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IVolatility Trading Digest™ Blog
Monday April 21, 2014
Volume 14 Issue 16
Rotation Bewilderment - IVolatility Trading Digest™
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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There are two unanswered questions currently facing the equity markets. Will they be able to absorb the flood of new IPO supply and can they successfully complete the leadership rotation from "growth at any price stocks" to those priced on reasonable earnings without first making a 10% or more correction. While there some good reasons to think a correction is inventible the S&P 500 Index is holding up better than expected, however the same cannot be said about the NASDAQ where many of the "growth at any price stocks" trade.
We have more in the strategy section below followed by some additional covered call writing insights from our friends at The Blue Collar Investor and then new long ideas for QEP Resources, Inc. (QEP) and General Electric Company (GE).
S&P 500 Index (SPX) 1864.85. The tide turned once again last Monday when it made an inside range day and closed up 14.92 followed by advances of 12.37 Tuesday and 19.33 Wednesday as confirmed by the VIX futures premium that began the week at 2.08% finishing in solid green territory at 17.82%. As it moves back up toward 1880 watch for another reversal.
PowerShares QQQ™ (QQQ) 86.18. Using PowerShares QQQ or the "NASDAQ-100 Index Tracking Stock®", an exchange-traded fund based on the Nasdaq-100 Index® for the NASDAQ since there are listed options with good volume and liquidity, we note it declined 8.84% from the March 7 high to April 15 low with 29 of the companies declining more than 20% from their highs. Now the challenge is back up at 89 where a reversal would set up a potential right shoulder of a new Head & Shoulder Top activated on a close below the neckline at 84.
The comparable decline for the NASDAQ was 9.7%, just about enough to qualify as a correction. Since the NASDAQ previously led the market higher and then declined faster and further it assumed the leading role and if activated by a close under the QQQ neckline at 84, it will take the entire equity market lower for the long overdue correction.
CBOE Volatility Index® (VIX) 13.36. Declining 3.67 for the week, it solidly confirmed the change of direction for the S&P 500 Index. The VIX futures premium began the week in the lower part of the yellow zone at 2.08% finishing near the upper end of the green zone at 17.82%. Similarly, the implied volatility of at-the-money VIX call options declined from 107.25 to 66.15 adding confirmation to last Monday's unexpected turn around.
iShares Barclays 7-10 Year Treasury ETF (IEF) 101.79. Last week's Digest Issue 15 "Goose & the Golden Eggs" included a chart making the case for an activated declining wedge with an upside measuring objective at 103.68. However, with Thursday's dramatic .58 decline taking it well back into the consolidation pattern negating the breakout, it now indicates higher interest rates once again as IEF appears to be forming a trading range between 101 and 102.75. Back at 101, the equivalent interest rate would be 2.80%. The sudden decline along with improving equities further supports the view that "risk on" and "risk off" trading remains as important for interest rates as fundamental economic expectations.
The sector rotation challenge is to identify where the proceeds from NASDAQ and other overvalued "growth at any price stocks" goes. Although it made a substantial .53 decline Thursday the Utilities Select Sector SPDR 42.30 (XLU) is up from 37.11 or 15.66% since January 3 to Thursday's Key Reversal high of 42.92. However, if 10 Year Treasury Note interest rates advance above 2.80% it would most likely end this current uptrend.
A second funds flow destination has been Consumer Staples Select Sector SPDR (XLP) 43.63 up 9.64% from the February 3 low of 39.83 to Thursday's high at 43.67.
Further funds have been going into Crude Oil as the front month May futures contract (CL/14K) 104.30 advanced 14.9% from the January 9 low at 91.35 to last Wednesday's high at 104.99. Checking United States Oil (USO) 37.66 we see the advance was even greater at 15.7% from the January 9 low of 32.68 to Wednesday's high at 37.81. As we noted last week in Digest Issue 15 "Goose & the Golden Eggs" USO uses futures that are now in backwardation so every time they roll over the near term futures contracts they pick up some carry.
