IVolatility Trading Digest™ Blog

Monday October 08, 2007

Volume 7, Issue 34
More Suggestions

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).

In this issue we are going to offer more than the usual number of trading suggestions with less detail. Most have positive volatility spreads, meaning IVs are higher than the Historical Volatility and likely to decline. They are suggestions for your research as to the fundamentals and to understand the level of risk you would be assuming. With the immense amount of data generated buy the options markets we use Rankers and Scanners to help us find price, volume, time and volatility relationships. They help select option suggestions based upon determined criterion and often the criteria are set for the difference in the relationship between Implied Volatility and Historical Volatility. The Rankers and Scanners do not know why the volatilites are different. It is your job as the user to determine why the volatility numbers differ and understand the level of risk you are assuming. You must do the fundamental research and know what to expect in the event that the stock does not respond as originally planned. For example, with covered calls the stock could go down more than you are protected by the short calls. In the case of short puts you should be prepared to buy 100 shares of stock for each put sold.

Market Review

From the perspective of our market indicators this week can be summarized as more of the same, all of which were supportive for equities. Market implied volatilites continue to decline, interest rates are mostly unchanged, the dollar rebounded slightly and the McClellan Summation Index continued higher at a slightly increased rate.

Strategy

Our strategy also remains unchanged. Long China, Rest of World (RoW) and the sectors that benefit from expanding export trade and short domestic spending sectors, such as housing and housing dependent consumer spending. Earnings reports start this week so implied volatilites of many reporting companies will be rising until their respective report dates.

Credit Spreads

We begin by responding to requests for credit spread suggestions. Good credit spreads that have favorable IV relationships are not very frequent and are harder to find. In general, the objective is to retain the net credit when both sides expire worthless. For stocks in uptrends consider using put credit spreads, and for stocks in downtrends use call credit spreads. Here are two examples.

Ryland Group Inc (RYL) 25.29. With a current Historical Volatility of 66.16, Ryland is one of the homebuilders currently in the bearish category.

Sell RYL Oct 25 call RYLJE 1.125 IV 54.56 Delta -.5580
Buy RYL Oct 27 ½ call RYLJY .275 IV 48.87 Delta .2054
Credit .95 Position net delta -.3526.

SLM Corporation (SLM) 49.50. With a current Historical Volatility of 32.76, SLM is also in the bearish group as the result of buy-out financing difficulties.

Sell SLM Oct 50 call SLMJJ 1.550 IV 43.30 Delta -.4815
Buy SLM Oct 55 call SLMJK .125 IV 35.34 Delta .0800
Credit 1.425 Position net delta -.4015.

Positive Volatility Spreads

SulphCo® (SUF) 8.78, has developed a patented safe and economic process employing ultrasound technology to desulfurize and hydrogenate crude oil and other oil related products. The Company's technology is designed to upgrade sour heavy crude oils into sweeter, lighter crude oils, producing more gallons of usable oil per barrel. With a current Historical Volatility of 79.30 consider one of these opportunities. .

Sell Nov 7 ½ put SUFWU .925 IV 135.73 Delta .2802
Or
Buy 100 shares of stock at 8.78
Sell SUF Nov 10 call SUFKB 1.125 IV 129.16 Delta .4769
Debit 7.655 Position net delta .5231
Or
Buy SUF Dec 7 ½ call SUFLU 2.625 IV 126.92 Delta .7194
Sell SUF Dec 12 ½ call SUFLV .95 IV 121.36 Delta -.3710
Debit 1.675 Position net delta .3484

LDK Solar Co. Ltd. (LDK) 50.95, is one of the hot Chinese solar wafer makers in the news with an inventory accounting investigation underway. The current Historical Volatility at 109.99 is likely to be declining.

Here are three ideas and three risk levels.

