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SPX Volatility



Will the SPX Continue Its Recovery?

The Significance of the Index's 320-day moving average!

The Critical S&P 500 Trendline!


by Ian Harvey

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May 29, 2012

SPX Volatility

Introduction

Last week was chock-full of intraday volatility, with drama both at home and abroad leading to significant pre-close price swings. Along with debt-strapped Greece, Facebook (FB) remained on the collective radar, extending its (somewhat controversial) post-IPO drop.

The broader equities market, on the other hand, finished in the black for the first week in four, as relatively encouraging reports on housing, durable goods, and consumer sentiment helped to tip the scales in the bulls' favor.

Also, the current technical and sentiment backdrops could point to a potential opportunity to accumulate stocks.

The Importance of a Critical SPX Trendline

1. “.....was last week's price action driven in part by a delta-hedging decline related to the huge build-up of put open interest on major equity indexes and exchange-traded funds (ETFs)?

As popular put strikes were violated one after another during expiration week, sellers of the puts may have been forced to short futures to keep a neutral position, creating a steady but sure stream of selling. The heavy put open interest strikes essentially act like "magnets," as one strike after another is taken out…..If last week's sell-off can be partly attributed to delta-hedging -- which is a high probability -- the market could right itself fairly quickly, as the short trades put on during expiration last week are covered, and mean reversion sets in after heavy selling in 11 of the past 13 days.....”

2. “.....the SPX comes into this week trading at yet another potential support level, as it sits on the late-October 2011 high, which coincides with a 38.2% Fibonacci retracement of the October low and April peak.....the RUT comes into the week trading 7 points above its year-to-date breakeven level at 740.92, which is potential support.....Finally, note the closing level of the PowerShares QQQ ETF (Nasdaq: QQQ - 60.81). As you might remember, the QQQ struggled to overtake the 60 level throughout 2011, but finally moved above this level in the first month of 2012. The 60 level is the key, as it is half the all-time high in 2000. Bulls would like to see the QQQ remain above 60, but a move below this area would put the bears back in the driver's seat.”
- Delta-Hedging Effect on the Stock Market, May 21, 2012

Equities got off to a poor start during May expiration week, thanks to looming European concerns, but it is now apparent the decline was exacerbated in part by delta-hedging, as explained in the excerpt above from last week's news article “Delta-Hedging Effect on the Stock Market”. While equities didn't exactly "right themselves" in a major way this past week, Monday's post-expiration-week rally suggests there was an abundant unwinding of short positions that were no longer needed due to the expiration of May index and exchange-traded options.

In addition, and as explained in the second excerpt above, this past week gave the bulls more life, as major indices rallied off support levels. Of particular interest was the Standard & Poor's 500 Index (SPX) rally from support, along with the fact that it came into last week trading at its October 2011 high and a 38.2% retracement of the October low and April peak.


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The 320-Day Moving Average Significance

Last week, the SPX had pulled back to its 320-day moving average, in the 1,291 zone. This moving average is far from mainstream in technical analysis, but has proven its significance as a support and resistance area on multiple occasions since the late 1990s nonetheless. Crossovers above and below this trendline have proven to be pretty effective buy and sell signals, as well, with the exception being the cross below that occurred this past August.

By comparing the magnitude of the pullbacks to this 320-day moving average in the late 1990s --when the un-hedged retail investor was actively investing in the market and tended to panic on market sell-offs -- to the time period since the hedge-fund industry played a predominant role, beginning in the mid-2000s -- professional hedge-fund managers, because they tend to hedge, are less apt to panic-sell, unless forced to do so (remember 2007-2008).

Simply put, the magnitude of pullbacks to the 320-day moving average in the late 1990s came in the context of 10-percent-plus declines, whereas since the mid-2000s, several pullbacks to this moving average have ranged between 4% and 7%, up until the latest pullback that has so far fallen just short of the magical 10% level. Admittedly, in the late 1990s, stocks had further to pull back, theoretically because those driving stocks higher in the 1990s did not hedge nearly as much as the buyers of today. Therefore, without as much hedging activity in the 1990s, stocks were free to run aggressively higher during advances, leaving more downside potential during corrective pullbacks to this long-term trendline.

This 320-day moving average provides the conclusion that the support at 1,291 on the SPX wrong-foots two constituencies:

1. Those wanting to see the round-number 1,300 hold

2. Those waiting for a full 10% pullback before entering the market or covering short positions .

The first group is faked out on the move below round-number support, but can potentially re-enter the market after it is retaken. The second group could theoretically wait forever for the 10% pullback that doesn't happen. In the latter scenario, this would represent sideline cash still waiting to be deployed and/or short-covering potential.

Even if the 320-day moving average is taken out -- the bears would likely be challenged by other longer-term support areas -- namely in the 1,240-1,280 area. This area represents the SPX's year-to-date breakeven (1,257), and is home to other long-term moving averages that have acted as support and resistance on pullbacks over the years -- most notably, the 80-week and 80-month moving averages, perched at 1,287 and 1,240, respectively.

SPX-volatility-1

SPX-volatility-2


Conclusion

As has been discussed during the past several weeks, the sentiment backdrop at present is one that usually marks important bottoms. Therefore, the SPX low at 1,291 support during expiration week, the PowerShares QQQ ETF (Nasdaq: QQQ) pullback to its half all-time high in the 60 area, and the Russell 2000 Index’s (RUT) pullback to its 2012 breakeven and the 750 area -- site of the peaks ahead of the Lehman Brothers crisis in 2008 and "flash crash" in 2010 -- argues for a bottom being in place. As such, it would be advisable to use the pullback to accumulate stocks in sectors such as homebuilding and the retail/restaurant group.

However, with the SPX trading below 1,333 (the March 2009 double-low) and 1,340 (resistance in 2011), the bulls are not yet out of the woods. And as an added risk, the CBOE Market Volatility Index (VIX) remains above 20.49 and 21.36, which are 50% above the intraday and closing March lows. Up until recently, this area provided resistance, but acted as support this past week.

One way to play this risk is buying put options on the mega-cap banking stocks, which appear to be underpriced in lieu of the trading losses at JPMorgan Chase (JPM), the continued issues in Europe, and the weak technical backdrop in these names, despite a strong contingent of supporters, that represent potential selling pressure.

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