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Market Review

Consider these reasons to proceed with caution.

• US Dollar Index (DX) 77.03, basis cash, another all time low.
• Dow Theory divergence between the DJ Industrials and the DJ Transports.
• McClellan Summation Index at 149.86 - lower once again this week.
• Potential Head & Shoulders Tops in some major indexes.
• FOMC policy statement release due on Wednesday October 31, 2007.

Now two more positive considerations.

• The NASDAQ index is trading above the July high and unlike the DJ Industrial and S&P 500 does not appear to be forming a Head & Shoulders Top.
• The Federal Reserve could once again lower interest rates on Wednesday.

Our Amazon Trip

Last week in IVolatility Trading Digest™ Volume 7, Issue 36, we reviewed the Amazon Featured Calendar Spread, and made a forecast in anticipation of their earnings report expected on October 23, 2007. This week we return to do an interesting review and since the stock is within .24 of its starting price most all of the results can be attributed to the change in implied volatilites.

This was the original Featured Calendar Spread suggestion.

The Calendar Spread, also called a Horizontal Spread, featured on the Home Page Friday, October 19, 2007 follows:

AMZN 89.76
Buy AMZN Apr 90 call ZQNDR 14.125 IV 53.16 Delta .5973 Gamma .0116 Vega .2468
Sell AMZN Nov 90 call ZQNKR 6.475 IV 63.51 Delta -.5387 Gamma .02446 Vega .1005
Debit 7.65

Here are the results as of the close on Friday October 26, 2007:

AMZN 90
Long AMZN Apr 90 call ZQNDR 12.700 IV 47.41 Delta .5931 Gamma .0131 Vega .2425
Short AMZN Nov 90 call ZQNKR 3.175 IV 34.57 Delta -.5306 Gamma .0521 Vega .0879
Debit 9.525

And the volatility chart.

We had forecasted a decline in Implied Volatility to 40%. As we can see above the actual IV Index is less than 40%. We also forecasted that the analysts had the earnings numbers right and the stock would not gap up on the earnings report. In fact, it gapped higher before the announcement then proceeded to gap lower after the announcement closing up just .24 for the week.

Our forecast for a .94 loss in the value of the spread was based upon a decline in IV to 40%.

The actual result was a gain of 1.875 as the spread value went from 7.65 to 9.525.

Here is why:

The IV of the short Nov 90 call declined 5.43% more than forecasted to 34.57%, while the IV of the long Apr 90 declined 7.41% less than forecasted to 47.41%, while the price of the stock increased by a net .24. Our forecast did not consider the IV skew that developed after the report.

The result is a one-week return on investment of 24.51%.

Now what to do? Here are some suggestions:

1. Close the spread and book the 1.875 gain.
2. Hold the spread to the expiration of the Nov 90 call. Some price risk is involved, but time decay is now accelerating on the short Nov 90 call.
3. Upon expiration of the Nov 90 call convert the long Apr 90 call into a bull call spread by selling an Apr 100 call.
4. Just before the next earnings report convert the bull call spread into a new calendar spread by buying back the short Apr 100 call and selling a Feb 90 call against the still long Apr 90 call. If the Amazon rising quarterly IV pattern repeats itself there should be another Calendar Spread opportunity.

Moving On

LDK Solar Co. Ltd. (LDK) 37.89, is the fast growing Chinese manufacturer of multicrystalline solar wafers claiming to be the largest and lowest cost producer. It is also the subject of media battle between analysts, the established financial press and bloggers. The controversy is over the accounting treatment of raw material inventory that could put its low cost claim in jeopardy. According to Briefing.com they are scheduled to report earnings on November 1, 2007 and to provide statements about their investigation into the alleged accounting irregularities. This one requires some investigation, homework and risk assessment. Make sure to read the many available articles and understand the risk.

The current Historical Volatility is 160.83, while call IV Index is 101.77 and the put IV Index is 101.84, having declined from the 130 level over the past two weeks. The Put/Call ratio at .4 indicates buying has been favoring the calls.

