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Current Market Implied Volatility

For the week ending 7-27-07, Market Implied Volatilities are considerable higher as expected - and appear to be heading even higher.

Index Close 7-20-07 Close 7-27-07 Change VIX - SPX Implied IVX - SPX 16.95 15.71 24.17 23.17 +7.22% +7.46%   QQV - Nasdaq 100 IVX - NDX 16.27 16.46 21.36 20.96 +5.09% +4.50%

US Dollar Index

Last week we wrote that the large capitalization stocks making up the Dow Jones Industrial Index (DJI) 13,265.47 and the S&P 500 Index (SPX) 1458.95 were beneficiaries of a lower dollar as measured by the US Dollar Index (DX) 80.946. Last week having closed at 80.288 it was testing the December low at 80.390 and we raised the possibility that the index may attempt to rally from this low. The DX recorded substantial gains on Wednesday, Thursday and Friday closing out the week at 80.946. In general, stronger currencies are concurrent with stronger economies and the likelihood of higher interest rates. This now creates a divergence, as the current selling of equities seems to be signaling a weaker economy. Is the DX rally just a technical bounce off the 80 support level and can we expect it to turn back down again? Stay focused on the US Dollar Index.

Market Breadth

If we ever had an early warning of the dramatic decline in equities it has been flashing for the past two weeks. The NYSE McCllelan Summation Index was turning lower as the DJI was attempting to breakout to new highs. In the most recent week the might of this divergence became apparent, as there were 2.6 times as many declining as advancing issues. Our indicator registered a 373-point decline and is now at –215.64. For reference this indicator was –500 last summer when the current leg of the bull market started and this would seem to suggest more declines to come.

US 10-Year Treasury Note Yield

The (TNX) yield again declined to close the week at 4.79 with the liquidation of equities now joining with the liquidation of riskier fixed income instruments and pushing down the yield as the 10-Year Treasury Note prices rose from the additional buying.

IWM Hedging Strategy

This is what we said about the IWM Hedging Strategy last week. Keep your IWM hedging trade plans handy they may still be needed. Expect the DJI to retest the 13,700-breakout level. The SPX and IWM have already pulled back below their respective breakout levels.

Our weekly format precludes us from sounding the alarm during the week. For those who were watching the developments of the DJI as it returned to retest and hold the 13,700 break-out level on Wednesday realized the jig was up as it screamed lower on Thursday closing down 311.50 at 13,473.57. This then was the last of the red lights to begin flashing.

In IVolatility Trading Digest™ Volume 7, Issue 23, dated July 16, 2007 we noted in Stan Weinstein’s words that "The Tape Tells All", but we failed to warn that there is also the possibility of a fakeout breakout. The DJI has just given us a classical fakeout breakout. Now is the time to hedge long positions and take the other side of the market. Keep in mind, in recent years corrections have been swift so remain flexible. Look for hedged long strategies with small positive delta in the strongest groups and look for opportunities to press on the weaker groups as they decline using put spreads and other negative delta combinations.

Noteworthy Update

In IVolatility Trading Digest™ Volume 7, Issue 23, dated July 16, 2007 we suggested bull call spread trade plan for Tellabs Inc. (TLAB) now 11.89.

On Monday July 23, 2007 news of a takeover was being circulated and it follows: TheStreet.com said Nokia Siemens Networks (NSN.UL: Quote, Profile, Research) was offering about $16 to $17 a share for Tellabs, citing a source familiar with the deal. That would be a 35 percent to 43 percent premium to Tellabs' closing price on Friday of $11.85 -- a price that many analysts said looked too steep.

Credit Suisse also called the reported price "expensive," but it said a deal would represent a "strategically and financially sound" move for Nokia Siemens by strengthening the company's position in North America and bolstering its portfolio of wireline gear.

The TLAB volatility chart follows:

The high IV would seem to confirm that options traders are expecting something to develop from this news. If the higher IV was only earnings report related it would have now declined back toward the 40% range.

The put/call ratio chart for the last 30 days follows:

The put-to-call ratio is computed as the total number of puts traded each day divided by the total numbers of calls. It is one of the best measures of market sentiment and it helps to determine whether option buyers are predominantly bullish or bearish and whether that relative bias is intensifying or diminishing. A rising ratio suggests a bearish bias while a falling ratio indicates a bullish bias. A high put-to-call ratio signals a market bottom and low number signals a top. If the ratio falls lower than 0.3, this implies euphoria, or as in this case, takeover speculation.

