A few important developments to discuss before we move on to our trade for the week.
We start with the VIX, the CBOE’s widely-watched implied volatility indicator. Sometimes called the ‘fear gauge’, the VIX of late has been manifesting anything but fright. Call it mirth or good cheer, maybe giddiness or gaiety, but fear we don’t see. Have a look –
As of last Friday, the VIX had plumbed new lows for the year, indicating traders expect higher prices for the S&P 500 over the next thirty days.
And is that a good thing?
Trouble is, the VIX is also used by many as a contrary indicator, as it generally signals market turns when it hits extremes.
So we sell now?
Well, not so fast, Schumpeter. The idea is first to identify the extreme reading, and the truth is, these can only be known in retrospect. That is, the VIX could continue to drift down from today’s 52 week lows toward an 11 read or even lower, should the market continue on its merry, helium-sucking, skippady-doo-dah way toward the wizard.
Conclusion: VIX may be getting close to signaling a top in the market – either an interim peak or the almighty, blow-off rocket-top that many fear is already upon us. We’ll know better when we get there, and a very subtle metric called ‘volatility compression’ will provide us with the information we need to make a more decisive determination.
Volatility compression is our own proprietary indicator, developed roughly a decade ago here at Normandy, and it works like this –
- When readings on the VIX appear as the candle on the left, with the day’s high and low, as well as the open and close in strict proximity to one another, we say they are ‘compressed’.
- Alternatively, the candle on the right represents a day of volatility ‘expansion’, with the day’s high, low, open and close stretched far from one another.
- It doesn’t matter whether volatility rises or falls to make the calculation. It’s just high minus low added to open minus close. The smaller the sum the greater the compression.
Our research indicates that stock market tops are generally formed at or directly after days of extreme compression, and most often when a number of such days form over the course of a week or two. We run an algorithm that helps us better identify such situations and, combined with several other proprietary sentiment and market internal measures gives us a tremendous advantage in identifying intermediate turns in the market.
As of today, we see no noteworthy compression on the VIX chart, though the VXX chart has been flashing a tremendous compression of late.
Take a look here –
Without getting into all the calculations surrounding the VXX, suffice to say that the index is a more complex affair than the VIX, being derivative of the performance of the first and second month VIX futures. It’s also problematic as a trading vehicle, for a number of reasons, none of which we’ll get into here, either.
But that doesn’t mean it lacks value altogether as an indicator.
On the contrary.
The amount of compression on the VXX over the last month is without question indicative of a near term market top. And though we’d like to get confirmation from the VIX before we act on it, even if it’s not forthcoming, we’ll remain on DEFCON 3 until then.
Moving Right Along
Our next look is at the precious metals, where several recent developments have caught our very attractive and thoughtful eyes.
Ahh, Sister Mary Margaret … gawd love her.
Anyway, we see on the gold chart a formation that’s known as a rising wedge (below, in red), a bearish pattern that signals a coming decline in price once the bottom edge of the wedge is broken.
Have a look at two years’ worth of the SPDR Gold Trust (NYSE:GLD), a reliable proxy for the metal. Note the formation and consider also the recent deterioration in RSI and MACD indicators (in blue).
Now, because the wedge is still wide, GLD may continue higher for some time yet before it breaks down. As to timing, we can’t be sure. At the earliest, a break is likely after MACD follows RSI beneath its waterline. As of today, that’s still a week away from happening.
Additional bearish indications for the precious metals come from the long-term (weekly) charts of both silver (SLV) and the miners (GDX), where stiff resistance emerges from the descending long term moving averages.
Have a look here –
The long term weekly MAs could allow for some additional gains, but not a whole lot, and it’s likely any negative scenario would be triggered by the break lower in GLD that we discussed above.
Taken together, the above charts spell out a likely breather for the precious metals over the next few months.
And that represents an opportunity.
We believe the best way to play it is to sell premium in the form of a short strangle with an expiration several months out.
We’ll select strikes that fall above resistance and below support, because while we have, indeed, adopted a bullish posture for the precious metals, turning the ship around after a protracted, five-year bear market will not happen overnight.
The perma-bulls will have to be shaken to the core before we see blue skies, a condition that plainly doesn’t yet apply. When the yahoos from the goldphile crowd start making bulk purchases of Depends, we’ll know we’ve arrived. Right now a little incontinence proves nothing.
We’re going to use the VanEck Vectors Gold Miners ETF (NYSE:GDX) to play it, as the volatility there offers us the best premiums. The trade goes like this –- Content protected for Normandy Executive Lounge, Wall Street Elite, Executive Lounge members only]
Breakeven is GDX $37.52 on the upside and $24.48 below. GDX today sits at $30.89.
With kind regards,
Hugh L. O’Haynew