The Week Ahead
- Outlook –
October 3rd, 2011


The week ahead sees the SPX still remaining locked in the same volatile trading range that has been in place since early August. The range-bound, sideways channel formed after the SPX had experienced a two-week, 17% decline from its calendar-year highs. While the SPX is still trading above the key 40-month moving average, situated at 1,108, bulls should take note of the lower highs that have occurred on the last two rally attempts.


spx since 1994

From a technical perspective, other concerns include the continued deterioration in the technical backdrop of small- and mid-cap stocks, as evidenced by the following developments:


1. The Russell 2000 Index (RUT - 644.16) closed below 650, which was the site of resistance in 2005 prior to acting as support in early 2008.


2. For the first time since September 2010, the S&P 400 MidCap Index (MID - 781.26) experienced a monthly close below 800, which is double its 2009 low. The index remains above its 80-month moving average, situated at 766.80 -- a trendline that marked major lows in 2002 and 2010.

As we move into the final quarter of the year, there is not a strong consensus as to whether or not this range will resolve itself to the upside or the downside. However, a recent Reuters poll of global strategists indicated that the SPX would be modestly lower by year's end. In fact, an analysis of option activity on major exchange-traded fund (ETF) options suggests that hedged players could be looking for weakness immediately ahead, particularly in the week ahead -- which marks a change from the past few weeks, when we saw evidence that this group was split.

For instance, we are now seeing a roll-over in the 20-day combined buy-to-open put/call ratio on the SPDR S&P 500 ETF Trust (SPY), iShares Russell 2000 Index Fund (IWM) and PowerShares QQQ Trust (QQQ), after a period in which this ratio turned higher. When the ratio is advancing, it is usually evidence that hedge fund managers are buying stocks, as they simultaneously purchase these puts to hedge the long equity positions they're accumulating.


The S&P500 as represented by the S&P 500 SPDRS (NYSE:SPY) rallied back into the channel it has recently been following before reversing near the $120 level. This was just above its 20-day moving average and almost within reach of its 50-day moving average. However, SPY never seriously challenged its most recent highs near $122.50 before heading lower. Price action in SPY remains consistent with a weak environment and it would not be surprising to see SPY retest its lows near the $110 level.


The Diamonds Trust, Series 1 (NYSE:DIA) ETF

The Diamonds Trust, Series 1 (NYSE:DIA) ETF is trading in a very similar pattern to the SPY last week, although it did show some relative strength. While DIA reversed after climbing back into its recent trading channel, it did hold up well above Monday's low unlike the other indexes. Because the Dow only represents 30 stocks, this strength can easily be attributed to the performance of a few individual names like International Business Machines (NYSE:IBM).

Traders should continue to watch the $106 level in the week ahead when specifically looking at DIA, but the other indexes are more relevant when assessing the overall markets.


The Powershares QQQ ETF (Nasdaq:QQQ) ETF

The Powershares QQQ ETF (Nasdaq:QQQ) ETF, which has been showing relative strength for weeks, finally caved in to selling pressure. In fact, it can be argued that QQQ performed even weaker than its peers by closing under the previous week’s lows. QQQ has now joined its peers in falling out of its recent trading channel.

This market will not be able to sustain any strength without participation from this group. With Apple, Inc. (Nasdaq:AAPL) slated to make an announcement in the week ahead, it may help dictate what the next direction is for QQQ.


iShares Russell 2000 Index (NYSE:IWM) ETF

In a recurring theme, the small caps, as represented by the iShares Russell 2000 Index (NYSE:IWM) ETF, continued to perform poorly. After a volatile week, IWM ended near not only its lows for the week, but also its 52-week lows. IWM appears destined for new lows, so the week ahead will provide a critical test for the index.

While a shakeout under recent lows can’t be ruled out, traders need to be prepared for a full fledged breakdown at this point.


Call Options – Hedging - VIX

Another hedging tool for those accumulating equities are call options on the ”CBOE Market Volatility Index (VIX – 42.96)”, as the VIX will usually advance sharply in the event of a correction. Thus, the profit from the call options could cushion equity losses. But, during the past 20 days, VIX puts have been in heavier demand than VIX calls. During the past several weeks, the VIX's buy-to-open call/put ratio has fallen below 1.0, due to a surge in put buying and a significant decrease in call buying. This could be a signal that the hedge fund world is positioning for a weaker market ahead, and using VIX puts to hedge growing short positions. The market has tended to struggle as this group turns negative, which they appear to be at the moment. 

The only piece of good news in the chart below is that the VIX's call/put ratio is approaching extreme lows. A turn higher in the ratio from these levels has been associated with major advances in the equity market on previous occasions. For now, though, bulls should be on guard for the week ahead, as this ratio continues to decline alongside a bearish roll-over in the 20-day combined SPY/QQQ/IWM put/call ratio (second chart below).


wo-sept30-2011-20day buy to open ratio


For the week ahead keep tight stops on your long equity positions -- especially those in the consumer-discretionary area, as we are seeing some breakdowns among former leaders in this group. Large-cap banks continue to be the biggest area of vulnerability, and these are names to consider if you are actively shorting. Treasury bonds should remain in your portfolio, and utilities are a sector worth adding, given the attractive dividend yields, strong price action, and the low percentage of "buy" ratings from analysts, hinting at future upgrade potential.

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