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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.

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.

Below, find some more great content from Schaeffer's Investment Research:

MGM Resorts Bulls Gamble on Additional Upside

US Steel Skeptics Won't Back Down

Dow Jones Industrial Average Looks to Bounce Back

Twitter: @schaeffers
No positions in stocks mentioned.
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