From the Top

Why You Need to Watch XIV at 40

How the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) works as a proxy for stocks

by 12/11/2014 1:22 PM
Stocks quoted in this article:

My guess is you are familiar with the appearance of charts of the CBOE Volatility Index (VIX) over the past year or two. "Ugly" would be a common way technical analysts (including this observer) steeped in charts of equities would describe them -- the endless, directionless chop; the declines that inevitably (and usually abruptly) terminate in the 10-12 area; the sharp rallies that seem to end as quickly as they begin (rarely lasting for more than three weeks, give or take).

Of course, there is a very plausible explanation for these VIX chart characteristics, in the sense that in charting a volatility measure we are, by definition, tracking the fluctuations in a mean-reverting series whose "perturbations" are (quite naturally) often quite extreme and simultaneously quite brief. (The fact that volatility behaves in this manner would seem to be a deterrent to the widespread use of volatility derivatives to "protect" portfolios, but that's a separate discussion.)

But the folks at Credit Suisse seem to have created some order out of chaos in designing and structuring their VelocityShares Daily Inverse VIX Short-Term ETN (XIV). This may be due in no small measure to the fact that equity volatility has had a bias to the low side in recent years. When this is superimposed upon the daily adjustments that characterize the calculation of the XIV (and the fact that the XIV -- as an inverse ETN -- increases in price over periods in which the VIX declines), it often translates into upward XIV price movement that can be rather smooth and steady (as illustrated by the XIV rally from February through July 2014, as depicted on the accompanying chart). And such equity-like price action also creates opportunities to identify price levels that may be of particular significance from a volatility perspective, such as the 40 level for XIV on which our chart is focused.

Note how XIV sliced through the 40 level in early June and, after a brief re-test, went on to what was then (and still remains) an all-time high at 47.66 on July 3. And except for a brief period in early August, XIV traded above 40 from early July through most of September. What turned out to be a decent warning signal for trouble ahead (in the form of the mid-October market correction) was the dip by XIV below 40 in late September, followed by an unsuccessful re-test on Oct. 6 (and further confirmed by the close on Oct. 9 below support at 36). To recap: We had a pretty clear indication that XIV -- which moves in the direction opposite that of the VIX -- was breaking down technically. And by straightforward extension, this was therefore an indication that the VIX may have been headed for an upside pop, which by now we all know strongly implied that the market was about to take a hit.

And right here and now, it looks like the XIV is at an inflection point, though none is apparent from the charts of the major equity indices, which have all been registering all-time highs with almost boring regularity. Because after rallying sharply from its low of 24.67 on Oct. 18 (in conjunction with the sharp decline in the VIX and the concurrent sharp rally in equities), the XIV's upside progress over the past week or so has been stalled in the 40 area. In fact, this past Friday was the first trading day since Oct. 6 that the XIV had traded above 40, and after its early peak at 40.74, the XIV barely managed to remain above the 40 level -- closing at 40.07 after dipping as low as 39.70 late in the session.

So -- as I pointed out in the discussion on the XIV chart -- we are at a juncture in which further upside progress by XIV above 40 would be consistent with further upside for the market. But if this assault by XIV on the 40 level is repelled, things could begin to get pretty dicey for the market pretty quickly, especially if we once again dip below XIV support at 36. Would this decline resemble October's crash-like (but thankfully, brief) market plunge? It is impossible to say at this point, and by this I mean anything would be possible -- including a pullback that inflicts greater damage over a longer time frame. But my strong inclination would be that if we are destined for major market damage, this would not occur until after the first of the year.

Daily Chart of XIV since December 2013

This "Chart of the Week" commentary originally appeared in the Dec. 7, 2014 edition of Weekend Player.

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Expect the Best for Stocks (But Buy Puts While They're Cheap)

What's next for the S&P 500 Index (SPX) after a string of new highs?

by 12/1/2014 12:08 PM
Stocks quoted in this article:

The following is a reprint of the market commentary from the December 2014 edition of The Option Advisor, published on November 20. For more information or to subscribe to The Option Advisor, click here.

"May you live in interesting times" goes the old curse -- but please don't take it the wrong way if we observe that it's been an interesting couple of months in the market, to say the least. Both bulls and bears have endured their fair share of jolts, but there have also been some remarkable profit opportunities for longs and shorts alike.

