Name That Trade – Avenue $QQQ

by Dan July 7, 2014 3:00 pm • Commentary

The Nasdaq has become very overbought over the past couple of weeks, though, as has been usual at various times over the past several years, many underlying divergences persist.  Tom McClellan noted one such divergence in a post at pragcap.com:

The Nasdaq 100 Index is making new multi-year highs, levels not seen since the weeks just after the 2000 Internet Bubble top.  But it is interesting for us to see that the average component stock in that index is down 7% from its trailing 52-week high.

This current divergence is not guaranteed to stay with us.  It looks like a genuine divergence now, but it is still possible that we could see a continued rally that takes the stocks in the Nasdaq 100 collectively up closer to the level of their 52-week closing highs, thereby closing the gap on this measure of average drawdown.  But for now, the message is that the average stock making up the Nasdaq 100 Index is not confirming the bullish message of the NDX’s higher price highs.

Nasdaq 100 stocks average drawdown amount


Now, we’ve learned not to place too much weight on these sorts of divergences given that the market has generally powered higher despite them in recent years.  However, we did find it interesting given the extremely low level of implied volatility in the Nasdaq indices.  30 day implied volatility in QQQ reached a 10 year low recently:

QQQ 30 day implied volatility, Courtesy of Bloomberg
QQQ 30 day implied volatility, Courtesy of Bloomberg

These extremely low levels of volatility are taking place against a market backdrop that is getting very overbought.

The longer-term perspective suggests two possible paths given the extreme overbought nature of the major indices.  For example, the Nasdaq 100 index has only been this overbought on 2 other instances over the past 10 years, as shown by the daily RSI over 80 in the chart below:

Nasdaq 100 index upper panel, daily RSI (14) lower panel, Courtesy of Bloomberg
Nasdaq 100 index upper panel, daily RSI (14) lower panel, Courtesy of Bloomberg

In the spring of 2010 (first red circle), the overbought reading came just a few weeks before the flash crash, so the extreme overbought reading was a sign of buying capitulation and a market top that lasted 6 months.  In the February 2012 instance, the Nasdaq had just broken out to a new 10 year high, and that breakout has held ever since.

The market is likely in the midst of either a buying capitulation or a continued breakout that could have legs for some time to come.  Either way, we don’t think the market just sits around here given the extreme nature of the recent price action.  However, the options market is implying very little movement over the next few months.  The Sept 20th $95.63 straddle is priced around $4.25, which would mean a 4.5% move in either direction over the next 2.5 months.  Over the last 2.5 months, QQQ has moved around 10 dollars, from around $85 to around $95.  So what’s the best way to play?

A cheaper way to play for volatility over the next 2.5 months would be buying the Sept 92.63/98.63 strangle, which would cost around $1.90 at current prices.  That implies a break-even of about $90.73 on the downside or $100.53 on the upside for QQQ in September.  The strangle plays for a breakout above $100 or a breakdown below the March highs around $91.

There’s also the option of just buying cheap puts that are near the money. The August 95 puts are 1.26 (stock ref $95.38) and it wouldn’t take much of a pullback in the index over the next month and a half for those to have been a nice buy and offering the potential to spread by selling a lower strike put when implied vol ticks up a bit.