In a Perfect World

One cannot simultaneously be a trader and a market ideologue. Of course, we all have our biases about how the markets "should" behave but that's in a perfect world. We aren't in that world. I personally would have liked to see more consolidation and level testing in the S&P before ramping up to new all-time highs from the October 15th v-shaped bottom. But that's not up to me. So instead of worrying about the market being overbought/oversold, disconnects from fundamentals, or plunge-protection teams, we should re-focus our efforts on profiting off the market's next move.

Although timing market moves can be difficult, it's not entirely impossible.

VIX expiration dates. Yellow line outlines time period between subsequent expiration.

If one pays close enough attention to small details, the larger and not-so-obvious trends start to appear on the charts. One of the more obvious ones are the brutal short squeezes that tend to occur on the days prior to monthly VIX expiration dates. For example, looking at the chart above, we can see that the month of September showed a well defined trend of increasing volatility. However, the trend seems to abruptly break on the three days leading up to the September 17th expiration, only to resume immediately the day after.

October 15th's v-shaped bottom happened to occur only several days before the month's VIX expiration, slamming the index almost entirely in half in about four trading days. I don't entirely discount the fact that VIX front-month rollover may cause sudden erratic behavior in the index, but I have to admit that there are some strong peculiarities behind the timing and magnitude of these movements around these dates.

Regardless of why this occurs, we can attempt to use this trend to our advantage. If there is a period of volatility in the weeks leading up to a VIX monthly expiration, expect some volatility slams on the days just prior to expiration.

Having said that, I'm looking for volatility Thursday and Friday of this week. Why? Another rule, straight from a CBOT pit trader, Danny Riley:

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. - Mr. Top Step

The converse is also true: look to short any strength on the Wednesday or Thursday morning. However, as with any rule of thumb, don't count on it to forecast trends with 100% accuracy. Be sure to do your own homework and back-testing.

Taking a look at the December S&P futures, the grind upward has seemed to lose momentum this week:

ESZ14 (Dec. S&P500 Futures)

Decreasing volume on the upside in addition to the heavier density of trades occurring at subsequently lower levels in the S&P seems to indicate a slowing of momentum on this rally and a need to pull-back and retest some lower levels. Notice that 2037.5 was rejected nearly five times today.

If the index decides to sell-off this week, look for 2024 and 2012 as major levels of support, of course keeping in mind that next Wednesday is this month's VIX expiration. Having said that, if the markets decide to continue their upwards trajectory without any consolidation, look for even numbers as levels of support: 2050, 2085 (20% S&P gain from Feb. lows), and 2100.

Looking at the monthly USD/JPY chart, Bollinger Bands seem to indicate extreme "over-bought" signals:

However, if USD/JPY decides to continue its upward trajectory without a pull-back, we should look for long positions on US equity indexes, albeit cautiously.

Remembering that we are in uncharted all-time high territory, there are no technical areas of resistance to stop the indexes from achieving high after high. Are we near the top? No one can be certain but having said that, there is ample liquidity and an enormous amount of stock buy-back that can justify these levels.

The limits of this bull market are only bound by zero-interest-rate-exuberance, which, to quote Chairwoman Yellen can last a "considerable amount of time". Good luck this week.

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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.

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Summer Into Fall

The S&P500 closed just south of 1978 today after trading within a 15-point range. We saw a strong late-day 10-point rally which nearly drove the index positive for the day.

Supports and resistance in $SPX

Where are we headed from here? Let's take a look at some historical and forward looking data.

September marks the end of the 3rd quarter. Taking a look back at the past few years, we've seen selling in the S&P that coincides with the end of the summer. The chart below shows the transition from summer into fall in 2013:

2013 Q2/Q3 transition in $SPX

Looking at the data from 2013, we saw a mid-September all-time high in the S&P followed by a sell-off right into the end of the month. October then saw brand new highs. We've seen similar activity thus far in the S&P this year: all-time highs in mid-September followed by an end of the month sell-off. Now let's look further back into 2012:

2012 Q2/Q3 transition in $SPX

In 2012, we also saw mid-September all-time highs in the index followed by a sell-off. An attempt at a new all-time high started several days before October but stopped just shy of it.

2011 tells a different story in the S&P500:

2011 Q2/Q3 transition in the $SPX

Going into fall 2011, the index saw nearly a 250-point drop from July to August which had traders and money managers a little more reluctant to attempt all-time highs in September. We did however see a decent sized rally in mid-September followed by a sell-off that coincided with the end of the month.

In 2010, the S&P saw a nearly uninterrupted rally right into Q4 with only some minor pullbacks at the end of September:

2010 Q2/Q3 transition in the $SPX

What can we take away from this data? First of all, this sell-off we are experiencing in the US indexes seems to be typical of market behavior during this time of year. Of course, the magnitude of selling depends highly on the environment. In 2010, we were still in the early stages of quantitative easing. So looking back at the data from that year, we can perhaps see why the markets saw a rally straight through October. As the years progress, we've seen a trend of increased selling in the summer to fall transitional period that intuitively makes sense as the Fed's money policy begins to tighten.

