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


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).
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