Smart Money Bets on Stock Market Sell-Off

from Barrons:

A wall of worry is building in the options market as the stock market surges higher at the onset of a new trading year.
Sophisticated investors are actively buying call options on the Chicago Board Options Exchange's Volatility Index (VIX) that would likely increase in value if the Standard & Poor's 500 index falls sharply by the middle of February.
These VIX call options will pay off if the VIX spikes to 27.50 in February from its current level of about 18. Such dire expectations are sharply at odds with bullish reports from major banks and news organizations detailing why the stock market will rise sharply in 2011.
The bearish posturing in VIX is ample evidence that some investors have not forgotten that the stock market never advances in a straight line, and never misses an opportunity to hurt the most people, most of the time.
"We're moving toward a euphoric peak where the market in aggregate will start acting like a bunch of rare-earth stocks," says Jim Strugger, MKM Partners' derivatives strategist.
Rare-earth stocks, like Molycorp (ticker: MCP), are viewed as little more than momentum trades propelled by a compelling thesis that prices will increase because China controls most of the world's rare-earth minerals and will increasingly limit exports. (Rare-earth minerals are increasingly in demand for their use in a wide range of electronic products including smartphones.)
Everyone intuitively understands the rare-earth logic just as everyone gets the idea that it makes sense to buy U.S. stocks because the Federal Reserve's latest phase of quantitative easing has demolished the prospect of returns in the bond market.
It is easy to sound Pollyannish about the stock market's recent strength, but the concerns evidenced in the options market are more than just naysaying.
January is traditionally a strong month for the stock market as investors, big and small, reposition portfolios for a new year. Inevitably, though, the stock market loses its upward momentum, and declines.
The retreat could be caused by a number of potential market hobgoblins including tension between North Korea and South Korea, European sovereign debt crisis or even serious financial troubles that could roil the municipal debt markets in the U.S.
The expected decline will likely not be the typical garden-variety correction. The drop will be sharp and quick, and more of a tradable event than a major maelstrom.
If expectations were for a more profound decline, the options market would be filling with large swaths of bearish trading, and it is not.
Strugger thinks that the VIX will tumble to 15 by the end of January but will then spike to 30 in February.
His view is reflected by VIX's trading patterns. Investors are buying VIX January 27.50 calls and February 27.50 calls. They are active in other VIX calls, including the February 30 and 35 strike price, but the action is less an indication of a future volatility spike, and driven more by a desire to lower the cost of buying 27.50 calls that cost just under $1.00.

Days Following Strong Momentum Days

from Dr. Brett--

Monday, we saw Demand--an index of the number of stocks closing above the volatility envelopes surrounding their short-term moving averages--exceed 190, while Supply (an index of those closing below their envelopes) was only 19.

Going back to late 2002, when I first began collecting these data, we've only had 31 days in which Demand has exceeded 180. That typically occurs after breakout moves, when many stocks display favorable upside momentum.

Interestingly, returns over the subsequent five days in the S&P 500 Index (SPY) have not been favorable. The average five-day change following a big upside momentum day has been -.82% (14 up, 17 down). Nor have returns been favorable 1-4 days out.

It appears that there has been no short-term bullish edge following large upside momentum days, with profit taking not uncommon.

Additional Comment 7 AM CT - I notice that the excellent Market Tells and Quantifiable Edges newsletters--both of which feature historical trading patterns--arrive at somewhat similar conclusions to the above, but each of them goes into more depth, with additional findings. Hats off to these worthwhile resources.

Note: Demand and Supply are proprietary measures; they're updated each morning prior to the open via Twitter (follow here).

Commodity Explosion

WheatCrude OilSoybeans
Apparently, investors are betting on inflation. This is significant today because stocks are not advancing, but investors are still betting heavily on renewed inflation. Crude oil has reached $53.65/barrel, and soybeans has reached $10.81/bushel. Both have broken out above previous highs, reaching new record highs for the year. This despite that crude oil inventories in the United States continue to build.

