Volume 8, Issue 19
Yahoo! Redux
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Last week in IVolatility Trading Digest™ Volume 8, Issue 18, Ocean Shipping, dated May 5, 2008, we expressed disappointment when updating the Takeover File with the news that Microsoft had withdrawn its takeover bid for Yahoo!. We were expecting this saga to provide us with several more months of stress free option premium selling lasting through the summer. If they had really withdrawn the offer as stated then the stock along with the implied volatility of the options were both sure to decline on Monday May 5, 2008. Now we are delighted by the prospect of renewing our Yahoo trading plans and our beach travel plans. First a few comments on our market indicators.
Market Review
S&P 500 Index (SPX) 1388.28. After trading above the 1400 level the SPX is now in retreat and has pulled back to the upward sloping trend line off of the March 17, 2008 low at 1256.98 passing just under the April 15, 2008 pivot at 1324.35. This is an important short-term trend line and if it fails the SPX could trade back down toward the 1300 level once again. While we still see the SPX as being in the process of making a bottom it could now be delayed.
The CBOE Volatility Index (VIX) 19.41. The VIX turned higher on continued call buying while the call open interest has expanded to 850K contracts. In the recent past this has been a leading indicator of a short-term market decline. The VIX call options buyers are giving us a warning that the SPX could fall below the upward sloping trend line. If the SPX holds above the trendline and the VIX call open interest declines it will confirm the index is turning higher once again.
The US Dollar Index (DX) 73.05. Now back under the previous resistance at 73.194 the DX is struggling to make a bottom while the trade deficit numbers for March improved even though we are experiencing a higher import bill for crude oil. Continued strength in the commodity group is creating a divergence that will be resolved either by declining commodity prices or by a declining US Dollar Index. The weakness in the SPX and the strength of crude oil prices is suggesting more trouble for the dollar and equity bulls.
Our market breadth indicator, the NYSE McClellan Summation Index slowed down last week adding 80.07 points and closing in positive territory at 282.39.
Strategy
We have a divergence between the US Dollar Index (DX) and rising commodity prices lead by crude oil and natural gas. Seasonally we would expect to begin seeing some weakness in the energy complex that would now be supportive for the dollar and equities. As yet, this is not the case and we advise some caution until it is resolved. If the dollar begins to breakdown and starts trading back down toward the lows around 71 we would expect to see continuing commodity price strength. Since Gold has now corrected almost 17% from the March 17, 2008 high at 1,038.60 basis Jun and is now lagging other commodities there could be a catch up opportunity if the dollar turns lower once again.
The other sector we recently highlighted that continues gaining momentum is Ocean Transportation, both crude oil tankers and bulk carriers. Look for more trades here.
IVOLopps™
Yahoo! Inc. (YHOO) 25.93. Last Monday May 5, 2008 after the news the Microsoft had withdrawn its offer Yahoo opened down 5.62 at 23.05 and then closed at 24.37 off 4.30 for the day. At the end of January before the offer was made the stock was trading at 19.18 and the Implied Volatility Index had just declined from 65% after the January 29, 2008 earnings report to above the 50% level. If investors and traders thought that Microsoft had really given up it seems the stock would have traded back down toward 20 and perhaps closing in the low 20’s. Further, if the takeover uncertainty was now gone the implied volatility would have declined at least back to the 50 level and more likely closer to 40 where it was in the middle of March. Here are the volatility and price charts from our Advanced Historical Volatility service.
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Because the options implied volatility did not decline as much as expected we conclude the options traders do not think Microsoft has given up despite news releases to the contrary. Further, high options trading volume of at around 700K contracts with an open interest of almost 4 million contract leads to the conclusion that multiple strategies, long, short and hedged are being employed. In addition, call open interest has accelerated in the last few days to over 2.4 million contracts now representing 60% of the open interest.
Microsoft stated they did not believe a proxy battle for directors was practical and now there are reports that disgruntled shareholders including some major mutual funds and perhaps activist hedge funds may take up the battle and attempt to force a sale of the company to Microsoft.
The initial offer at 31 represented at 62% premium over the pre-offer price of 19.18. The reported revised offer at 33 would represent a 72% premium. Currently technology is not one of the favorite groups and many shareholders are dismayed with the current directors handling of the negotiations.
