Published December 21, 2012
In 2010 it was the flash crash.
In 2011 it was the political debt ceiling debacle and the corporate meltdown and fraud of MF Global (MFGLQ).
This was followed up in 2012 by Knight Capital's $440MM trading "glitch" (KCG).
And now just last night we had a mini-flash crash on the S&P futures to add to the mix.
What will be thrown at investors next?
Needless to say not having protection in this environment is downright dangerous!
A look at last Night
Before we talk about last night's mini-flash crash, here's a quick recap about the significance of rogue waves:
"Rogue waves (also known as freak waves) are large and spontaneous ocean surface waves that occur at sea and are a threat even to very large ships and ocean liners. In oceanography terms, any waves whose height is more than twice the significant wave height (SWH), is considered rogue. Interestingly, rogue waves are not necessarily the largest waves found at sea, but instead, unexpectedly big waves for a certain ocean atmosphere. Furthermore, exceptionally large waves are often caused by a conglomeration of factors, rather than just one."
Rogue waves don't just exist in nature, but in financial markets too.
Last night at 7:18 Central Time, the S&P futures (already down 1% at the time) plunged on the back of the fiscal cliff "no deal" vote by the House.
At its lowest, prices were down 3.5% to 1391 and fell 2.5% in well under a minute.
Chart one below shows the action from last night including the spike low on the S&P March 2013 futures (CME:SPH13.CME) along with key price levels.
Digging down one level deeper is a tick chart that shows all the transactions that occurred at 50 trade increments. It allows us to zoom into any time period including 19:18 Central Time and see that prices fell from 1422 to 1391 (SNP:^GSPC) in well under a minute.
Prices collapsed to 1391 before eventually being bought back up to 1407, all by the time 19:19 Central rolled around.
This time buyers stepped in, next time the outcome may not be as rosy.
In the ETF Profit Strategy Newsletter one of our Mega Investment Themes has been Rogue Waves. In this day and age of extremely high correlations there is a greater potential for unforeseen (and even unrelated) events to affect your portfolio.
We have been big advocates of buying portfolio protection during times of high complacency such as in September, earlier in this month, and even earlier this week.
On 12/13 in an article entitled "3 Contrarian Signals Flashing Red Alert" (found here) we identified the high level of complacency (and increased levels of risk) shown by historically low implied volatilities (VXX), historically high levels of "dumb money" speculative buyers and "smart money" hedgers, and decreased levels of actual price volatility (CHICAGOOPTIONS:^VIX).
All of these are signs that the market is ripe for a surprise, which indeed occurred last night with the "fiscal cliff" let down.
As suggested in our ETF Profit Strategy Newsletter released this week, "we like going long the VIX Jan 14 CALL options at $271 per contract (OPR:VIX130116C00014000). VIX options are our preferred method for playing volatility". Those options are now trading for $470 and up over 70% in less than a week.
We also stated, "Almost every time the VIX has been below the 15 level, at a minimum a short term top in the S&P occurred and the VIX eventually rallied to 19." This has been a high probability trade setup time and again. Today the VIX is again trading above 19 (for more on VIX opportunities click here).
Although the market (IVV) is down 1% today and is selling off as momentum is waning, one down day does not make a trend, and it is too early to call a near term top.
In order to gain more confidence that a near term market top is here, we have identified three key price support levels to watch.
The first level the market needs to take out is its recent channel support trendline currently at 1420 and shown in the chart below.
Once this level is breached it raises the odds that a larger market (SPY) top is forming. At that point we will look to our other two important support levels along with some of the other tools we use to help identify high probability trade setups and if this market really is rolling over.
The ETF Profit Strategy Newsletter uses the VIX along with technical analysis and sentiment measures to identify high probability trading set ups for stocks, bonds, forex, and commodities.