Finally as mentioned in Digest Issue 13 "Stampede Trigger", and again last week in Digest Issue 15 "Goose & the Golden Eggs" the IPO frenzy appears to be partly responsible for the current wobbly market and is probably the most important threat since there are still more to come especially in the hard hit biotech sector. As previously mentioned, comparisons with the 2000 tech bubble are hard to ignore.
Checking the typical sector rotation chart we see energy and consumer staples in the late expansion and early contraction zones while capital goods, transportation and utilities appear misplaced assuming the market is in late expansion making rotation analysis easier said than done.
While the current upturn certainly appears strong enough to close short positions, we suggest watching the S&P 500 Index around 1880 and PowerShares QQQ at 89 for signs of turning lower once again as the equity markets appear to be living on borrowed time. IPOs remain a concern along with several others suggest late expansion is the most likely current market condition. To alter this view the S&P 500 Index would need to close back above the April 4 high of 1897.28 along with the QQQ closing back above the March 7 high of 91.36 thus negating the current reversal patterns that appear to be forming.
Achieving the Highest Covered Call Writing Returns Using the Blackjack Analogy
Covered call writers and all investors using stock options strategies have one thing in common: we all want to achieve the highest possible returns within the framework of our own personal risk tolerance. The focus of The Blue Collar Investor is to provide education and share ideas that will help achieve these goals. Education is power and that is our starting point but where do we go from there? The focus of this article is the thought process used to become an elite covered call writer, and its resemblance to the casino game of blackjack.
Recently, a Blue Collar Investor member wrote with a valid question: If I achieve a 2% return on the sale of my call option and the trade turns against me, I will end up with less than a 2% return…should my initial goal be higher than 2%? The question becomes how to generate an initial return while protecting and managing positions to achieve final returns as close as possible to the goal. The answer lies in putting the odds in our favor in ways that few covered call writers consider.
Just for fun, let's look at blackjack. While not an expert at this card game, when I do play, I have all the charts memorized. That tells me given my 2 cards and dealer's one up card, what the computer says is the best play…take a card, stand pat, split, or double down. If our 2-cards total 11 and the dealer is has a 6, we double down (double our bet) to take advantage of a situation where we may increase our returns. If we have a 6 against a dealer's ace, we take a card hoping to improve a losing situation. As we strive to move the odds in our favor, the merit of each situation is considered on its own and much like covered call writing, it all starts with education. The major difference between these two endeavors is that most covered call writers make money in the long run while most blackjack players lose money. The main point here is that Blue Collar Investors must take advantage of all aspects of the BCI methodology to get the odds in their favor making them elite covered call writers.
The three parts of the strategy giving us opportunities to generate the highest possible returns are:
- Stock selection
- Option selection
- Position management
By selecting the best performing underlying securities from fundamental, technical and common sense perspectives, we begin the process of getting the odds in our favor. Stock selection details are included in the program we offer iVolatility.com subscribers and considered in future articles. An overall market assessment along with chart technicals and personal risk tolerance determine option selection.
Turning to a real-life example for KORS, a stock on the BCI Premium Stock List at the time of this article, here are the details. With KORS trading @ $95.56, here was the options chain for March 2014, for a 5-week return:
Evaluating in-the-money $92.50 and $95 strikes as well as the out-of-the-money $97.50 and $100 strikes as we feed these stats into the "multiple tab" of the Ellman Calculator (free in the "free resources" link @ the top black bar of the Blue Collar site):
Now it's time to get the odds in our favor. In a bull market environment with favorable chart technicals, we have an 11 against the dealer's 6 meaning it’s time to select an out-of-the-money strike. These will generate excellent initial returns (2.9% and 2% in yellow field) but also give us the opportunity for additional income streams from share appreciation (2% and 4.6% more in pink field). This is like doubling down in blackjack or taking advantage of a favorable situation to elevate our returns.
In a bear market environment or with chart technicals mixed, we need an insurance policy to protect our capital. We are sitting with a 6 against the dealer's ace. We get the odds in our favor by selling an in-the-money call, both of which return decent initial 5- week option profits (2.5% and 3.6% in yellow field) and one (the $92.50 strike in brown field) offers decent protection of that option profit. What we have accomplished here is to generate some protection against a potential losing trade and to enhance profit potential for winning trades allowing us to achieve our goals in normal market conditions.
