From the Sidelines

2-5-18

Wait and see....

For Today's blog I will not be focusing on price action of individual stocks but rather a strategy in how to approach the market during this sign of weakness. We may have a very quick pull back, less than a week or we could start to see some extended chop. Either way trading the market solely to the long side would be a mistake at this time. I personally expect to see some profit taking and bears enjoying a period of profitability.  

Low-float momentum may remain unaffected for the time and profits may still run hard in that space. Just be mindful as the market sell and panic starts, retail can act very unpredictable. During our last real pullback in 2016, momentum slowed to a sickening crawl and many retail traders turned to volatility trading at the height of the slowdown. Use caution trading volatility if you are unfamiliar with its extreme moves. (Lesson on volatility below)

- Overall Market - 

The Dow plunged more than 660 points, while all 11 sectors on the Standard & Poor's 500 dropped, led by a 4.1% plunge in the energy sector. That was after ExxonMobil (XOM) disappointed investors with weaker-than-expected earnings, while Chevron (CVX) came in above analysts' views.

While earnings weighed on Friday, markets were wobbly all week after a hawkish Federal Reserve statement coupled with strong labor data raised concerns about climbing interest rates, sparking selling in bonds that pushed yields on US Treasuries higher.

The Labor Department reported an increase of 200,000 in non-farm payrolls and 0.3% gain in average hourly earnings. The data drove the 10-year yield to a four-year high of 2.85% and the Dow below 26,000. The last time the Dow posted a decline of more than 600 points was in June 2016.

Expect weakness to continue, remember we also still have a looming government shutdown that was only placed on the back burner and must be yet resolved.

Bear market? most likely no. Pull back? absolute. The bigger concern is where does this pull back end. To avoid any wide spread hysteria lets start with the basics. Should the market show weakness beyond the below price levels, we can talk about preparing for a shift in market sentiment. 

I will continue to assume we are in a bull market and are seeing a healthy pull back. No reason to go full on bear just yet. The mindset now needs to be finding value and being ready to pull the trigger when the time comes. 

- Finding the "bottom"

SPX - For trading levels, we're watching 2,765 (minimum retracement from Aug. low) followed by support at 2,715 (50-day m.a.) and 2,700 (Dec. high /38.2% retracement) These levels will be our first line of defense. The market may very well blow through all of these. I expect at the least the convergence of the 50dMA and retracement from December to provide a target most traders will be watching to see if the market catches a bid.  

I typically track the SPY for most trading days however, For the time being I will use the SPX, it is more exact in terms of value. 

Should we break through these targets we will discuss monthly resistances, slower moving averages and larger retracements. For now focus on the above key levels for clues.

 

Futures - At open last night E-mini futures tanked hard flushing 20 points and probing under 2,740 to a low of 2,733. Throughout the evening a slow and steady grind to "fill the gap" persisted. At time of writing we have rejected Fridays close price, confirming this as resistance (for now). Price action is now selling off and look to be headed back to retest lows. While the futures market is its own animal and low volume speculation that occurred in the last 13 hours can be easily reversed once the volume of the market steps in. We have a good clue that weakness remains. No sign of another -4% day but weakness none the less. 

 

VIX (Volatility) Volatility has been the play the past few sessions for me. These times are great to capitalize on a deeper understanding of the market. Just as this indicator helped us spot coming weakness before price action showed, we can look for signs of strength before price action shows. Be mindful that this classic "fear&greed" indicator has some serious flaws.

I call this an indicator because that is how I use it. By definition is is an index, similar to spx. It is derived by a complicated series of steps. Reading between the lines so to speak, I use price action on this index as a way to track psychological fear and greed hidden in the market.

Smart money and fund managers routinely use this to hedge the market. Small and subtle clues can be inferred by looking at this daily and comparing or overlaying this on charts.   I personally trade volatility futures and occasionally alert TVIX/UVXY calls for swing subscribers. I am often times hesitant to do so as most do not understand the instrument and its incredible price swings. Below is a expanded lesson on VIX, volatility futures trading and the idea behind this index few understand.

- Volatility Lesson - 

As I have made reference to this mysterious index and its value many time, I find it prudent to expand and provide a better understanding of why I track this on a daily basis.

What is VIX?

VIX is an implied volatility index. It measures the market's expectation of 30-day volatility implicit in the prices of near-term S&P 500 options. VIX is quoted in percentage points, just like the standard deviation of a rate of return, e.g. 23.26. Cboe (Chicago board options exchange) disseminates the VIX index value continuously during trading hours.

How is VIX Calculated? (simple answer)

VIX is a measure of expected volatility calculated as 100 times the square root of the expected 30-day variance (var) of the S&P 500 rate of return. The variance is annualized and VIX expresses volatility in percentage points.

The Theory behind the VIX Calculation (just for the finance geeks, Skip this if your not into finance mambo jumbo.)

