Convinced that rising options implied volatility signals potential pullbacks in the S&P 500 Index we decided to have one more look at correlation, this time using the short- term volatility index. While the VIX uses SPX monthly options with 30-days to expiration, the VXST Index looks out just 9 days and includes options that expire in one week making it more responsive to changing volatility. The chart in the Market Review shows VXST correlation makes a better timing indicator.

S&P 500 Index (SPX) 3140.98 gained 30.69 points or +.99% for the short Thanksgiving week, making new closing and intraday highs Monday, Tuesday and Wednesday. On any significant pullback, the 50-day Moving average at 3028.72 should provide support, then 2950 from May and August previous highs. However, without some fundamental change pullbacks will likely be limited. This 13-month chart shows the 10-day correlation with the short-term volatility indicator VXST at the bottom.

As expected using the VXST 10-day correlation gives more signals than using the VIX as shown in Digest Issue 47 "VIX Correlation Indicator Update [Charts]." Setting the blue horizontal line at -.25 shows when the correlation reaches or advances (becomes more positive) above -.25, pullbacks in the SPX soon follow or in some cases are underway. In the 10 times it advanced above -.25, including November 30, 2018, it gave valid signals,  However, the degree of the declines vary and are not consistently proportional to increasing correlation. 

One noticeable failure occurred on July 30 when it failed to reach the -.25 line before an important pullback marked with a red arrow. Changing the correlation period to 20 days resolved this specific shortcoming as the correlation advanced to zero as the decline began. Although using the longer period gives fewer signals, they may warn of greater declines. 

In conclusion, increasing option prices reflected by VXST can foretell SPX declines. Using 10-day correlation will generate more signals, some better than others while using a 20-day correlation will generate fewer but more important warning signals.    

CBOE Volatility Index® (VIX) 12.62 gained .28 points or + 2.27% 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, added just .01 points or + .10% to end the week at 10.17% vs. 10.16% for the week ending November 22. On Tuesday, when the SPX made new closing and intraday highs, it decline to a 52-week low at 9.12% shown below.

VIX Futures Premium

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

With 12 trading days until December expiration, the day-weighted premium between December and January allocated 60% to December and 40% to January for a 19.13% premium, still in bullish green zone, vs. 22.22% for the week ending January 22.  

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 expiration on Wednesday, December 18.  

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.

Strategy

The overriding strategy consists of hedging long positions when pullback risk increases as determined by the indicators and the VXST correlation indicator closed at .05 on Friday suggesting increased pullback risk this week.

While the markets respond to every China trade news leak and announcement, expectations remain high for an agreement with China that will result in lower China tariffs, despite new tariffs scheduled to begin on December 15. Keep in mind, the potential for a "sell the news" event on any conclusive China trade agreement announcement, whenever it comes.

Along with China trade news, ample liquidity is the other important driver for the markets. This October 11, Reuters quote details the Fed's year-end plan.

"The Federal Reserve said on Friday that it will start buying about $60 billion per month in Treasury bills starting Oct 15, to ensure 'ample reserves' in the banking system, but emphasized the new program does not mark a change in monetary policy.... also said it would continue to inject cash into overnight lending markets until January by offering daily operations in the market for repurchase agreements, or repos.

Remember on Friday the November employment report is scheduled for release before the market opens.

Since the VXST indicator turned positive on Friday the long Jan 17 305/295 SPDR S&P 500 ETF (SPY) put spread, (long Jan 17 305 put and short Jan 295 put), from Digest Issue 46 "VIX Correlation Indicator Confusion [Charts]" booked for 1.70 and market- to- market on Friday for 1.36, carries forward and remains a good idea for some inexpensive downside protection with 46 days to expiration using a SU (stop/unwind) at .85, if needed.

Summary

Although the VIX futures and options indicators remain bullish, the short-term VXST correlation indicator turned positive on Friday suggesting more downside risk this week ahead of Friday's employment report along with news of an expected China trade agreement before the December 15 when additional new tariffs are scheduled to begin. Therefore, long Jan 17 out-of-the-money SPY put spread as portfolio insurance remains a prudent hedging strategy.