We are not finished yet because we haven't started to execute our exit strategy opportunities. Some ("hitting a double", the "mid-contract unwind") will allow us to generate a second income stream in the same month with the same cash) and others (like rolling down or closing the entire position) allows us to mitigate losses.
Getting the odds in our favor and taking advantage of opportunities are factors that distinguish Blue Collar Investors from all the others. When we're sitting with a 16 against the dealer’s ace we do not sit there like a deer in headlights with sweat pouring down our foreheads…we take a card. While there may not be a great play all the time there is always a best play and it's all about getting the odds in our favor like nobody's business (an expression my mother uses).
My book and DVD Program, available at a discount to all iVolatility subscribers discusses these strategies in detail with examples.
Best Stock Trend Selection
As a regular feature in the Options Data Analysis and Rankers & Scanners sections on our home page we show the results from the Stock Sentiment Ranker based upon the short- term market trend, which considers, the Historical Volatility term structure, call/put ratio, exponential moving average, 14 day RSI (relative strength index), and the 21 day Chaikin Money Flow. Keeping in mind the whipsaw risk in the current market, here is Thursday selection with a bullish rank of 50% to consider.
QEP Resources, Inc. (QEP) 32.32, an independent oil and natural gas exploration and production company fits well into the late market rotation category. However, should there be a market decline as discussed above it will likely decline as well.
As for options, the volume is low with wide the bid/ask spreads so be careful or just use stock with a close stop under the last pivot at 31.
Bottom of the Implied Volatility Range
Here is an idea from the Top and bottom 5 stocks within IV Index Mean Range found in the "Rankers and Scanner" section of our home page, a regular complimentary sample at the " Top 5 stocks by implied volatility change" link.
General Electric Company (GE) 26.56 reported .33 per share earnings Thursday compared to .40 per share expectations due to onetime events while reaffirming 2014 guidance and reporting the oil and gas segment posted 27% revenue and 37% income growth. After reporting, the options implied volatility declined to a 52-week low of 14.49.
Here are the options details.
The current Historical Volatility is 13.74 and 13.38 using the Parkinson's range method, with an Implied Volatility Index Mean of 14.49 down from 19.50 the week before. The 52-week high was 24.22 on October 9, 2013 while the low was 14.49 Thursday. The implied volatility/historical volatility ratio using the range method is 1.08 so option prices are low relative to movement of the stock and low relative to the 52 week range as well. The put-call ratio at .25 was bullish as the call volume increased more than three times. Thursdays' option volume was 210,927 contracts traded compared to the 5-day average volume of 102,690 contracts so there is reasonable options liquidity.
Here are two long call ideas to consider.
The June 27 call is slightly more expensive in implied volatility terms, but has less time decay than the shorter term May call. Use a close back below the last pivot at 25.50 as the (stop).
The suggestions above use the closing middle prices between the Thursday bid and ask. Monday option prices will be somewhat different due to the time decay over the weekend and any price change.
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Last week, with the first warm winds of spring the short-term trend unexpectedly improved although many of the "growth at any price stocks" continued lagging the broader averages. In the meanwhile, the continuing supply stream of IPOs remains a drag threatening further advances. Both the S&P 500 Index and the PowerShares QQQ will need to exceed their previous highs in order to resume bullish postures. For now, we remain cautious and weary of more whipsaw losses from rotation confusion.
We now offer daily trading ideas from our RT Options Scanner before the close in the News section of our home page based upon active calls and puts with increasing implied volatility and volume.
Follow us on twitter for more ideas from our scanners and other developments.
In next week's issue, we will update our market indicators and report on the disquieting IPO situation.
Finding Previous Issues and Our 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. Another way to find them is the Table of Contents link in the blog section of our website.
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 us to look at a specific stock, ETF or futures contract, let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com.
IVolatility Trading DigestTM Disclaimer
IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.
Our purpose is to offer some ideas that will help you make money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".