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IVolatility Trading Digest™ Blog


Volume 14 Issue 37
Interest Rate Jitters

Interest Rate Jitters - IVolatility Trading Digest™

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Interest Rate JittersIn the past two weeks, concern about rising interest rates intensified after the European Central Bank announcement surprised investors with a rate cut and plans for possible bond purchases. In addition, last week renewed speculation surfaced that the Federal Reserve may change the wording in their policy statement due this week implying interest rates may begin increasing sooner than previously expected. Accordingly, market participants pushed both interest rates and the dollar higher. Since Fed announcement speculation recurs, perhaps the ECB announcement was more important as is implies a major policy shift in an effort to fight deflation in the Eurozone.

At week's end, both the US Dollar Index (DX) and Treasury interest rates appeared overbought and will likely retreat if the Fed maintains or slightly alters the "considerable time" wording in their statement. We have an updated US Dollar Index chart along with another for ProShares UltraShort 20+ Year Treasury (TBT) our preferred interest rate indicator included in our regular market review. Then we update a previous high IV/HV ratio suggested idea for GT Advanced Technologies Inc. (GTAT) made last week in Digest Issue 36 "Two Upcoming Event Ideas."

 

Review Notes Clip ArtS&P 500 Index (SPX) 1985.54 last week it looked as if the breakout above the July 24 high at 1991.39 had been successfully retested, but that was not the case as the modest decline continued and now looks as if it could go down to 1975 where there should be good support. As a reference, the long-term upward sloping trend line from the November 16, 2012 low now crosses at 1934.16, about 2.6% lower.

iShares Russell 2000 (IWM) 115.37 despite dollar strength that favors domestic small capitalization stocks it continues underperforming the big capitalization indexes and remains well below the July 1 high of 120.97 needed to breakout out above the current range thereby establishing a new uptrend. In the meanwhile, a potential double top remains the operative technical pattern.

Powershares QQQ (QQQ) 99.48 since breaking out above the July 24 high at 97.51 and now moving in a narrow range just under 100, it remains the relative strength leader advancing 2.02%, compared to -.29% for SPX. The bulls are likely to say it demonstrates relative strength while the bears say it's lagging the SPX weakness and will eventually accelerate lower to close the gap.

CBOE Volatility Index® (VIX) 13.31, up 1.22 for the week, it appears to be trending higher from the August 24 low of 11.24.

The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan's day-weighted average between the first and second months.

 

 

The day weighting applies 10% to September and 90% to October for a 10.48% premium shown above. Our alternative volume-weighted average between September and October, regularly found in the Options Data Analysis section on our homepage, is a bit lower at 8.26%. Premiums for a normal term structure are 10% to 20%, while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Premiums less than 10% suggest caution and negative premiums are unsustainable suggesting an oversold condition. Last week, the premiums remained below 10% every day, averaging 7.33% for the week. Friday's preliminary volume report was 253,796 contracts up substantially from the previous week at 137,313 reflecting increased hedging along with contracts rolling over into October since Tuesday is the last trading day for the September contract.

VIX Options

With a current 30-day Historical Volatility of 79.38 and 91.45 using Parkinson's range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday's closing option mid prices along with their respective month’s futures prices, since the options are priced from the tradable futures.

 

 

Compared to the range historical volatility of 91.45 the September and October options are slightly undervalued. Friday's volume at 829,907 contracts was considerably higher than the 545,880 average for the week.

 

 

CBOE S&P 500 Skew Index (SKEW) 127.37 measures the purchase of out-of-the-money S&P 500 Index puts that require a very large downside move to profit from long put positions. An increase of this index indicates greater expectations for an extreme down move. The CBOE explains further, a Skew value of 100 means the perceived distribution of S&P 500 log-returns is normal so the probability of outlier returns is negligible. As Skew rises above 100, the left tail of the distribution acquires more weight increasing the probability of outlier returns.

After spending most of the week above 130 it made a sizable -5.35 decline Friday to close back below the middle of the current range between 143.26 and 120.36.

