Sell in May Update

Since the month of May ends this week and since stocks have a long history of declining in May or June now is a good time for a progress report. So far, there is little evidence the major averages as represented by the large capitalization blue chip averages are the least bit concerned. However, the continuing disparity with the smaller capitalization stocks will eventually be resolved either by the big capitalization indexes declining, or by the laggards finding support and turning higher. Indeed, there was some evidence the smaller laggards found some support Friday.

After adding options to the perspective in our market review, we focus once again on the divergence between the S&P 500 Index and the iShares Russell 2000 and then add crude oil into the mix with a long suggestion for United States Oil (USO).

 

S&P 500 Index (SPX) 1900.53 with the new intraday and closing high made May 13 at 1897.45 thereby exceeding the April 4 high at 1897.28, negating the possibility of a Head & Shoulder Top. Then after a brief decline it came right back to challenge the high once gain by closing at a new all time high Friday, but just slightly under the intraday high of 1902.17 made on May 13, the new objective.

The larger capitalization stocks have been relatively stronger since March 4 when the iShares Russell 2000 (IWM) 111.97 peaked at 120.58 and then abruptly began selling off. Last week in Digest Issue 20 “Tale of Two Markets” while looking for a potential right shoulder of a possible IWM Head & Shoulders Top that was not previously evident, the decline down to test 107.50 on Thursday May 15 had seemed to form either a possible double bottom or an attempt to advance back up to define a right shoulder. Either way, it looked oversold and due to rebound, so we suggested long call spread. Indeed, it continued higher closing at 111.97 Friday and notably above the well-defined three-point downward sloping trendline line from March 21 at 120.26. If Friday had not been the last trading day before a long weekend, it may have not exceeded the downward sloping trendline since small stock short covering was most likely the driving force that even helped push the S&P 500 Index higher to a record close.

CBOE Volatility Index® (VIX) 11.36 created the other notable event last week closing 1.08 lower challenging the March 14 intraday low at 11.05 with the 11.30 close.

The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan’s day-weighted average between the first and second months.

 

 

The day weighting applies 85 to June and 15% to July for an average premium of 23.88% shown above. Our alternative volume-weighted average between June and July, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 26.07%. We consider premiums less than 10% to be cautionary while the premiums for a normal term structure are 10% to 20%. Premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. From a contrary regression to the mean perspective, it suggests caution.

VIX Options

With a current 30-day Historical Volatility of 67.36 and 68.65 using Parkinson’s range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday’s closing option mid prices along with their respective month’s futures prices, since the options are priced from the tradable futures.

 

 

Comparing to the range historical volatility of 68.65 to the implied volatilities show both the June and July at-the-money options are underpriced. Friday’s volume was moderate at 582,815 contracts compared to the weekly average of 748,050 contracts. Like the VIX futures above, the options suggest little current enthusiasm for hedging just when it’s least expensive.

 

 

CBOE S&P 500 Skew Index (SKEW) 125.13 measures the purchase of out-of-the-money S&P 500 Index puts that require a very large downside move to profit from long put positions. An increase of this index indicates greater expectations for an extreme down move.

Lower by 2.10 for the week, SKEW, like the VIX futures and options above implies there is little additional interest in adding out-of-the-money S&P 500 Index puts for hedging. It remains 2.84 points below the midpoint of our arbitrarily defined relevant range between the rapid decline to 112.66 on March 14, followed by the spike higher to 143.27 on March 17. Until a close above 127.97, we consider SKEW to be confirming the sanguine views suggested by the VIX futures and options. It will deserve more attention when it closes back above 130.

While the VIX premium appears to be a coincident indicator, rapid advances in SKEW indicates significant increases in out-of-the money put buying normally near the top of an advance as a contrarian strategy by these seeking to hedge gains.

US Dollar Index (DX) 80.39, May 8 it tested the important chart level at 79 going back to last October and quickly made a key reversal. It now appears to be trending slightly higher in a range defined by the low at 79 and 80.50, a level twice tested since mid February.

iShares Barclays 7-10 Year Treasury ETF (IEF) 103.59 the gap opening breakout on May 14 followed by another advance May 15 took interest rates as low as 2.49% before consolidating in what appears to be a symmetrical triangle continuation pattern. If so, another upside breakout could take interest rates below 2.45% in a “risk off” flight to the safety of Treasuries perhaps due to macro concerns more than expectations for a slower US economy.

iShares Dow Jones Transportation Average Index (IYT) 143.09 no signs of expectations for a slower US economy here since the advance continues. In the meanwhile, overbought comments are being heard since it’s about 6% above the upward sloping trendline from the February 5 low at 125.50 and inconsistent with declining interest rates since the transports are one of the most economically sensitive groups. Keep an eye on IYT for any sign of weakness.

