Monday Morning Outlook

The Volatility Discrepancy That Could Move the Market

Why the 'death cross' might be good news for Apple (AAPL) shareholders

by 12/8/2012 10:33:55 AM
Stocks quoted in this article:

Investors were cautiously optimistic this week, as the nation's leaders huddled in an attempt to find a mutually acceptable alternative to falling off the fiscal cliff. Against a backdrop that featured lackluster trading volume and a better-than-expected monthly jobs report, stocks ended mixed for the week. Tech stocks brought up the rear -- thanks in large part to Apple Inc. (NASDAQ:AAPL) -- but the Dow settled north of both its 10-week moving average and the 13,000 millennium mark. Meanwhile, as Todd Salamone points out, we saw historical volatility take a fairly dramatic plunge, while the CBOE Market Volatility Index (VIX) remained stubbornly inert (though heavily traded). Also, Rocky White performed a forensic analysis on AAPL, after the stock experienced a "death cross" during Friday's trading.

  • The continued dance of historical and implied volatility keeps everyone guessing.
  • One short-term risk to keep in mind.
  • Is the "death cross" as morbid as it sounds? Not always.

Finally, we wrap up with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: This Week's Crash You May Not Have Noticed
By Todd Salamone, Senior V.P. of Research

"One trend that stands out to us is the tendency for the VIX to advance immediately after the monthly expiration-related collapse in VIX call open interest ... VIX 'pops' have occurred after expiration-related call open interest 'drops' during the past several months."
-Monday Morning Outlook, November 24, 2012

"As markets react to various headlines, we find it interesting that major benchmarks are trading around key round-number millennium levels simultaneously, perhaps keeping a lid on rally attempts ... The S&P MidCap 400 Index (MID - 1,000.15) is once again bumping into the 1,000 level, an area it has failed at numerous times since early 2011, when it tested this region for the first time ever ... While round millennium levels are not coming into play for the S&P 500 Index (SPX - 1,416.18) there is visible resistance above. The 1,420 level [on the SPX] ... is significant, as it marked a top earlier in the year and is the site of a key moving average."
-Monday Morning Outlook, December 1, 2012

"Since 11/19, $VIX up 8.7% and $SPX historical vol down 26.3%"
-@toddsalamone on Twitter, December 7, 2012

The S&P MidCap 400 Index (MID - 1,002.71) and Nasdaq Composite (COMP - 2,978.04) continue to trade around key millennium areas, as investors moved into blue chips and out of technology names last week. The Dow Jones Industrial Average (DJI - 13,155.13) closed below 13,000 the first two trading days of the week, but finished strong with three consecutive closes above 13,000, ending the week solidly above this mark. Stay tuned, however, as the Dow's 80-day moving average resides overhead around 13,200, and this trendline has been significant at various times this year.

The S&P 500 Index (SPX - 1,418.07) was virtually unchanged for the week, finding support in the round-number 1,400 area, but resistance in the 1,420-1,425 zone, as a narrow range took hold. In addition to the 1,420 area marking a significant peak in late-March/early April and the important 80-day moving average currently situated in this vicinity, it is also noteworthy that the 61.8 Fibonacci retracement of the September high (1,474.51) and November low (1,343.35) resides at roughly 1,425.

Elsewhere, there was a crash this week, as SPX historical volatility (HV) plunged from 15.40 at last week's close to the current reading of 11.02 (see second pane in chart below). The good news for bulls is that roll-overs from relatively high HV levels have historically set the stage for bullish price action.

Despite the plunge in historical volatility, the CBOE Market Volatility Index (VIX - 15.90) advanced slightly for the week, as expectations for future volatility rise as budget negotiations (if that is what you can call them) continue in Washington.

Daily Chart of SPX since January 2012

The advance in the VIX since Nov. 21 expiration is not a surprise to us, as such post-expiration advances have been prevalent throughout 2012. One observation that we made, however, is that the VIX has remained elevated, despite the plunge in historical volatility.

There have been 28 instances since 2010 during which SPX HV declined by 10% or more during a 15-day period, but the VIX simultaneously advanced by 5% or more. We used "since 2010" because this is around the time that volatility products -- such as VIX options and futures -- became popular. Per the tables below, this combination of declining historical volatility and rising implied volatility has had bullish implications over one- through four-week time frames.

SPX historical volatility_VIX signal since 2010

SPX at any time since 2010

But, we will caution, in the eight occurrences in 2012, a combination of declining historical volatility and rising VIX have not been nearly as bullish. The table below suggests you should approach the next week with caution, although a pullback would likely present a buying opportunity, as the returns in weeks 2-4 are better than the returns at the end of the first week.

SPX historical volatility_VIX signal in 2012

With seven trading days left for VIX December options, there are about 5.3 million call contracts, which is about 200,000 more contracts than this point in the November VIX expiration cycle, and one million short of the record 6.3 million call options outstanding at October VIX expiration. This suggests the consensus still expects a pop in volatility. But so far in 2012, high expectations for a sharp spike in volatility have been flat-out wrong, and, if past is prologue, a breakout above resistance could be around the corner, with positive seasonality amid heavy short-covering potential (see chart below) on the side of the bulls.

SPX and total short interest since January 2011

The short-term risk we see is the big rotation into safety (DJI-type stocks) and out of those deemed "risky," or Nasdaq Composite stocks. The relative strength of the Nasdaq Composite has now rolled over relative to the Dow Jones Industrial Average. This phenomenon transpired two other times in 2012 (late-March and early-September), and both instances preceded periods of weakness.

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