Sell LDK Oct 45 put LDKVI 3.05 IV 143.88 Delta .2815 (Expensive, risky)
Or
Sell LDK Oct 40 put LDKVH 1.70 IV 152.61 Delta .1725 (More expensive, reasonably safe)
Or
Sell LDK Oct 35 put LDKVG .95 IV 167.47 Delta .0999 (Most expensive, safer)

An alternative long term bullish position:

Buy LDK Dec 55 call LDKLK 8.40 IV 104.24 Delta .5420
Sell LDK Dec 60 call LDKLL 6.65 IV 102.46 Delta -.4663
Debit 1.75 Position net delta .0757 (Maximum gain of 3.25 – good risk/ reward)

More Put Sale Suggestions

Symbol	Company	Price	Option	Month	Strike	Put Price	IV	Detla
CHL	China Mobile	84.96	CHLWN	Nov	70	1.400	60.04	0.1421
SYNA	Synaptics	45.89	QYGWH	Nov	40	1.425	63.39	0.2221
FARO	Faro Tech	45.15	QEJWH	Nov	40	1.125	57.27	0.2020
MOS	Mosaic	52.40	MOSWI	Nov	45	1.400	62.69	0.2001
OMTR	Omniture	34.52	MOQWF	Nov	30	1.675	80.64	0.2530
OSTK	Overstock.com	32.29	OKTWE	Nov	25	0.800	83.83	0.1460
WNR	Western Refin	40.49	WNRWG	Nov	35	1.025	59.69	0.2002
MEDX	Medarex	14.94	MWMWV	Nov	12 1/2	0.825	97.23	0.2366

When a put with negative delta is sold the result is positive delta as shown above. Usually stocks that are attractive for a put sale also make good covered call candidates. For those with restricted accounts that do not allow put sales consider the stocks above for covered calls.

Takeover Update

The lower dollar is attracting Canadian, Australian and European companies with growth expansion plans. Here are two from previous issues.

A.K. Steel Holding Corp. (AKS) 42.98. The company sells flat-rolled carbon steel products primarily to automotive manufacturers and customers in the appliance, industrial machinery and equipment, and construction markets. After the August sell off the stock recovered quickly and is now above its July high. With talk of price increases the earning estimate for the coming quarter may be too low. The current Historic Volatility is 44.15. Consider this put sale.

Sell AKS Nov 37 ½ put AKSWU 1.275 IV 61.47 Delta .2204

Alcoa Inc. (AA) 38.79. Alcoa is scheduled to report third quarter earnings on Tuesday. Interestingly last Thursday they announced plans to sell the packaging and auto-related businesses and that they would take a $845 million charge in the third quarter for the restructuring. These are the business operations that BHP did not want included last July when the companies we talking about a takeover. This would appear to confirm that the two companies are still in talks and that AA is preparing itself to be more attractive to BHP, or perhaps another acquirer. While we noted last July that this process could take a long time, it does seem to be continuing. With a Historical Volatility of 34.76 consider this put sale if the IV remains in the 40 range after they report on Tuesday.

Sell AA Nov 35 put .675 IV 40.67 Delta .2077

For the longer term consider that when the takeover talks resume the options implied volatility will start rising. This would be the time to have a call ratio backspread.

Here is one possible opportunity.

Sell AA Jan 35 call AAAG 5.50 IV 37.95 Delta -.7449
Buy 2 AA Jan 40 calls AAAH 2.75 each =5.50 IV 37.25 Delta .5004 each=1.008
Credit 0 Position net delta .2559

This is a 0 (or near 0) cash cost position with appreciation potential as the takeover talks resume. The invested capital is just the margin requirement for one of the credit spreads, as the extra long call is paid for cash. With a move back to the previous $50 price level and with a return to the 60 IV level this position should produce a nice return on investment.

Required Research

All of the suggestions we offer require you to do additional research. Check the fundamentals and read the news stories, which are available on the Internet. Go to the company Website and read about the company, their products and services. Then by looking at a price chart locate support and resistance areas, gaps and other technical patterns. Finally look the volatility charts of the Implied and Historical Volatility. IVolatility.com offers several levels of service to assist in this process. My Favorites and Basic Options offer a lot of good information and are available without subscription. This is the best source of basic information available anywhere. Advanced Options and Advanced Historical Volatility provide you will all the data needed for serious options trading, including open interest, put/call ratios and more. The volatility charts in Advanced Historical Volatility are the best in the business.

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.

