Volatility Trading Digest - Oversold Bounce
By most measuring techniques, the S&P 500 Index (SPX) is oversold and due for a bounce. The challenge will be to decide if the expected bounce forms the bottom for this down leg or is there still more downside to come.
S&P 500 Index (SPX)
The downward momentum accelerated, both in terms of the number of declining issues compared to advancing issues, as well as increasing volume that peaked with Friday's key reversal, much like the previous Friday, but with slightly higher volume. Both key reversal Fridays looked like short covering counter trend moves. Two weeks ago, we highlighted the close below the important 1400 support level set off the Head & Shoulders Top with the minimum downside-measuring objective at 1327.
Friday's key reversal objective is for a higher high than the Friday high and it could continue for a few more days before turning down once again. There is unlikely to be real buying support before reaching the 1327 minimum objective. The early April decline that lasted until early June was 10.7%, while the current decline is 9%. Presuming it eventually equals the spring decline it would reach 1317 thereby fulfilling the Head & Shoulders Top minimum objective.
A large contributor to the SPX key reversal was the very noticeable key reversal in Apple, Inc. (AAPL), after testing 500 with a low of 505.75 on 45.2 million shares, the highest since March 14 at 50.7 million shares, as it was advancing. Since the decline from 705.07 was almost a straight line down it would very unusual to see a V shaped bottom pattern. More likely, it will continue higher for a few days or even a bit longer and then retest 500 once again. AAPL makes a good indicator for the overall market, and we would be looking for another short entry when the rally from the key reversal looks complete.
S&P 500 Index Implied Volatility (IVXM)
At the end of last week, the Implied Volatility Index Mean declined from 16.97 to 15.36, while the CBOE Volatility Index® (VIX) declined from 18.61 to 16.41.
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.
Since the last trading day for the November futures is Tuesday, the day weighting applied 8% to November and 92% to December resulting in an average premium of 1.64 or 9.98% shown above. Our alternative volume weighting between November and December is 6.62%. Despite the declining SPX, this indicator is not showing as much premium to cash as seen in previous declining periods. Initially we thought it was due to less hedging with VIX futures, but now we are beginning to think it could be related to the increasing volume in the short VIX futures ETN and ETF that need to short the VIX futures and their selling is reducing the premiums.
Fridays VIX futures volume was 177,816 compared to the week before at 128,566 contracts as the open interest increased from 375,058 to 384,448.
From a somewhat longer-term historical perspective, Jeffrey Hirsch at the Stock Traders Almanac, speaking at the Traders Expo in Las Vegas, said he is concerned since November is usually a good month and if it continues lower without recovering before month end, the usual seasonal year-end rally is likely to be weak. As for next year, he points out periods when there is a divided congress usually results in sub-par market performance and he thinks it may not improve before 2017.
Other than special situations, we suggest reducing overall market exposure using any short-term rally from the current oversold condition as an opportunity to increase hedges or open new shorts until SPX closes below 1327.
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