Analytical Toolbox: Market Measures: Volatility & Breadth

Clare White, CMT, Optionetics.com
March 18, 2011

When I began preparing my article this past Monday the synopsis went something like this, “Given global events over the last four weeks, the US stock market has held up relatively well with a maximum decline of 3.4% (close) as of 3/14.”

Since Monday, that number has increased to 6.2% with Wednesday's close and as of Friday morning we appear to be in the midst of the two-day advance. Current conditions and an expiration Friday should provide good volume for the move. Even with the larger decline, it can be said for US markets held up relatively well. With the hopes that this weekend will be less news oriented that the last two, what might you want to consider with your analysis?

Seasonality

It’s not uncommon to see an intermediate term market low in March and it seems the advance since December may be setting conditions up for another such low to occur. Although we won’t know if this occurs until after the fact, the information is still very useful going forward. Consider the strength September’s market indicated for an intermediate term bullish move. Typically one of the weakest months, the gains made in September 2010 defied what’s expected from a seasonal standpoint. It provided information about the sustainability of advance under way.

So the point here is not to trade an expected low, but to assess the timing of an intermediate low given current conditions. A low that occurs in March is consistent with seasonal patterns. If a low has already occurred—which is not what I’m suggesting here—it would point to market strength given global uncertainty. In the event that decline continues beyond March, the market may be telling us something.

Volatility

The CBOE Volatility Index® (VIX) is a widely followed sentiment indicator to track fear in the market. Its construction changed in 2003; however, by measuring implied volatility of a broad-based market index it signals fear via moves to spike higher. It's important to note that while the VIX has a strong negative correlation to the S&P 500 index, it behaves differently than price. There is a stronger reversion to the mean tendency, as well as a downward drift in the measure.

Figure 1 provides daily VIX data within SPY overlay chart as of Wednesday's close. This recent spike upward approached 29.65, a previous high area. A more important horizontal line is shown at the 15.50 level, which did seem to serve as a support area. While the market moved higher from mid-December through mid February the VIX generally remained above 15.50.

Figure 1 Daily VIX Chart with SPY Overlay, EMA's and RSI (3/16/11)

The chart also includes an RSI indicator. This measure cannot be used in the same way it is used to monitor price action since price behaves differently than volatility. Based on past movement it appears a divergence in RSI tops from VIX spikes basic chest subsiding volatility ahead. Unfortunately there are not enough cases to test or provide statistical significance for this hypothesis, so instead it is being monitored on a forward test basis.

If this assumption holds current conditions suggest high volatility could continue in the weeks ahead. A VIX advance that does not correspond with an RSI spike higher than the previous one will set the stage for declines in volatility. Remember, this is just a theory at this point.

There are many sentiment indicators traders may want to add to their regularly used tools. Put to call data is available from exchange websites and measures such as investor sentiment readings are available from different sources such as AAII (American Association of Individual Investors). You need to monitor these measures over an extended period to get a sense of relative extremes and how long such extremes can be sustained.

Breadth

Breadth measures provide information on the number of the dancers decliners were unchanged securities; the number of 52-week high and low values; percentage of shares above a simple moving average [SMA]; and advancing volume and declining volume on an exchange. A great resource on this topic is the 2006 book from Greg Morris titled, “The Complete Guide to Market Breadth Indicators”.

One problem with breadth indicators in general is that the number of issues traded on the exchange changes over time. As a result you cannot identify an absolute value for an indicator that suggests an extreme has been reached. The issue of changes in the number of securities traded also impacts the makeup of the breath measures. Some data can include closer bonds while other data providers may exclude such securities.

In addition to issues impacting daily data the analyst needs to keep in mind that weekly data must be calculated on a cumulative basis. Morris recommends the following when assessing breadth data:

•Know what securities are included to the measure;
•Be sure to correctly calculate cumulative weekly data if using that timeframe, and
•Use a percentage or ratio calculation when viewing a year or more of daily data.
A favorite of Morris’s is the McClellan family of indicators including the McClellan Summation Index. Figure 2 provides a 35 day SMA on the Ratio Adjusted McClellan Summation Index along with daily close data for the New York Stock Exchange composite index (NYSE). Rather than Advancers – Decliners, a ratio adjustment calculates (Advancers – Decliners) / (Advancers + Decliners). Additional information regarding the McClellan Oscillator and Summation Index, along with other breath measures is available from moscillator.com by accessing the Learning Center tab.

Figure 2 35-Day SMA on Ratio Adjusted McClellan Summation Index (3/16/11)

Although this decline has been accompanied by a strong downward move in the smoothed McClellan Summation Index it's quite possible further declines are possible. Sustained support at these levels for the breadth measure would be more consistent with a typical March seasonal low. A renewed downward move in the weeks ahead would suggest a longer-term top may be in place.

In addition to Sherman, Marian and Tom McClellan, Carl Swenlin is another market technician well-versed in breath measures. Figure 3 provides Swenlin’s Double Smoothed Short-Term Oscillator. The indicator uses the Advance-Decline ratio: [(Advancers – Decliners) / (Advancers + Decliners)] multiplied by 1,000 and takes a four day exponential moving average [EMA] then smooths it a second time by taking a five day SMA. According to Morris the double smoothing allows the indicator to continue directional moves while the measure tops near short-term tops and bottoms near short-term bottoms. The measure moved back towards the zero line as of Thursday's close and will be monitored in the days ahead.

Figure 3 Swenlin Double Smoothed Short-Term Oscillator (3/16/11)

Please note that advance and decline data as well as the NYSE data was downloaded from Worden Brothers TeleChart platform.

Price Charts

Since the price of momentum picture has changed a bit since last Wednesday, Figures 4 and 5 provide updated weekly and daily views for SPY. With the price move below the previously constructed regression channel, a new channel constructed using a start date of 7/3/09 and an end date of 7/2/10 displays a price move just below the middle regression line as of Wednesday’s close. However, Thursday's positive action with price above the regression line making it possible for price to find support at this level when the week closes today. RSI momentum has moved below the 60 level and is bearish providing a warning for the weeks ahead.

The 19, 39, 9 MACD, which is suggested as a slow signal during sustained trends by the indicator’s creator, Gerald Appel, is just beginning to rollover, however it does not appear a cross will occur this week. This once again allows for a seasonal low in March. In the event a cross occurs in the next couple of weeks, price could certainly move puts the 40 week EMA and even the lower regression channel line.

Figure 4 Weekly SPY Chart with Regression Channel and Momentum (3/16/11)

The daily chart shows a price move below the middle regression line with bearish RSI momentum below the 40 level. The 20 day and 50 day EMA have both turned downwards providing an objective reading of bearish short-term and intermediate-term trends. Any advances in SPY will need enough power to push through resistance at the middle regression line, the 50 day EMA and the 20 day EMA. Given the decline in yesterday's volume, it may be difficult for price to push above the 130 level in the short-term.

Figure 5 Daily SPY Chart with Regression Channel, EMA’s, RSI and Volume (3/16/11)

At this point it appears the decline has further to go, however it remains possible we are simply seeing a typical seasonal move for March. If the latter is the case, the bull has been very resilient in light of the global environment. As always the market will keep us attentive in the days and weeks ahead.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site