Monday Morning Outlook: Mixed Signals from the VIX Premium Ratio
Three indicators suggest the bulls could remain in charge
by Todd Salamone 7/9/2011 1:34 AM
schaeffersresearch.com
It was a back-and-forth week for the major market indexes, as dueling jobs data sent investors on an emotional roller-coaster ride. Friday's non-starter of a nonfarm payrolls report incited fresh economic concerns, but it still felt like a victory for the bulls when stocks settled north of the key technical levels we've been watching all year. In fact, after checking on a few of his favorite sentiment indicators, Todd Salamone sees at least three reasons why this market may still have legs to run higher.
However, short-term traders should be aware that one of those buy signals carries a caveat -- and, to make matters more interesting, July options expiration has a proven flair for the dramatic. Meanwhile, Rocky White explains how you can harness the power of gamma to amp up your expiration-week returns, complete with a list of tickers to watch over the next five days. Finally, we wrap up with a preview of the week ahead, as well as a few sectors of note.
Notes from the Trading Desk: July Expiration Could Spark a Major Market Move
By Todd Salamone, Senior VP of Research
"...if you're a contrarian investor, what's not to like? After all, the major market indexes pulled back to (successfully) test technical support -- creating a lot of anxiety among investors in the process -- and the ensuing rally has been so sharp, and so sudden, that you have to believe many have been left behind... the sentiment backdrop is one that suggests there is enough sideline money and short-covering potential to drive a sustained move through these areas relative to two months ago."
-- Monday Morning Outlook, July 2, 2011
The "areas" being referred to in the above excerpt are the 1,333-1,340 zone on the S&P 500 Index (SPX -1,343.80), the round-number 1,000 level on the S&P 400 Midcap Index (MID - 1,004.98) and the 850 level on the Russell 2000 Index (RUT - 852.57), site of the RUT's 2007 all-time high. The 1,333 level for the SPX represents a double of its March 2009 low, while 1,340 marked peaks in February, April and June this year. After challenging these resistance levels in late April, equities endured a correction in May and June.
This past Thursday and Friday, the SPX, MID and RUT each closed above these benchmark resistance areas, after the SPX tested its March 2009 "double-low" at 1,333 earlier in the week (and again on Friday morning).
Thursday's stronger-than-expected ADP employment report was the catalyst that first pushed these indexes above resistance. On Friday, disappointing nonfarm payrolls data and House Speaker John Boehner's warning that a budget agreement with Democrats is not "imminent" sparked early selling, pushing the SPX, MID and RUT temporarily below these important levels. However, the bulls mounted a charge as the lunch hour was about to begin, erasing the worst of the day's losses and leaving all three indexes north of their respective technical milestones. (The House Speaker's remarks were made as President Obama prepares to work this weekend with Congressional leaders to reach a compromise, which will likely gain the attention of investors next week.)
Despite Friday's minor setback, the bulls have at least three points in their favor:
1. Evidence that hedge funds are moving back into equities from an underweight position, as the ratio of buy-to-open put volume relative to call volume on major exchange-traded funds (ETFs) continues to advance from an extremely low level. The change in direction of this ratio would suggest hedge funds are in accumulation mode, as they often use ETF options as hedging vehicles.
2. An unwinding of the pessimism that built up during the May/June correction, as the customer-only, equity-only, buy-to-open put/call volume ratio recently peaked at a two-year high and is now rolling over. In the past, when this ratio has declined from a relatively high reading, it's presented a major buying opportunity as short-covering and sideline money has emerged.
3. The "VIX premium" ratio, which measures the percentage by which the VIX is trading above 20-day historical SPX volatility, currently favors the bulls. During the past year, when the CBOE Market Volatility Index (VIX - 15.95) and SPX historical volatility have converged to the point that there is little-to-no VIX premium, the market has rallied strongly. Currently, the VIX is no longer trading at a noticeable premium to SPX historical volatility. This buy signal follows a sell signal in late April/early May, when the VIX was trading at double SPX historical volatility.
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 -- well above the current 15-16 region, pullbacks to which have tended to precede VIX advances and market declines.
The upcoming week marks the expiration of July options, as well as the unofficial kickoff of earnings season. Investors are expecting generally good earnings reports, but will likely be more interested in what companies are forecasting for the next quarter and second half of the year. July expirationConsumer discretionary stocks could be a point of particular interest, as many investors have been waiting for a major slowdown in consumer spending that hasn't yet materialized.
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. The caveat here is that four of the past six July expirations have favored the bulls. Plus, there have been two huge market moves during July expiration week since 2000: the 8% SPX decline in July 2002, and the 7% advance in 2009.
Options are still relatively cheap, which should present some appealing expiration-week trading opportunities for those with a short-term time horizon. We see SPX support in the 1,320-1,333 area, and resistance at the early May high of 1,356.