Where to begin with an analysis of the recent action in the S&P 500 Index (SPX)? Well, the Sept. 19 initial public offering (IPO) by Chinese e-commerce giant Alibaba Group (BABA) is a logical place to start, as many pundits predicted the widely hyped IPO would mark a top for the S&P. (A quick Google search for "Alibaba IPO market top" is informative here, yielding north of 5 million results.) In fact, the same day that BABA made its trading debut on the Big Board, the S&P touched a then-record high of 2,019.26.

Of course, as discussed in this space last month, the index proceeded to tumble 9.8%, peak to trough, over the next 18 sessions. While the magnitude of the correction wasn't all that remarkable within the context of a long-term bull market, the sheer speed of the drop sparked panic -- as well as a few victory laps by perma-bears and BABA top-callers.

Those victory laps were a bit premature, though. After bottoming at 1,820.66 on Oct. 15, the S&P spent the final 12 trading days of the month riding the rebound express. The index finished October at a new daily closing high -- and then rang in the month of November by tapping a record intraday peak right out of the gate. For the first time in its history, the S&P went from an all-time high to a six-month low, and then back to an all-time high, in less than two months.

Since then, the S&P has been grinding steadily higher, creating a string of new all-time highs despite a lack of major day-to-day moves. As of this writing, 10-day realized volatility on the S&P stands at 3.03% -- just high enough to confirm the market has a pulse, though the patient appears to have come down with a minor case of exhaustion.

So, where do we go from here? Over a sufficiently long time frame, history tells us that the market will always trend higher -- but, of course, it's the ability to capture the not-quite-so-predictable short-term moves that defines our success as traders. With that in mind, there's good reason to think stocks will continue their steady march higher over the coming weeks.

For starters, there's good old Santa Claus and his reliable rally. The S&P averages a return of 1.5% during the month of December -- second only to April -- and finishes the month higher 74% of the time, going back 50 years. Most of those gains are racked up during the second half of December; the S&P has advanced an average of 1.4% during the last five days of December and the first two days of January (the traditional "Santa Claus rally" period).

Of course, it's fair to theorize that these year-end gains are generated not by St. Nick, but (to a non-trivial extent) by fund managers scrambling to boost their paper performance -- the reliable old "window dressing" tailwind. According to Morningstar data, the average U.S. equity fund was trailing the S&P by more than 5 percentage points, on a year-to-date basis, as of Nov. 19. As fund managers rush to keep pace with the stock market, buying activity by these deep-pocketed players should be a positive catalyst through year-end.

In addition to our regularly scheduled end-of-year programming, it seems the type of "V bottom" the S&P just created may also have bullish implications. Our Senior Quantitative Analyst, Rocky White, ran a study to measure the index's performance following moves similarly dramatic to the one described above. Since 1929, there have been 12 instances where the S&P has touched a 52-week high, pulled back to a two-month low, and -- less than one month after that -- overtook the recent 52-week high again. Following these signals, the S&P has averaged gains that outstrip its "anytime" returns over one-month, three-month, and six-month time frames.

So, while the forecast seems to point to additional upside ahead, the recent S&P whiplash reinforces the notion that it's always wise to expect the best, but prepare for the worst (advice that rings equally true whether you're a perma-bear, perma-bull, or pragmatist). At 13.58, the CBOE Volatility Index (VIX) is currently running at a considerable premium to S&P realized volatility -- but, that said, the VIX is down about 56% from its highs of just over a month ago. As such, now is as good a time as any to pick up portfolio protection, in the form of put options, to both protect your paper profits and guard against any additional shocks over the short term.

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Why the S&P's 200-Day Is Only Part of the Story

The S&P 500's 200-day moving average is just one of the indicators you should be watching

by 11/3/2014 11:26 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the November 2014 edition of The Option Advisor, published on October 23. For more information or to subscribe to The Option Advisor, click here.

The week of Oct. 13 was a wildly volatile one for stocks. Due to a combination of disappointing economic data, mixed corporate earnings, and fears about the spread of Ebola, the major equity indexes were hit with heavy selling pressure.

