Yesterday’s trading was volatile which is business as usual on the day of options expiration. The dollar index and the S&P had large intraday swings and the closing prices yesterday tell us a lot about the near term direction of the market. As you know, I am bearish on equities and have put together a few ways to play this as well as found a few downside targets that we may see the S&P hit over the next 1-3 months.
The dollar had a strong open and continued to rally in the morning session. Dollar index call options were up substantially as Jun and Sept 11 calls were trading 20-50% higher while the UUP had reached a highpoint on the day of $21.69. However, during the afternoon session the dollar collapsed and the market attempted to break positive for several hours. This trend broke down as soon as the dollar failed to make a new low and in addition it appears that at 3pm, there was a margin call on the SPY which propelled the dollar back near the highs of the day as it ended 0.7% higher.
During the dip, I purchased options for the Jun 11 $22 expiry. The premium’s are still only going for $.12 – $.14 due to the low implied volatility rating. If however UUP reaches $22 before June, this trade will become extremely profitable as the premiums for the first strike that is currently the money is going for nearly $.70, or a 500% increase. Due to the resiliency of the dollar on Friday and the current momentum that it already has had over the past 2 weeks, I think that it is likely that the next target for UUP would be the 100 MA which is currently right above $22. The last time the dollar rallied (December 2010) it rallied just above the 100 MA in almost exactly 1 month. This time, the dollar has rallied to the 50 MA in 2 weeks, so it has 2 more weeks to make a run at the 100 MA if it is to follow that similar pattern.
Looking at the dollar from a bit longer term point of view, the last big reversal in the dollar came after QE 1 ended and the market dropped on European debt concerns. Currently QE 2 is scheduled to end in one month and the problems in Europe are making headlines yet again. Last summer, UUP rallied 15% from $22.02 to $25.84. If it is to rally another 15% in the coming months, the upside target would be in the $24 range.
Some interesting data about the S&P to Dollar Index ratio – there are four major highs and lows in this ratio in the last 10 years.
March 2000 – SPX – 1,498.58 / USDX – 105.71 = 14.17
Oct 2007 – SPX – 1549.38 / USDX – 75.82 = 20.43
Feb 2009 SPX – 683.38 / USDX – 88.49 = 7.72
Mar 2011 SPX – 1370.58 / USDX – 72.64 = 18.85
The average ratio is 15.2925 and the most recent peak which was recorded just two weeks ago is 18.85. The ratio as of the close yesterday is 17.63 meaning that the ratio must fall an additional 14% to reach the mean of 15.2925.
The S&P fell 18% from its peak last year and bottomed out in early July at 1010. Assuming it loses the same percentage once again, the downside target this time would be 1124. There is support in that area from 2010 though the market will likely have to test 1226 once again before it can fall as far as 1124. These targets are hypothetical and not something that I would recommend using as a strict trading strategy, but I think that they serve as a good general model to go by as the same situations and headwinds are presenting themselves right now and at the same time of year as it was in 2010.
One way to play a correction in the S&P would be to short the S&P 500 SPDR (NYSEARCA:SPY). Using the above price targets, you could make up to 15% in just a few months. You could also buy UUP which acts inverse to the market. However, another way to gain leverage and make even more without shorting would be to buy the ProShares UltraShort S&P 500 (NYSEARCA:SDS). During the same time period that the S&P lost 15%, SDS gained 13% more for a total return of 28%. If you don’t have a margin account or you don’t like borrow, this can be a useful way to short the market and gain additional leverage without paying interest. If you don’t have the risk tolerance to use the leveraged bets, you could also buy the ProShares Short S&P 500 (NYSEARCA:SH) which is short the S&P but does not take on the additional leverage that SDS does. SH is safer, but won’t return quite as much.