So what can we expect for this year's September to October transition? Let's take a look at the option skew in $SPY based on today's sales:

The quarterly expiration for $SPY

By the end of today, traders seem to have developed some optimism in the S&P. We see a well defined parabolic skew in option sales which indicates equally bullish and bearish bets on the index by the end of tomorrow's trading day (and the end of Q3).

In the past weeks when the S&P was entrenched in the 2000 level tango, I showed you option skews in the index which showed only pessimism in the future direction of US markets. The following $SPY skew is from earlier this month (Sept. 9):

$SPY option skew from September 9

The above skew is a nice example of market pessimism. A few days before September 9th, we hit a new all-time high in the S&P of 2011.00 which had the markets a little frightened. We did see a slight pullback in the days following only to see another all-time high of 2020.

So taking a look back at today's option skew in $SPY, we can extrapolate that traders are a little more optimistic especially in light of the much needed pull back from those all-time highs.

Finally, let's take a look at what the $VIX has to say about all of this:

Volume bars - Green: Calls sold; Red: Puts sold

The VIX rose a whopping 7.6% today with an even greater increase in the implied volatility. The volatility of volatility rests just south of 100, which historically speaking, represents a higher value than 60% of the time in the past 52-weeks. Despite the bullish bets made on the markets today, the VIX implies a lot of anxiety still lurking beneath the surface.

Please exercise caution when trading within an environment of elevated volatility, and as always, good luck tomorrow.

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So What Now?

The fat lady finally sang last Friday when $BABA was unleashed onto NYSE. Shares rose as high as 33%, pushing up the S&P500 to an all-time high near 2020 and the Nasdaq to a post-2001 high of 4580. Some big players took this opportunity to take some handsome profits:

Current levels of support for $SPX. First support to watch: 2007.5

So what now?

Let's take a look at some option skews:

The skew for $SPY shows two possible scenarios for this week. Some traders are betting on upside action in the S&P500 up to the 201 level, which translates to 2013.00 in the $SPX. This level is also the 50% retracement of last Friday morning's highs.

Most traders are seeing sell-offs up to 199.5 in the $SPY, which would translate to 1990.00 in the $SPX. Puts in the index outsold calls 2:1.

On the volatility front, the $VIX got slammed to just slightly north of 12.00 last week after spending considerable time above its 50 and 200 day moving averages. The dip in volatility coincided with the September monthly expiration in the VIX which I talked about last week. We wouldn't want those calls to expire in-the-money would we?

Let's take a closer look at market volatility:

Traders took the opportunity last Friday to buy calls in the VIX with calls outselling puts 15:1. The 30-day forward looking volatility (red curve) retraced its August lows, presenting a good opportunity for volatility speculators to buy contracts in the index for a relatively low premium. Interestingly, the 10-day historical volatility finally surpassed the 30-day forward looking volatility, while the 30-day historical volatility converged with the 30-day forward volatility.

According to the Stock Trader's Almanac, the week following Sept. expiration is historically the worst performing in the S&P, Nasdaq, Russell 2000, and Dow Jones.

Since 1988, weekly declines average from –0.88% for NASDAQ to –1.43% for Russell 2000. S&P 500 has only posted full-week gains five times in the last 26 years.

They speculate that this is due to managers re-adjusting positions ahead of quarterlies. As always, please remember that indexes do not go straight up or straight down. Hedge accordingly.

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All Quiet on the Western Front

Today was the 5th anniversary of the collapse of Lehman Brothers and the markets were all quiet on the Western front.

Today's front page of Google Finance

A quick glance at Google Finance's front page showed lackadaisical sideways action in the US indexes interjected with headlines of Alibaba's IPO, which is apparently showing such "strong demand" that the offering has been raised even higher.

A glance at the high beta momentum ("mo-mo") stocks showed a different story today:

$TSLA -10%, $NFLX -4%, $FB -3.75%, $TWTR -5.25%

It's almost as if the big players suddenly became lucid of the risk that US markets face and wanted to quietly take profits without causing the public much alarm. A quick glance at the S&P500 shows that the 2000 mark failed to hold on this run-up:

Notice a cross-over on the moving averages and that all major supports for this rally, save for 1984-1982 have been breached. Let's take a look at the options skew for $SPY:

We usually see some optimism in $SPY skews which is represented by a parabolic risk curve (also known as a volatility "smile"). Today saw zero optimism as traders saw almost entirely downside risk. Puts in the index outsold calls 6:1. That's not to say the indexes can't go up this week, but I would certainly not put my own money (or anyone else's for that matter) on any sort of rally ahead of this week's FOMC meeting. This Wednesday's FOMC meeting presents major risk to US markets due to increased perceptions of hawkishness from Chairwoman Yellen.

The $VIX moved across its 200-day moving average today to close above 14 for the first time since middle August:

Volume bars indicate puts (red) and calls (green) sold (log scale)

The $VIX seems anxious to inch up but at the same time waiting for some events to occur before doing so. Perhaps it could be tomorrow's VIX September expiration, which also happens to be the day before the FOMC meets. Hedge accordingly.

