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Why the 'Low Volatility' Crowd is Missing Out

Do low-volatility streaks suggest better times ahead?

by 6/21/2014 9:53:05 AM
Stocks quoted in this article:

The Dow Jones Industrial Average and S&P 500 Index resumed their quest for record highs last week -- and the CBOE Volatility Index retreated to a seven-year low -- as encouraging central bank fodder overshadowed turmoil in Iraq. However, as Todd Salamone notes, even though the market's "fear gauge" is low on an absolute basis, recent options activity suggests there's still a healthy amount of caution levied toward U.S. equities.

  • Charts to watch: six indexes eye critical levels
  • Keep a close eye on this put/call volume ratio
  • Why Rocky White wants this low-volatility streak to continue a little while longer

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus our featured sector.

Notes from the Trading Desk: Two Signs Fear is Unwinding
By Todd Salamone, Senior VP of Research

"... there is a possibility that the SPX breaks through its 1,950 half-century mark and moves on to the 1,980-2,000 resistance area, before retesting 1,950 once again."

-Monday Morning Outlook, June 7, 2014

"... anticipated support levels held, with the S&P 400 MidCap Index (MID - 1,402.38) holding the round-number 1,400 level, and the RUT bottoming last week just above its 80-day moving average, which has been significant in the recent past ... While resistance levels on the Dow, SPX, and RUT that we identified last week came into play, and the VIX advanced off support that we anticipated, we are not giving up on key equity benchmarks such as the SPX and RUT moving above resistance levels at 1,950 and 1,163, respectively, before month's end ... the short-term pessimism among equity option players -- which recently reached its highest levels since July 2013 -- is currently being unwound, supporting the market."

-Monday Morning Outlook, June 13, 2014

"The CBOE's VIX Volatility Index- otherwise known as the stock market's fear gauge- dropped 12% Wednesday to 10.61 ... concerns are mounting that the markets have become too calm. Even Ms. Yellen is worried that volatility may be too low ... To be sure, just because volatility is low doesn't necessarily mean tough times lie ahead."

-The Wall Street Journal, June 19, 2014
"The last time $SPX experienced 10% correction, $VIX call open interest was peaking around 3.6 million contracts vs. the 7-8 million today"

"$SPX 20-day historical vol at 5.36; lowest since the 5.30 reading on 1/31/13. SPX rallied 2.1% by 2/20/13, and up 10% by May '13 $VIX"

-@ToddSalamone on Twitter, June 17 and 19, 2014

The unwinding of the negative sentiment that built up during the narrow trading range from early March through most of May continued last week, as the S&P 500 Index (SPX - 1,962.87), Dow Jones Industrial Average (DJI - 16,947.08), Wilshire 5000 (W5000 - 20,834.76), and S&P 400 MidCap Index (MID - 1,425.36) notched new all-time highs, while other benchmarks rallied from support. Notably, the SPX pushed back above potential resistance at its half-century mark of 1,950, the RUT surged back above its year-to-date breakeven mark of 1,163, and the MID bounced strongly off the round 1,400 century mark.

Meanwhile, the Nasdaq Composite (COMP - 4,368.04) rallied back to its early March high around 4,370, recovering from a sell-off that sparked caution among many market participants. But the COMP stalled in the zone of its early March peak, as those caught by the sell-off in early March likely viewed the rally back to this area as a second chance to exit.

Daily Chart of COMP since December 2013

The Russell 2000 Index (RUT - 1,188.43), although it has rallied from its significant 80-day moving average, has still not yet fully recovered from its March-May 10% correction. It comes into this week around 15 points below the round-number 1,200 area, where it peaked in early March.

Daily Chart of RUT since December 2013 with 80-day moving average

In addition to the current unwinding of short positions on SPX component stocks (graph immediately below), the second graph is another illustration of the unwinding of short-term fear that is occurring in the option market.

Shorts getting squeezed -- but total short interest on SPX components is still far above levels that preceded past pullbacks of significance
S&P 500 Index with total short interest since January 2011

The 10-day, customer-only, equity-only, buy (to open) put/call volume ratio has declined swiftly from its highest level since July 2013. As long as the direction of this ratio is lower, you can expect stocks to advance. However, and as we discussed last week, if this turns higher from what is becoming an extreme low, the market would become more vulnerable to negative news, resulting in short-term weakness by way of a modest decline of 3-5% (or another consolidation like we saw in March through May). We will keep a close eye on the direction of this ratio, especially with DJI millennium resistance at 17,000 overhead, RUT 1,200 overhead, and the SPX facing potential resistance in the 1,980 area (target after the recent inverse "head-and-shoulders" breakout) and 2,000 (millennium area that is triple the 2009 low).

10-Day Equity-Only BTO Put-Call Ratio with SPX since 2012

Finally, we should touch on the new lows in the CBOE Volatility Index (VIX - 10.85). The VIX traded below the 10.75 level -- one-half of this year's peak and a potential area of support -- following the Federal Open Market Committee (FOMC) meeting last week. The "low" (quotes intentional) VIX has been a dominant theme, with many concluding that the VIX level is a sign of complacency that will precede a sharp rise in volatility that is coincident with a dramatic decline in stock prices.

Sure, on an absolute basis, the VIX is low, when compared to past historical prices. But one might argue that the VIX is high, when the 10+ reading is compared to actual volatility, which as of Friday's close, is only 5.54. Additionally, in recent months, just ahead of each VIX expiration, VIX call open interest has reached around 8 million contracts, easily more than double the outstanding call contracts that preceded the SPX's 10% correction in 2011.

The fact that portfolio insurance is expensive relative to actual market volatility, and that there is an insatiable demand for portfolio insurance via VIX calls, suggests there is still a good amount of caution toward U.S. equities, which is healthy in context of the current strong technical backdrop.

Finally, while it is true that high volatility follows periods of low volatility, it is also true that low-volatility periods tend to exist longer than many expect. A perfect example of a low-volatility environment like we are experiencing now (and that persisted for months) came in early 2013, when actual SPX volatility hit the 5.0 level in late January of that year. It wasn't until four or five months later, and a 10% move higher, that the SPX finally experienced a setback (see graph below). The equity market's trough following the May-June 2013 pullback was well above the levels of January (see graph below), suggesting those that stayed on the sidelines due to low volatility missed a huge opportunity.

SPX from August 2012 through August 2013 with 20-day historical volatility

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