Contracted Volatility is a Trading Opportunity

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After the +9.9% gain from the 1270.05 low to 1396 (2/13), the SPX declined -5.7% to 1316.75, which is the .618 retracement zone (1318) and then bounced +4.0% to 1369.23 last Wednesday (2/13) before closing at 1350 (+.08%) on option expiration Friday. The other major indexes finished red Friday, with the $INDU -0.2%, QQQQ -0.3% and $COMPX -0.5%. The SPX was the major index leader on the week at +1.5%, following a -4.7% loss the previous week. Volatility has contracted, with the SPX finishing the week in a narrow-range triangle (chart) and closing at 1350. Contracting volatility patterns usually get resolved with aggressive moves. As you would expect with a contracting volatility situation, the short-term internals are neutral, with the 4-MA of the volume ratio at 51 and breadth -109. Both of these are about as dead-center as it gets, so there is no obvious short-term trading edge, on either a price or a momentum basis. It is a bear market, and daytraders have capitalized on the extended news reactions in both directions. The initial resistance the last 4 days has been the 1364-1371 price zone, which has provided several good intraday strategy short opportunities. The next high probability short-term position trade will be if the SPX hits that 1420-1450 price zone or 1270 gets taken out.

The SPX would have been hard-pressed to finish +1.5% on the week without the leadership of the energy and commodity related sectors. The OIH was +6.1% on the week, with the XLE +4.1%, and XLB +2.5%. The XME, which is the S&P Metals and Mining SPDR, closed at 69.60, just below a new high-range breakout at 71.37. The XME has advanced +31.3% in 18 days off the 1/23 53 low, to the 71.12 intraday high on Thursday, while the XLE was +17.8% and OIH +17.4% for the same period. Crude oil has rallied from the low of its 4-month trading range at 85.42 and closed Friday at 95.45 ($WTIC). That is versus the all-time high close of 99.62 on 1/2/08.

The financials are 20% of the SPX, and the focal point of the expanding liquidity/credit crisis, with the increasing pressure on the banks and broker's balance sheets/capacity. The banks are obviously in a fear mode regarding extending credit, and are hardly even lending to each other in overnight markets, which is obviously negative. Last week, GS and C backed away from the failed municipal bond auction, and will not commit their own capital to the debt. The bond insurer/Rating problems will probably be the focal point of the news this week, and if that is the case, then that $SPX contracted volatility pattern will be resolved quickly. The XLF financial SPDR bounced 24.1% off its 1/23 24.11 to 29.93 in 8 days to 1/31, but has declined to a 26.17 low on Friday, versus the .618 RT to 24.11 at 26.33 before closing at 26.83. The $XBD has retraced to just below the .50 RT level to its 1/23 168.92 low from the 212.84 rally high, and closed Friday at 193.21, so it is also in position for a possible reversal this week, news permitting. The XLF is the financial ETF to use, because it uses both the banks and the brokers, but if you want to focus on the brokers, use the IAI ETF.

The foreign markets were open Monday and finished to the upside, with the S&P emini future finishing +1.24% (+16.75 points) to 1368 from Friday 1351.25 close. As I complete this at 6:00 AM ET, it is trading at 1358 which is +6.75 points from Friday's 1351.25 close.

The SPX (cash index) Volatility Band levels for today are (rounded off):

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Have a good trading day,
Kevin Haggerty