VIX is obtained as the square root of the price of variance, and this price is derived as the forward price of a particular strip of SPX options. The justification for this derivation is that variance is replicated by delta-hedging the options in the strip. An intuitive explanation of the mechanics of this replication based on Demeterfi, Derman, Kamal and Zou2 is:

  • The price of a stock index option varies with the index level and with its total variance to expiration. This suggests using S&P 500 options to design a portfolio that isolates the variance.
  • The portfolio which isolates variance is centered around two strips of out-of the money S&P 500 calls and puts. Its exposure to the risk of stock index variations is eliminated by delta hedging with a forward position in the S&P 500.
  • A clean exposure to volatility risk independent of the value of the stock index is obtained by calibrating the options to yield a constant sensitivity to variance. If each option is weighed by the inverse of the square of its strike price times a small strike interval centered around its strike price, the sensitivity of the portfolio to total variance is equal to one. Holding the portfolio to expiration therefore replicates the total variance.
  • Arbitrage implies that the forward price of variance must be equal to the forward price of the portfolio which replicates it. Observing that the S&P 500 forward positions in the portfolio contribute nothing to its value, the forward price of variance reduces to the forward price of the strips of options.

Performance of VIX Futures

VIX is more volatile than most assets, and traders can expect VIX futures to be among the most volatile futures contracts as well. To illustrate, from May to November 2004, a period of relatively low volatility, the daily percentage variation of nearby VIX futures ranged from 0.06% to 7.12% and averaged 2.13%. The daily dollar variation ranged from $10 to $1330 and averaged $358 (per contract). In turn this makes ETS's that track VIX just as dangerous if not more so when discussing 2x or 3x leveraged daily return (UVXY/TVIX and their inverse)

Trading the Direction of Implied Volatility

The most straightforward application of VIX futures and options is to trade implied volatility. While implied volatility can also be traded with straddles or by unwinding delta-hedged option positions, VIX contracts offer a cleaner and less costly exposure which does not need to be adjusted when the market moves. Another attractive feature is that VIX is relatively simple to track and that it can be forecast from several readily observable variables: the current deviation of VIX from its mean, past realized volatility, the performance of the S&P 500, and even the month of the year.

Hedging Implied Volatility Risk

Because VIX futures settle to the implied volatility of the S&P 500, they are natural to hedge the "vega" risk of S&P 500 options. VIX futures are also effective to cross-hedge the vega risk of stock options and stock indexes correlated to the S&P 500, whether these are exchange-traded or embedded in other assets. For stock only traders the same scenario applies with the use of leveraged ETF's.

Characteristic Patterns of VIX

VIX has been calculated since 1990, covering a period in which financial markets not only passed through several bull and bear cycles but were impacted by three major financial crises. The history of VIX throughout these events may provide useful background information for trading VIX contracts. Or a potential insight into historical repeats.

Relationship between VIX and Other Assets

VIX and the S&P 500

VIX moves inversely to the S&P 500, and more significantly when the S&P 500 declines, which is why it is called the fear gauge. In fact, this inverse correlation has become stronger since 1990. From 1990 to 2004, daily returns of VIX and the S&P 500 had a correlation of .56 for down S&P 500 moves and .40 for up moves. Over the same period, a 1% decrease of the S&P 500 was accompanied by a 4.26% average increase in VIX while a 1% increase of the S&P 500 was accompanied by a 2.30% decrease in VIX.

Bringing it together

You can see why this index can become a powerful tool when utilized properly. It does take a bit of previous knowledge and experience to spot some of the subtle details in its movement. The great thing is, with today's charting software, you can look back and overlay the price action of this instrument and the S&P chart of your choosing.  Take some time and study this index, learn to use it. While hardly the holy grail of trading, it can and will be wrong from time to time. It is just another tool we can use to help consistently extract money from the market.
 

- Closing Notes -

I will remain calm and not attempt to act like I know what the market will do next. There is a chance by market close all of the recent loss in the market is undone, unlikely but remember we are in a bull market. 

When the market catches a bid expect money to pile back in and everyone on social media will be screaming about how they "#BTFD". I do believe there is a dip buying opportunity coming, just not sure when. Let the market tell us, you will never tell the market. 

Just as I used fear to advantage when others were in extreme greed, I will look for the opportunity to be greedy when others show extreme fear. We are somewhere in between right now. I will not be a pig. 

Bulls make money, Bears make money, Pigs get slaughtered... Try not to play the part of dumb money in the market. 

Remain hungry and humble!

Thank you again, lets go team! 

 

Disclaimer: We are not responsible for losses for any reason. We are just an investing club here, seek financial advise from a professional before acting on any of this information. This information is strictly my opinion and what I am seeing in the market. The information above is not a trade recommendation to buy or sell. I am not a licensed broker, dealer or finical adviser. Trading comes with considerable risk and may not be for everyone. Past performance is not indicative of future performance. Never trade with money you can not lose and paper trade to prove profitability before using real money.