Market Direction and Stock Trends

[DiscoverGold]

Should Wall Street Be Bracing for Another Volatility Pop?
By: Schaeffer's Investment Research | May 10, 2021

• What traders should pay attention to after another record-setting week for the SPX

• Plus, potential areas of support for the SPX in the week ahead

“… Cboe Market Volatility Index futures options buyers have returned, with the 20-day buy (to open) call/put ratio at 2.21… its highest level since late-May 2020, which preceded a VIX pop. Long-term readers of Monday Morning Outlook have seen comments in the past along the lines of VIX option buyers historically being smart money… the VIX moved below one half its 2021 closing high (37.21) at 18.60. Be on the lookout for a sharp move higher if the VIX closes back above 18.60 in the days and weeks ahead.”

-Monday Morning Outlook, April 12, 2021

One month ago, the CBOE Market Volatility Index (VIX--16.69) hit a pandemic low with a reading just below 16. The volatility decline that we were seeing at the time is usually bullish for stocks, but there was something amiss, as described in the observation that I made during that mid-April period, excerpted above.

Specifically, option buyers on VIX futures were buying calls at an increasing rate relative to puts, an action that has historically preceded VIX pops. As such, I noted that this option activity increased the risk of a pullback, although momentum continued to favor equity market bulls.

It was at that time, and in hindsight, that the 20-day, buy (to open) call/put volume ratio on VIX futures peaked at 2.50. Meanwhile, the VIX made a calendar-year and 52-week closing low at 16.25 just a few days after my mid-April comments.

Fast forward to early last week, with the VIX hitting an intraday high of 21.85 and a closing high of 19.48. VIX option buyers were correct about the direction of the VIX during the ensuing month. But another move above the 18.50 level, or half its 2021 closing high, proved only temporary.

Encouraging for equity market bulls is that the option activity I observed last month preceded a narrow trading range around all-time highs in the S&P 500 Index (SPX -- 4,232.60), resulting simply in a loss of momentum from the late-March into mid-April rally.

While volatility expectations, as measured by the VIX, advanced during this period, it was hardly a volatility pop like that of early June 2020, when the VIX increased by nearly 50% in only one week. This pop occurred after the ratio of VIX futures call buying to put buying on VIX futures in late May hit 2.50, like we saw in mid-April of this year.

With the VIX back below 18.60, following the gradual advance higher discussed above, the 20-day ratio of call buying to put buying is on the decline, currently at 1.75. With VIX call buying relative to put buying decreasing, the worst of a volatility increase hinted at last month may have passed.



“… after the Fed meeting, the SPX completed a third successive day in which the open and close were roughly the same. I referred to them as ‘doji-like,’ as the open and closes were not exactly the same, but close enough that it was easily observed… It remains to be seen if last week’s reversal pattern precedes an immediate decline like we witnessed in January and February.“

“A move into the channel suggests loss of momentum since last month’s breakout and risk of a further pullback to a second line of defense at 4,131, which is exactly 10% above the 2020 close. A third potential support level is 4,100, which is the level at which the breakout above the top of the channel occurred on April 9.”

-Monday Morning Outlook, May 3, 2021

I have noted increasing vulnerability to a market pullback for weeks now, whether sentiment-based or, in the case of last week, daily candlestick patterns that emerged in late April -- the tri-star doji pattern (circled in graph below) -- that traditionally hint at trend reversals like we saw in January and February.



At the same time, I have suggested that with the trend in equities obviously higher and the index still respecting support levels on pullbacks, one can manage emerging risks by simply hedging long positions versus selling them. Or, at the very least, these various risks suggest that one have a plan to hedge a portfolio without hesitation, if or when support levels on the SPX are no longer holding.

As such, I would not have argued with anyone that began hedging last week when the SPX broke back into its channel and the VIX moved above 18.60, as it makes sense to buy insurance when it is relatively cheap, and the technical backdrop looks “iffy.” Last week, for example, the SPX moved back into a channel that it has been generally trading above since early April.

But as I noted last week, there are multiple support areas not far below the SPX’s current level. It was the level that coincides with the round 10% -- above the 2020 close that marked support. This SPX 4,131 level was situated only about 1% below that channel line. As such, if last week is indeed a low for the time being, the bearish “tri-star doji” pattern from late April proved to be a good for a negligible 1.3% decline within a few days of the pattern emerging at last week’s intraday lows. In fact, while the SPX broke below its popular 20-day moving average intraday, it never closed below it. The action around this moving average was like that of late March.

With the SPX closing Friday at an all-time high and more than a week surpassing since the emergence of the bearish “tri-star doji” reversal pattern, one must wonder if the bulls dodged yet another bullet?

With the top of the SPX channel at 4,200 to begin the week and at 4,215 by Friday and last week’s intraday low around 4,130, or 10% above the 2020 close, the area between 4,130 and 4,215 are potentially strong areas of support in the week ahead. But keep in mind that other support levels (discussed in detail last week) lie not far below this zone, so hedging is still recommended as a cheap way to guard against a major unwind of optimism in lieu of moving to cash or even getting overly aggressive on the short side and thus fighting the major trend.

Continue to stay in tune with support levels that I have discussed. With many companies reporting earnings during the past two weeks, implied volatility on many equity options has decreased substantially. Therefore, you can play the price momentum with call options with those equities helping support the market, such as re-opening plays like traditional retailers, restaurants and metals names that are showing strong price action amid low expectations.

Read Full Story »»»

DiscoverGold