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Waiting for Godot, by Samuel Beckett, voted "the most significant English language play of the 20th century", premiered on the 5th of January 1953 at the Théâtre de Babylone, in Paris France.

In the present-day popular culture even those unfamiliar with the play are aware that "waiting for Godot" means waiting for someone or something that will never arrive.

We will know on September 18, 2007 if we are "waiting for Godot" or if Ben will deliver the goods. The goods, of course, is the anticipated cut in the Federal Funds rate from 5.25% to 4.75%.

US Dollar Index

On Friday, after the employment report, the large decline in the trade weighted US Dollar Index (DX) 79.958 gave us a clear and dramatic indication that the financial markets are expecting a rate cut.

This is the lowest level for this index in 14 years. It is too soon to know if this is a brief violation of the 80 support level or a major breakdown. While the 80 level has held a good number of previous attempts, the downtrend in this index is clear. Through the mechanism of interest rate differentials the DX is reflecting the lower dollar that will result from an interest rate cut. However, some doubt remains as the Federal Reserve has clearly differentiated between the availability of credit and the cost of credit. It is clear they intend to make credit available, it is not so clear they intend to reduce the cost anytime soon. After all, cutting interest rates too soon just creates the conditions for the formation of the next bubble. At this point our bias is on the side of those who are expecting the 80 level to make a stand and hold. We have seen this level tested enough times to put us squarely in the "show me" camp. One panic day to the downside will not do it. We do however, want to review some of the available hedging alternatives in the event this breakdown is the real thing. If you have US dollar denominated investments or trading accounts you should be watching this index.

US Dollar Hedge

In IVolatility Trading Digest™ Volume 7, Issue 23, dated July 16, 2007 we first introduced PowerShares DB US Dollar Index Bearish Fund (UDN) 26.74 as an alternative to trading DX futures as a dollar hedge. This Fund seeks to track changes, whether positive or negative, in the level of the Deutsche Bank US Dollar Index (USDX) Futures Index Excess Return, plus the excess, if any, of its corresponding Master Fund's interest income over expenses. Trading since February there is still not a lot of volume, but it could be a way to hedge dollar risk for 401K and IRA accounts.

Golden Hedge

An alternative is to look for hedging opportunities in the group that often provides a mirror image of the US Dollar Index. Moving upward from 690 to 716 in two days gold futures, basis December 2007, fully reflected the drop in the dollar index. The resistance at the April 20, 2007 high of 718 gives us reason to be cautious about this move. In the gold market commercials often fade breakout attempts and this could be just one more time. On the other hand, we see some encouraging signs in the gold mining stocks. The Market Vectors Gold Miners ETF (GDX) 41.17 has a way to go to take out the July 24, 2007 high at 43.30 but some of the major gold miners are breaking out and making new 52-week highs.

Nevertheless, based upon Friday's employment report there could be a dramatic slowdown coming that would force the Federal Reserve to cut interest rates soon, if not on September 18, 2007. With this possibility in mind we are going to see if we can find and effective and low cost way to hedge the dollar risk using options.

Agnico-Eagle Mines Ltd. (AEM) 49.19. Agnico-Eagle engages in the exploration and development of gold in northwestern Quebec, Canada. The company holds interests in LaRonde Mine, and Goldex and Lapa mine projects, as well as in the Bousquet and Ellison properties located in the Abitibi region of northwestern Quebec; Kittila mine project located in northern Finland; and Pinos Altos project located in northern Mexico. Having traded under 35 on August 16, 2007 this stock has quickly turned around and made a new 52-week high.

The volatility and price chart follow:

As indicated by the orange line to the left Implied Volatility rose above 55% with the decline in August and then quickly returned to the 40% level as the stock turned higher and now trading at a 52-week high of 49.19. The current Historical Volatility is 56.

Trade Plan

DR: The dollar index is trading lower on weaker economic prospects and gold mining stocks are reflecting the dollar weakness. The usual relationship is for gold to reflect inflationary expectations not economic weakness. If the dollar declines further inflation could become a problem as the cost of imports rise. If gold and the gold mining stocks continue higher they could be used to hedge dollar weakness. Breakout attempts by the mining stocks often fail just when they are attracting the most attention. While this could be another attempt that will fail we will have a low cost position that will benefit in the event the breakout continues and it will keep us focused on the dollar index and gold. On some strikes the bid/offer spreads are wide so careful attention must be given to the order entry.