US Dollar Index (DX) 84.24 this chart suggests the dollar is overbought challenging the July 9, 2013 high at 84.75. An advance above this level would change the intermediate trend up. After the rapid advance up from 81 in the last few days, the odds are good that it will pause and consolidate around 84 or even decline somewhat.

 

 

Next, interest rates,

10 Year Treasury Note Yield (TNX) 2.61 the substantial 8 basis point advance Friday on speculation the Federal Reserve will delete "considerable time" from the wording in their statement after the FOMC meeting this week demonstrates just how jittery the markets are about any increase in interest rates. Although Friday's advance was important, the yield was as high as 2.69 on July 3 and 2.74 on April 22. The sensitivity to any suggestion that interest rates will rise is understandable since both bonds and equities will decline, perhaps substantially when the market begins discounting advancing rates, which is widely anticipated. However, this has been the situation for the last year or more.

ProShares UltraShort 20+ Year Treasury (TBT) 59.37

Since bonds with longer maturities are more sensitive to interest rate changes adding the leverage of the ultra short ETF adds additional sensitivity making it a good indicator to use for an interest rate perspective. Here is the chart for the last year.

 

 

The downward sloping trendline marked DSTL begins at the December 31, 2003 high at 80.28 touching the July 3 high at 63.92. Thursday it closed above the DSTL and then gapped higher Friday something often seen as prices cross trendlines. The next point to watch is the July 31 high at 60.22 marked A, and then finally the July 3 high marked B. While it appears the downtrend is over it will take closes above both A & B to confirm interest rates are turning higher.

 

While the interest sensitive equity sectors such as REITs and MLPs declined last week, emerging markets that should benefit from dollar strength also declined. In the event the dollar continues higher this week and TBT closes above 60.22 we suggest implanting a hedge strategy using near term VIX at-the-money call options. An alternative could be a long TBT call spread since the implied volatility index is 24.54 and the options volume is good.

 

Reviewing High IV/HV Ratio Ideas

Low implied volatility for the last several months has made selling options premium difficult since it was necessary to use strike prices that were near at-the-money in attempt to generate income while increasing the risk from movement of the underlying stock or ETF.

High-implied volatility relative to the historical volatility, usually found before events such as earnings reports or FDA announcements, indicates expectations for a large move in the underlying. While the subsequent move may not be as severe as suggested by the implied volatility, on occasion it may be even more severe resulting in what could be a substantial loss for an option position that is short on one side. One way to mitigate this risk is to be short both sides by using an Iron Condor or perhaps an Iron Butterfly. Another alternative is to go with the flow and accept the possibility to underlying could move even more than suggested by the implied volatility.

In Digest Issue 36 "Two Upcoming Event Ideas," we suggested this long approach for GT Advanced Technologies Inc. (GTAT) 12.82 before the Apple new product announcement last Tuesday.

We booked a September long 20/22 call spread (long Sep 20 call/short Sep 22 call) for .23 and a long 14/12 put spread (long Sep 14put/short Sep 12 put) at .18 for a total .41 debit.

Tuesday the stock closed -2.21 at 14.94 so the call spread went to zero while the put spread was .40. Now to make money the stock needed to decline further and by Friday it was off another -2.12 at 12.82 increasing the put spread to 1.07. We could have closed it Friday for a .66 gain in four days but decided to let it run for another week until the September options expire since the decline may not be over. However, should it close back above the Friday's high we will close it sooner.

In this example, as with many others a high IV/HV ratio before an event underestimates the subsequent move of the stock.

 

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Summary

The continuing US Dollar strength appears to be reflecting expectations for higher interest rates relative to the euro and yen and "flight to safety" as geopolitical tensions remain unresolved. While now overbought it could stabilized relieving some pressure on both bonds and equities. However, in the event both the dollar and interest rates continue higher this week it will be time to begin implementing hedging strategies.

 

Twitter Follow us on twitter for more ideas from our scanners and other developments.

 

Actionable Options™

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.

 

In next week's issue, we will again run our ranker and scanner tools in search of more trading ideas.

 

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.

Next week's 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 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.

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