Stocks Surge on Vaccine and Dovish Fed
CNBC has revised their Option Action show which is aired every weekday night at 5:30. They have really beefed up the Friday show to the point that we think it is one of the best option oriented shows on the air. Check it out.
The following is an excerpt from this week’s ‘Weekly Market Letter’ from Market Edge (www.marketedge.com).
| The major averages were able to push ahead to new record highs this week as investors celebrated the Pfizer (PFE) and BioNTech (BNTX) vaccine getting full FDA approval to fight the Covid Delta variant. Reopening and travel stocks were sharply higher on hopes that more people would get the vaccine. Economic data was mostly better than expected with Home Sales beating estimates, while jobless claims saw a small uptick after five weeks of lower claims. Q2 earnings continued to blow out estimates led by strong results from salesforce.com (CRM), Snowflake (SNOW), Dick’s Sporting Goods (DKS), Ulta Beauty (ULTA), Best Buy (BBY) and others. The back and forth rotation from growth to cyclical stocks shifted back to cyclicals this week as Energy (XLE), Materials (XLB) and Industrials (XLI) moved higher on hopes that more vaccines would speed up the economic recovery. The Financial (XLF) sector was also strong as Bank of America reported that weekly share buybacks for banks had reached the highest level since 2010. Defensive sectors lagged the broader market on an uptick in yields and Utilities (XLU), Consumer Staples (XLP), Healthcare (XLV) and REITS (XLRE) finished red. Investors were cautiously optimistic ahead of remarks from Fed Chair Jerome Powell on Friday and he settled investor’s nerves as he delayed setting a timeline for the reduction of asset purchases sending stocks higher. The different indexes were able to close out the week on a high note with the S&P 500, NASDAQ and NASDAQ 100 sitting at new record highs.
For the period, the DJIA gained 335.72 points (+1.0%) and closed at 35455.80. The S&P 500 picked up 67.70 points (+1.5%) and settled at 4509.37. The NASDAQ jumped 414.84 points (+2.8%) to close at 15129.50, while the small cap Russell 2000 surged 109.55 points (+5.1%) finishing at 2277.15. Market Outlook: The technical condition of the market improved this week as several of the major averages were able to finish the period at new record highs. The technical indicators for the different indexes were in bullish ground and Momentum, as measured by the 14-day RSI, is positive and moving higher. The small cap Russell 2000, DJ Transportation Index and Philadelphia Semiconductor Index outperformed this week and market technician’s like to see these secondary indexes lead the market higher. The Russell 2000 was able to blast through key moving average resistance levels on Friday spiking +2.85% and +5.1% for the week, which also bodes well for the market going forward. Internal breadth was supportive of higher prices as the NYSE and NASDAQ Advance/Decline lines showed good accumulation and new 52-week highs outdid the new lows during the week with some expansion in the numbers. Investor Sentiment remains firmly in the bull camp but has backed off extreme levels seen weeks ago. This week’s full FDA approval of the vaccine is a game-changer and should hasten the reopening of global economies. Add to that Fed Chair Powell’s preference to let inflation run hot before tapping on the brakes to taper bond purchases and the stock market should be able to climb higher into the fall. As mentioned last week, while the major averages have not seen a 5% correction since last October, there has been a revolving correction and rotation under the water line within the different indexes. Stocks aren’t cheap, but they remain the only game in town. Look to small caps and European markets to gain favor from here. The target for the DJIA remains 36229 and 4519 for the S&P 500 over the near-term. A chart of these indicators can be found by going to the Market Edge Home page and clicking on Market Recap, which is on the right-hand side of the page just below the Second Opinion Status numbers. Cyclical Trend Index (CTI): The underlying premise of the CTI is that the market, as measured by the Dow Jones Industrial Average (DJIA), tends to move in cycles that often resemble sine waves. There are five identifiable cycles, each with different time durations at work in the market at all times. Currently, the CTI is Positive at +14, unchanged from the previous week. Cycles B, C, D and E are bullish, while Cycle A is bearish. The CTI is projected to remain in a positive configuration into the fall. Momentum Index (MI): The market’s momentum is measured by comparing the strength or weakness of several broad market indexes to the DJIA. Readings of -4 and lower are regarded as bearish since it is an indication that a majority of the broader based market indexes are weaker than the DJIA on a percentage basis. Conversely, readings of +4 or higher are regarded as bullish. The Momentum Index is Neutral at +0, unchanged from the previous week. Breadth was positive at the NYSE as the Advance/Decline line gained 3475 units while the number of new 52-week highs out did the new lows on all five sessions. Breadth was also positive at the NASDAQ as the A/D line added 5068 units while the number of new highs beat the new lows on each day. Finally, the percentage of stocks above their 50-day moving average jumped to 49.6% vs. 36.1% the previous week, while those above their 200-day moving average rose to 65.1% vs. 60.1%. Readings above 70.0% denote an overbought condition, while below 20% is bullish. Sentiment Index (SI): Measuring the market’s Bullish or Bearish sentiment is important when attempting to determine the market’s future direction. Market Edge tracks thirteen technical indicators listed below that measure excessive bullish or bearish sentiment conditions prevalent in the market. In addition, we track money flows into and out of Equity Funds and ETFs which as of 8/25/21 shows outflows of $6.4 billion. Currently, the Sentiment Index is Negative at -1, down a notch from the previous week. Market Posture: Based on the status of the Market Edge, market timing models, the Market Posture is Bullish as of the week ending 7/30/2021 (DJIA – 34935.47). For a closer look at the technical indicators and studies that make up the market timing models, check out the tables located below.
