Notes from the Trading Desk: When the Consensus Calls for a Volatility Spike

Schaeffer's Investment Research
  OCT 22, 2012 10:30 AM

Here are four reasons why bulls still have the edge.


Stocks struggled for direction last week, as traders got bogged down by a muddled mass of headlines. Spanish bailout speculation continued to circulate, China released a flood of economic data, the race for US president became increasingly contentious -- and Google (NASDAQ:GOOG) spawned more than one parody Twitter account with its bleak, leaked earnings report. Against this hectic backdrop, stocks endured some roller-coaster price action, but most broad-based benchmarks settled relatively close to breakeven for the week.

The market action could remain hectic this week, as we're heading into a five-day stretch featuring a Fed policy meeting, the advance reading on third-quarter GDP, and earnings from the likes of Apple (NASDAQ:AAPL), AT&T (NYSE:T), and Amazon (NASDAQ:AMZN) -- and that's just to name a few of the A's. So how should contrarians trade this hot-and-cold market right now?
"The four 'Es' -- Earnings, Economy (a/k/a the 'fiscal cliff'), Europe, and Elections -- continue to breed uncertainty in the equity market. The ambiguity is translating into caution and hesitation on the part of major market-movers, such as hedge funds. With respect to price action, major indices are situated around all-time highs or multi-year highs, with small- and mid-cap indices -- such as the Russell 2000 Index (NYSEARCA:IWM) and S&P 400 Midcap (INDEXSP:SP400) -- challenging resistance levels in the 850-860 and 1,000 areas, respectively. With major benchmarks trading at or near their respective highs, price action at present suggests we could be in for some choppy action, at least until we see some resolution among the four 'Es' looming over the marketplace at present."
-Monday Morning Outlook, October 6, 2012
"Investors are snapping up options that pay off if there is a rise in the 'fear gauge,' the Chicago Board Options Exchange Volatility Index, or VIX. A record 6.2 million contracts were outstanding as of Monday, a rise of 12% over the past month."
-The Wall Street Journal, October 16, 2012
"$VIX 20-day cumulative buy (to open) put activity at 8-month low - few expecting lower vol."
-@ToddSalamone on Twitter, October 18, 2012
"Trading in an exchange-traded fund tracking the Chicago Board Options Exchange Volatility Index has jumped more than any other US ETF this year, drawing investors betting that stocks will decline after the biggest rally in three years. [The average daily volume of the ProShares Ultra VIX Short- Term Futures has risen to 6.5 million from about 4,000 at the end of last year, according to data compiled by Bloomberg from the past 30 days. That's the biggest increase among US ETFs trading at least 600,000 times a day.]"
-Bloomberg Businessweek, October 19, 2012
Two weeks ago, we outlined a couple of reasons why the market might be in for a period of choppiness. Since this time, a choppy, sideways market is exactly what has transpired, as trips to both support and resistance levels, amid a mix of negative and positive headlines -- ranging from strong housing data to poor big-cap tech earnings -- that has motivated both buyers and sellers, resulting in a churn for the S&P 500 Index (INDEXSP:.INX).

The SPX's mid-September closing high at 1,465 continues to cap rallies, while former resistance at 1,420 is so far acting as support. Meanwhile, the S&P MidCap 400 Index continues to hit a brick wall at the round-number 1,000 millennium mark, a resistance level that has been in place since it was first challenged in April 2011.

So, the bad news is that the major equity indexes are failing to take out key technical resistance levels, as the four Es -- earnings, elections, Europe, and economy (namely, the fiscal cliff) -- prevent buyers from taking a chance by adding long exposure when resistance lies just overhead.

The good news for the bulls is that the equity benchmarks continue to trade above support areas. For example, the SPX is not only above 1,420 -- which acted as resistance during the first eight months of 2012 -- but secondary support lies in the 1,400 area, which was the late-August/early September low ahead of a major rally.

Moreover, the MID remains above the 925-960 area, with 925 representing the 2007 peak and 960 having served as both support and resistance in 2012.

Meanwhile, the Russell 2000 Index  is above support at 820, which acted as resistance in early July and is the site of a trendline drawn through higher lows in June and August. Even if 820 breaks, there is backup support at the 780 level. From a contrarian perspective, the sentiment backdrop is very supportive of an advance in equities. Last week, Senior Technical Strategist Ryan Detrick did an outstanding job of highlighting the various sentiment indicators on our radar. That said, I will add a few things for you to ponder:

1. The American Association of Individual Investors (AAII) weekly survey indicated only 28% bulls and 44% bears, the highest bearish reading since June 7, 2012. Early June was an excellent buying opportunity, as the SPX was trading around 1,314.

2. Last week's National Association of Active Investment Managers (NAAIM) weekly survey showed the lowest allocation to stocks since mid-July, when the SPX was trading near 1,340.

3. Our analysis of option activity on major exchange-traded funds (ETFs) suggests hedge funds could have their lowest exposure to equities since early 2009.

4. Finally, as indicated by the various opening excerpts above, the consensus bet is that volatility is headed higher -- and, therefore, stocks are headed lower. In fact, the sentiment seen in these excerpts is supported by the chart below, courtesy of our friends at TradeAlert. Open interest on VIX call options, which are bets on a higher CBOE Market Volatility Index (^VIX), hit a record level just ahead of October expiration. We would expect this to build back up once again, which could be a headwind in the immediate term.

At present, more than half of the 4.1 million VIX call contracts are in the November series, which expires Nov. 21. Nearly a quarter of this open interest is located at the 25 and 35 strikes, and a healthy amount at the 55 strike, as speculators look for a VIX spike of anywhere between 50% and 200%. At the same time, bets on lower volatility are very few, despite the VIX trading well in excess of the SPX's historical volatility of 11%. The difference between the VIX and SPX actual volatility is high, but not yet at an extreme. However, the prevailing mentality that a VIX spike of significance is imminent seems to be at an extreme, making it less likely to occur.

Our favorite group remains homebuilding, with bullish housing data this week against a backdrop of skepticism and strong price action. If you are looking for a sector to short, we think technology looks most vulnerable, as this is where the hedge funds tend to invest, and major companies in this sector took earnings hits this past week.

This article by Todd Salamone was originally published on Schaeffer's Investment Research.

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