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A growl is a low guttural vocalization produced by predatory animals as a warning to others, as a sign aggression, or to express anger. It may also be emitted by human beings when discontent with something.

Chances are many market participating human beings have recently been practicing their bear growls, spelled Grrr, it is one of the rare pronounceable words of the English language that consists solely of consonants.

Market Review

The Head and Shoulders Top reversal pattern in the S&P 500 Index that we first detailed in IVolatility Trading Digest™ Volume 7, Issue 44, Merry Yuletide, dated December 17, 2007 best describes the current condition of the US equity market.

For the week the S&P 500 Index (SPX) closed at 1325.19 and is now clearly below the crucial neckline thus confirming the expectation of a decline to a minimum measuring objective of 1225, at least another 100 points on the downside.

Strategy

As for strategy, continue looking for shorting opportunities in US equities and indexes, especially those in the consumer discretionary sectors. Because even the few remaining sectors that continue to show positive fundamentals are now struggling we will limit our new suggestions to the short side.

VIX Review

In IVolatility Trading Digest™ Volume 8, Issue 1, Political Risk, dated January 7, 2008, we made the case for a Call Ratio Backspread using the CBOE Volatility Index (VIX) 27.18 for the expected increase in market implied volatility accompanying the market decline. The market declined and the VIX increased as expected, but interestingly the market implied volatility of the VIX options declined.

The position was long more options than short so an increase in the implied volatility would have been beneficial. Here are the volatility and price charts. The upper chart reflects the market implied volatility of the VIX options and the lower price chart actually reflects the market-implied volatility of the S&P 500 Index.

Last August when the VIX was higher than 30 (lower chart) the IV Index Mean shown in orange (upper chart) was in the 160% range (see 1 above). Then in November when the VIX again traded up to 30 the IV Mean Index reached 125% (see 2 above). This time as the VIX approaches 30 once again the IV Mean Index appears stalled at 75% (see 3 above) and does not appear to be rising.

Since establishing the call ratio backspread the market implied volatility of the February calls have declined from 99.81 to 67.61 for the February 22 ½ s, the short side, and from 95.45 to 74.92, for the February 27 ½ s, the long side of the position. The backspread widened from a credit of .15 to a credit of .60, reflecting a .45 loss on the position, composed mostly of the unfavorable decline in market implied volatility and some loss in time value as well.

Since this trade is not performing as expected we suggest that it now be closed by selling the two long February 27 ½ calls and buying back the short February 22 ½ call for an indicated loss of .45.

Alternative VIX Trade

Since it appears that we can not expect the market-implied volatility of the VIX options to increase as originally expected we can use a bull call spread to trade the direction of the VIX as it increases with the further market decline.

With a Historical Volatility of 96.29 consider this short suggestion.

Trade Plan

DR: This trade is expected to increase in value as the VIX rises. Previous rises have been short lived so be prepared to quickly close the position on VIX trades above 30. With the near term expectation of lower interest rates we should consider how they will change position valuations.

SU: Unwind the spread on a decline and close below 22 ½.

• Buy VIX May 25 call VIXEX 4.10 IV 44.29 Delta .6929 Rho .05
• Sell VIX May 30 call VIXEF 2.35 IV 52.15 Delta -.4485 Rho -.0334
  Debit 1.75 Position net delta .2444 Position net rho .0166

The position has good edge with a 3.25 potential gain at a cost of 1.75 and with a low interest rate reduction risk (rho) of just .03 in the event of a 2% interest rate reduction (.0166 x 2 = .0332) between now and the May expiration.

The interest rate risk is calculated using rho, which calculates the change in the theoretical value of options with a change in interest rates. In this example we are long rho of .05 which means that the value of the May 25 call should decline by .05 for each 1% decline in interest rates. Because we are also short the May 30 call we are also short rho of .0334. When combined the net exposure to an interest rate decline is .0166 or less than two cents per 1% point decline. For a 2% decline between now and the May expiration date the risk is .03 as shown above. You can easily find rho at Advanced Options; it is one of the “greeks” and is located in the last column for each option listing.

Shorting the Qs

Until the minimum price objective of 1225 is reached for the S&P 500 Index we suggest the short side of the market. In recent previous issues we have detailed many short ideas from homebuilders, to mortgage companies, to banks with mortgage exposure and to individual consumer discretionary stocks. Now we will take a look at an ETF to use on the short side as a hedge or for a short direction trade.

Most of the Short and UltraShort ETFs do not have listed options and the few that do have limited volume and open interest, the exception is the QID the UltraShort on the QQQ with fairly good options volume and open interest.

UltraShort QQQ Proshares (QID) 48.12. UltraShort QQQ ProShares seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the NASDAQ-100 Index®.

With a Historical Volatility of 49.62 consider this bull call spread that will rise in value as the NASDAQ-100 Index declines. There is a well-defined upward sloping trend line off of the December 26, 2007 low at 36.10. Although currently overbought it could remain overbought for a considerable period as the market declines.

Trade Plan

DR: The QID is a leveraged 2 times to the NASDAQ – 100 Index. Until the S&P 500 Index reaches its minimum downside objective of 1225 this bull call spread will benefit from the decline while providing protection against increasing volatility, time decay and interest rate declines. This is a downside direction trade with limited risk. Because it is leveraged to the Index it will require daily monitoring.

SU: The spread should be unwound if it closes below the 42-40-support area, which could occur very rapidly in the event of a short covering rally in the stocks comprising this Index.

• Buy QID Jul 45 call QIDGS 8.60 IV 53.39 Delta .6543 Rho .0994
• Sell QID Jul 52 call QIDGZ 6.20 IV 57.27 Delta -.5119 Rho -.0883
  Debit 2.40 Position net delta .1424 Position net rho .0111

The maximum upside is the difference between the strike prices less the debit, or 4.60 and a defined 2.40 downside risk providing a good risk reward ratio. If there were a further 2% decline in interest rates the position should lose just .02 (.0111 x 2 =. 0222) as defined by the net rho exposure of .0111 as more fully explained in the VIX section above.

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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