Comments:

I'm new to IVolatilty and have been trading options for about 8mo now. Iam pretty excited about what is offered. This blog is excellent!!. I'm doing all I can to learn how to use IV to my benefit. I do have a question about the AA Call Ratio Backspread. Given you sold the Jan 35 and say the price does rise to $50, your risk of assignment increases. As an alternative, would a calendar spread (selling front-month option against longer term long) reduce this risk. I know you will get killed by higher IV when rolling the short side each month, but at some point, you will have sold the short side somewhere near the IV peak and would benefit from IV reduction. In the meantime, your long side will have gained tremendously. After reading several months of the Blogs, I notice very few Calendar Spreads and more Ratio Backspreads and wondering why? Thanks much and glad to be here, Jeddah62

Posted by Jeddah62 on October 08, 2007 at 12:00 AM EDT

Jeddah62, Thanks for the comment. It appears that you are dong a good job of understanding some of the complexities and risks. You are right about the assignment risk using the backspread once it goes in the money. You would need a plan to manage this risk. The longer-term option has less risk than the near term option, but it is possible. The calendar spread would be an alternative but as we know they have problems when there is a large move in the underlying. For AA this is exactly what we are planning, a large move in the underlying. We do not know when, but that they have been working on it since July. It could come at anytime. For the backspread our investment is the margin on one credit spread and it is designed for the large move in the underlying with increased IV. Jacktrader

Posted by Jacktrader (130.13.240.205) on October 08, 2007 at 01:27 PM EDT

Thanks Jacktrader, much appreciated.

Posted by jeddah62 on October 08, 2007 at 04:24 PM EDT

What is the best way to determine if an individual option is fairly priced or over/under priced using the services on this site? thanks, Jeddah

Posted by 65.28.66.247 on October 08, 2007 at 10:43 PM EDT

Jeddah, Thanks again for the question. There is no absolute answer as there are many variables to consider. As a suggestion start with Advanced Options and Advanced Historical Data. Jacktrader

Posted by Jacktrader (130.13.243.73) on October 09, 2007 at 01:09 AM EDT

I'm not sure if this question is fair game for this blog ... if not, I apologize. I've been thinking about trying to use the VIX to hedge my long equity positions. Now that the VIX is dropping, I figured it might be a good opportunity to try this out. I think how it traditionally suppose to work is you buy a call and if there's a downdraft in equities, the volatility usually shoots up. However, it appears that calls and puts are expensive on the VIX right now, so what I think I'm learning here on this blog is that I should be looking at selling a put instead of buying a call. Is this reasonable logic so far? If so, what strike prices and expirations tradeoffs should I be aware of? I was thinking one month out and a put slightly out of the money would be a nice conservative option to try. Does that sound reasonable? Thank you very much, Dave

Posted by Dave on October 09, 2007 at 10:46 AM EDT

I'm not entirely sure this question is appropriate for this blog ... if not I apologize and please disregard. For a bit now, I've been interested in trying a hedging strategy where one buys a call on the VIX to hedge against long equity positions. I believe the logic here is that when a equity downdraft comes it is usually accompanied by a surge in volatility, but if equities continue higher then the volatility hedge might lose less than a pure put on an index etf. I've watched the VIX come down in value and was thinking it might be a fine time to play a conservative hand at this. From what I've been learning on this blog, it seems that the VIX puts and calls are expensive right now. So, perhaps I should consider selling a put instead of buying a call. Is this sound reasoning so far? Past that though I'm kinda wondering what I should consider for expiration and strike. I was thinking a Nov. slightly out of the money would be conservative way to try it out. Does anyone have any input on this idea?

Posted by Dave on October 09, 2007 at 09:48 PM EDT

Dave, This is a very good topical question. Since I do not have personal experience trading VIX options you are right to wonder if this is the proper venue. It is on the to do list and I hope to be able to give it the consideration it deserves in the near future. I can offer some cautionary observations. First the trading is not based upon an underlying asset. Second the disparity in the IV between the at-the-money calls and puts indicates the lack conversion and reverse conversion arbitrage. At this point I think the answer is probably in call spreads, but is yet to be determined. Perhaps your question will encourage our subscribes to participate in the discussion right here. Jacktrader

Posted by Jacktrader (130.13.243.126) on October 09, 2007 at 11:44 PM EDT

Dave, Since this is basically the same as your earlier question I please refer to my previous response. I would caution against selling a put on something that has no underlying to deliver. Perhaps we can get some others to express their opinions. Jacktrader

Posted by Jacktrader (130.13.243.126) on October 09, 2007 at 11:56 PM EDT

I love your newsletter. It is one of the easiest to read and most informative of all of the newsletters out there. You really do your homework. I typically receive "tons” of emails with free newsletter promotions that I just trash, but you are the real deal. I read it top to bottom. Thanks so much. tom

