As I watched the market action on Friday, April 01, 2011, I was reminded of a few market and trading realities that I thought I might round up in a this-and-that type of article.
Anyone who watched Friday's market action knows that futures had again been trending up overnight, even before the non-farms payroll number was announced, presaging yet another gap up at the opening. As has become typical in such situations, the SPX climbed swiftly in the first few minutes of trading, precluding much chance of profiting from a newly entered long play unless one was especially swift to enter and exit the trades. Inflated volatilities at the open were likely going to leak out swiftly once the initial move settled down, or at least after the 10:00 numbers were released.
By the day's end, however, the SPX and many other underlyings had done more than flatten, as they've been doing lately on the gap-higher mornings.
Daily Chart of the RUT:
After gapping higher Friday morning, the RUT moved even higher, but settled beneath its opening level, leaving a doji-type candle isolated above the recent highs. For now, this move suggests indecision. A gap-down opening Monday and a long red candle could mean a retest of the February high, and if that's not support, even lower. Another gain or even another small-bodied candle could be more bullish.
Unlike the RUT, the SPX remained above the day's open, but it also produced a candle that was indicative of some selling at the gapped-into highs of the day. That might have been selling ahead of the weekend, taking risk off the table, so we shouldn't make too many assumptions about what will happen next.
I've often warned of the tricky nature of the first thirty minutes to an hour of the trading day, necessitating some decision making. If a trade is approaching an adjustment level, should we wait out that tricky first period of the day, letting the volatilities settle and determining whether the first move, up or down, will hold? Should we wait out the 10:00 EST period when so many economic releases are scheduled? Friday's action brought up another question that's often on experienced traders' minds. Should they adjust intraday or wait until the end of the day?
I know traders who choose one side or the other. I tend to adjust intraday if an adjustment is needed while another experienced trader I know examines all her trades about thirty minutes before the close and makes a determination then whether she will adjust. She avoids some of my adjustment points because markets have reversed by the close, but she may pay more for her adjustments when she does adjust. I know another experienced trader who adjusts intraday but who will wait, if possible, two hours past the time an adjustment seemed needed, to see if the move that necessitated the adjustment holds or is reversed.
Guess what I'm going to say about which method is preferable? If you've been reading these articles long, you know the answer. There's no right or wrong way to do this. Those who adjust intraday tend to be early adjusters, like me, who want to even out returns and who accept the possibility that the end-of-the-day move will take away that need to have adjusted. Those who wait for the end of the day reason that it's really what happens by the end of the day that determines the tenor of the market, not what happens intraday. A strong more-than-a-standard deviation move up in the morning can be met by a close below the open, as happened with the RUT on Friday. People who were in a RUT butterfly, for example, who adjusted intraday might have wished they hadn't by the end of the day.
This idea has merit, but at least two caveats exist. A runaway move will put end-of-day decision makers into worse shape by the end of the day, of course. Also, imagine the scenario Friday if the markets had kept running up into the close. Those who had held onto their positions all day, accumulating bigger and bigger losses, would have been scrambling to increase the deltas in their positions or to get rid of losing short positions by buying in those positions. Once again, volatilities will have been pumped up in the calls, at least. Market makers who were scrambling to even out their own weekend risks would have been reluctant to go more bearish in their own inventories by selling us calls, so they would have exacted a higher premium for doing so. Therefore, if you're going to wait for an end-of-the-day decision and the market has been trending all day, you might consider moving ahead of that last few minutes of trading, at least. We sometimes wait to see if there's a reversal when those market-on-close orders start being apparent at about twenty minutes before the close, so some traders will want to wait a few minutes past that time to see if the markets reverse. Don't wait too long, though, in a fast-moving market, particularly if you're trying to move spreads or other complex orders.
The last this-and-that matter relates to what was happening to volatilities. We'll look at the chart of the VIX, but subscribers should be aware that while the VIX is calculated from SPX options, it doesn't exactly describe what's happening with implied volatilities on all SPX options and certainly not those of other underlyings. However, let's look at a daily chart of the VIX to see what it can show us. This will be the chart I showed several weeks ago, now updated.
Daily Chart of the VIX:
After gapping up above a long-term descending wedge, usually a bullish formation, the VIX zoomed higher while the SPX was turning down. As a stock will often do, the VIX then returned to retest the trendline it broke through, with the determination yet to be made whether that trendline will hold as support and the VIX will again bounce hard. (Newbies should be aware that equity prices often move in opposition to the VIX, although the VIX isn't always a good market-timing tool. A bounce in the VIX could be bad for equity prices, then.) We just don't know the answer to this question yet. While the RSI is also at a point from which it often reverses upward again, there's nothing here that promises that the VIX will bounce instead of sliding down that trendline to test lower support again. The trendline would be holding, but the VIX would be drifting lower while SPX prices might be climbing higher. The VIX could even break back inside that pink wedge.
However, not making too many assumptions doesn't mean we should forget about making some preparations for a low-VIX environment. If we're placing trades such as iron condors and butterflies, those low vols are going to mean it's difficult to get much premium for our trades. That means the sold strikes are closer in on iron condors when the risk is that the markets will roll over and cascade down right while volatilities explode. Exploding volatilities would hurt either trade. It's time once again to consider whether you want to throw in some extra out-of-the-money puts into the equation for your iron condors or employ some of the other tactics I mentioned in my February 18 and February 25 articles. Butterflies are usually negative delta after they're constructed, due to the skew of the options, so it may not be as necessary to protect them with put insurance, depending on the way the trader adjusts them. Traders should be thinking this weekend about how they'll adjust open positions if volatilities expand, by either adjusting early, risking making too many adjustments but making the adjustments as cheaply as possible, or by giving the formation a wide range in the hopes that you won't have to adjust so often. Don't swamp your trades with so many extra puts that you're going to quickly get into trouble on any upside move and try not to overadjust, but do consider how you want to approach trading in a low-volatility environment.
Once again, as I mentioned in my February 18 article, I want to assert that I'm not warning of catastrophe. I'm not a doomsayer. I've already shown that we just don't know what will happen next with the VIX or with those small-bodied candles on some equity index charts. However, when I think about how the VIX tends to behave historically, I think that it's again time for me to think about employing some of those tactics I mentioned in February's articles. I will take the precautions that I always take when the VIX drops down into this area, but I'm not going to withdraw all our money from the bank and hide it under the mattress.
I also noted today that the TED spread, a spread that measures default risk, moved to a one-month high, coincidentally closing just .01 above its February 18 high. February 18 marked the February high. The equity markets sometimes move in opposition to the TED spread, dropping while the TED spread climbs. While the VIX is testing support, the TED spread is testing resistance. I don't know what's going to happen with either of these. The point of what we're seeing on the VIX and the TED spread is that tests are going on, and we really don't know how that test is going to be resolved. Preparations may again be in order, and we'll hope that the insurance we bought just isn't needed.