Saturday, October 11, 2014

SPY Weekend Update for 10-10-14

SPY, the ETF proxy for the Standard and Poor's 500 Index, fell sharply this week after riding a roller-coaster of highs and lows.

When it was all over with, SPY found itself down nearly 6 full points to 190.54.  Price broke below the -2 standard deviation level on the 20 week moving average for the first time since May 29, 2012!


Right now, from my anecdotal findings, the Bulls that I know have been shrugging off the downturn, proudly proclaiming, "I'm buying more here on the dip."  I had to chuckle the other day when one well-known economic prognosticator commented on CNBC that he felt that the market was now going to start going down until people start to puke.  So where are we now?

The weekly chart looks a bit different than the daily chart that I usually post.  On the daily chart, we were able to see a well-defined, long-term, area of support and resistance at the 190.5 level.  It appeared the be a very good setup for a head and shoulders top formation which has likely been discussed in a previous commentary here.

The weekly chart though shows a declining neckline but still a head and shoulders possible set-up.

It's been quite a long time since we had a decline so I went back to see how the previous decline, back in June, 2011, played out.  I was surprised to see quite a few similarities.

Last time, which we will call P2, we can see a top formation that also resembled a head and shoulders with a declining neckline.  We can observe that price broke through the 20 week moving average to go to an oversold level (at the #40 marker), then rallied back up to form the right shoulder of the formation, then dropped down dramatically.

In both cases, we see that the Standard Deviation level of price went to an oversold -2 level but this oversold level came rapidly because for the previous period of time, volatility had been shrinking.

This chart shows the current picture of 20-week volatility.  One would probably scratch his/her head to see volatility so low when we've had so much daily volatility but based on weekly data over an intermediate period of time, we have been relatively flat.

What is interesting though is to go back and look what was happening back when the market made its last series of lows.

The arrow shows the relative position to where we are today.  You can see that the last time the market started to go down, volatility was also very slow.  This causes the market to be oversold quickly and often can result in the oversold bounce that we saw in P2, resulting in the Right Shoulder.

What happened next in for P2 Standard Deviation was quite dramatic.  Standard deviation fell to nearly a -3!

I often use Standard Deviation as the emotion indicator.  When I used to train futures traders at a bank in Mexico City, one of my first exercises was to allow the new trader to trade freely without any guidance or restrictions.  At the end of the day, we would review the trades, now analyzing the trades with my standard deviation tool.  Almost always, we would see that the trader was buying when there was euphoria, at the +2 standard deviation and generally, the trader was selling at the -2 level, when there was panic.  These emotions cannot be avoided, even for the most experienced trader.  That is why I use this tool as my guide.  It's hard to be buying when the news is horrible just as it is hard to sell when everything looks great and there is no apparent reason to sell.

There's more though.  While the +2/-2 (easily viewed using Bollinger Bands) works as a great buy and sell signal on hourly or daily time frames, when we start getting into longer time frames, we then move to volatility measurements.  This is where I use the rule, when the volatility is rising, especially after a weekly positive or negative 2 reading, you stay with the trend until the volatility turns and begins to decline. 

If I look at a shorter time frame though, the 4-week and 10-week readings, I can see that Volatility is skyrocketing!

This is the weekly chart with the four and ten week moving averages. 


So quite a bit going on here.  The setup looks very similar to the P2 time frame, starting with a potential head and shoulders top with a declining neckline, declining volatility on the long-term measurements, and a quick oversold condition.  Other levels of support seen on a daily chart are the 200-day moving average and the daily head and shoulders neckline.

On the short-term weekly chart, with expanding volatility, one could expect the market to continue free-falling.  On the longer-term weekly chart, one could expect a similar setup to P2.

As for me, I closed all of my October puts and most of the November ones as we approached 190.55 on Friday as that was the previous SPY daily low.  I am still holding some Nov 190 puts and some Oct 24 and 31 calls, just in case we get some pop. 

1 comment:

  1. Closed out all puts at the end of the day. Had purchased some Dec 180 puts and more Nov 190 puts on the slight rally to 191. When the market totally fell apart at the end, I sold all puts. At the close, purchased some 190-195 Dec call spreads.

    Think that SPY could go as low as 185 but today's washout made me think that a bounce could follow.

    Another old rule that I developed years ago was in a down market, when the market closes down on Friday, you sell the open on Monday and cover at the close. (opposite is true in up markets). So as part of that rule, I wanted to close out at the end of the day.

    Expecting a three month test of the highs next month. We shall see how things play out in the days to come. At this point, I still have some calls for 10/31 at the 195 level and the Dec 190-195 call spreads I got at the end of the day.

    Expect a move up, as noted in the post, and then a major move down.