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Ask Mr. Seifert
What is Implied Volatility?
Implied Volatility (IV) is the rate at which the price of a security increases or decreases for a given set of returns. It is derived by calculating the standard deviations from the current mean. To the average investor that definition doesn’t mean that much but if you watch your portfolio you should notice that when we are in a high volatility environment and when volatility is low. As a rule, volatility will go up when the market is breaking down and will be down when it is rallying.
Since most option trading volume usually occurs in at-the-money (ATM) options, these are the contracts generally used to calculate IV. Once we know the price of the ATM options, we can use an options pricing model and a little algebra to solve for the IV. For those of you who snoozed through Statistics 101, a stock should end up within one standard deviation of its original price 68% of the time during the upcoming 12 months. It will end up within two standard deviations 95% of the time and within three standard deviations 99% of the time.
To option traders, implied volatility is more important than historical volatility because IV factors in all market expectations. If, for example, the company plans to announce earnings or expects a major court ruling, these events will affect the implied volatility of options that expire that same month. Implied volatility helps you gauge how much of an impact news may have on the underlying stock. With an option’s IV, you can calculate a published range – the high and low of the stock by expiration. Implied volatility tells you whether the market agrees with your outlook, which helps you measure a trade’s risk and potential reward.
Let’s assume a stock trades at $50 with an IV of 20% for the at-the-money (ATM) options. If we assume a normal distribution of prices, we can calculate a one standard-deviation move for the stock by multiplying the stock’s price by the IV of the at-the-money options. For example, if the stock is trading at $50 with an IV of 20%, there’s a consensus in the market place that there is a probability of a one standard deviation move over the next 12 months which would be plus or minus $10 since 20% of the $50 stock price equals $10. Simply put, the market thinks there’s a 68% probability that at the end of one year, XYZ will wind up somewhere between $40 and $60. By extension, that also means there’s only a 32% chance the stock will be outside this range. In addition, 16% of the time it should be above $60, and 16% of the time it should be below $40.
All implied volatilities are quoted on an annualized basis, which means the market thinks the stock would most likely neither be below $40 or above $60 at the end of one year. Statistics also tell us the stock would remain between $30 and $70 (two standard deviations) 95% of the time and would trade between $20 and $80 (three standard deviations) 99% of the time. Another way to state this is there is a 5% chance that the stock price would be outside of the ranges for the second standard deviation and only a 1% chance of the same for the third standard deviation. Knowing the potential move of a stock which is implied by the option’s price is an important piece of information for all option traders.
Since we don’t trade one-year options contracts, we must break down the first standard deviation range so that it can fit our desired time period (e.g. the number of days left until expiration). As a short cut, divide the quoted IV by 19, which is a whole number when solving for the square root of 356 to get the weekly IV. It can’t be emphasized enough, however, that implied volatility is what the marketplace expects the stock to do in theory. And as you probably know, the real world doesn’t always operate in accordance with the theoretical world. In the stock market crash of 1987, the market made a 20 standard deviation move. In theory, the odds of such a move are positively astronomical: about 1 in a gazillion. But in reality, it did happen. Not many traders saw it coming.
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