It seems very likely that Nokia Siemens Networks could see the current weakness in the equity markets as an opportunity to proceed with their offer in the hope of completing the deal at a somewhat lower price.

Take a look at adding these put sales to the previously suggested bull call spread.

Sell TLAB Aug 12½ put TEQTV 1.075 IV 63.08 Delta .5923 (sold put = positive delta).

Getting More Shorts

A well-structured portfolio should always have a short position or two in the event of a market decline. Having already done some of the work on the homebuilders we are ready to increase the shorts.

In IVolatility Trading Digest™ Volume 7, Issue 21, dated July 2, 2007 we suggested an Oct40/Oct 35 put spread with a debit of 1.90 and a position net delta of -.2263. The spread is now priced at 4.10 with a net delta of –. 2089, as the stock has declined from 39.37 to 31.28.

This is what we said at that time:

If you are thinking that the move is over consider what Jesse Livermore said in Reminiscences of a Stock Operator by Edwin Lefèvre in 1923. "Remember that stocks are never too high for you to begin buying or too low to begin selling." p.89.

Here is what Fitch, one of the debt rating agencies said:

In a report Thursday, Fitch Ratings said the housing downturn has worsened since the subprime meltdown. "Following a disappointing spring, the housing contraction, at present, continues to be as intense, if not more severe, than in pre-spring," the ratings firm said. "Recently, interest rates have risen noticeably, including mortgage rates. The tightening of standards and more expensive mortgages are incrementally affecting demand," Fitch added. "For the moment, issues of affordability, excess supply and poor buyer psychology still dominate."

The momentum is underway and it appears there is more to go. Our risk is they rally before returning to the downside again. In the current market environment this risk is somewhat mitigated. A put spread is just right in this situation.

Here are some suggestions:

KB Home (KBH) 31.28. Historical Volatility 29.40

Buy KBH Oct 30 put KBHVF 2.35 IV 51.05 Delta -.3831
Sell KBH Oct 25 put KBHVE .925 IV 58.49 Delta .1720 (sold put = positive delta)
Debit 1.425 Position net delta -.2111

Centex Corporation (CTX) 38.54. Historical Volatility 33.58

Buy CTX Oct 40 put CTXVH 3.90 IV 44.30 Delta -.5155
Sell CTX Oct 35 put CTXVG 1.75 IV 47.60 Delta .2829 (sold put = positive delta)
Debit 2.15 Position net delta -.2326

Ryland Group Inc. (RYL) 33.85. Historical Volatility 32.59

Buy RYL Oct 35 put RYLVG 3.80 IV 50.92 Delta -.4951
Sell RYL Oct 30 put RYLVF 1.575 IV 52.80 Delta .2627 (sold put = positive delta)
Debit 2.225 Position net delta -.2314

Standard Pacific Corp. (SPF) 15.00. Historical Volatility 32.59

Buy SPF Dec 15 put SPFXC 2.275 IV 63.35 Delta -.4111
Sell SPF Dec 10 put SPFXB .625 IV 76.61 Delta .1348 (sold put = positive delta)
Debit 1.65 Position net delta -.1348

Washington Mutual Inc. (WM) 38.65. Historical Volatility 23.39

Buy WM Oct 40 put WMVH 2.275 IV 30.08 Delta –54.82
Sell WM Oct 35 put WMVG 1.025 IV 36.26 Delta .2375 (sold put = positive delta)
Debit 1.75 Position net delta -.3107

FANNIE MAE (FNM) 59.39 Historical Volatility 23.90

Buy FNM Dec 60 put FNMXL 4.90 IV 32.70 Delta -.4657
Sell FNM Dec 55 put FNMXK 2.90 IV 34.84 Delta .3089 (sold put = positive delta)
Debit 2.00 Position net delta –.1568.

Oil Service Hedge

Finally in the event it’s needed here is an oil service hedge suggestion we found running the Spread Scanner. The oil service sector looks overbought and with a weak market there is a chance the selling could spread to this sector.

PHLX OIL SERVICE SECTOR INDEX (OSX) 271.28. Historical Volatility 23.39

Buy OSX Dec 270 put OFJXN 18.85 IV 32.52 Delta -.5870
Sell OSX Aug 240 put OSJTH 1.20 IV 40.98 Delta .0926 (sold put = positive delta)
Debit 17.65 Position net delta -.4944

Reader Response

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 futures issues. If you have questions or comments just let us know. If you have some trading ideas that you would like to share with us just use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.