increase of this index indicates a higher expectation of an extreme down move. After fluctuating within the 113-126 range for the last three weeks, it made an unusual spike to 129.99 on August 21, the day SPX made the key reversal before returning to the middle of the range last Friday.
CurrencyShares Euro Trust (FXE)
Now up against resistance at 125, it has closed the gap created by the one-day 2.08-point advance made on June 29 where it encountered selling that pushed it back below 120. Since the European holidays are over and the euro has been working its way higher since July 24, it looks vulnerable to selling pressure, which means the dollar would go higher putting pressure on equities and crude oil. However, a continuing advance beyond 126 could be a leading indicator of a favorable decision by the German Federal Constitutional Court on September 12, when it will announce its decision on whether to impose a temporary injunction against laws setting up the permanent bailout fund and the fiscal pact for the euro. If it remains at this level or higher, expect to see selling on the news.
NYSE McClellan Summation Index
In the past three weeks since we last reported, the NYSE Composite breadth index, our favorite early trend change indicator, declined 43.54 points and now is moving sideways in a range between 500 and 668 as the divergence has been resolved since breadth and the index are both moving in the same direction.
iShares Dow Jones Transportation Average Index (IYT)
Since IYT remains almost unchanged, we said it about right a few weels agp, "The potential Head & Shoulders Bottom pattern seems to be morphing into a range between June 4 low at 86.09, the head of the Head & Shoulders Bottom, and the June 19 high at 94.66. While the pattern remains valid until there is a close below 86.09, the range interpretation is more likely until crude oil declines to provide some additional cost pressure relief for this important group."
SPDR Homebuilders (XHB)
On the .72 advance to close at 23.09 on August 16, XHB finally exceeded the May 2 high of 22.43, an advance we had been expecting. This negates the prior potential Head & Shoulder Top pattern and replaces it with a multi-point upward sloping trendline from the June 4 low at 18.93. The homebuilders are the top ranked group with several good trend continuation candidates.
iShares S&P GSCI Commodity-Indexed Trust (GSG)
This energy heavy index is vulnerable to the seasonal decline in crude oil now due, however gold is an exception after breaking out Friday in what appears to be a classical flag pattern.
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