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MarketWatch Options Trader: The stock market is skating close to the edge. If it breaks down past this level, the drop could be big.

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The S&P 500 Index rallied from early October into early December.

By that time, the benchmark
SPX,
+0.74%

had reached the downtrend line that defines this bear market. (See the solid blue line on the accompanying chart, below.) That line held, and now the bulls find themselves on the defensive once again.

There is support at 3900 points. If that is violated, we could be in for yet another dismal December — contrary to the long history of positive seasonality during the last month of the year.

The McMillan Volatility Band (MVB) buy signal remains in force, since SPX has not touched either of the +/-4σ “modified Bollinger Bands.” In actual practice, we have rolled our MVB positions up a couple of times and locked in profits there.

Equity-only put-call ratios have come under severe pressure over the past couple of weeks. The standard ratio, in fact, has not made a new low since mid-November. By definition, that is a sell signal (a local minimum on the chart that lasts for at least 10 days). So, it is marked that way on the chart. The weighted ratio has been acting more bullish, though, as it did make new lows on the way down, and — although it jumped higher Wednesday — it is still on a buy signal at this time.

Breadth has been a flighty and somewhat fickle indicator in the past month or so — giving a sell signal and then quickly whipsawing the other way. Currently the breadth oscillators are on sell signals and have not yet descended into oversold territory, despite the relatively heavy selling of the past three days.

New 52-week highs numbered more than 100 for one day — Dec. 1. That was the setup for a buy signal that was never completed. So, this indicator remains negative as it has since last April.

VIX has moved higher this week as the broad market has sold off, and for the first time since early October, VIX is back in “spiking” mode. While VIX is in spiking mode, it is a dangerous time for the market since VIX can sometimes spike quite high. Eventually, though, a new VIX “spike peak” buy signal will set up (when VIX closes more than 3.00 points below the eventual high of this move).

The accompanying chart of VIX shows that it bottomed once again in the 19 area, the third time since last January that it has been this low; each of the other two times saw a massive rise in VIX after that.

The trend of VIX buy signal is still in place. (It began with the green circle on the VIX chart, when the 20-day MA of VIX crossed below the 200-day MA.) That buy signal will remain in place unless VIX itself crosses back above the 200-day MA. Since those two (VIX and its 200-day MA) are nearly 4 points apart, that crossover won’t be happening anytime soon.

The construct of volatility derivatives remains bullish in its outlook for stocks. That is, the term structures of both the VIX futures and of the CBOE Volatility Indices slope upwards, and the VIX futures are trading at relatively large premiums to VIX.

December is generally a positive time period for stocks — especially small-caps. That seasonality has not kicked in yet, although the Russell 2000 Index
RUT,
+0.78%

has outperformed SPX over the past few days.

In summary, we continue to maintain a “core” bearish position, due to the fact that there is still a downtrend line on the SPX chart. We are trading other confirmed signals around that “core” position. A breakdown below 3900 should be respected as a severe negative development.

New recommendation: Aerojet Rocketdyne Holdings

This is a repeat recommendation from last week, since the calls never traded at our buy limit. The recommendation on Aerojet
AJRD,
+0.37%

has been adjusted, in that we are attempting to buy a higher strike now. Stock volume patterns are strong and improving. There is support at 51.

Buy 2 AJRD Jan (20th) 52.5 calls

At a price of 4.20 or less.

AJRD: 54.83               Jan (20th) 52.5 calls: 3.30 bid, offered at 4.50.

New recommendation: Potential SPX breakdown

As noted in the market commentary above, a close below 3900 by SPX would be quite negative:

IF SPX closes below 3900,

THEN Buy 1 SPY Jan (13th) at-the-money put

            and Sell 1 SPY Jan (13th) put with a striking price 25 points lower.

If this position is established, stop yourself out if SPX closes above 3940 for two consecutive days.

New recommendation: Another potential SPX breakdown

VIX is in “spiking” mode. When it comes out of spiking mode, a new “spike peak” buy signal will occur. This system of trading around the spike peaks in VIX has been a very successful one over the years, but I am going to state this caveat: The last three times that VIX bottomed near 19 and then rose, the first “spike peak” buy signal was a loser. Even so, we are going to take the trade, because of the overall track record.

IF VIX closes at least 3.00 points below the highest price that is reached while in “spiking” mode (that is, from today going forward),

THEN Buy 1 SPY Jan (20th) at-the-money call

            And Sell 1 SPY Jan (20th) call with a striking price 15 points higher.

If the position is established, then stop yourself out if VIX subsequently closes above that previous highest price that it reached while in spiking mode. If the position is established, we will give specifics each week as the trade progresses.

Follow-up action:

All stops are mental closing stops unless otherwise noted.

We are using a “standard” rolling procedure for our SPY spreads: in any vertical bull or bear spread, if the underlying hits the short strike, then roll the entire spread. That would be roll up in the case of a call bull spread, or roll down in the case of a bear put spread. Stay in the same expiration, and keep the distance between the strikes the same unless otherwise instructed.

Long 2 Dec (16th) 375 puts and Short 2 Dec (16th) 355 puts: This is our “core” bearish position. |As long as SPX remains in a downtrend, we want to maintain a position here. The spread is worth so little that placing a stop isn’t useful.

Long 1 SPY Jan (6th) 408 call and short 1 SPY Jan (6th) 423 call: This trade is based on the MVB buy signal, which was established on October 4th. This trade’s target is for SPX to trade at the upper, +4σ Band. The stop for this position would be if SPX were to close back below the -4σ Band. We will keep you informed if either Band has been touched.

Long 0 KLXE: The stock was stopped out for a profit on December 6th.

Long 2 WRK Jan (20th) 32.5 calls: Sell these calls now, since the put-call ratio has rolled over to a sell signal. This position will also generate a profit.

Long 1 SPY Jan (6th) 410 call and short 1 SPY Jan (6th) 425 call: The spread is based on the rare CBOE Equity-only put-call ratio buy signal. As a stop, we will close it out if SPX closes below 3900.

Long 2 KMB Jan (20th) 135 calls: We rolled this position up last week. We will hold these calls as long as the weighted put-call ratio of KMB remains on its buy signal.

Long 2 IWM Jan (20th) 185 at-the-money calls and Short 2 IWM Jan (20th) 205 calls: This is our position based on the bullish seasonality between Thanksgiving and the second trading day of the new year. We will adjust this position if IWM rallies during the holding period, but initially there is no stop for the position, so the entire debit is at risk.

Long 2 PSX Jan (20th) 105 puts: We will hold these puts as long as the weighted put-call ratio remains on a sell signal. That is, as long as the put-call ratio is rising.

Long 1 HZNP Jan (20th) 100 call: Stop yourself out on a close below 95.

Send questions to: lmcmillan@optionstrategist.com.Lawrence G. McMillan is president of McMillan Analysis, a registered investment and commodity trading advisor. McMillan may hold positions in securities recommended in this report, both personally and in client accounts. He is an experienced trader and money manager and is the author of the best-selling book, Options as a Strategic Investment. www.optionstrategist.com

Disclaimer: ©McMillan Analysis Corporation is registered with the SEC as an investment advisor and with the CFTC as a commodity trading advisor. The information in this newsletter has been carefully compiled from sources believed to be reliable, but accuracy and completeness are not guaranteed. The officers or directors of McMillan Analysis Corporation, or accounts managed by such persons may have positions in the securities recommended in the advisory.

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