Volatility Interpretation

Volatility is a tricky asset class.  At least for me.  I’m sure quantitative methodologies utilizing various derivatives make it easier for the more mathematically inclined, but I do with what I got.  Chart interpretation is definitely more art than science, and I wanted to share what could be a set-up for a short-term burst in risk-off sentiment.

VIX Weekly (8-31-2021)

We’re only two weeks removed from that spike in fear that got everyone’s under-garments in a bunch.  Since April, the last 4 times the VIX spiked up resulted in intra-week advances but never closing a week above that top channel line.

Price action across all markets says to me that there is a lot of FOMO and confusion, as evidenced by declining or negative breadth and sentiment readings with new highs across various asset classes.

In order for a proper selloff across multiple asset classes, I’d like to see the VIX close out the week above 20.  Not a bear here.  Just positioned accordingly for some short-term profit should things soon get a little sparky for a minute.

“It’s not what you don’t know that kills you, it’s what you know for sure that ain’t true.”

I return to this statement over and over as I play the markets.  Mark Twain had unending wisdom.  The speculating public, usually not so much.  November’s stock market returns were a delightful 10% for the S&P 500 and an eye-watering 18% for the Russell 2000; thank you very much hard and fast sector rotation.

Major Indexes November Returns (12-2-2020)

Despite this, ambiguity still reigns supreme currently.  Context is critical.  So does the ambiguity matter to long-term investors?  No.  But if you’re swing trading any asset classes in these markets then the ambiguity matters a whole lot.

Let’s use some simple, classic technical analysis to better illustrate how muddy the waters have become.  We’ll start with the S&P 500.  Depending on your trend-line bias, there’s a few different ways to perceive current action.

SPX Weekly (12-2-2020)

It looks like a very legitimate breakout.  It’s been a hard chop since late July, but I thought we might see yet one more leg down to the high 3100s or low 3200s.  The reason for this was the curious inter-market activity among various asset classes.  Typical correlations weren’t holding up in November and the breakout just felt fake.  But therein lies the problem of using “feel.”  Obviously, I don’t just go with the gut when allocating capital but it has often paid to at least listen to it.

We know that one major, semi-new factor driving markets is option activity.  Never before has one had to care so much about option Greeks to simply trade the underlying.  Observe the enormous rise in single-equity options premiums as a result of the tidal wave of buying, most of that in Calls by retail and institutional.

Buy to Open Calls Spot Premium (10-18-2020)

Options activity has seen market makers make unparalleled purchases in the underlying stocks in order to hedge their Call sales books.  As a result, volatility has chopped right along with the markets as moves have been fast and furious.  So where is volatility possibly headed next?  Again, the trend lines paint a couple of different pictures.

VIX Weekly (12-2-2020)

We have the current liquidity flood and more coming in 2021 to support fund flows into risk assets.  There’s also the beginning of a sector rotational move into value.  I don’t think that’s a done deal yet.  I think growth i.e. tech still has legs left.  I hypothesize that the bounce in energy and small caps is only the first strike of sector rotation, but the growth of SaaS and big tech will soon parry in 2021 which should stunt recent returns in energy and small caps…at least temporarily.

The one asset class that continues to dominate my thoughts is the US dollar.  I’m reading tons of obituaries.  They feel premature.  A swift move up to the 95 area would not surprise me here; swift relative to its usual multi-month cadence.  A “swift-ish” move in the USD would drop a hammer on commodities, which wouldn’t bode well for the recent rotation into energy.

USD Weekly (12-2-2020)

The grains and sugar have been on an unfailing tear upwards.  Typical COT activity would have already seen correlated reversals in these crops.  I’ve seen insinuations that perhaps we’re in a regime change for those specific assets, but like the death of the dollar, that innuendo feels a bit premature.

For my own long-term portfolio of equities, I continue to evaluate the plays that many deem to have great forward looking prospects as not only technology evolves but society as well.  They may seem obvious, but it’s hard to shake what a well chosen play can mean for the potential of a portfolio.  This means gene-editing, cutting edge biotech, AI, data dissemination, and two of the oldest vices on the planet with tremendously long runways as a result of only barely being legitimized.

In the short-term, I think the commodity shorts present a most compelling current opportunity but so much rides on the USD’s anti-correlation.

If you really want to generate some returns with equities, consider after hours trading.  This has been widely reported on for a few years now, but just look at a recent chart put out by Bespoke to truly illustrate the marked difference in strategies.

Bespoke After Hrs. Trading Since Inception (Nov. 2020)

Of course, 2020 has flipped that on it’s head.  See below, but after-hours is starting to reassert it’s dominance.

Bespoke After Hrs. Trading Since Start of 2020 (Nov. 2020)

Stay sharp.  Recent choppy action may not be over just yet.  And with everyone predicting an amazing 2021, including myself, it might just take a little time to get the real momentum going next year.

Look For The Wick

I have come to utilize charting techniques less and less as their ability to help handicap asset price movements continues to wither away.

You’re either trading algorithmically in front of the market or you’re a trading loser.  Every single chart pattern and set of indicators in every conceivable combination has already been mathematically expressed by people smarter than technical analysts, and easy profits have been completely arbitraged out of the market from visual chart cues.

