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IVolatility Trading Digest™ Blog
Monday June 17, 2013
Volume 13, Issue 24
June Swoon - IVolatility Trading Digest
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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The title and image for this week's Digest summarizes our view on the current market from optimistically constructive to definitely cautious in one week. While swoon actually means to faint, any further decline in the equity market this week will probably lead to something more dramatic than just fainting. We make our case below and conclude by suggesting using any market strength early in the week to hedge market risk.
We then follow with another VIX hedge idea and another suggestion from our friends at Market Taker for an interesting contrarian approach to the oil & gas sector using Linn Energy, LLC (LINE).
S&P 500 Index (SPX) 1626.73. Last week in Digest Issue 23, we noted the reversal up from support at 1600 was usual without any stuttering and stammering around the support area making the reversal seem too easy making us wonder if we should prepare for another retest. Well that is exactly what transpired last week, a second retest, once again down to the upward sloping trendline (USTL) that begins from the November 16, 2012 low at 1343.35 making it the fourth successful test of this uptrend. See Digest Issue 23 for the chart.
However, instead of improving market internals there was more deterioration as the market breadth continued declining, the VIX futures premium declined as the term structure flattened. In addition, the equity only put-call ratio increased and SPX now looks like it is about to make a symmetrical triangle continuation pattern down with a measuring objective at 1565, leading us to wonder if "Sell in May" has only been deferred to a "June Swoon."
We were planning to offer more long trading ideas in this Digest, but the circumstances have changed. As J.M, Keynes famously said long ago when being grilled on why he changed his option,
"When the facts change, I change my mind. What do you do sir?"
NYSE McClellan Summation Index 202.12. We begin by observing the continuing decline in market breadth, down every day last week, losing 313.34 points. If more issues are declining than advancing it is hard to conclude the market is healthy. Last week completed the second weekly decline without one up day. If more issues continue declining than those advancing it is only a matter of time before the SPX breaks down below the upward sloping trendline, which also activates the symmetrical triangle continuation pattern down.
CBOE Volatility Index® (VIX) 17.14.
Instead of a quick up spike and retracement the VIX seems to be seeking a new higher range between 15 and 18 compared to the 12 -13 range when the market was trending higher.
Looking at the relatively flat VIX futures term structure, we see the volume weighted VIX Futures Premium closed the week at 4.42% with the 5-day average of 2.66% including Wednesday when it was negative 1.07%. The lower the premium the more the futures have been bid up toward the cash VIX by those using futures to hedge market declines. Friday's volume was 233K contacts compared to 196K contracts the week ending June 7 and 181K contracts on May 17 just before the key reversal that set off the current decline. Since the July futures contract replaces June expiring Wednesday, here is a look at the July chart.
The orange horizontal lines show the at-the-money July 18 call and the out-of-the money July put for the hedge trade suggestion below.
Despite having tested the SPX upward sloping trendline 4 times the since starting from the November 16, 2012 low at 1343.35, unless market breadth improves and the VIX term structure widens as hedging is withdrawn we think it is just a matter of time before the important upward sloping trendline is broken.
However, we also are aware that SPX does not usually begin a major correction without attempting to retest the old high, so the current weakness could become part of a larger forming top pattern. Regardless we suggest implementing the VIX options hedge on a close below the upward sloping trendline, now at 1612.
CBOE Volatility Index - VIX July Futures (VIN3) 18.30.
Referring to the chart above, we suggest implementing this hedge on a close below the SPX upward sloping trendline now at 1612.
Using the July 18 call with 30 days to expiration, now ATM with the greatest gamma and the July 16 put right on the support line shown in the chart above consider this hedge idea.
Note the different strike prices and the unusually low implied volatility for the puts due to considerable put selling. Friday the volume for the July 16 put was 27,640 contracts with an open interest of 179,852 compared to the July 18 call with 13,952 contracts and 110,483 contracts open interest. For those unable to sell the put just use the long call. Once implemented we suggest using a close back below 16.50 as the SU (stop/unwind) on any market rebound.
Our friends at Market Taker offer this interesting Put Credit Spread as a contrarian idea.
Linn Energy, LLC (LINE) 31.07
The trade: Sell the July 28/30 Put Credit Spread (selling the July 30 put and buying the July 28 put) for .50 or better.
The strategy: The maximum potential profit for this trade is .50 if LINE is trading above 30 at July expiration. The maximum loss is 1.50 (2 – .50) if LINE is trading below 28 at July expiration. Breakeven is 29.50 at expiration based on a credit of .50.
The rationale: Linn Energy is an independent oil and natural gas company. The company has struggled over the last year posting a return on equity of -15%. However, Linn Energy has been consistently growing their dividend yield, which currently stands around 9.4%. Natural gas producers in particular have not fared well recently but according to some analysts that could be improving.
Since the beginning of May, the stock has fallen from just above 38 to where it is currently trading. On Friday, the stock opened traded lower and buyers brought the stock back considerably from the low. This could be a bullish sign that the decline may have ended. Looking at a two-year chart of the stock, every time the stock has ventured lower, buyers have moved the stock higher again especially when it drops below 32. The IV of the options has increased too because of the decline. The current IV is around 36% compared to the HV, which is about 29%. A nice skew makes selling a put spread a little more attractive. Consider exiting the position if LINE closes below 30 anytime before July expiration where it hasn’t traded in over two years.
Note: The Friday options volume was 42,509 contracts compared to the 5-day average of 13,560 contracts.
The suggestions above use the Friday closing middle price between the bid and ask. Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.
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Last week, after retesting the uptrend, the market internals continued deteriorating along with increased VIX futures activity and a potential negative symmetrical triangle continuation pattern, leading to the ominous conclusion that "Sell in May" is about to become a "June Swoon."
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In next week's issue, we will update all our market indicators and check on the progress of the trendline.
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".