Back in the Saddle

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The S and P 500 index with implied and historical volatility. Click to Enlarge.

Today was very exceptional; we witnessed a three standard deviation move in the S and P 500 index when measured against an implied volatility percentile of 11% at the open of trading.

Before the move began, my delta or the sensitivity of my position to price was flat. When I returned to my desk after a walk at 10:30 AM PST, the position was very short delta. I have an acronym for my adjustment strategy: Remove. Add. Longs. (R.A.L.).  I followed my plan.

I first removed some iron condors that were quite exposed to a further negative price pressure. The market continued to move down. Not sure of how long this move would continue, I sold some call spreads, adding to my risk but cutting the delta. When the market continued to push down, I consulted charts and deleted recent technical overlays that had been violated by the move. Eventually, I had to add long puts. I added puts, and they became profitable. When the market started to shows signs it would reverse, I sold some puts against the long puts. With these, I reduced the cost basis of the long options and cut back on the time decay that would affect the price of these options in the days to come. The market continued to go down; so, I repeated the above steps several times.

My thought at the end of the day was that I should lean a little short overnight but not too short; for the chart above shows 50-day moving average support at 1801. Moreover, the 30 minute chart below of the S and P 500 E-mini futures (the SPX trades at a small premium to the futures at this time) shows probable resistance at 1812.5, the high price of November 29.

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S and P 500 E-mini futures, 30 minute chart.

The S and P 500 E-mini futures’ chart shows a Fibonacci range and an inverse Head and Shoulders pattern. Both have been invalidated. The volume profile to the right shows the market has moved down below its ten-day value area. Since 1812 in the futures and 1813.55 in the S and P 500 index (SPX) should hold at least once, we can probably expect a bounce tomorrow– when many of us will offload some vulnerable spreads.

The implied volatility reading on the SPX tells us further that the market took notice of the change, but it wasn’t in full panic mode. Market makers were selling puts all day, presumably with the intention of buying them back for cheaper prices on any bounce.

If the implied volatility reading moves above the 40-50% level, it is probably a short. At the same time, the S and P 500 may well have reached or breached the 50 day moving average of 1801.12. The prior time the market pulled back, it got no further than the 50-day moving average. The SPX only touched this moving average before launching upwards on December 18 for the vaunted Santa Clause rally.

My operating assumption is that the market will move down to 1813 or even 1800. Everyone will become very afraid; they will dump their stock and buy puts. Professionals will be ready to reverse the trend and send the nervous, weak hands back to the condition of psychic emptiness. Wednesday would be a good day for a turn around because the Federal Reserve bank will purchase outright 4-5 billion dollars in treasury coupons, giving the market material reason or symbolic coverage to move higher.

If the market pushes down to the 100-day moving average (currently, 1747.6), the buying opportunity will appear very risky, and the chart will look ugly. Most of my spreads should be trashed by then. But the proper response at that point will be to go long.

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