 

Returning to Sell in May, there is little doubt that selling in small capitalization stocks continued while the large stocks advanced. However, when comparing to last year it is still too soon for the bulls to declare all is well. Last year on May 22, 2013, the S&P 500 Index made a key reversal setting up a 7.5% decline that lasted until June 24. At the same time, the iShares Russell 2000 also made a key reversal from a new high of 100.38 and then declined 6.5% ending on June 24. This is in sharp contrast to this year since the small capitalization index is nowhere near a new high having just tested a potential neckline that would set off a Head & Shoulders Top that would suggest much lower prices in the event of activation. This seems to indicate much less tolerance for equity risk than this time last year.

In fact comparing IWM to SPY, we see relative risk trended higher until March 4 when it broke below the upward sloping trendline beginning November 15, 2012.

 

 

Here are the points used to construct the chart above where USTL is the upward sloping trendline as a proxy for relative equity risk.

 

 

While both indexes could decline, in the lower right, we see the index currently at .5880 is still above the November 15, 2012 low of .5695 suggesting a further relative decline is still possible.

Eventually the divergence with the NASDAQ and small capitalization stocks represented by the iShares Russell 2000 along with “growth and any price stocks” will be resolved either by the big capitalization indexes declining, or by the laggards finding support and turning higher. As mentioned above the low VIX along with the steep futures curve and low options prices implies a decline in the large capitalization issues could begin to resolve the divergence.

Referring to the ongoing rotation issue, we see energy as defined by crude oil and the related energy sectors have been increasing.

When comparing last year’s S&P 500 Index decline to crude oil using United States Oil (USO) we notice SPX declined 5.35% between May 22 and June 24 while USO advanced .54%. This suggests seasonal strength in crude oil and we are seeing similar strength again this year. Accordingly, a long crude oil positions would appear to have relatively less risk.

Seasonal Crude Oil

United States Oil (USO) 38.18. July crude oil closed at 104.36 and has been in backwardation, when the near term futures contracts are priced higher than the deferreds, for 20 weeks. This is important for USO since when the term structure is in normal contango there is a loss as the contracts are rolled out to the next month. However, when in backwardation this ETF underperformance risk is reduced or eliminated.

Next checking the options implied volatility shows they are near the 52 week low and would normally be expected to rise if the underlying declines in price. However, since we are not expecting to see a price decline there is no reason to expect the implied volatility to increase signficantly unlike the major stock indexes described above. If increasing implied volatility was expected then a strategy using more long options would offer an advantage. In this situation it does not seem necessary.

The current Historical Volatility is 10.43 and 8.00 using the Parkinson’s range method, with an Implied Volatility Index Mean of 14.58, up slightly from 14.21 the week before. The 52-week high was 28.16 on August 28, 2013 while the low was 13.66 on December 26, 2013. The implied volatility/historical volatility ratio using the range method is 1.82 so the option prices are expensive relative to movement of the ETF but below the midpoint of the 52 week range. The put-call ratio at .80 is normally just bearish, but relatively low since it makes a good hedge against crude oil prices. Friday’s volume was 29,333 contracts traded compared to the 5-day average volume of 34,730 contracts, so options liquidity in the normal expiration months is reasonable.

Here is a long call spread to consider.

 

 

With a good risk to reward ratio use a close back below the April breakout support at 37.81 as the SU (stop/unwind).

The suggestion above uses the closing middle prices between the Friday bid and ask. Tuesday option prices will be somewhat different due to the time decay over the weekend and any price change.

 

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Summary

May is not quite over and rotation out of “growth at any price stocks” along with weakness in small capitalization stocks continues to cause concern about the successful exit from high price to earnings ratio stocks without causing an overall market decline. Although the S&P 500 Index reached a new closing high, the smaller capitalization issues may continue struggling and since the VIX along with VIX futures and option are now at extreme levels long inexpensive put options used for hedging remains a prudent course of action. In the meanwhile, crude oil appears to be seasonally strong.

 

Actionable Options™

We now offer daily trading ideas from our RT Options Scanner before the close in the News section of our home page based upon active calls and puts with increasing implied volatility and volume.

 

In next week’s issue, we will again run our ranker and scanner tools to find more ideas.

 

All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. Another way to find them is the Table of Contents link in the blog section of our website.

As usual, we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like us to look at a specific stock, ETF or futures contract, let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com.