SU: Stop/Unwind should be considered for a close under 37.50. However, with this position we are less concerned as we have constructed a credit spread and we will simply let it expire in the event of a lower stock price.

Buy 2 AEM Oct 55 calls AEMJK 1.275 each = total 2.55 IV 46.59 Delta .2826 each = .5712
Sell 1 AEM Oct 50 call AEMJJ 3.10 one = total 3.10 IV 49.23 Delta = -.5114
Indicated Credit .55 Position net delta .0598.

This position is a credit spread Oct 55/50 and long one additional Oct 55 call.

Due to the bid/offer spread you may have to give up some portion of the credit to get the first spread. At the indicted mid prices the credit on the first spread would be 1.825. If you give .05 on each side for all three trades you will still have a net credit of .40. The important thing is to end up with a credit, as this is the downside cover in the event that the breakout fails, AEM retraces and the dollar index turns back up. On a theoretical basis if the stock were to continue higher and go to 53.19 or a 4-point increase in the stock price while the implied volatility remained unchanged around 45 the position would be valued at $139 or a $84 gain. On the downside at a stock price of 45.19 or a 4-point decrease the position would be valued at $32 or a decline of $23. An increase in the implied volatility would be helpful while a decrease would de detrimental. Also keep in mind the possibility of assignment when the short 50 call goes in the money requiring some additional management attention.

Slowing Economy

Harley-Davidson, Inc. (HOG) 49.09. Harley-Davidson riders, like other consumers, are curbing their spending amid the credit crisis and economic uncertainty. HOG now expects lower sales and reduced profit margins. They now expect 2007 earnings to fall between $3.69 and $3.77 per share, a good bit less than the consensus estimate of $4.12 per share. The company also reduced its third-quarter shipments estimate to a range of 86,000 to 88,000 units from 91,000 to 95,000 earlier. With a slowing economy and without the ability to refinance the house in order to make the payments on the all-chrome dual overhead cam Road King we think there is a good chance business will be slower than indicated in their announcement. If so, here is a bear put spread to consider.

Buy HOG Nov 50 put HOGWJ 3.20 IV 33.46 Delta -.5036
Sell HOG Nov 45 put HOGWI 1.35 IV 37.10 Delta .2575
Debit 1.85 Position net delta –.2461

The bid/offer spreads are wide so you may have to pay a bit more for the spread. It would still be worth considering up to a debit of 1.95 or about .10 more than indicated.

With the Historical Volatility of 39 and with the put Implied Volatility at 34 the motivation for the trade is directional and based upon the slowing economy. Even after a 5 point stock price decline on their announcement there is still a lot of room to the downside. A close back above 55 would be the signal to unwind the put spread.

Remember to adjust the price of your debit on the next day of trading to correspond to the change in price of the stock. This can be done using the position net delta shown above. A one-point decline in the stock will increase the spread by .25 and a one-point rise will reduce it by .25.

Yahoo Bargain Basement

Yahoo! Inc. (YHOO) 23.76. Yahoo provides Internet services to users and businesses worldwide. It offers online services to users with various tools and marketing solutions to businesses. Financial market participants use Yahoo to manage the immense daily data load. While there is some concern about the loss of revenue from declining mortgage advertising, in the low 20's there is a good chance the company will be taken over. In August 65, 000 shares were reported being bought by insiders, including Susan Decker, President and Head of Advertiser & Publishing Group, along with Director Arthur Kern. If insiders are willing to buy the stock at 22 1/2, we too should be willing to buy at this price. One way to buy stock is to first sell the put. If the stock goes up you keep the premium. If the stock closes down below the strike price at expiration you will be assigned the stock at the strike price and you will in effect be buying the stock at a discount.

With a Historical Volatility of 31 consider this suggestion:

Sell YHOO Oct 22 1/2 put YHQVX at .85 IV 45.69 Delta .4131.

Reader Response Request

Once again 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. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.