There will always be pockets of sheer luck.  There are always exceptions.  But earning consistent profits on price/indicator pictures…get real.

I have come to rely more and more on fundamental analysis, experience (see “gut”), and semi-quantitative tools to manage the risks of trading capital.  Like a degenerate heroine addict, I still chart.  I’ll never give it up, but it’s just another input.  Mostly noise.  Sometimes valued signal.

Despite all that, here’s one visual cue I think a lot of professionals are probably waiting for and that is a second long-stem on the S&P 500.  It could potentially indicate that risk appetites have returned.  If the HFTs see this then we could see a “schooling” move upward, like fish or a flock of birds, as the programs feed on each other’s momentum calls.

Take a look to better understand.  We are looking for a 2% to 3% wick below the weekly closing price.  That’s it.

Everybody's Waiting for a Stem - SPX (3-28-2018)

That might be all it takes to re-engage risk taking.  Not without increased volatility, of course, because liquidity is draining and conditions are tightening.

Flat or Bumpy: Choose Your Own Adventure

                                                                     The Abominable Volatility

Last week’s “whopping” 1.8% selloff on Wednesday shocked market players but was also blown way out of proportion.  The selloff also presented a nice little set-up to possibly scalp a few bucks out of the market over the next week or two.

Was Wednesday’s price action a precursor to some further weakness?  Or was it a one-inch pothole in the continued advance of this bull?

You choose the trade.  For you children of the 80’s, remember these books?  Hours of time wasted flipping back and forth as the protagonist.  The book reference is a good metaphor for the current state of the US stock markets.

                                            Volatility Hunter                 Don't Bother Trading

As I see it, the price action is saying we’re in for another little move downward.  I suspect no more than 5% down to around 2,260 on the S&P 500.  In the chart below, I’ve circled and described what I think can happen.

SPX Weekly (5-19-2017)

The recovery on Thursday and Friday are just small snapback moves for the real players and market makers to close out certain positions with a more positive effect on P&Ls.  Then the rug get’s pulled out from the crowd in a panic-inducing 5% “real” selloff.

This is just what the price action is telling me.  I’ve arbitrarily assigned a probability and bet (regional banks) and hedged (volatility) accordingly based on nothing but my hunch.

Incidentally, my old friend in the credit department thinks there’s room for a little further downside in the larger market.  Below is the chart of the action of what the credit-friend thinks.  Notice the tight correlation between the S&P 500 and my credit-friend.  It’s only over 90% positive, so maybe it’s nothing.

Friend in Credit (5-19-2017)

Besides my friend in credit, there is the alarming increase in vol shorts.  Or maybe the crowd is right.

VIX Shorts - ZH (5-21-2017)

To scalp or not to scalp?  You choose your own trading adventure the next couple of weeks.

Volatility and Price Action

On March 13th, I made a call that I thought it was time for the markets to begin consolidating. Now some may label that call incorrect as the markets have moved a couple of percent higher, even surpassing 2,100 at one point, but I stand by the call. I think late-comers to the rally pushed the S&P 500 that 2% higher.

Specifically, I guessed we’d “see about 7 weeks of sideways consolidation.” Well in order to get a sideways move, the market will need to see a little correction soon. I suspect we’ll get one starting this week. It wouldn’t surprise me to see a move downward of about 5% in the S&P 500 to the 2,000 – 1,975 area over the course of this week and possibly the next. That stem created last week on a weekly chart is the tell.

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But here’s the thing. I think market participants will completely overreact to the 5% or any move downward. I think the bears will start beating on their keyboards and cranking out articles and blog posts saying things like, “See! I told you! Here comes the real start of a 50% correction!” Pay these cranks no mind.

Instead, utilize the negative sentiment to leverage a potential move in volatility. I could see the VIX spiking to 20 in an over-reaction by hedgers. Those same late-comers to the rally in February will overdue it with VIX options potentially causing a spike.

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So how do you leverage the potential? As usual, if you’re a futures player then just structure your option strategy to take advantage of the fear. For the ETF traders and retail guy trying to swing trade some profits off his work salary, there’s the ProShares Ultra VIX ETF, UVXY. Now this ETF is a trading tool only and it’s not for the faint of heart. If you’re going to trade it then you have to be nimble and ready to take profits. The moves are sudden and quick, but profits can be spectacular if you accurately time an upward thrust.

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You can see in the last two moves of late summer last year and the start of this year, that perfectly timed trades have huge potential. In a 3 week run last August, UVXY moved up almost 300%. From late December to February, it moved up 150% in just 6 weeks. Again, not for the undisciplined. If this puppy isn’t played right, it’s easy to get shell-shocked and lose any profit potential.

Are these calls bold? Maybe, in that I don’t have any quantitative analysis to back my assessment. It’s just the gut feel I’m getting from price action and general sentiment. It can be dangerous to trust someone else’s instincts, let alone your own. A trade like this requires precision and a hawk-like watch over the action. Trading volatility can very often turn into a sucker’s bet. Let price action as opposed to greed guide your moves.