Option Investor
Market Wrap

Volatility is Shrinking

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With less than a 17 point range today, the S&P 500 (SPX) had a much more subdued day today versus the last few months. The 14 day Average True Range (ATR), which measures the average difference between a price bar's High and Low, shrunk to 57 from its October 16th peak of 75. That translates into the average range over the last 14 days has been about 57 points! Coincidentally, the $VIX is roughly the same level.

Today’s market internals showed a little more strength than the closes may have indicated. For instance, the NYSE closed down 9.22 points to 6,054.98 on 1,963 advancing issues versus 1,503 decliners. The volume today pf 1.29 billion, however, was about 500 million less than the 50 day average of 1.93 billion. There were 8 new 52-Week Highs and 65 new 52-Week Lows. The NASDAQ Composite closed up 5.28 at 1,726.33 on 1.79 billion shares. There were 1,600 advancers versus 1,271 decliners. The NASDAQ saw 13 new 52-Week Highs and 68 new 52-Week Lows.

While it was a good day today, in that the markets were flat and they were less crazy, there was still a lot of news that came out throughout the day. The morning was very slow until the ISM or The Institute for Supply Management Manufacturing Index fell to 38.9 for October and at lows not seen since the early 1980s. Even though the report suggests the recession is deeper than many thought, the markets held up fairly well. Construction spending in September reduced 0.3% from the prior month’s 0.3% increase.

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Goldman Sachs (GS) took another hit today when they had their 2008 to 2010 earnings estimates cut by Ladenburg Thalmann. The analyst said the short-term outlook for the company is poor, intermediate outlook is challenging, while the long-term outlook is good. Ladenburg cut its price target on Goldman to $80 from $140 and maintained its sell rating. GS closed down 3.41 to $89.09.

In other corporate related news, Boeing's (BA) machinists union voted in favor of a new contract as expected. Goldman Sachs added BA to the Conviction Sell list today. BA battled the sell indication by closing up 0.43 to $52.85. Wal-Mart (WMT) was upgraded to Overweight from Neutral at JPMorgan. WMT closed up a little to $55.97.

The Telecom sector showed some relative strength from companies like AT&T (T) and Verizon (VZ) leading the way from The Wall Street Journal reporting some FCC commissioners want to put off an Election Day vote to revamp the system of how telephone companies pay each other to transfer calls. T and VZ closed up 1.04 to $27.81 and 1.08 to $30.75, respectively.

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After downloading all of the companies that are slated to report earnings tomorrow and seeing that there were over 200 companies, I decided to chop the list down to a more manageable list. Starting from the top, AMMD, HNT and THC are among the medical services companies reporting. Health care and medical devices have been and should continue to provide some relative strength into the new year. While some other beaten down sectors (energy and financial) may provide the largest potential returns from an oversold bounce, you might find that sprinkling in some best of bread health care sector stocks into your portfolio can add some balance to an otherwise speculative mix. NILE is an online jewelry store that may provide some guidance into the trends of discretionary spending. Compare NILE results to Tiffany's (TIF) to see if the trend is shifting toward staying at home and shopping rather than visiting the brick and mortar store. Watch KCP, a clothing store, for additional insight into the consumer. SAM is the maker of Samuel Adams beer. Usually alcohol and cigarettes sell in bad times. SAM makes more exclusive brews, though. I will be watching UBS, an international wealth manager, for further indications of the financial crisis hitting overseas companies worse than here. Finally, AUY is involved in gold exploration, development, and operation of gold properties. Gold has declined decidedly from its near $1,000 an ounce high.

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The S&P 500 declined only 2.45 points or 0.25% today at 966.30. The chart below shows the 8 and 21 day (EMA) Exponential Moving Averages (pink and green, respectively) as well as the 21 day EMA Bollinger bands, the 5 bar RSI and Slow Stochastics. The 21 day EMA closed at 969.60, which is higher than today’s close. As I have written before, one can short at a test of a major resistance level. Today’s test actually breached above the 21 day EMA but then closed lower. A close higher would have signaled a potential long entry. A short position taken tomorrow could have a stop at a break above today’s high of 975. The upper and lower Bollinger bands are closing in on the current price and shrinking the range associated with the bands. Basically, the bands are pinching together and squeezing the volatility out. The 8 day EMA is curling upward now and getting close to crossing above the 21 day EMA. Once the crossover starts, the only short signals to watch for will be at over bought levels and/or the upper Bollinger bands. The oscillators aren’t overbought though. The RSI closed today at 61.44; down from Friday’s 62.64. Until the SPX can get above the 21 day EMA the RSI doesn’t need to reach up over 70 to signal overbought. It is all relative. However, the Slow Stochastics looks to have had a flat day. The magenta line actually declined marginally. If the Stochastics line crosses below the green line (3 bar moving average), the signal will turn to a downward one. The only thing that is consistent is that the SPX is looking to be running out of momentum. Personally, I believe that the markets will eventually run up to resistance and then fall back down to these levels before making any recovery. But a recovery depends upon the banks adoption of the economic stimulus package and Wall Street’s interpretation of the election tomorrow.

