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Current Market Implied Volatility

For the week ending 8-3-07, Market Implied Volatilities continue higher

Index Close 7-27-07 Close 8-3-07 Change VIX - SPX Implied IVX - SPX 24.17 23.17 25.16 23.10 +0.99% -.07%   QQV - Nasdaq 100 IVX - NDX 21.36 20.96 23.24 23.32 +1.88% +2.36%

US Dollar Index

The US Dollar Index (DX) cash 80.177 rebounded from the July 24, 2007 low of 80.016 up to 81.090 on July 30, 2007 before turning down once again last Friday, leading us to conclude that the upward move was indeed a short-term oversold rally in a declining market. We now expect it to decline below the 80 level. Remember an alternative to trading futures as a dollar hedge is the PowerShares DB US Dollar Index Bearish Fund (UDN) now 26.37.

Market Breadth

The McCllelan Summation Index of the NYSE advancing and declining issues is now –525.72, a decline of 310.08 for the week. Using this indicator the market breadth is now comparable to low last June 29,2006 at –517.14. Watch the rate of decline for indications of stability. Last week the decline was 373.30, this week it was 310.08. Start looking for an inflection point when the rate of decline begins to slow.

US 10-Year Treasury Note Yield

The (TNX) yield continued to decline this week closing at 4.70 as the proceeds from stock and bond sales are being parked in the 10-Year Treasury Note.

IWM Hedging Strategy

We should be hedging existing long equity positions using bear put spreads on the iShare Russell 2000 Index (IWM) 75.38. The Historical Volatility of the IWM is 22.46 and the IV Index for the puts is 30.09. We prefer using a put spread to reduce the probability of overpaying for expensive puts and to offset time decay of the long put with time decay of a short put. For example, consider the Nov 75/70 put spread with a debit of 1.615.

Bear Protection

By now we should all be convinced that we are experiencing more than a normal correction in an uptrending market. Bear protection can be a hedging strategy as we described in the section above or it can be outright shorts and put purchases. While shorting stocks as a part of an options strategy is a standard practice it can be hazardous in the event of a takeover offer or other favorable news. A better strategy is to use an options combination that gives you a defined maximum risk level. Maintaining a few bear put spread combinations in weak sectors is a good portfolio approach. We outlined several such opportunities with the homebuilders and mortgage finance companies in IVolatility Trading Digest™ Volume 7, Issue 25, dated July 30, 2007. These put spreads are now doing very well as the market declines.

Another alternative is to use the Short Russell 2000 Proshares (RWM) 74.09. As the market goes down this ETF goes up. In addition, there are a dozen or more specific sector UltraShort ETFs that can be used as a proxy for shorting stocks or for hedging long positions.

Relative Strength

One suggestion to find opportunities is looking for stocks that are rising in a declining market. Since the summer earnings reporting season is not yet complete some companies are rising before reporting while others are rising after reporting. For example, in IVolatility Trading Digest™ Volume 7, Issue 14, dated May 14, 2007, we reviewed and suggested several casino stocks with operations in Macau, including, Las Vegas Sands (LVS) 93.76, that just reported last Wednesday after the close. The earnings number was not impressive, but the management comments were. They will be opening the Macau Venetian on August 28th as planned, all 3,000 suites, the largest hotel in Asia. In addition, they will open the Palazzo in Las Vegas on December 20th also 3,000 suites. When added to the existing Venetian it will create a hotel complex in excess of 7,000 rooms.

Macau continues to grow faster and is more profitable than Las Vegas. Some slowing was seen at the Macau Sands from the new visa restrictions, but this is now largely discounted in the news and the hype, which has already begun, over the Macau Venetian opening is in the focus. We should expect a lot more in the next month. The management of the Las Vegas Sands has earned a premium for executing the plan to open the massive Macau Venetian on time. This is being recognized as an impressive accomplishment. On the earnings report the stock is up 8.08 from 85.68 to 93.76 in a weak market environment. While we now consider LVS to be overbought we would place it in the alert category awaiting a correction.

Another company detailed in IVolatility Trading Digest™ Volume 7, Issue 14 was Melco PBL Entertainment (Macau) Ltd. (MPEL) 12.79. While this is a smaller company they have staked out the ultra high net worth players market and have completed the opening of their 216-room hotel in time to benefit from the marketing efforts of Las Vegas Sands. Further they have formed a Joint Venture Special Purpose Vehicle (SPV) to buy back up to $250 million dollars worth of stock, in the event it is needed. MPEL has yet to report second quarter results and the announced date should be coming in the next week. The potential repurchases of shares buy the Special Purpose Vehicle improves the odds of limiting the downside. Consider this call ratio backspread, a long directional position with some allowance for a short-term decline.

Trade Plan

DR: Growth potential of Macau market makes this an attractive opportunity. Should benefit from the marketing efforts of Las Vegas Sands. Downside somewhat limited by SPV formed to buy back stock. Using Oct calls gives us two reporting periods including the third quarter before Oct call expiration.

SU: A close under the last pivot at 12 would be the signal to unwind the trade.

Sell MPEL Oct 12 ½ call NBQJV 1.45 IV 52.80 Delta –.6038 (sold call = negative delta)
Buy 2 MPEL Oct 15 calls NBQJC .575 IV 53.54 Delta .6358 (.575x2=1.15; .3179x2=. 6358)
Credit .30 Position net delta . 0320.

Chinese Junket

Ctrip.com International Ltd. (CTRP) 42.90 provides travel-related services including hotel reservation, air-ticketing, packaged-tour services, as well as Internet advertising in China with a 52% market share of the travel agency business. This company seems well placed for the Macau excitement and the Beijing Olympics next summer. This stock added 5 points in the last two days largely in anticipation of the earnings report they will present Monday evening August 6, 2007. Consider this put sale.

