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Ben Again

Once again all eyes and ears are directed toward Ben Bernanke and the Federal Open Market Committee and its announcement on interest rates expected in the afternoon, on Tuesday December 11, 2007. Many market participants think a 25 basis point reduction will cause disappointment and a market decline. The market wants a 50 basis point reduction and may have already discounted this amount into the current market prices.

Market Review

In the past week, the volatility indexes declined rapidly with the rising market. Now we should expect a pause until after the Fed announcement. The long end of Treasury yields rose along with the Dollar Index (DX) perhaps anticipating more Fed easing and greater inflationary exceptions. With banking capital ratios now declining as they write off mortgages loans, it seems that the Fed would welcome, and is perhaps even encouraging, higher long term rates in an effort to build some slope into the yield curve. The NYSE McClellan Summation Index, our market breadth indicator continues higher again this week with a reading of –439.91, an improvement of 204.88 points.

Strategy

Caution is the operative term for this week and hedging is a prudent strategy. We can see put/call ratios rising in the major indexes as portfolio managers hedge long stock positions. Look for opportunities to hedge long stock positions, especially the ones in weaker sectors, such as retail, or perhaps technology. Consider some bear put spreads for hedging long stock.

Suggestions

In IVolatility Trading Digest™ Volume 7, Issue 41, Bearskin Jobbers, dated November 26, 2007 we suggested iShare Russell 2000 Index ETF (IWM) at 75.06. We said, “ The markets appear oversold and are likely to bounce in the near term. In the case of the IWM the bounce could carry it back toward the 78 level and may last a week or more. With a Historical Volatility of 26.94 consider this short-term trade.” The suggested put sale was the Dec 74 IOWXV then priced at 1.9375 with an implied volatility of 32.88.

iShare Russell 2000 Index ETF (IWM) 78.36, has reached the target price objective and the put, is now priced at .34 while the implied volatility has declined from 32.88 to 28.29. Consider closing this position and booking the gain of 1.595 for a 13% return on investment in 2 weeks.

Now that the implied volatility has declined just before the Fed announcement, an event of considerable uncertainty, perhaps we should look at buying a straddle.

DR: Uncertain market before the Fed announcement. Hedgers buying puts have driven the put/call ratio to a bearish 2.9. This is a short-term trade with 12 days to expiration. A market disappointment would cause implied volatility to rise once again. The current Historical Volatility is 29.30.

SU: This is a short-term event trade that will be unwound within the week.

• Buy IWM Dec 78 call IOWLZ 1.895 IV 25.59 Delta .5623
• Buy IWM Dec 78 put IOWXZ 1.370 IV 25.50 Delta -.4418
  Debit 3.265 Position net delta .1205

The position is not quite, but close to delta neutral. IWM will have to move beyond the range of 75 to 81 in order for the position to make money.

High Implied Volatility Event

The previous section was an example of a volatility trade where the implied volatility had declined before the event, in this example we are going to offer some ideas for high-implied volatility before the event.

Last week’s In IVolatility Trading Digest™ Volume 7, Issue 42, Dim Green Light, dated December 3, 2007 we introduced Medarex Inc. (MEDX) now 13.37, the biopharmaceutical company working to commercialize human antibody-based therapeutic products to treat cancer, inflammation, autoimmune disorders, and infectious diseases.

We suggested considering the sale the MEDX Dec 12 ½ put MWMXV at 1.35 with an IV of 119.14 and a delta of .4172. The put is now at 1.075 from the sock price rise while the implied volatility has risen to 141.96. The Historical Volatility is 58.30 with a bullish put/call ratio of a .3. Here is the adjustment suggestion:

DR: This is a quality biopharmaceutical company with a good number of projects, not a one-product company that would likely collapse if the one product has problems. We would be comfortable holding the stock and selling calls, as they would likely continue being expensive as the company makes future product development announcements.

SU: A close below 11 would be the signal to reevaluate and perhaps unwind.

• Buy 100 MEDX shares of stock 13.37 Delta 1.000
• Sell MEDX Dec 15 call MWMLC 1.00 IV 147.24 Delta -.4095
  Debit 12.37 Delta .5905

Combining the adjustment with the original short put the delta of .3504 makes the new delta reading total .9310. The result is a low cost basis with a high delta value, however it is not a desirable position unless you would want to own the stock for a longer period of time.

Interestingly four of the five companies in Friday’s TOP volatility ranking scan on the IVolatility.com home page are biotech companies. They are shown below with their IV/HV ratio rankings in the far right column. The ratio indicates the current positive volatility spread, which we refer to as a Type I volatility spread. For example, for NBIX, below the IV is 2.53 times greater than the HV, for MEDX it is 2.06 times greater.

