Catching a Falling Knife

It looks like volatility is back. The S&P500 traded within a 19-point range today, seeing highs near 1977 and lows near 1958. The day closed just south of 1965 to finish in the red.

A linear channel shows a downward drift in $SPX

If you believe that the trend is your friend, you should also believe in not catching falling knives. Drawing a linear channel down from the September highs near 2020 shows a clear downward trend where selling strength in the index proved to be a very effective strategy. The exception would've been the rally up from last Thursday's low of 1925 to today's morning highs of 1977. However, anyone who follows the markets closely (or reads this blog) should have been aware that Fridays almost always show remarkable low volume, "thin-to-win" S&P rallies.

Some speculate that this may be due to money managers covering short positions, algorithms squeezing out shorts, or a variety of other reasons. Regardless of the actual mechanics, anyone who made this Friday trend "their friend" received handsome returns.

Looking ahead into this week, I expect a confluence of factors to contribute to further downside action in the index.

Last Friday showed a huge divergence between 30-year yields with USD/JPY and the S&P500, which was bound to converge. (The chart below courtesy of ZeroHedge).

Courtesy of zerohedge.com

USD/JPY began its convergence with 30Y very early this morning while the S&P took a little while longer. Nonetheless, there was a very strong convergence, and a well-timed shorting of strength in the index would have yielded a nice return. There is still quite a bit of spread left between SPX and 30Y, however, that does not necessarily imply a drop in the index: there may also be a lowering of 30Y yields (notice that 30Y's axis is inversed on the left).


@WallStreetJesus provided a study over the weekend that made the case that the S&P hadn't bottomed out yet:

Courtesy of @WallStJesus via Stocktwits

Looking at the relative put/call ratio of CBOE options, WallStJesus showed a consistent pattern where bottoms and tops in the S&P correlate with price action breaking out of the bollinger band. Looking at the P/C ratio, the trend is currently towards increasing put volume relative to calls. Price action has not yet broken out of the band, but it is slowly nearing.

On the volatility front, we appear to be an upward trending environment for market volatility.

The VIX has found a strong level of support at 14.00 since September 25th. Any attempts to breach this level since last Monday has been rejected, indicating increased risk perception by the markets. Also notice that the 50-DMA has crossed over the 200-DMA.

Taking a look at VXX, we can see moving averages inching to make a cross-over:


Based on volume, we see an increasing amount of buyers interested in VXX at and below 30. As a reminder, VXX was priced at 7,680.00 back in early 2009.

What are traders seeing in $SPY for the remainder of October? Let's take a look at some option skews:

Option skew in $SPY based on today's sales (Oct. 6)

Traders seem split on the S&P500 for the month of October: Most seem to agree that maximum upside in the S&P seems to be around 1967.5 (or 196 in $SPY). A majority of traders are however placing their bets on downside as far down as 1930 (or 193.5 in $SPY).

Going into the October expiration, there is a nice trading rule called "The Pit Bull’s Thursday/Friday low the week before expiration" that I like to look out for:

The S&P tends to make a low on the Thursday or Friday the week before the expiration (more so on the quartiles). The rule is to look to buy weakness on that Thursday or Friday, looking for a low to hold into Monday or even into the expiration itself. Generally, the trade is to buy on Friday and hold into Monday. (Courtesy of Mr. Topstep at CME Group)

According to this rule, the S&P tends to make a relative low on the Thursday or Friday on the week before the monthly expiration. This week would be the week before the October expiration. If this rule holds true for this month, we can still look for some further downside action in the S&P. But don't take my word for it, take a look at some charts and try to confirm this trend for yourself: there were some nice lows on September 12 and August 7 this year.

Best luck to all of you tomorrow.