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The chart below shows a longer term perspective by viewing the 50, 89 and 200 day Simple Moving Averages (SMA). The 50 day SMA, at 1,104, is the lowest and closest SMA to the SPX's current price. The SPX will have to break above the 10/14 high of 1044 before attempting to test any moving averages. The good thing about using moving averages as support and resistance is that they offer dynamic price levels; and when they coincide with fixed levels both can provide a substantial basis for using that price level. In addition, at times when oscillators, fixed price levels and moving averages all suggest the same indication, there is a lot of reason to trade off of that level. I think that the 50 day SMA will be about the same level as the price resistance from 10/14. That may be a good time to take some newly invested capital off the table and/or hedge existing positions. One may choose to short such a coincidence of resistance. If it happens, we will have to look at all of the components that brought the market up. The Money Flow indicator shown below has bounced aggressively off it's oversold levels and has begun to level off. We need to watch to see if the indicator suggests that selling is coming back. Finally, the ADX has finally trending lower. However, a declining ADX only suggests that the previous trend is subsiding. If the ADX begins to move upward while the overall market is too, the indicator suggests that there is an uptrend.

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The NASDAQ 100 appears to be making a similar chart pattern as that of the SPX. The NDX had a 24 point range today and closed just shy of its 21 day EMA. Perhaps the NDX will sell off to the 8 day EMA at 1304 before making a run on the 21 day EMA again. The lower volatility is slowly translating into the Indexes volatility index. The VXN is the NDX's Implied Volatility measure established from the NDX options on the CBOE. As with the VIX, the VXN calculates the continuous implied volatility of a hypothetical option contract that always expires 30 days out.

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The Slow Stochastics has curled over and is only a couple of percentage points above the 3 day average. There will be some negative sentiment from the indicator once the crossover occurs, if it does. The RSI that I use is only 5 bars or one week of market data. My RSI is usually choppier than others but the shorter time frame provides a quicker response to volatile environments. My take on the RSI is that it is indicating that the upward momentum has decreased. However, neither of the indicators are overbought yet and could shoot up from a post election rally. The difference between the upper and lower Bollinger bands is 234 points or 17% from top to bottom. While volatility has declined a lot in the past week, it is still very high.

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The above chart shows the longer term moving averages. The blue dots on the price bar are from an embedded Doji indicator. My readings of the meaning of this indicator suggest that a large counter trend move is about to occur as indicated by the indecision to advance any higher. But I am probably wrong. Another indicator to watch here is the MoneyFlow. It has been unable to break above the 50 threshold and actually ticked lower today's action. The ADX suggests that the downtrend has ended but has yet to indicate a new trend.

The 10 Year Treasury Note or TNX bounced nicely since last week's test of 3.5% yield. The TNX closed at 3.904% today. Assuming the Federal Reserve has to reduce the rates again next month, the TNX could drop again as investors are forced to rebalance to safer, lower yielding assets such as the 10 Year and TIPs (Treasury Inflation Protected Securities). [Image 9]

Crude Oil (CL) has been relatively choppy over the last week or so. Oil declined $3.43 on continued demand reduction. As the 60 minute chart below shows, there has been a series of higher lows followed by lower highs. Stochastics and RSI are both oversold and may suggest a long entry on any bounce above the 8 bar EMA (64.27). One way to play a long oil trade is to buy the Ultra Long Oil & Gas Proshare (DIG) or buy the United States Oil Fund, LP (USO). The USO is supposed to track the underlying price while DIG tends to move up with the components of the Oil and Gas sector. A strong market bounce can move DIG up while the commodity is declining. As many of you know there are options on both ETFs. You may choose to sell the premium or create a stock replacement position by purchasing longer term calls and selling shorter term out of the money calls as a volatility hedge.

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The CBOE Volatility Index (VIX) dipped below the 200 day upper Bollinger band. The Bollinger bands have provided a consistent long term range that the VIX has cycled within. However, since the SEC removed the uptick rule last year, the box that contained volatility within a 10 low and 50 high was been busted. My suggestion in today's intraday Contrarian post was to wait to add Positive deltas to your portfolio until the VIX bounces up to the 20 day SMA. The 10 day SMA has begun to decline and is at 66.31 while the 20 day SMA closed today at 63.93. Along the way down, a prudent trader would have headed my advice and added Negative deltas on the VIX tests of the 10 day SMA. No signal or indicator is perfect. That's why we use so many in concert with one another. If multiple indicators of various types suggest the same thing, it is probably in the trader's interest to trade according to the suggested directional bias of all of those coicidence indicators. But always use stops. Finally, scaling into and out of positions has been especially useful in more volatile environments. Be safe at the polls. Good trading tomorrow!!

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