Consider these alternatives:

• Sell LDK Nov 35 put LDKWG 2.425 IV 104.90 Delta .3275
• Sell LDK Nov 30 put LDKWF 1.025 IV 113.21 Delta .1612 (more expensive with less risk)

Takeovers

There are two very interesting stories in the takeover category this week.

BEA Systems Inc. (BEAS) 16.50, the largest independent supplier of “middlware” used to build Internet applications. Oracle made a 17 bid for the company, but management is holding out for 21. Carl Icahn is involved with talk about a proxy battle for control. Unless Oracle walks away, which seems unlikely, there is downside protection at 17 and a likely agreement at somewhere near 20. The current Historical Volatility is 98.77.

Consider one of these put sales:

• Sell BEAS Nov 15 put BUCWC .375 IV 61.98 Delta .2358
• Sell BEAS Nov 17 ½ put BUCWW 1.425 IV 51.86 Delta .6507

Tesoro Corporation (TSO) 64.48, the San Antonio based refiner of petroleum products is the object of a substantial investment by Kirk Kerkorian and his Tracindia Corp. who said, “Tricendia believes that the fundamentals of the petroleum refining industry make it an attractive area for investment”. What’s interesting is the timing. Currently refiner’s margins, measured by the industry standard crack spread, are being squeezed by high crude oil prices and weak product demand. One analyst at Bear Stearns, said the bid was an "ill-timed purchase," due to weakening industry fundamentals. High oil prices and low gas prices have hit refining margins in recent months, despite refiners efforts to lower production and inventory levels to support demand. Kerkorian’s motivation may be to beat the hedge funds to the punch by buying while the fundamentals appear unattractive. Whatever his current motivation his actions are likely to put a floor under the refinery stocks.

Consider this suggestion:

Western Refining Inc. (WNR) 38.15. El Paso based WNR is the fourth largest independent oil refiner operating four refineries with a capacity of 223,000 barrels per day. The current Historical Volatility is 45.59 and shows an attractive positive volatility spread with the put IV Index at 59.81.

Consider this suggestion:

• Sell WNR Nov 35 put WNRWG 1.00 IV 63.26 Delta .2581

Beating Our Own Drum Once Again

Yahoo! Inc. (YHOO) 33.63. Yahoo provides Internet services to users and businesses worldwide. It also owns 39% of Alibaba, the Chinese B2B web portal that is likely to be the next hot Hong Kong IPO when it comes public on November 6th. There will be an institutional tranche, subject to a two-year lock up period, including the AIG Global Investment Group, Industrial & Commercial Bank of China, Wharf Holdings Ltd., and other prominent investors. Now we have a better understanding of the Yahoo insider buying that was reported in August.

In case you missed it, Yahoo has been dutifully marching higher since our suggestion in IVolatility Trading Digest™ Volume 7, Issue 30, dated September 10, 2007, when we noted the insider buying and when the stock was trading at 23.76. The suggested sale of the Oct 22 ½ put at .85 was never in doubt as the stock closed at 29.03 on the October options expiration.

Yahoo reported, as expected, earnings of .11 on October 16, 2007, which were flat, compared to the recent previous periods. Earnings growth is not the current driving force behind the higher stock price. The most likely causes are a change in market sentiment for e-commerce in general and its equity stake in Alibaba.

With a current Historical Volatility of 39.34 and an IV Index for the calls at 48.79 and the puts at 47.69 the bias is definitively on the call side with 5 times as many calls traded as puts making the Put/Call ratio below the .2 level. For the last 6 weeks the call buyers have been on the right side of this market, and chances are they will continue to be right awhile longer.

DR: Market momentum returns to e-commerce and Yahoo has a large stake in Alibaba.

SU: A close back below 30 would change this picture requiring a reassessment and unwinding.

Consider one of these suggestions:

• Sell YHOO Nov 32 ½ put YHQWZ 1.055 IV 49.14 Delta .3580

Or this longer term bull call spread,

• Buy YHOO Jan 32 ½ call YHQAZ 3.60 IV 44.05 Delta .6262
• Sell YHOO Jan 37 ½ call YHQAU 1.66 IV 45.35 Delta -.3688
  Debit 1.94 Position net delta .2574

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