Buying Time for the Bull

There’s a boatload of sentimental evidence that points to the current correction being overdone.  Let’s have a look at it.

I.    We’ll start with the VIX, the CBOE’s widely watched volatility indicator, which just jumped above its long term moving average at the end of May for the first time since the trauma of 2008.  Here’s the chart:

•    According to the VIX – which is, at best, a relative measure of volatility – we have just passed through a considerable measure of market fear.  VIX readings above 40 generally bespeak a market that’s in strong panic selling mode.  Even if it didn’t last long, it does contribute to an overall picture of a correction that has run its course.

•    In addition to this, the indicator dropped back below its long term moving average and below the RSI ‘waterline’ – both of which point to a potential completion of the pullback.

Altogether, the VIX data points strongly – though in no way categorically – to a northbound trajectory for the market.

Note: If the VIX should move again above the long term MA, we’d say the market is headed lower for one more leg before the bottom is in.

II.    Consider now the latest trend among the broad mass of corporations in America toward buying back their companies’ shares.  This is a development that could prove meaningful.  Look here:

The chart shows a significant increase in 2010 in firms initiating and/or announcing commitments to repurchase shares on the open market – a development that naturally adds to buying pressure.  We’re currently on pace to triple buyback levels set in 2009.

What’s key here is the understanding amongst CFO’s that there is no significant credit risk remaining in the system.  If there had been, the majority of these companies would have opted to hold their cash hoards in order to better weather a storm like we experienced two years ago.

Remember, too, these buyback programs were announced and initiated, and in some instances maintained, throughout the worst of the Greek credit crisis and subsequent loss of faith in the Euro.  That, too, gives them some credence.

III.    A third item to ponder is sentiment among investment advisors.  At this point, it looks like this:

No doubt it could move higher still.  But relatively speaking, folks like me believe things are appreciably more dire than the January-February pullback of this year.  From a contrarian standpoint, that’s bullish.

IV.    One more sentiment indicator worth considering  is the TRIN Index, also known as the ARMS Index, a measure of the relative strength of market breadth and volume.  For the last eight years it looks like this:

In short, the picture is one of gargantuan selling volume – even more than obtained during the worst of the Lehman-Credit crisis of 2008-2009.  In fact, levels of selling volume (as a percentage of buying volume) are now back to levels that existed just prior to the beginning of the bear market in 2007.  The 2.62 ARMS reading of March 2007 was set some seven months before the S&P 500 peaked.

This Week We’re Hedging Against Our Hunches

Even though we still feel the market is due for one more steep plunge of a 10%-15% magnitude from current levels, the evidence appears to be mounting against us.  As we’ve shown above, a number of technical and sentiment indicators are nudging us toward a more bullish outlook.  The question is how do we trade the market, given our current mixed proclivities?  How, indeed, does one navigate a market that appears to be in bull mode when one’s hunch is that a significant drop is at hand?

To sharpen the point further: what trade will allow us to capitalize on a potential near term drop and the possibility that the market has seen its worst and is now resuming its bullish trend?

What is a Neutral Calendar Spread?

The trade we like at this juncture is called a neutral calendar spread, a position involving two CALL options, one short, one long, the first a near term expiration, the second longer dated.  It works like this.

1.    You sell the near term CALL to collect premium and reduce the purchase price of your longer dated CALL.

2.    Ideally, the short CALL expires worthless and henceforward you possess a discounted, longer dated CALL with unlimited upside potential.

3.    What you do with the remaining longer dated Call will determine the overall profitability of the trade.

Now let’s examine some more possible scenarios:

First, the market diddles sideways or falls, the near term options expire worthless and you pocket the premium.  You’re now left with a discounted long CALL with unlimited upside potential.  At this point, however, you have some important choices to make.

1.    If you believe that the market is now headed lower, you have the option of selling the long CALL and pocketing whatever time value still remains on it.

2.    If you believe the market is headed higher, you would hold the option and profit as the underlying security approached the strike price.

That is, you enter the trade with a neutral disposition, ready to profit from either eventuality.

The second scenario goes as follows:

The market falls and both CALLS expire out-of-the-money, worthless.  Your maximum loss is the total debit you paid to put on the trade.  That is, your downside risk on the Neutral Calendar Spread is limited.

Now let’s look at some real options.

The S&P 500 currently sits at 1091.60.  Here’s the chart:

The CBOE offers a cash settlement option on the index (CBOE:SPX), whose JUNE 1105 CALLS expire this Friday.  Selling them will net you $6.50.

The SPX JULY 1105 CALLS will cost you $26.00 to buy.

Take on as many pairs as you like/can afford.  The trade is essentially a short term covered call on the S&P 500.

Wall Street Elite recommends simultaneous purchase and sale in equal numbers of the SPX JULY 1105 CALL (purchase) and SPX JUNE 1105 CALL (sale).  And stay tuned next week for our recommendation once the JUNE expiration hits.

With kind regards,

Hugh L. O’Haynew