The temptation is to sell the volatility using a short straddle ahead of an event with the expectation that the declining volatility will yield positive results. The problem is the potential for the stock price to move in either direction exceeding the credit from sale of the call and put. Selling straddles or selling calendar spreads for time premium on stocks that make large moves is not a good long-term strategy. If you want to sell volatility find stocks that you would be comfortable owning in your portfolio and then either sell puts, covered calls or some combination of both.

Found on the IVolatility.com home page, The Top 5 and bottom rankings, is a good daily reference source for volatility trading ideas.

Some of the others that were included in the TOP 5 ranking during the past week are shown below with their stock price and the Implied Volatility/Historical Volatility (IV/HV).

Savient Pharmaceuticals Inc. (SVNT) 15.14 IV/HV 122.51/63.01
Alliance Data Systems Corporation (ADS) 78.25 IV/HV 37.62/14.82
PDL BioPharma Inc. (PDLI) 18.20 IV/HV 52.36/43.63
XM Satellite Radio Holdings Inc. (XMSR) 15.27 IV/HV 118.53/78.97
Sirius Satellite Radio Inc. (SIRI) 3.61 IV/HV 88.05/54.78

Here are two with Type II high volatility patterns (both high but expected to decline).

Solarfun Power Holdings Co. Ltd. (SOLF) 25.90 IV/HV 142.10/166.94
Cree Inc. (CREE) 23.90 IV/HV 77.24/67.95

Low Implied Volatility

You may be wondering if there is anything other than high volatility. The answer is yes - low volatility. Let’ s take a look at a low volatility example. First, what do we mean by low volatility? We consider low volatility options strategies when the implied volatility and or the historical volatility to be 20 or less. The obvious strategy is to buy low volatility in the anticipation that it will rise. With the assistance of IVolatility.com’s rankers and scanners we can find these low volatility trades by looking for volatility readings that are at the low end of their 52 week range.

If you investigate the variables that are included in the various options pricing models, you will discover there is no allowance made for the trend value. Using a log normal distribution rather than a normal distribution makes some adjustment for the upward bias but there is no specific variable included for trend. Now if we can find a stock or ETF that is inexpensive in volatility terms and one that also is in a defined uptrend then we have a real edge. The reason that the casino wins over the long term is the fact that they have a defined edge. It is this defined edge we are seeking.

Unitedhealth Group, Inc. (UHN) 56.65. Minnetonka, Minnesota based UNH provides healthcare and well being services to employers, individual consumers, and other health care organizations.

In the upper graph you will notice the orange line representing implied volatility is near to low for the year. In the lower chart you will see an upward sloping trend line drawn under the price bars from the late October low defining the trend. The current price is at a resistance level from last March so it may take some time to move above this resistance. The current historical volatility is 17.55.

Consider this synthetic long position that allows time to clear the resistance level.

DR: Health care and biotech companies seem to be returning to favor. This company was recently burdened by a compensation dispute with its former CEO and the matter appears nearly settled. Prior to this issue the company had been regarded as well managed. Expect the trend to continue higher one the current resistance is overcome.

SU: Risks include the sector loosing favor once again if cyclical stocks take money from the more stable groups including health care. A close back below 54 would be the signal to hedge or unwind the position.

• Buy UNH Mar 55 call UHBCK 4.05 IV 22.31 Delta .6663
• Sell UNH Mar 55 put UHBOK 1.75 IV 23.26 Delta .3505
  Debit 2.30 Position net delta 1.0168

In The News

Rio Tinto Plc (RTP) 468. London based mining giant RPT is squirming and trying to get away from an unfriendly takeover bid from Melbourne Australia based BHP Billiton Plc. Early in the week there were rumors, which have been denied, that Shanghai Based Baosteel Group would make a bid for RTP. The Baosteel bid seems highly unlikely just based upon the $130 billion price tag that BHP has put on RPT.

In the meanwhile, it seems more likely that a bid will made for Cleveland-Cliffs Inc. (CLF) 98.02. Since CLF is priced in dollars and both BHP and RTP have the advantage of using their more valuable currencies to obtain the US, Australian and Brazilian iron ore reserves of CLF, and whose stock has risen from 75 in the last two weeks. With a historical volatility of 57.89 consider this longer-term synthetic long position.

DR: Activity in the mining sector makes CLF a likely target for BHP, RPT or even Rio de Janeiro based Companhia Vale do Rio Doce (RIO)

SU: A close back below 75 would indicate that there was no current interest in this company and the position should be hedged or unwound.

• Buy CLF Apr 90 call CLFDR 16.45 IV 49.18 Delta .6890
• Sell CLF Apr 90 put CLFPR 7.25 IV 50.38 Delta .3176.
  Debit 9.20 Position net delta 1.0067

Reader Response Request

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. Send us your questions or comments, or if you would like for us to take a look at a specific stock or ETF just let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.

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