Taking a look at a 30-minute chart of the SPX you can see that the overall trend is down. Several levels of one-time support have given way providing the next level of support to be tested. Assuming a short-term low is in (we are entering bullish seasonality) you can see the 50% retracement from the September highs up at 1408.93. The yellow highlighted area is the key area that should dictate whether or not we see new highs before the close of 2012. If we can’t even bounce up to 1410 quickly then there’s no reason to be long and we should see hedging occur en masse.
If you look at the weekly chart you can see the prior downtrend combined with the uptrend (all subjective lines) provided support this week. However, price did close outside the lower Bollinger Band and those same bands are beginning to widen. There’s a blue vertical dashed line that shows where the 1420 level gave way and if you look to the bottom of the chart you can see that the Aroon indicator crossed at that time. If you don’t use the Aroon indicator and want to know more about it click here.
I think 2013 could bring with it more downside, especially if the fiscal cliff fails to preserve the loop holes provided for capital gains. How far down could we go? I don’t know and wouldn’t bother insulting your intelligence by trying to tell you otherwise. I focus about 1-2 months out in my trading and that’s it. This method has worked well for me over the years and I’m pleased with the results. I do know that if capital gains move from 15% to higher than 20% that I’ll take a significant hit in my trading. I trade the SPX for a reason and that’s so I can take 60% of my short-term gains and get taxed at 15% versus the standard tax rate. It’s a significant bump to my returns so I’m a concerned market participant here. I believe I’m not alone in this thinking.
I also know that Q4 is on track to give back all of Q3s gains as it broke through the 1420 level doing so. 1420 holds significance on many time frames and thus I watch it closely. While we still have 6 weeks of trading left in the quarter, the holiday season is upon us and that typically suggests lighter volume. Speaking of volume, check out the decline since the financial crisis crushed many a dream of financial riches. Remove the incentive of capital gains loopholes and we more than likely see even lower volumes in the coming years.
If you think the market is heading lower and you have a portfolio you want to hedge there are numerous ways to do it. You could short the S&P futures, buy puts in the S&P 500, write covered calls on the underlying stocks in your portfolio, buy a volatility ETN such as VXX (boo, use VIX futures instead if you can). There are other ways to hedge but you get the idea. Dividends are one additional ways to hedge as you’ll receive some extra return for holding stocks that pay a dividend. This cushion allows you to withstand a small pullback in your portfolio.
The chart below shows dividend providing stocks outperforming the S&P 500 as a whole. You can read more about the SDY here but for now know that the index allows traders to hedge or take a view on dividends for U.S. stocks, independent of price movement. This is really telling us that the hedge provided in the form of a dividend is enough, for some market participants, versus going out and buying protection via an out-of-the-money put in the $SPX. Take a look at the free fall the S&P 500 skew has seen and it’s easy to see the argument of where the hedging is taking place.
Im watching for a spike in VIX along with the SKEW to move higher to signal some real fear in the market and that the dividend isn’t providing enough protection. I believe that sentiment changed from buying bounces to shorting tests of resistance when 1420 was broken in the SPX. If we fail to break through some of the levels mentioned earlier then we should see the SDY:SPX ratio back down along with a move higher in the SKEW and VIX. One word of caution regarding the SDY is that dividend taxes are set to triple come January 2013. While SDY itself has pulled back the ratio compared to SPX is at 2012 highs making it something to watch as the end of the year approaches.
As of the close Friday I’m long XIV and SPX via Jan ’13 calls.