Volatility Trading Digest - Bond Market Vigilantes: Strategy
Volatility Trading Digest - Bond Market Vigilantes: Strategy
In last week's post we suggested many stock indices along with some commodities, gold and silver were overbought and due for a correction and indeed we did see the beginning of the correction last week. However, for the S&P 500 Index it will still need to close below 1197.96, the November 3 high to reverse the breakout on the QE2 news. While gold based on the December futures contract is now approaching its upward sloping trendline from the July 28 low at 1159.30 that touches the November low at 1325.50. Now at 1365.50 it will take a close below 1349 to breach this trendline.
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Further assurances from the euro area on the Irish bond default issue could take the selling pressure off the euro creating a weaker dollar while further supporting equities, commodities and precious metals.
Short-term traders may want to try the downside in the event the S&P 500 Index closes below 1197.96 this week. Since the Digest is limited to weekly suggestions, we think the risk of a quick reversal at the support for both equities and gold makes the short side unattractive since counter trend corrections have a tendency to reverse quickly to the upside. For our weekly strategy suggestions, we think the better strategy is waiting for the correction to be completed before adding more longs. Since there have been no real fundamental changes from the G20 meeting we are inclined to think the equity uptrend will resume shortly and last week?s sell off will have be declared a correction of the recent breakout. This also includes commodities and precious metals. However, we do acknowledge rising long- term interest rates are a concern and could become an issue it they continue their ascent.
Volatility Update
S&P 500 Index (SPX)
Here is the one-year volatility and price chart.
The Implied Volatility Index Mean is currently 18.01 with the current 30-day Historical Volatility at 12.11, up from last week at 11.26. The IV/HV ratio is 1.49.
In the chart above notice how the IV Index Mean declined down to about 15 on two prior occasions, first in January and then in April, before turning higher with the increase of the underlying Historical Volatility as the index declined. Both times the IV/HV ratio widened crating a positive volatility spread as the IV Index Mean failed to follow the Historical Volatility lower. Then they both turned as SPX declined. Currently we have the same situation as both volatility measures appear to be turning higher and this is consistent with the two previous market declines. While not predicative, it is certainly instructive and in conjunction with divergences in both the McClellan Summation Index and the RSI it suggests the breakout correction is likely to continue going lower.
Summary
The equity market along with commodities and precious metals began correcting last week, but so far, the decline has been limited while there have been no real fundamental changes, with the possible exception of rising long-term interest rates. If equities continue declining this week, consider the possibility of a developing double top.
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