Langlui's Big Board and Options Plays

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Schaeffers<>Monday Morning Outlook: VIX Pendulum Swings in the Bulls' Favor
However, familiar resistance could keep stocks in check
by Todd Salamone 7/16/2011 12:25 PM

Ramped-up anxiety was the theme on Wall Street this past week, as traders promptly overreacted to nearly everything Ben Bernanke said during his two days of testimony on Capitol Hill. Then, just as the QE3 rally gave way to the QE3 sell-off, ratings agencies started tripping over themselves to issue U.S. debt downgrade warnings. But by the end of the week, John Boehner and Nancy Pelosi agreed about only one thing: They definitely don't want to take a Camp David budget retreat together. With major fiscal risks still looming, stocks suffered yet another negative July expiration week -- and the CBOE Market Volatility Index (VIX) skyrocketed more than 22% along the way.

However, after crunching the numbers, Todd Salamone explains why this latest VIX spike may actually provide some short-term relief for weary bulls, even as the S&P 500 Index (SPX) remains sandwiched between support and resistance. Meanwhile, Rocky White uncovers an encouraging trend among recent five-week expiration cycles, as August-dated options prepare for their extended run as the front-month series. Finally, we wrap up with a preview of the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Keeping an Eye on SPX Retracement Levels
By Todd Salamone, Senior VP of Research

"The 'VIX premium' ratio, which measures the percentage by which the VIX is trading above 20-day historical SPX volatility, currently favors the bulls... The risk here is that the current signal was triggered at a level where the VIX has tended to trough in 2011. This is unlike the previous buy signal in March, when the VIX was trading in the 20 area."

"Since 2000, July expiration week has tended to cater more to the bears than the bulls, with seven of the last 11 ending in negative territory."
-- Monday Morning Outlook, July 9, 2011

Last week, we focused on three indicators that favored the bulls: Evidence of hedge fund managers showing interest in equities after weeks of selling; an improving technical backdrop after a relative extreme in pessimism; and the CBOE Market Volatility Index (VIX - 19.53) trading on par with SPX historical volatility, which is a set-up that has preceded market strength during the past couple of years.

Unfortunately for the bulls last week, the accompanying risks that we outlined -- specifically, the low absolute level of the VIX and the historical tendency toward weakness during July expiration week -- trumped the three favorable factors we discussed. The market was weighed down by disappointment after Federal Reserve Chairman Ben Bernanke, in his testimony to Congress, indicated that another stimulus was not on the immediate horizon -- not to mention a couple of threats by ratings agencies to downgrade U.S. debt, due to continued gridlock on the budget compromise. In the short term, the debate over the debt ceiling and deficit reduction could continue to be a headwind for the market, as could the ongoing fiscal problems in Europe (with Italy now in the spotlight).

Familiar resistance levels on the S&P 500 Index (SPX - 1,316.14), Russell 2000 Index (RUT - 828.78) and S&P 400 Midcap Index (MID - 976.11) continue to present major roadblocks for equities, as has been the case since late April. At the risk of sounding like a broken record from week to week, these levels are as follows:

SPX 1,333-1,340: The 1,333 level is double the March 2009 low, and the 1,340 area has acted as resistance on four different occasions this year

MID 1,000: The first-ever attempt to break above this key millennium mark was in April

RUT 850-855 : The 2007 peak



That said, we still think the probability of a sustained breakout above major resistance levels is higher now relative to earlier this year, given that there is currently more sideline money and short-covering potential to fuel such a rally.

The absolute level of the VIX is now a risk to the bears, after posing a threat to the bulls just one week ago. In the 2011 calendar year, a strategy of selling equities when the VIX approaches 15 and buying equities when the VIX advances above 20 has proven to be a rewarding timing approach. This could be related to the growing trend among institutional investors to keep portfolio insurance in place. So, when index options are deemed "cheap" by this crowd, demand for protective puts suddenly increases. This activity applies coincident pressure to stocks, as those selling the puts to these option buyers turn around and sell stock futures to hedge their put sales. Conversely, when index options are deemed "expensive," the appetite for portfolio protection decreases, thereby removing this headwind.



In fact, the VIX spike above 20 last week was quite notable, as the index closed 18% above its 10-day moving average. There is a clear mean-reverting behavior in the VIX after such spikes, as described in the table below. The VIX often moves inverse to the SPX, and the data indicates that the SPX has a greater-than-usual probability of closing higher in the immediate days following a spike of last week's magnitude or more.



The SPX's low last week occurred at a 50% retracement of its post-holiday July 7 peak at 1,356.48 and its June 16 low at 1,258.07. This retracement level is at 1,306.90. With the 1,300 century mark immediately below, and the 61.8% retracement of these highs and lows at 1,296.10 (the site of a short-term low on April 18), we'll call the 1,295-1,305 area support heading into this week. Resistance levels are the usual suspects discussed above.



We continue to emphasize consumer discretionary names, and would avoid financials. JPMorgan Chase (JPM) and Citigroup (C) posted earnings reports well above analysts' lowered expectations this past week, but neither stock was able to sustain the positive price action through Friday's close.

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