Having fixated on the Island Top Reversal pattern on the S&P 500 Index chart, distinguished by its noticeable breakaway gap since it first occurred, and reported in Digest Issue 24 "Island Top Reversal [Charts]," the time has come to wrap it up and move on. Then consider a Microsoft (MSFT) collar before earnings. Second-quarter Volatility Kings™ next week.

S&P 500 Index (SPX) 3185.04 added 55.03 points or +1.76% last week, closing the breakaway gap that formed a potential Island Top Reversal. The 50- day Moving Average at 3033.70, now the first support crossed back above the 200-day Moving Average last Thursday.

The story begins with the June 5 Exhaustion Gap, EG above, followed by a Breakaway Gap, BG made on June 11, four days later creating an Island Top. The measuring objective was to retrace the minor price move that preceded it or the entire move from the March 23 low.

Typically, Breakaway Gaps occurs at the beginning of a new price move with no requirement for closing. The higher the volume on the day the gap formed the less likely it will be closed. June 11 volume looks high enough. As a rule, they mark the start of significant moves.

While the open gap created upside resistance for eight days it finally give way on Friday, trading up to 3186.82 then ending at 3185.04 and above the June 10 low of 3181.49 thereby closing the gap.

On closing Breakaway Gaps, the authority says:

On the other hand, if high volume developed at the far side of the gap, and a great many transactions took place there and as prices moved away from the gap, then the chances are remote that any near-term throwback will close the gap. In such cases a throw-back reaction is almost always stopped at the outside of the gap. – Edwards & Magee, Technical Analysis of Stock Trends, Revised 5th Edition, p.198.

Based upon the current strength of the Nasdaq and especially the Invesco QQQ ETF (QQQ), called "the decider," that gained another 11.78 points or +4.975 last week to close at 263.97, the SPX will likely continue higher and soon exceed the June 8 high thereby finally closing the book on the potential Island Top Reversal pattern. Since a group of momentum tech stocks in the Nasdaq 100 Index account for about 24% of the market capitalized weighted S&P 500 Index their influence exceeds other measures such as market breadth and some technical analysis patterns.

By traditional valuation standards, many Nasdaq stocks are more expensive now than were the high-flyers in the 1999-2000 era. Some claim it's different this time citing low-interest rates, support from the Federal Reserve, and the Treasury while disregarding economic dislocations caused by Covid-19. When the relative value of the high flying momentum stocks are being compared based upon their price-to-sales ratios, all above 10 times, not price-to-earnings, but price to sales, remember it's never different, it's just a matter of timing.

CBOE Volatility Index® (VIX) 27.29 slipped .39 points or -1.41% last week. Our similar IVolatility Implied Volatility Index Mean, IVXM using four at-the-money options for each expiration period along with our proprietary technique that includes the delta and vega of each option, nudged up .21 points or +.95% ending at 22.24%.

The spike up to 77.15% on Monday, March 16, the day SPX declined 324.89 points, likely marks the top for this market decline. Based upon regression to the mean theory, its arrival near 20% supports the view that the SPX will likely continue higher.

VIX Futures Premium

This next chart shows as our calculation of Larry McMillan’s day-weighted average between the first and second-month futures contracts as of last Friday.

With seven trading days until July expiration, the day-weighted premium between July and August allocated 28% to July and 72% to August for a premium of 9.32%, at the edge of the green bull zone.

The premium measures the amount that futures currently trade above or below the cash VIX, (contango or backwardation) until front month futures contract converges with the VIX at the next monthly futures expiration on Wednesday, July 22.

For daily updates, follow our end-of-day volume weighted premium version located about halfway down the home page in the Options Data Analysis section on our website.

The relationship of the futures curve to the VIX, as measured by the premium, makes a good real-time sentiment indicator based upon actual commitments of large Asset Managers and Leveraged Funds.

Other Indicators

Market breadth measured by our preferred McClellan Summation Indicator continued lower again last week declining another 77.99 points to end at 659.53. Declining breadth reflects more and more market support coming from fewer and fewer stocks.
Bank of America research says the top five stocks: Microsoft, Apple, Amazon, Alphabet, and Facebook, now represent about 22.5% of the S&P 500 market capitalization. Narrowing market breadth will eventually make a difference.

Equity only put/call ratio, considered a contrarian indicator, as in buy the market when the ratio spikes higher and sell at extreme lows. Last week's average =.43

Strategy

For nimble traders consider staying on the QQQ train until it runs out of steam by using out-of-the-money call spreads with defined risk and with enough time to expiration to allow for minor pullbacks like to one in Digest Issue 27 "Invesco QQQ ETF Uptrend [Charts]" last week.

By traditional valuation metrics, it sure looks like the Nasdaq 100 stocks are in bubble territory. The bulls retort, so what, what's the alternative? Something dramatic other than COVID -19 needs to happen to change sentiment.

Collars

Using collars that are often touted as costless hedges for specific at-risk stocks, like the momentum favorites, may not be costless if the stock trends higher creating a loss on the short call in order to maintain the long stock position.

For example, Microsoft (MSFT) 213.67, on the earnings calendar for July 22, after the close, with a whisper estimate of 1.50 per share, 7% more than the previous quarter. Assuming the same rate of growth for the next four quarters results in a forward estimate of 1.97 per share and a forward p/e ratio of 108 times. Hum! Perhaps the forward earnings estimates are too low. Then research shows the price-to-sales ratio exceeds 11 times.

Suppose the stock was added to the portfolio in early April around 150 and with earning due shortly perhaps the time has come to consider a collar as a hedge.

Create collars by selling an out-of-the-money call and purchasing an out-of-the-money put with the sale proceeds, against a long stock position. Sometimes for little or no net cost depending upon the strikes selected.

If selling the stock resulting from the short call produces a taxable sale as mentioned above, make sure the strike price selected is far enough out-of-the-money that it doesn't need to be bought back at a loss to prevent a taxable event should the stock close above the short call strike price.

Presuming a sale would not be taxable, make an estimate of how far the stock could move on July 23 after reporting earnings. Last quarter it gained 1.77 or 1% of the stock price. It was 176.94 on the day before.

Also, remember many Wall Street analysts follow this stock so the whisper estimate will likely be very close to the actual number.

Consider this combination about six points out- of- the money on both sides.

Using the ask price for the buy and mid for the sell, Friday's debit was .05 with a combined net negative delta of -.7183 for a 72% two-day hedge since the options expire at the close on July 24.

Summary

After closely following the potential Island Top Reversal pattern previously created by exhaustion then a breakaway gap, the S&P 500 Index managed to close the breakaway gap on Friday thereby putting the pattern in doubt. Hot stocks in the Nasdaq 100 Index represented by Invesco QQQ ETF make up a sizable proportion of the S&P 500 Index so the pattern failed due to the continuing advance of the momentum favorites that may be entering bubble territory from a traditional valuation view. Since Microsoft, one of the momentum favorites will soon report earnings perhaps the time has come to consider a collar.