They would like the opportunity to cash out.
Since many shareholders think the current Yahoo directors have not represented their best interests they are reportedly seeking ways to unseat the entire board. In the meanwhile Yahoo scheduled the next shareholder’s meeting for Thursday July 3, 2008 presumably hoping that few would attend before the July 4th holiday. While it seems unlikely this will be resolved before the shareholder’s meeting it does give us a time frame to plan some trading strategies.
Here are all of the open Yahoo suggestions along with the original basis and current market value that we have recorded.
Synthetic Long
Long Jul 27 ½ call/short Jul 27 ½ put, debit 1.125. Current market -1.455. Loss 2.58
Calendar Spread
Long Jan 27 ½ call/short Jul 27 ½ call, debit .925. Current market. -.345. Loss 1.27
Put Sale
Short May 25 put, credit .68. Current market .645. Gain .035
Bull Put Calendar Spread
Long Oct 25 put/short May 25 put, debit .9850. Current market 1.715. Gain .73
Summary at Current Market (before commissions). Loss 3.085.
As we would expect the largest loss was from the synthetic long. The May 25 puts will expire at the end of the week, assuming the stock is above 25 and then the calendar spreads have the opportunity to be renewed with the expiration of the short legs.
If the shareholders are successful in forcing a sale the positions should be ok, in the meanwhile the accounting and management will become tedious.
Bull Put Spread
We recently received a request for bull put credit spreads and since they are an income strategy and fit our original plan for Yahoo we scanned our Advanced Options page for YHOO and found this suggestion.
- Buy YHOO May 22 ½ put YHQQX .095 IV 69.65 Delta -.0759
- Sell YHOO May 25 put YHQQE .645 IV 69.78 Delta .3408
Credit .55 Position net delta .2649
Since we are already short the May 25 put (see open positions above) at .68 we will match it with the long 22 ½ put for this position and record a credit of .585.
For those who are not already short the May 25 put the pricing for this spread will change when trading starts on Monday as it will expire at the end of the week. In order to adjust for any price change use the spread delta and multiply it by the price change. Credit spreads with a volatility edge are hard to find and this one just qualifies.
The expectation is the stock will rise and both puts will expire worthless with the objective of retaining the net credit. This is a short-term trade that could help to reduce the now negative book position in this stock. If the stock declines the breakeven is the higher strike price less the net credit received, 24.45 in this case. The maximum loss is 1.95 the difference between the strike prices less the net credit received (2.50-. 55).
Now when we compare the maximum gain of .55 to the maximum loss of 1.95 we see the problem with credit spreads. The risk to reward ratio is 3.5. This means we can lose three and one half times the amount we can make.
Since we have an unfavorable risk/reward ratio we want to pay close attention to the stop/unwind.
Yahoo’s rapid decline last Monday gave us some idea that there is support for the stock at the 24 level and we will set this as the SU (stop/unwind) even though the spread will expire at the end of the week.
Last week when Microsoft announced they were withdrawing their bid for Yahoo we first thought we would be recommending closing the positions and booking loses. Now however, we think there is a good chance that it will stay alive for several more months. If the shareholders are successful in forcing a sale it will take until July before the result can be determined. If a new board of directors accepts a friendly deal with Microsoft it could then still take several more months to complete considering the necessary regulatory approvals that would be required.
With an upside of 31-33 and a likely downside of 24 this could still be a stock suitable for income options strategies. If the stock now trades around the 26 support level we would expect to see the Historical Volatility return to 37 while the Implied Volatility remains in the 50% plus area giving us a nice positive volatility spread. Some other income ideas to consider include covered calls, covered short straddle or strangle, long iron condor and long iron butterfly.
We now think the chances are good we will still be doing Yahoo trades in the fall while rolling over the Oct put spread and maybe even next January rolling over the January call calendar spread. While there will be considerably more management and record keeping we are hoping there will still be some time for the beach this summer.
Previous Issues and Reader Response Request
All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. As usual we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like for us to take a look at a specific stock or ETF just let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.
Posted by Demetrius Tsitrelis on May 13, 2008 at 12:10 AM EDT
Posted by Jacktrader (66.182.123.195) on May 14, 2008 at 06:59 PM EDT