By Kyle McEwan

Fall tends to be a more active time for investors and traders than the summer, and volatility tends to increase in the market as well. I think there are some great opportunities ahead for savvy and nimble investors.

This two-week period before Labor Day is typically the lowest trading volume of the year. The S&P 500 has been trading in a range between 1,010 (the low in early June) and 1,130 for several months. Recent economic data has been uninspiring, and I think we are in for a period of slower growth on a global scale. While we might not get a double-dip recession, it could feel like it. I think after we get through some headwinds this fall, the market should be able to grind higher into year-end.

The two charts below show a recap of summer action in the S&P 500, and how commodity markets have performed from May through the end of August.

Recap of This Summer

Historically, September and October are the worst performing months for the stock market. Over the past 13 years, we have had seven negative third-quarters. We can see this in the next chart below. The blue boxes represent flat quarters and red, negative quarters. The third-quarter looks to be another bearish quarter this year as investors don’t anticipate much improvement in 2011, and are already discounting continued weak conditions.

The next big economic report is the August employment report, due out in the U.S. on September 3 and in Canada on September 10.  Expectations for the US Non Farm Payrolls number is – 110K. We also have a Bank of Canada policy meeting on September 8.  In the next chart below, the red lines below represent U.S. employment report releases. From the March 2009 bottom, every unemployment report except the last has caused the market to go up.  I think the poor unemployment reports have caused the Federal Reserve to reiterate an extended low rate environment.  I think this is an interesting chart for traders to study.

Hedging With S&P E-Minis

If you are a bear, you can use stock index futures to hedge a current equity-based portfolio quickly and in a cost-effective manner. The CME Group E-Mini S&P futures are one of the most liquid markets in the world, and the leverage provided by futures allows you to use less capital. Be aware, however, that leverage can work for or against you. The advantage of trading stock index futures is that you can bet on the overall direction of the market–you don’t need to be a good stock picker.

If you anticipate the stock market will decline 10 percent during a given timeframe and you want to protect your current equity holdings, you can determine an appropriate amount futures contracts to hedge your specific portfolio.  This example below is a simple way of calculating an appropriate hedge but to calculate more accurately we could use a more sophisticated calculation based on the betas of your equity holdings. In this example, I will assume a hypothetical $1,000,000 portfolio, expected to lose $100,000 in value. I will also assume the S&P 500 is trading at 1,100.

Example: Hedge against a 10 percent market decline by selling S&P E-mini futures

Equity portfolio value = $1,000,000

Expected loss in value = $100,000

E-mini S&P contract = $50 per each point move

E-mini notional value = $50 x 1,110 = $55,500

Portfolio value = $1,000,000/$55,500 = 18 futures contracts needed to hedge

Change in value of the index = 1,110 x 0.1 (10 percent loss) = 111.0 pts x $50 – $5,500 potential profit or loss

$5500 profit/loss x 18 contracts = $99,000

U.S. Treasury Bond Vs. S&P 500

There is generally an inverse relationship between stocks and bonds. Investors don’t want to take risk associated with the stock market during times of duress and uncertainty, so they move into assets perceived as more secure, such as U.S. Treasuries. That has driven up bond prices dramatically, and therefore driven yields on short term notes to record lows and has long term bonds trading close to their lows.

Bonds will fall, although it is tough to say.  I think there is a trade here but we need to be patient. When we get a whiff of inflation, it will be bad news for bonds.  Inflation is bad for bonds because it eats into the principal.  The bond market money will move to the equity market as investors become less risk averse and seek more attractive returns.  Many blue chip stocks dividend yields are now higher than their ten year corporate paper.

There are a variety of strategies you can pursue once these trends between stocks and bonds shift. The chart below shows the relationship between stocks and bonds. The S&P 500 is represented by the line in black, and the 30-year U.S. Treasury bond in red.

The VIX

The CBOE Volatility Index (VIX) is based on real-time prices of options on the S&P 500 Index listed at the CBOE, and is designed to reflect investors’ consensus view of the future (30-day) expected stock market volatility. This index is often called the “fear index” as it is used as a barometer of investor sentiment. When options buyers are anxious, volatility increases, and premiums paid for options are driven up. This tends to occur when the stock market is declining sharply, or is expected to as investors attempt to protect themselves.

The VIX uses near-term and next-term out-of-the money SPX options with at least eight days left to expiration, and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.

Inverse Relationship

The level of the VIX and the S&P 500 tend to have a negative correlation. The VIX will peak during sharp stock market declines, and will remain at low levels during more stable or bullish markets when investors are more confident.  You can see how the VIX (represented by the line in blue) rose when the stock market (represented by the line in black) fell during the “flash crash,” and then declined amid an optimistic start for corporate earnings season.

Trading VIX Futures

You can trade futures on the VIX at the CBOE Futures Exchange, and the futures contract size is $1,000 times the index. So if the price of the VIX is trading at 20, the notional value of a futures contract is $20,000. If the index went to zero (although theoretically impossible), you’d lose $20,000 if you were long the VIX futures from $20. Regular trading hours are similar to other stock index products, from 8:30 a.m. – 3:30 p.m. CT. View full contract specs at: http://cfe.cboe.com/Products/Spec_VIX.aspx

You can use VIX futures to hedge your long equity positions on individual stocks, exchange-traded funds, or stock indexes. If you expect a decline, or a higher degree of volatility in the market, you would go long a VIX futures contract. If you are bullish, you could take the opposite position, sell VIX futures. Trading VIX futures can be advantageous to other hedging vehicles for a number of reasons. They are generally less expensive than maintaining options positions, and it’s possible to profit even if the market has no clear trend, but is very volatile.

Speculators can also successfully trade VIX futures. The VIX can start climbing (or falling) even if the stock market doesn’t actually make a move; in that case, it’s investor perception or anticipation that rules the VIX. Fall is a good time to consider these types of strategies. Typically, the fall tends to be a more volatile time for the market than the summer, when more investors and traders return from vacations.

I think this fall we are likely to see heightened volatility, which should present investors and traders with plenty of good opportunities. Don’t feel as if you are missing out if you don’t take a particular trade that doesn’t feel quite right—there will be more! Be patient, the market always gives you a chance to buy and a chance to sell. I think we may see some further downside in the stock market, but it should grind higher into year-end. Please feel free to call me with any questions you have about the markets, and to help develop specific strategies based on your unique goals and risk-tolerance.

Kyle McEwan is a Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading, you can contact him at 877-840-5333 or via email at kmcewan@lind-waldock.com.

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