Idea of the Day there could be trouble ahead

What: Ahead of earnings season kicking in with gusto, there are some ominous signs that do not bode well for risk in general. The first sign is the continued rise in the gold/ silver ratio, as gold outperforms the silver price. The second is the divergence between volatility in the Nasdaq 100 and the Vix, and lastly, the (very) recent underperformance of the Dow jones’ transports index, which tends to be a lead indicator for risk appetite.

We believe that the gold/ silver ratio is worth watching closely. A couple of weeks’ ago we noted that this ratio had risen to its highest level since April 2016, and that this can be a sign that precious metals traders are getting ready to buy silver as it looks cheap compared to gold. However, that was not the case and the gold/ silver ratio has continued to rise. When this happens, it is worth taking notice. When the market isn’t willing to buy silver over gold, even when silver is looking cheap in comparison, then it suggests that gold downside could be protected due to safe haven demand.

The Nasdaq/ S&P volatility comparison is also worth noting. The chart below shows how the two measures of volatility are at their widest level for well over a year, as tech stocks continue to struggle (volatility is higher) even though the Dow Jones made a fresh record high earlier this week. This supports the view that there is volatility in the market if you look beyond the general indices. Also, how long can the important tech sector suffer before it drags the rest of the index lower? The jury is out on that one, but it is an interesting question for traders to consider.

Regarding the last point, the Dow transports sector is worth watching. Right now its weakness has not had enough time to develop to suggest that it will be a leading indicator for the Dow. But another couple of sessions of weakness could get investors’ worried and may trigger a sell off in the broader index.

How: In terms of using this information for your trading, signs that all may not be well in the markets suggests vigilance, especially if you are long risk. If you want to take advantage of a potential risk-off scenario in the future then you could consider buying put options on a stock index, which could allow you to benefit from a sell off. At City Index we offer options of the major indices, and we offer spreads from 4 points on the FTSE 100 and the Dax. Buying a put is essentially buying volatility, so you are looking for volatility to rise and stocks to fall. The cheaper options tend to have out-of-the-money strike prices, and long times to expiry. We would suggest a put option on the FTSE 100 with a 3-month expiry (enough time for a sell off to happen), and a strike price of 7,180 – the 200-day sma – or 7,000 if you want an even lower premium. In this scenario you would be looking for the index to fall below these levels within 3-months, so that you could sell the index higher than the actual price in order to make a profit.

Overall, the risk of loss is your premium only, and if you think that the signs outlined above are ominous enough, buying a put option on an index can be a good way to express that view, without having to commit to a directional move right now that may not go your way and could dent your capital position.  

Chart: Nasdaq volatility and the Vix index 

Source: City Index and Bloomberg