In fact, the dramatic market action that week resulted in the highest total number of selling climaxes since Sept. 29, 2011. (A "selling climax" occurs when a stock hits a new 52-week low, but then settles above the previous week's close.) As indicated on the chart below, important market turning points in the recent past have often been accompanied by a huge spike in the total number of these types of climaxes. While it's obviously too soon to make the call -- there was a cluster of multiple selling climaxes in 2011, before the market eventually found its footing -- this could be a sign that we're in the process of capitulation.

SIR All Optionable Selling Climaxes since July 2011

With such dramatic volatility accompanied by a sharp sell-off, did we finally get the infamous 10% correction on the S&P 500 Index (SPX)? Not quite. Based on the index's 2014 intraday high of 2,019.26, and its Oct. 15 intraday low of 1,820.66, we registered a 9.8% pullback. Despite "failing" to reach this benchmark, the S&P did break below its 200-day moving average for the first time since November 2012.

Prior to breaching this widely followed trendline, the S&P had spent 477 consecutive trading days above it -- the third-longest such streak since 1950. As you might imagine, the index's drop below its closely watched 200-day sparked a ripple of panic among market watchers. This surging anxiety was reflected by a nearly three-year high in the CBOE Volatility Index (VIX), which occurred simultaneously with the S&P's 200-day break. (Anecdotally, StockTwits data shows that message volume for VIX spiked dramatically on Oct. 15 and 16, confirming a sudden flurry of interest in the market's "fear gauge.") So while the 200-day breach clearly triggered a wave of fear among investors, does this technical development necessarily suggest more pain and selling is ahead?

If history is any guide, the answer is most likely "no." Since 1950, there have been 13 other streaks similar to the one that just ended, where the S&P spent at least 252 trading days (approximately one year) above its 200-day moving average. The last three times a streak like this ended, the S&P proceeded to collect double-digit returns over the next 12-month period -- ranging from a 45.8% rally following the July 1996 trendline breach, to an 11.5% rise after the July 2004 break.

From a broader view, looking back at all 13 prior occasions when the S&P has breached its 200-day moving average after a long winning streak above it, the index has averaged a gain of nearly 12% over the next 12 months -- besting its average "anytime" one-year return of 8.8% since 1950. In other words, in circumstances in which the index has been firmly entrenched in upside action consistent with a bull market, that first break below the 200-day has typically represented a correction and a buying opportunity, rather than a sell signal.

However, for those traders who may have panicked out of their long positions following the S&P's break below its 200-day trendline, the market's quick and nimble reversal from its recent slump may have come as an unpleasant (and potentially costly) surprise.

On the other hand, if you'd also had the less-popular 320-day moving average -- a trendline we at Schaeffer's have favored for years -- on your trading radar, you would have spent Oct. 15 witnessing a very tidy S&P pullback to this level. While the index briefly dipped below its 320-day in intraday action, this trendline was never breached on a daily closing basis. This test of moving average support was followed in short order by an S&P rebound back above its 200-day, and the index has continued to recover impressively from that bout of wild mid-October volatility.

In light of these developments, it seems safe to affirm our belief that one indicator does not a trading system make. Despite the surge in fear that accompanied the S&P's most recent 200-day breach, the index's past performance suggests that this technical occurrence, when it follows on the heels of a long streak of outperformance, is rarely a reliable sell signal. By viewing day-to-day price swings within the context of longer-term trends, it's possible to keep your head while others around you are losing theirs. And it's worth reiterating that a roughly 10% pullback within the context of a years-long uptrend is, to a certain extent, inevitable -- as bull markets are quite unlikely to take the form of a straight vertical line (even though some of these 10% haircuts may transpire a little faster than the typical trader's constitution can comfortably endure).

Going forward, we recommend that you continue to watch the S&P's 320-day moving average as a key level of support, in order to keep the bigger-picture trend in perspective. And with earnings season, mixed economic data, and shifting monetary policy keeping traders on their toes, our Monday Morning Outlook column will help you stay current with the crucial technical levels we're watching each week.

Daily Chart of SPX since February 2014 with 200-day and 320-day Moving Averages

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When It's OK to Break the Trading Rules

Considering a paired precious-metals play on GLD and SLV

by 10/6/2014 10:22 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the October 2014 edition of The Option Advisor, published on September 25. For more information or to subscribe to The Option Advisor, click here.