Arlan Suderman says that the "first of the month brought fresh fund buying". He also said yesterday that there were liquidations to lock in profits on the last day of the month. Prices rebounded strongly, however, with fresh buying yesterday also. This is notable for me to take advantage of the volatility on the last day of each month and the first day of the following month as well. Suderman also said, "Soybeans at 7-month highs on supply concerns; Money is flowing again."

Stock Indexes Go Stale

The Dow is trading within a very tight trading range from 12,000 and 12, 065 today. Volatility is insufficient for reliable and profitable trading. I had early traded stock index futures today, but volatility has declined, and is now too poor for trading. The same holds true for treasuries.

Wheat Trading Contracted, Difficult

The tick chart on the right showed volatility, but the 3 minute chart on the left suggests a contraction of the Bollinger Bands and poor volatility. When the Bollinger Bands are so contracted and tight on the 3 minute chart, trading activity on the tick chart tends to become erratic and difficult to trade. With corn and soybeans limit up, I am using the time today to read trading books. My favorite is Phantom's Gift. It always charges my trading batteries.

Corn: Done Gone Flat!

Untradable Grains

Grain charts are too erratic for me to trade profitably today. When this happens, I read a book and watch the charts. When the charts begin to look right to me again, I'll begin to trade. Until then, I watch and wait.

I watch for three conditions in order to trade:

1. Tight spreads. On this measure, soybeans and corn are fine. Wheat spreads haven't widened to the point that I won't trade them.
   
2. Sustained, reliable movements, either up or down. This is hard to describe, but I know what it looks like. Perhaps the term market noise is a good way to describe poor trading conditions. Right now, the charts don't look right.
   
3. Volatility. Without volatility, it become worthless to try to trade because the risk/loss ration is too high and profits can't be obtained.

Commodities Rebound Higher on Continued Dollar Weakness

The GSCI Commodities futures index has rebounded and moved even higher, but volume is dampened slightly from prior levels in this daily chart. If the volume indicator doesn't move above its yellow moving average line within a few days, this may be suggestive of a consolidation phase in commodity prices. If this is the case, shorter-term trades of a few days could become the order of the day. Another sign of weakening commodity price strength occurs when higher highs close within the Bollinger Bands, which indicates slowing momentum and falling volatility. Even still, some commodities (energy, for example) may continue to show extreme price strength. Note that for now, the Klinger Volume indicator has moved below its moving average.

Soybeans Regains Volatility Ceded to Wheat

For the past few days, wheat had become the most actively-traded of the grains. The overnight volume for wheat two nights ago was 60,000 contracts. However, soybeans are once again the most volatile grain product, having taken the lead back today from wheat. Wheat is still very active, but has once again fallen behind soybeans for the time being.

Klinger + ATR indicator Leads

On a day like today, where volatility is high, the value of the Klinger Volume indicator is obvious. Note that at the locations where I have placed the arrows, the Klinger+ATR Volume indicator tends to anticipate an imminent change in direction of the market.

When the market changes direction so rapidly, accurate execution of trades can become difficult, and a trader must remain extremely alert at all times. Many of these trades last less than 2 minutes each.

On occasions that the Klinger indicator suggests a change of direction, but price action consolidates rather than reverses, the likelihood increases that when prices reverse again in the direction of the previous trend, that trend force will be amplified. Additionally, if prices do not reverse powerfully in the direction of the original trend, the probability of a new trend or consolidation increases. In truth, one never knows precisely what is going to happen. There is no perfect indicator except prophecy!

Wheat Back Down!

Wheat Rebounds 40 Cents in 5 Minutes!

Volatility for grain prices, and particularly wheat, has gushed higher with anticipated force at the open of the grains market this morning. When volatility is high, traders can make excellent profits by acting quickly and executing trades with precision.

Wheat - Back to Lock Limit Again

Wheat prices, after retracing significantly, have rebounded to the lock limit price multiple times today. Since volatility for wheat is so much higher than any of the other grains, I am concentrating my trading almost exclusively on wheat for now. However, now that wheat prices have reached lock limit, I will trade other grains until price either retrace or the lock limit ages away this evening.