Trade Plan

DR: Growing e-commerce company in a growing market that seems to be accelerating. Short term trade as the company reports on Monday night. Strike price is at the last pivot of 37 ½. Even if the stock declines after reporting the excess implied volatility will be gone. If assigned on the short put, take in the stock and sell calls.

SU: A close below the pivot at 37 ½ would be an indication that there is a concern. Would only consider unwinding the position below 35.

Sell CTRP Aug 37 ½ put QCTTU .55 IV 72.07 Delta .1564 (sold put results in + delta)

Girl's Best Friend

Blue Nile Inc. (NILE) 81.07. This Seattle based company operates as an online retailer of diamonds and fine jewelry offering stones at discounts of up to 40%. Their inventory is on consignment and they don’t have the high end retail fixed costs associated with traditional jewelry stores on Fifth Avenue or Rodeo Road. This is not an undiscovered stock having risen from 30 to over 80 in the last year and now selling at 73 times forward projected earnings. The option implied volatilities have risen in anticipation of their second quarter earning report to be released at 5:00 PM Monday August 6, 2007.The volatility chart follows:

With an Implied Volatility Index Mean (calls and puts) at 75.52 % and with the Historical Volatility at 49% this makes a tempting target. In the last few days call volume has exceeded put volume and the put/call ratio is .7 about neutral. However, put open interest exceeds call open interest by a good margin.

Trade Plan

DR: This is a short-term earnings report trade on a high priced growth stock. The excess premiums associated with the high-implied volatilites will vanish with the earnings report on Monday. The plan is to capture the decline in implied volatility using a straddle. Ideally a straddle should be used when there is no news expected in a quite market - and this is our risk. We will close the position Tuesday by buying back the straddle. A large move in the stock will hurt this position. The upside is somewhat limited by the overall poor market condition, so there is more downside risk in the event they don’t meet earning expectations. The breakeven price range is 67.55 to 92.45. This is a high-risk trade so manage the position size accordingly.

SU: Buy back the straddle after the earnings report Tuesday.

Sell NILE Aug 80 call JWUHP 6.70 IV 93.22 Delta –.5701 (sold call = negative delta)
Sell NILE Aug 80 put JWUTP 5.75 IV 97.57 Delta .4305 (sold put = positive delta)
Credit 12.45 Position net delta -.1396

Alternative Trade Plan

DR: The less risky alternative is to use out-of-the money options making this alternative position a strangle. This alters the breakeven price range from 63.15 to 91.85. The plan is to close the position Tuesday after the report. The IV on the Aug 70 put at 105.31 is an attraction.

Sell NILE Aug 85 call JWUHQ 4.55 IV 93.23 Delta -. 4427 (sold call = negative delta)
Sell NILE Aug 70 put JWNTN 2.30 IV 105.31 Delta. 2105 (sold put = positive delta)
Credit 6.85 Position net delta -.2322

Special Situation

EMC Corporation (EMC) 18.68. EMC Corporation headquartered in Hopkinton, Massachusetts engages in the development, delivery, and support of information infrastructure technologies and solutions worldwide. Its VMware Virtual Infrastructure subsidiary offers virtual infrastructure solutions and services used by enterprises for server consolidation and containment. EMC is planning to spin off 10% of VMware in an IPO; the road show began last Monday. The offering is scheduled for August 14, 2007. Unless you have been asleep for the past month you already know about this much-hyped offering. Since EMC has already risen from the 14 level since April the question is how much is of this story is already in the price of the stock? The other risk factor to consider is the possibility of delaying the offering due to unfavorable market conditions

Trade Plan

DR: Much hyped partial IPO of VMware is scheduled for August 14th. Blackstone, the last big hype IPO, was not well received by the market. Market conditions are a factor here and may cause the deal to be delayed, therefore give the trade sufficient time for this possibility.

SU: A close under 17 would be an indication that sentiment has changed and would be the signal to unwind the trade. First step would be the sale of the second long call converting it into a spread.

Sell EMC Oct 18 call EMCJS 1.85 IV 40.54 Delta -.6380 (sold call = negative delta)
Buy 2 EMC Oct 20 calls EMCJD .95 IV 40.39 Delta .8322 (.4166 x 2 = .8322)
Debit .05 Position net delta .1952

Bargain Basement

Compagnie Generale de Geophysique-Veritas (CGV) 51.31. CGGVeritas, headquartered in Paris, France, provides seismic data services, for the oil and gas industry. In addition they also manufacture and sell marine and land geophysical equipment primarily to other geophysical service companies. They reported last Thursday 2.11 for the second quarter and 5.53 for the first half of the year with a backlog at July 1, 2007 of $1.6 billion. If they continue at this run rate they will earn more than $10 per share and this is a $51 stock. What’s wrong with this picture? There is a good deal of information available on the Web and they have a very interesting Website. Take a look.

Having just reported the IV Index at 30.42% is actually lower than the Historical Volatility at 35.28%. While this looks like a bargain, there is always a catch. In this case it is the lack of options trading. This is a thin market so you need some order execution skills and patience for this one.

Consider this suggestion:

Trade Plan

DR: Oil service company providing seismic data. Fundamentals appear attractive with a good backlog of work.

SU: A material decline in the sector will hurt this position. Would start unwinding below 45 by selling the extra long call.

Sell CGV Jan 50 call CGVAJ 5.45 IV 29.85 Delta -. 6368 (sold call = negative delta)
Buy 2 CGV Jan 55 calls CGVAK 3.15 IV 29.68 Delta .9040 (.4520 x2 = .9040)
Indicated Debit .85. You may be able to improve on this debit by working the bid/offer spread
Position net delta .2672

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.