Not many people are excited (in a positive way) by the prospect of "catching a falling knife." But many who would be repelled by that scenario engage in similarly dangerous activity from a financial perspective when they attempt to "pick a bottom" by taking a bullish position in an asset that has been mired in a bear market and is regularly recording 52-week lows. And, in fact, trying to catch a falling knife is how many veteran traders would disdainfully describe such attempts at taking a bullish stance in a bear market and, implicitly expecting the decline to terminate and then reverse and then for the backdrop to turn bullish -- all within the holding period for their position. And even more challenging still is to make such a situation work for you when using options as your trading vehicle, which by their very nature will deteriorate in value if this process takes too long, and will disintegrate all the way to "worthless" should this not occur (arguably the most likely scenario).

And though I had all these concerns at top of mind when I recently recommended a January 2015 call option on the SPDR Gold Trust (GLD) exchange-traded fund (ETF) in our Weekend Player service, for a number of other reasons this call trade passed muster with me.

So, I'd like to excerpt here from my discussion of this call trade in Weekend Player -- which essentially amounts to "calling a tradable bottom" in gold -- because I feel it is a good illustration of the fact that while basic trading rules (such as the one that admonishes against taking a bullish position in a bear market, but instead waiting for some evidence of a change in direction before acting) have been developed for the simple reason that they help you avoid making the same serial mistakes most non-professional traders make with regularity, there is also an accompanying element of "Good trading rules are made to be broken by those who thoroughly understand those rules, but who feel they recognize a major opportunity in leaning against them." Plus, since this trade has not yet resolved itself one way or the other, it gives you an opportunity to view the results as they unfold in the weeks and months ahead.

The following is an excerpt from Weekend Player, Sunday, Sept. 21, 2014:

While it is undeniable the SPDR Gold Trust (GLD) remains in a bear market, it is equally true that by June 2013 the bear's damages had been fully inflicted. And since then, GLD has basically range-traded between $120 and $130. There's not much money to be made by options traders in "hurry up and wait," range-bound markets that are very choppy and exhibit high volatility, as the price you pay to play (in terms of the option premium level) is too high relative to the magnitude of the potential directional move (even if you catch a top or a bottom with some precision). But this is far from the case for GLD, which has traversed this $120-$130 range no less than six times since June 2013, in "steady as you go" intervals of roughly three months' duration.

In addition, the options on GLD are very reasonably priced relative to this ongoing directional movement. In fact, our recommended GLD January 2015 120-strike call sports a super-charged "Leverage Ratio" of 18.6. While we'll discuss the Leverage Ratio concept in a future "Chart of the Week" commentary, for now suffice it to say that a Leverage Ratio in excess of 10 for options that are near-the-money is very high, and this all accrues to the good for option buyers.

To put a more concrete face on what high Leverage Ratio options can accomplish for buyers, consider the fact that on a rally of 10% by GLD from its closing price of $117.78 on Thursday, Sept. 18 (which would place GLD at $129.56 -- near the top of its range), the January 120 call would gain about 250% from its closing "mark" of $2.75 on that same day. A 250% call option gain on a 10% rally in the underlying security can be an extremely attractive proposition for the call buyer.

Of course, the leverage becomes moot if we don't get the direction right (and the move does not occur over the life of our option). But there are other reasons -- aside from the roughly three-month cyclicality for GLD in traversing the range -- to expect the next major GLD move to be to the upside. As indicated on the accompanying chart, there are several levels of "auxiliary support" below the $120 mark, and in the vicinity of GLD's Friday close at $117.09.

Another theme from this chart relates to the tendency of many assets to develop "significant levels of interest" for multiples of two or three times (and sometimes more) a "base level." In the case of GLD, this base level is $60, with multiples of two and three at $120 and $180, respectively. The fact that $120 is a level of interest within this framework, and is also the level at which declines in GLD have terminated over the past 15 months, serves to reinforce the expectation of yet another GLD rally to the top of the range.
Weekly Chart of GLD since May 2012
Also encouraging is the 3-point increase in 30-day implied volatility (IV) for GLD options on this most recent pullback -- a very similar IV pattern to that which occurred on the five-week GLD rally from $120 in early June 2014 to a peak at $129.21 in early July. While IV for the precious metals does not tend to spike on pullbacks and peak at bottoms in the same manner as that for equities, over the past 18 months or so this has been the case for gold.

