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Merry Yuletide - Generally refers to the period of cultural festivities surrounding Yule, a winter festival celebrated in Northern Europe since ancient times, Winter solstice, Christmas and the New Year.

Market Review

The volatility indexes are slightly higher for the week and the trend appears higher although volatility usually declines during the last two weeks of the year.

As for interest rates both 10 and 30-year Treasury yields are higher once again. On the short end the 13-week Treasury bill is trading to yield of 2.8% while the one-month LIBOR (London Interbank Offer Rate) is 5%. This is making it hard for banks to make money if they have to borrow at 5% while Treasury bill yields are just 2.8%.

For the week the story is the US Dollar Index (DX) cash 77.44. The upturn is noticeable, having risen 3.18% since the November 23, 2007 low at 75.05. There may be more than the usual year-end dollar rally at work here. At the end of last year the rally was just 1.9%. As we have previously suggested, stay focused on the DX.

Our market breadth indicator, the NYSE McClellan Summation Index –324.95, has slowed its rate of increase from last week and is about to turn down once again. This makes us somewhat more cautious and it is not a good development for the bullish outlook.

Strategy

The operative strategy continues to be caution and hedging, especially any high price/earnings ratio stocks in the portfolio. While volatility will most likely decline into the year-end, now may be a good opportunity to bargain hunt in the natural gas sector.

IVOLalerts™

CurrencyShares Japanese Yen Trust (FXY) 88.04. The Yen has now returned back to the support level at 88 from where it broke out on November 11, 2007. It shows a strong inverse relationship to the S&P 500, so a reversal to the upside would be associated with declines in the SPY and iShares Russell 2000 Index (IWM). There is a chance the inverse relationship may not hold up as well at year-end since we will likely see position closing for year-end statement purposes. Interestingly the implied volatilites are about half that of the IWM meaning it could be used as in inexpensive hedge for IWM, SPY or other long positions. For example, compare a long March FXY bull call spread and a March IWM bear put spread.

Buy FXY Mar 88 call FXYCJ 2.775 IV 11.70 Delta .6021
Sell FXY Mar 93 call FXYCO 1.050 IV 13.35 Delta -.2863
Debit 1.725 Position net delta .3158

Buy IWM Mar 75 put IQQOW 4.825 IV 31.75 Delta -.4518
Sell IWM Mar 70 put IQQOR 2.950 IV 33.85 Delta .3057
Debit 1.875 Position net delta -.1461

Assuming the inverse relationship continues the FXY provides a less costly spread with twice the delta, hence more hedging power for the price.

Long Straddle

iShare Russell 2000 Index ETF (IWM) 75.00. Last week we bought the straddle as a long volatility trade before the Federal Reserve Open Market Committee meeting. The IWM declined from 78.36 but there was no corresponding increase in implied volatility. While we are now at the lower end of the price range we are suggesting that the position be closed according to the plan.

Here are last week’s numbers:

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

Now at 75 here are the current values:

IWM Dec 78 call IOWLZ .23 IV 25.27
IWM Dec 78 put IOWXZ 3.20 IV 26.56
Debit 3.43

Since the DR (Determining Rationale) for the position was an increase in implied volatility and it did not occur we suggest closing this position.

Medarex Inc. (MEDX) now 10.27, the biopharmaceutical company working to commercialize human antibody-based therapeutic products to treat cancer, inflammation, autoimmune disorders, and infectious diseases. The experimental drug ipilimumab that they are developing with Bristol-Meyers Squibb (BMY) failed to meet its goal and the stock declined more than 3 points by the end of the week. Such is the risk with biotech. Using the numbers from the previous suggestions we would now have 100 shares at 12.37 and we will receive another 100 shares from the December assignment on expiration. The second lot will cost 11.15 (12 ½ less the premium from the sold put of 1.35). Here is the new suggested trade plan:

Keep the long 200 shares and wait for the implied volatility to rise one again before the next product trial announcement. While the stock could go lower we think the downside risk is now limited and worth waiting for higher premiums to begin selling calls against the long stock.

Big Speculation in the Sky

XM Satellite Radio Holdings Inc. (XMSR) 13.55 and Sirius Satellite Radio (SIRI) 3.31 are attempting to merge. This in the special situation category as their fate is not a function of the current equity market. The shareholders have voted in favor of the merger and now the political process will determine their future. They require approval of both the Department of Justice and the Federal Communications Commission. Some are expecting a decision before the end of the year. This is exactly the type of uncertainty that causes high market implied volatility. For some added flavor it has been reported that hedge fund manager George Soros has taken substantial stakes in both companies.