Posted by tom dineen on October 10, 2007 at 11:45 AM EDT

I have a question regarding Historical IV and IV Index and stock price. I am looking at GR in Advanced Historical Data and I see that price has moved up very steady but I see 30DHV has declined to ~18% whereas the IVIndex has increased to near 29%. 1) Does IVIndex tend to move to HistIV or vice-versa? 2) Would I be able to get you expert interpretation of what you think is happening between Price,HistIV and IVIndex. By no means what you say will cause me to run out and buy/sell, I am doing this as a learning exercise so I can better spot trading opportunities using the Advanced Historical Data Service. Thanks much! Brian

Posted by Jeddah62 on October 10, 2007 at 06:56 PM EDT

Tom, Thanks for your kind and encouraging words. Please let us know if you have any requests or suggestions. Jacktrader

Posted by Jacktrader (130.13.241.10) on October 10, 2007 at 09:59 PM EDT

Brain, Thanks for you question. Let me start by saying you are on the right track. With GR or any other stock I would first want to see the long-term volatility trend. At Advanced Historical Volatility select All Data and look at the long-term trend. You can clearly see from 2/03 there is a defined downtrend in both volatility measures. As companies become larger the volatility declines. Sometime you can associate periods of changing volatility with management changes or acquisition activity. Now do the same with the 2-year chart and you will see the recent rise in volatility around August of this year was a reversal of a long downtrend. This is even better defined by looking at the 1-year chart. Now check the news stories in this time frame and look for unusual earnings reports, pending lawsuits, or government contract awards to see if the rise in volatility can be associated with a specific event or series of events. In this case it does not appear to be specific event related, but is does seem to be associated with the general market decline at this time. Now compare the HV at 15 to the IV Calls 28.26 and IV puts 30.22. The skew here is a clue that put buyers are willing to pay more for the puts. This would be logical as this is a large institutional name and put buying would be the method of protecting long stock holdings in hedge funds, for example. Now select 3 months and look at the Options Volume and Open Interest and the Put/call ratio charts. You will see that put open interest exceeds call open interest. This would seem to confirm the hedging assumption. Now at the Put/call ratio chart you will see wide swings from .3 (very bullish) to 5 (very bearish). Again this would support our hypothetical assumption about large occasional put buying for portfolio protection. When the risk has passed the puts are sold and the ratio declines back toward the lower numbers. Now for to be more specific and address your question. Look at the chart and you will see several instances when HV crossed above IV or below IV and then seemed to drag the IV in the same direction. The current period is a good example. With HV at 15 and IV at 28-30 the likely course for IV is to follow HV lower. You have a positive volatility spread, so option selling is the preferred strategy with edge. Sell some puts or do a covered right. This is my reading of the GR volatility charts at Advanced Historical Volatility. Jacktrader

Posted by Jacktrader (130.13.241.10) on October 10, 2007 at 11:03 PM EDT

Jacktrader, Is there more of a chance that a stock will go up if the large spread between the IV & HV is in the UPPER percentile (eg. above 50% or so) as opposed to the lower percentile (around 20%)? Thx, Bob

Posted by Bob on October 12, 2007 at 08:19 PM EDT

Bob, Thanks for the excellent question. I don’t have a quantitatively definitive answer, as I have not done the statistical work. It does stand to reason the move will be larger, in either direction when the volatility measures are in the upper percentile range, but this is not a direction determinant. For the direction we need to look elsewhere. As a practical matter we can suggest some guidelines for consideration. When looking to sell volatility consider IVs in excess of 40%. When looking to buy volatility consider IVs in the 15-20% range. However, both of the guidelines can be altered based upon the relationship between IV and HV. Jacktrader

Posted by Jacktrader (130.13.241.59) on October 13, 2007 at 01:41 AM EDT

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IVolatility Trading Digest^TM 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".

IVOLopps^TM
In this section which we call IVOLopps^TM (IVolatility Opportunities) we will focus on recommendations that should be made now, or Action Now! For many event driven opportunities volatility will be abnormal for very short periods of time so action is recommended without delay. Our assumption is the trade will be made the next day.

IVOLalerts^TM
Our next section we call IVOLalerts^TM (IVolatility Alerts). These recommendations require some additional time before being made. Often we will be waiting for confirming fundamental or technical developments before making these trades.