Along these same lines, the extent to which GLD is "oversold" (as measured by its 14-day Relative Strength Index, currently at 25.49) is very similar to the oversold condition that existed at the lows of early June.

Going a step beyond the above excerpt, I'd also caution you to avoid long positions in silver, even as I am feeling quite friendly toward gold at this juncture.

Using the iShares Silver Trust ETF (SLV) as a good proxy for the silver market, I see SLV traders as having exhibited huge complacency compared to GLD traders, based on SLV option activity over the period since each of these metals peaked in April 2011, even as SLV's price performance continued to lag that of GLD.

Most striking of all is the fact that call option speculators in SLV are back in "hot and heavy" mode (as illustrated on the chart below of SLV open interest since January 2011). Meanwhile, interest in GLD call options is significantly more muted these days than at the 2011 GLD price peak.

SLV Open Interest since June 2014
Chart courtesy of Trade-Alert

Finally, for those a bit reluctant to make a bullish stand on gold (through GLD call options), I think a pretty decent hedged trade right here would be long GLD calls/long SLV puts. I see this as one of those combination trades in which one has the ability to profit based on a huge directional move in the precious metals one way or the other, even if I am completely wrong about gold outperforming silver. But I would not take such a trade for options that expire sooner than January 2015, as such situations almost always need at least a month or two to sort themselves out before significant profits can be realized.

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Whatever Happened to the Earnings Catalyst?

These six stocks barely budged in response to their latest earnings reports

by 8/5/2014 10:51 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the August 2014 edition of The Option Advisor, published on July 25. For more information or to subscribe to The Option Advisor, click here.

Remember a time when earnings reporting day was truly a day of reckoning for a stock, especially on the tech front? A time during which the market's enthusiastically positive response or its palpable disgust with that all-important "number" could catapult stocks to price levels never before seen, or wipe out five years' worth of price appreciation?

I think I still might remember, but my vision has become clouded after quarter upon quarter of the kind of post-earnings action as illustrated on the accompanying charts.

Visa (V): Down by about 5% at its lows today -- but has been grinding higher ever since, and if you wipe out the action of the previous 10 days this could be just another dull trading day from early July. No trajectories changed here.

20-Day Chart of Visa (V) with 2-Hour Bars

E*Trade Financial (ETFC): Can you guess the date this (allegedly) highly volatile brokerage name reported on this 3-month chart? Hint: It was after yesterday's close. But don't say it too loud, or you might wake the stock up.

3-Month Daily Chart of E*Trade Financial (ETFC)

General Motors (GM): At point A, the headlines were that GM was a dead man walking after Congress finishes with them; at point B, the GM perma-bulls were crowing about how well sales have held up despite all the bad publicity; at point C (two days after earnings), the bears are back. The only problem (assuming you are a trader who likes to profit from strong directional movement) is point C is disturbingly close, price level-wise, to point A. Only airline passengers like to buy round trips.

3-Month Daily Chart of General Motors (GM)

Google (GOOGL): So Google finally took out with authority that pesky $600 level on its post-earnings surge? Well, for at least a week or so. And if you don't count intraday. And if you don't count today (so far).

20-Day Chart of Google (GOOGL) with 2-Hour Bars

Apple (AAPL): What's not to like? They sold the "(insert your word here)" out of their gadgets and gizmos, and once again "proved" they were not even approaching irrelevant (just check out their TV commercials), and the Street liked it, and the people liked it, and the first bar was big and (what could be more perfect?) it was green, and there was dead aim on that September 2012 high just north of $100. And then many little tiny baby steps.

3-Month Daily Chart of Apple (AAPL) (AMZN): Okay, that Bezos guy is finally gonna taste it, right here and now! Down north of 10% in the pre-market? That's nothing -- here comes the 2-handle! But wait -- what's with that niggling little smarty-pants of a rally since the opening? And isn't the stock trading at just about the same level as a couple of weeks ago? So, nothing has changed. Except perhaps for some gratuitous Fire phone buzz?

20-Day Chart of (AMZN) with 2-Hour Bars

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