In IVolatility Trading Digest™ Volume 7, Issue 40, Mortgage Disaster, dated November 19, 2007, we suggested the sale of December and January 10 & 12 ½ puts. Since the December puts will expire next Saturday we took a look to see if there are any other interesting combinations for this long delayed merger. If the approvals continue to drag out, which is quite likely, then plan is to keep selling the XMSR puts. If they come through sooner with an approval then here is an added upside suggestion.

With a Historical Volatility of 47.87 take a look at this bull call spread on Sirius (SIRI).

• Buy SIRI Mar 4 call QXOCH .375 IV 86.80 Delta .4339
• Sell SIRI Mar 5 call QXOCA .20 IV 89.68 Delta -.2665
  Debit .175 Position net delta .1674

This is a defined risk low cost spread with a risk/ reward ratio of 5:1 assuming you pay as much as .20 for the spread. It should produce a good return on investment if the approval comes in the next 90 days and SIRI rises 51% from the current price.

Reader’s Market Forecast Challenge – Potential Head & Shoulder Top

We see a potential Head & Shoulders Top in the S&P 500 developing. Here it is using the IVolatility.com line chart found in Advanced Historical Volatility.

If you are familiar with technical analysis you will recognize the Head & Shoulder Top as the most reliable reversal pattern in the toolbox. In order to have a reversal you need a prior uptrend which is labeled USTL (upward sloping trend line) and can be seen in the chart below starting from the March 14, 2007 low of 1363.98. The uptrend was broken when the index turned lower and broke the USTL on July 26, 2007 after forming the Left Shoulder at 1555.90 on July 16, 2007 marked LS on the chart below. The first decline leg ended on August 16, 2007 at 1370.60, see B on the chart. The next leg took the index up to the Head at 1576.09 on October 11, 2007, so marked on the chart. The third leg was the decline to 1406.10 on November 26, 2007, see C on the chart. If it is to become a Head & Shoulders Top we would soon be working to complete the fourth leg on a rise back to the 1550 area marked RS ? for Right Shoulder on the chart. It would then reverse once again and move lower toward the neckline down about 1425, marked NL with the dotted line. Upon penetrating the neckline the measuring objective would be down at about 1225 (Not shown).

We often see symmetry in the patterns for both price and time, and it appears to be developing a symmetrical pattern. Look at minor uplegs labeled A&D. If the symmetry remains consistent then we should see the fourth leg rise back toward 1550 between now and year end. Then when it once again turns down we want to begin implementing our plan.

If the pattern develops as we have described then we need an options trade plan in place to capitalize on the potential decline. According to technical analysis tradition the H&S Top is not actually set off until the price closes below the neckline. Since that is a long way down we think the plan should start sooner. Although we are using the S&P to define the market we suggest using a bear put spread on the iShares Russell 2000 Index (IWM). We would have a trade with a defined downside in the event the index turns higher thereby invalidating the H&S Top by closing above the Head at 1576.09 made on October 11, 2007. In this event we would reverse direction and buy a bull call spread.

We think the more likely outcome will be the validation of the H&S Top with a close below the neckline. If this occurs then we would buy back the short put of the spread keeping the long put. This will give us the maximum advantage of the price decline along with the rise in volatility that will surely accompany the price decline. We are selecting IWM, the ETF for the iShares Russell 2000 Index rather than the SPY the ETF for the S&P 500 Index since the IWM has a higher beta, and we would therefore expect it to make a larger move than the SPY would.

We welcome your comments, criticisms, and suggestions with respect to our analysis of the potential Head & Shoulders Top and the proposed trade plan outline. If you think this analysis makes any sense send us your proposed trade plan suggestions. It may be easier to see the pattern using another S&P chart and there are many other sources for charts. Take a look and tell us what you think. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.

Perhaps we can even arrange a premium for the most insightful response that would benefit all of our readers.

Since we think many market participants will otherwise be entertained for the next two Mondays this is last Issue of IVolatility Trading Digest™ Volume 7, for this year. We will return next year with Volume 8, Issue 1 on January 7, 2008 – Merry Yuletide.

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