As we head into the rest of the week, please be aware that many bulls are still stuck above levels in the $SPX as high as 2011 and that many bulls in momentum stock got burned today. Major geopolitical risk that the markets have largely ignored still looms: Scotland will soon vote for their independence, ISIS is still out and about causing trouble, the Fed will most likely continue to trim their balance sheets, and several tropical storms are building up in multiple regions of the world.

Good luck tomorrow.

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In Like a Lamb, Out Like a Lion

The S&P500 closed today at 1997.5 bringing us back to now the 12th day of the S&P 2000 tango. The 1996 level which I pointed out was the critical pivot for this dance was breached again today bringing us less than 3 points from the valuable 2000 level for the index.

Reaching 2000 tomorrow should be no problem should the indexes go up. The point to watch, however, is 2002.5 to 2004. These are critical points of resistance and many bulls have been trapped above that level since the beginning of September.

Let's take a look at the option's skew for $SPY:

Looking at tomorrow's expiration (white curve), we see a nice smirk beckoning us towards this week's close. Traders are seeing one of two possibilities for tomorrow. Puts having outsold calls today nearly 2:1, a majority of traders are seeing downside action with a possibility of a free fall past the current lowest point of support of 1982.5, down to as far as 1970.

Another group is seeing a Hail Mary all the way past 2004. Expect both or none of those scenarios to occur tomorrow. Typically, Friday's see a late day rally around 3:30PM. Also keeping in mind that Fridays are an option expiration day, we also have a tendency to see sideways action to deplete time premiums on contracts.

On the volatility front, we've seen the $VIX range bound between its 50 and 200 day moving averages for the past 3 sessions:

As the S&P has been range bound for the past 12 days, the markets seem unsure of whether to go long into the rally or cash out their positions, which has led to the sideways actions of the past two weeks.

The 10 day realized volatility (white line) has been relatively suppressed since June but has been inching to go up in the past few days. The 30-day forward looking volatility has been flat.

As we all know, volatility is mean reverting. Periods of high volatility dissipate back to low volatility, while periods of low volatility periodically get interrupted with high volatility or as Daniel Davies would say:

“I like this concept of “low volatility, interrupted by occasional periods of high volatility”. I think I will call it volatility."

When volatility will again occur is simply a matter of time but as the old saying goes, "In like a lion, out like a lamb" (and vice versa).

Taking a look at $VXX, or the iPath Short Term Volatility ETF, we've seen lately an upward trending environment in near-term forward-looking market volatility:

The price action has been inching above its moving averages but was slammed down at today's close below its 30-day and with the 60 and 100-day averages acting as support.

Crude Oil futures dipped below the critical $93 support yesterday,which buyers took as an opportunity for bargain-basement prices for contracts.

Prices in crude oil and equity markets are often times inversely related, but not always. If crude oil maintains above $93, look out for a period of market inversion.

As always, good luck tomorrow, and watch for those critical S&P500 levels I pointed out earlier.

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It Ain't Over Till the Fat Lady Sings

The S&P500 finally rejected the 2000 level after spending 11 days trying to hold the line. After $AAPL failed to please the Street, we saw a 10 point free fall in the index with 1986 acting as the first level of support:

Where are we headed from here? Let's take a look at some option skews:

For the remainder of the week, a majority of traders, based on option sales, are expecting further downside action to levels as far as 1970. Another group is betting on a rally back to the highly significant 1996 pivot.

Yesterday I talked about a trading rule straight from the CME Group (formerly Chicago Merc, CBOT):

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. (Pit Bull's Low)

This is a rule-of-thumb and remember these should not be construed as 100% predictive of the future. However, do consider this factor for the remainder of your trades for this week.

The $VIX increased nearly a full point today and has for the first time since mid-August moved above its 30-day moving average:

 The VIX implies a 3.9% movement in the S&P500 in the next 30 days. This translates to about 75 points, which if realized, would bring back the index to about 1910, or right where we were before this incredible 100 point rally.

Remember that markets do not go straight up or straight down but it would be wise to hedge against volatile downward movements from a much needed consolidation in this current rally. Big players have already started to take profits as the Fed trims its balance sheets in October.

The largest company (by market capitalization) $AAPL has been seeing large profit taking in the past few days:

Heavy sell-side volume has dominated Apple's price action since the 3rd of September. Today's event failed to impress the markets as all announced products were practically already known months ahead of time and priced into the stock. Many "Apple-stock-price-to-the-moon" enthusiasts are now trapped at levels high above today's $98 close (some as high as $103.50).

As buyers of this current rally are exhausted, more and more bulls are being trapped at increasingly difficult levels. Let's remember that we had many buyers of $SPX at levels between 2000 and 2010, which is now pretty distant from today's 1986 close.

But it ain't over 'till the fat lady sings. This fat lady being Alibaba ($BABA), which will be pricing its IPO next week. Alibaba is currently being priced to be the largest IPO in US market history, which from one perspective can bring new buyers into US indexes. Another perspective could be that this offering might find more bulls to be trapped at these index all-time high's.

Please be careful this week and good luck tomorrow.

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