Soybeans Selling, Profit-Taking Begins

That was probably the shortest-lasting long-only decision in history. As you can see from this chart, soybean bullish exhaustion occurred just a few minutes following my last posting. I went short almost as soon as I sent the "send" button on my previous posting. As you can see from this chart, a head and shoulders top formed almost immediately, and prices only weakly set another new price high. Then, the bulls began to liquidate to take profits. This is evident from the heavy selling on the volume indicator that I have enclosed in a blue box at the bottom left of the chart. Volatility was still very good, and I shorted at the second shoulder for another profitable short trade.

I expect that more profit-taking will occur into the close, and then another bullish run will occur as people like me liquidate their short trades, causing another price spike before the closing bell for the week. I also anticipate a very high probability of a new closing high, as I indicated on my posting earlier today.

Wheat Trading Back to Normal

Today, wheat trading has resumed normal trading volatility, although volume is still a little light.

Soybeans: Trades 14-15

Trade 14 was an attempt by the soybean bears to defend resistance at yesterday's settlement price. It barely made a profit. When the Klinger Volume indicator turned bullish and profits were meager, I moved my stop to the top of the previous candle, where price movement took it out.

Trade 15 has proven once again that the soybean bulls are still very firmly in control. Prices have closed up again for the day! I've noticed that the best trades typically take off. This one was a good example of that. I closed it out less than one minute before the end of the trading session.

What a great day for trading. It had all the requirements for good trading, including volatility, solid movements in both directions, and excellent liquidity. What more could I ask for?

Soybeans: Trades 12-13

Volatility increased once prices broke through the support barrier of yesterday's settlement price (dotted magenta line). Now the question is: Can it break back through the same barrier at resistance?

Soybeans: Volatility Too Low to Trade

The Bollinger Squeeze indicator, shown as red dots in the blue box in the bottom panel, has fallen too low to trade further on the 3-minute chart. I will now wait until the red dots disappear on this chart, or until I see a trade that I have missed that would have been profitable, had I taken it, on the tick chart. This will be a hint to me that sufficient volatility has returned to the market to once again make additional profitable trades. The Klinger Volume indicator (also known as Klinger+ATR) still shows selling volume, but prices have thus far remained steadfastly above the closing price for yesterday. The bulls have valiantly and successfully defended yesterday's settlement price thus far.

Soybeans: Trades 5-11

Trade #8 was too tiny for the arc to be seen, and was a small loss of 4 ticks. Trade 11 is still active at this posting, but the Klinger indicator has turned down, so I have tightened my stop in anticipation of this trade being closed out. Trade 10 started off very shaky, but has become one of the most profitable of the day.

Trading Win/Loss Ratio

Thus far, 9 of my 11 trades have been profitable, and the ones that lost money cost me only 5 ticks and 4 ticks. Good day! Working these up and down movements in the markets is what swing traders are most effective at doing.

If the trade looks questionable, I consider other factors:

• What do other indicators tell me (for example, the Bollinger Squeeze, Moving Averages, and MACD)?
  
• What do the indicators in the higher time frames suggest?
  
• Is there important support or resistance at this point? In this case, prices had already found support at the same price point three times today, so I considered it to be a good risk to remain in the trade.
  
• How much profit have I made so far today? Am I willing to take a little more risk, or are my profits too sparse to risk losing them today?
• How good is volatility right now? If the past few trades have shown sufficient volatility to take reasonable profits from the market, then I consider volatility to be good.
  

Wheat trading over the past few days has been supported by poor volume, and liquidity has suffered somewhat. I will wait until volume and volatility improve again.

Wheat: Hold Onto Your Hats!

The primary wheat exchanges over this past weekend agreed to double the daily lock limit for wheat from 30 cents/day to 60 cents/day. If prices stayed at the 60 cent lock limit up price, the lock limit would increase to 90 cents when trading resumes tonight for evening trading. If wheat prices lock limit up again tonight, then the lock limit will increase tomorrow night to $1.20, etc.

Fortunately (and mercifully) for short traders, prices have begun trading again in an amazing feeding frenzy (no pun intended) of volatility. Here are the 15-minute, 3-minute, and tick charts for wheat for the first hour of trading this morning. Conceivably, prices could still rebound to the lock limit price, so hold onto your hats for a wild ride in wheat today!