Indicator of the Week: Gamma-Weighted SOIR
By Rocky White, Senior Quantitative Analyst
Foreword: One indicator that's especially important for expiration week is the front-month, gamma-weighted Schaeffer's put/call open interest ratio (or, for our purposes, the FM gamma SOIR). The regular SOIR is the Schaeffer's put/call open interest ratio, which measures the amount of put open interest relative to call open interest among options set to expire within the next three months. A high ratio indicates a large number of puts compared to calls.
Here's how it works: Delta, one of the option "Greeks," tells us how much an option price will change based on a one-point move in the stock price. Gamma, another Greek, tells us how much delta will change. What's important, though, is that the strike prices closest to the stock's current price will have the highest gamma. Therefore, when we use gamma to weight the open interest configuration, the strike prices nearest the stock price will be most relevant, and the strike prices that are far away from the stock price become meaningless. Finally, for this variation of the SOIR, we only consider options that expire in the nearest month (in this case, that would be July-dated options, which expire on Friday).
In short, this indicator is a fine-tuned put/call open interest ratio, focusing only on option contracts that are close to the stock's current price, and set to expire on the nearest monthly expiration date. This is clearly a very short-term indicator -- when the July series expires in one week, the FM gamma SOIR will be using a whole new set of options, rendering the current reading irrelevant.
Expiration Week & FM Gamma SOIR: Below is some data I gathered using S&P 500 Index (SPX) stocks and their FM gamma SOIR during expiration week. For each monthly options expiration since 2010, I put the stocks into five groups depending on their FM gamma SOIR. Group 1 consists of stocks with the lowest ratios, and Group 5 has the highest ratios.
Generally speaking, we would tend to be more bullish on stocks that have a higher ratio. The reasoning for this is twofold. First, a sentiment case can be made that the presence of more puts than calls indicates the investing crowd is bearish, which can have contrarian bullish implications if the price action of the equity is strong. Second, due to the mechanics of hedging, heavy put open interest near a stock's price can act as support, and potentially spur a rally. On the other hand, a preponderance of call options can act as resistance.
So, as context, keep in mind that the SPX averages a slightly negative return during expiration weeks since 2010. Looking at the average returns, there is outperformance by the stocks with the highest FM gamma SOIRs compared to those with the lowest (+0.09% vs. -0.03%). The outperformance is also evident when looking at median returns (+0.25% vs. +0.09%). However, FM gamma SOIR doesn't seem to have much bearing on the percentage that finish positive.
One thing that's important to us as option traders is the last column, which shows the percentage of stocks that gained at least 5% or more during expiration week. These aggressive stock moves can translate into huge gains for option players. In this category, Group 5 and Group 3 have the highest percentage of big hits. The three groups with higher FM gamma SOIRs (Groups 3-5) have 35% more big hits than those in the lower two groups (7.8% vs. 5.8%).
FM Gamma SOIR Breakdown for SPX Stocks since 2010
Finally, below is a current list of SPX stocks with a FM gamma SOIR above 1.5. It's a list we'll be combing through this expiration week, to see whether any of our other indicators can confirm the likelihood of a potentially large move to the upside.
SPX Stocks with High Gamma SOIR
This Week's Key Events: Alcoa Signals the Start of Second-Quarter Earnings Season
Schaeffer's Editorial Staff
Here is a brief list of some of the key events this week. All earnings dates listed below are tentative and subject to change. Please check with each company's respective website for official reporting dates.
Monday
* There are no major economic reports on the calendar for Monday, but Alcoa (AA) will herald the unofficial start of earnings season when it reveals its quarterly results after the close. Also expected to report earnings are Novellus Systems (NVLS), Joe's Jeans (JOEZ), and Material Sciences Corp. (MASC).
Tuesday
* The May trade balance will hit the Street Tuesday. Fastenal (FAST), Infosys (INFY), and Wolverine World Wide (WWW) are expected to report earnings.
Wednesday
* On Wednesday, we'll hear reports on import/export prices for June, the Treasury budget, and weekly crude inventories. The afternoon features the minutes from the latest meeting of the Federal Open Market Committee (FOMC), while the day's earnings calendar includes ASML Holding (ASML), Bank of the Ozarks (OZRK), Marriott International (MAR), and Yum Brands (YUM).
Thursday
* A round of inflation data kicks off on Thursday with the producer price index (PPI) and core PPI for June. The weekly update on jobless claims will also be released, along with retail sales for June and May's business inventories. On the earnings front, we'll hear from Google (GOOG), JPMorgan Chase & Co. (JPM), AngioDynamics (ANGO), Cubist Pharmaceuticals (CBST), and Fairchild Semiconductor (FCS).
Friday
* The economic calendar wraps up with the consumer price index (CPI) and core CPI for June, the preliminary Reuters/University of Michigan consumer sentiment index for July, the Empire State manufacturing index, and reports on industrial production and capacity utilization. Scheduled to report earnings are Citigroup (C), First Horizon National (FHN), Mattel (MAT), and Genuine Parts Co. (GPC). |
