Just about all my clients have been asking what I think of the stock market, and whether the powerful rally we’ve seen over the past year will continue. It’s taken a lot of people by surprise. If you missed this rally, you may be feeling left out, but there are ways to participate using futures and options, no matter what your view.
The S&P 500 has gone almost straight up since March 2009. A lot of the gains have come on lighter volume, indicating that not many people have been participating in the gains. It has been a slow-grind type of rally. When the rally started, the economy was still in bad shape, bailouts were being handed out left and right, and unemployment was steadily increasing. While many economic questions still remain, particularly regarding employment, traders who tried to short the market in disbelief paid the price.
The meltdown stemming from the financial market crisis in 2008 – 2009 saw many investors being forced to pull out of the market. Many large market participants were overleveraged and panic set in, and individual investors were forced out as their life savings dwindled. It seemed everyone was in the market at that time. Institutions didn’t realize how leveraged they were. There were a lot of surprises, including bank failures, hitting the market daily.
I don’t see as many people participating in the market today, so I don’t see the same type of panic likely that we had in 2008 – 2009. Many investors never came back into the market. They have been on the sidelines, or just don’t have the capital to get back in. And firms active in the market are more cautious now. Market participants have been forced to re-evaluate their balance sheets, and as such have a much better understanding of the risks they face. This awareness lessens the chances for financial surprises that could fuel a meltdown. To me, this means we won’t have a severe stock market correction, even if the economic outlook isn’t that bright.
Market Volatility Index (VIX)
One indicator that can help determine where the market may head next is the CBOE VIX. The VIX is an implied volatility index. It measures the market’s expectation of 30-day volatility implicit in prices of near-term S&P 500 options. As S&P index option prices as a whole increase, the VIX rises.
As the demand for options increases, options prices increase. The VIX is often called the “fear index” because if investors are afraid a market correction might be ahead, they are more likely to purchase protective puts as a hedge. When the financial market crisis hit, the VIX increased; that’s the typical response we’d expect to see.
This spring the VIX fell under 16, its lowest level since July 2007 (when the market was rallying and it seemed all was right with the world). Then on April 16, it rallied to above 18 on news the SEC charged Goldman Sachs with civil fraud.
Looking at market activity last week, we see that the VIX spiked to a new recent low (15.23), before recovering and finishing the week positive. Comparing this type of market action to recent history, we can see a pattern develop regarding the performance of the S&P 500 in subsequent weeks. Looking at the weekly chart of the $VIX and the S&P 500 futures, we see that the week of January 11 this year, the VIX spiked to new lows and finished positive. Over the next three weeks, the S&P futures sold off from around 1,130 to 1,040. Similarly, the week of October 19, 2009, the VIX spiked to a new low and finished positive. Over the next two weeks, the S&P futures moved from 1,099 to a low of 1,026. As with any technical formation, there is no guarantee that the pattern will repeat itself, but it is interesting to note.
Chart: E-Mini S&P Futures
Chart: $VIX
I don’t see the bottom falling out for the stock market. These market movements were simple corrections in the midst of the longer-term uptrend. I don’t anticipate a test of 800, 900, or even 1,000. There have been signs employment has been picking up, both in the most recent employment report and from anecdotal evidence. In March, nonfarm payrolls rose 162,000, the largest gain in two years.
Moving Average Convergence/Divergence (MACD)
Another indicator I like to look at for direction is the MACD daily crossover. When we see the moving averages cross, it indicates a possible shift in trend. Last week, the blue line crossed over the red on the chart below, indicating a possible short-term market top.
Chart: E-mini S&P w/MACD
Even though indicators are showing we might be in a short-term top, in my opinion we should see a healthy correction, not a panic one. If you want some downside exposure, and/or you are bearish because believe the economy is still in bad shape, I would caution against shorting futures. If you do, buy a call against them to protect yourself.
A low VIX equals cheap options. So if you are looking to trade the S&P for a bearish move, you might consider an options strategy such as buying puts on the S&P 500. Buying puts offers you the advantage of defined risk. If you want a longer-term play, you might consider a trade such as the September 1150/1100 put spread.
You might also consider selling an additional 1000 put against the spread to finance it, if you feel the market will correct, but hold above 1,000. Selling the put changes your risk profile dramatically, and you must be familiar what this strategy entails. If the S&P is below 1,000 at expiration, you are then long a futures contract at 1,000, and your risk is potentially unlimited if the market continues to decline. However, if you are believe that any correction will hold above 1,000 in a few month’s time, and are comfortable with the possibility of having an effective long position from this level, this might be an appropriate strategy for you.
For bullish investors, you can simply buy an S&P futures contract. If you do so, I recommend you also buy a put to protect yourself for a near-term correction. The put acts as a defacto stop. If the market corrects and then resumes its uptrend, the long futures/long put strategy will allow you to define your risk without the frustration of being stopped out. Please feel free to call me with any questions you have about the markets, and to develop strategies appropriate to your particular situation.
Matt Krupski is a Senior Market Strategist with Lind-Waldock. He can be reached at 877-847-3034 or via email at mkrupski@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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