IVolatility Trading Digest™ Blog

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We now know the Federal Reserve’s unusual cut in the Fed Funds rate last Tuesday was likely prompted by the massive unwinding operation at the French bank Societe Generale. Friday they said a rogue trader had been dealing with more than €50 billion, or more than $73 billion. They cited significant growth in volumes, volatility, and instrument complexity in recent years that resulted in a €4.9 billion or more than $7 billion loss when the smoke cleared and the unwinding was completed on Wednesday. It seems the rogue futures trader had been using the bank’s money to hedge European equity indexes, but actually had a massive unhedged long position in a declining market. When the whole story is told we would not be surprised to discover that option strategies on futures contracts we involved.

Thus, the great Paris unwinding no doubt accelerated already defined downtrends in the major Indexes worldwide.

For the short-term we would expect a bounce and then resumption of the downtrend in the S&P 500 Index to 1225 or lower.

Head & Shoulders Top Update

For the shortened week the S&P 500 Index (SPX) closed at 1330.61, up 5.42. We are now unambiguously 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.

Nimble traders will find opportunities in the bounces but remember for the time being the trend is lower so the odds favor the short side. We would not consider long strategies until the minimum measuring objective of 1225 is met and we began to see the formation of a bottoming pattern. The H&S Top Reversal took just under 6 months from the left shoulder to the close below the neckline. It could well take several weeks to reach the minimum measuring objective. Keep in mind we are basing the downside measuring objective on probabilities and any real positive fundamental development could quickly alter the downside target. Keep alert and start looking for the formation of a bottoming pattern.

VIX Review and the Alternative VIX Trade

Last week In IVolatility Trading Digest™ Volume 8, Issue 3, Bear Growl, dated January 21, 2008, we suggested a bull call spread using the VIX Index to benefit from the expected increase in market implied volatility. We said, “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.” We correctly anticipated the increase in market-implied volatility and the decline in interest rates. Here is last week’s suggested trade.

• 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

When we wrote the plan we showed the VIXEX as the May 25 call when it should have been written May 22 ½ call. Therefore the potential gain should have been 5.75 and not 3.25 as originally written.

For those who followed the trade plan and closed the position on Tuesday when the VIX opened at 35.12 and traded up to 37.57 the gains were significant. Even if you missed this two day trading opportunity here are closing numbers for Friday.

Long VIX May 22 ½ call VIXEX 4.85 IV 74.65 Delta .8005
Short VIX May 30 call VIXEF 1.975 IV 34.15 Delta -.4964
Indicated current debit 2.875 Position net delta .3041

Based upon the disparity in the market implied volatility of the legs (74.65 vs. 34.15) this pricing indicates there is still 1.125 of gain in the position. (2.875 less the original debit 1.75 = 1.125) and we now suggest closing the position for a 64% one-week gain.

Shorting the Qs

UltraShort QQQ Proshares (QID) 51.12. 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®.

Last week’s QID suggestion with a 2.40 debit is now 2.95 and we would suggest keeping this bull call spread until we reach the downside S&P 500 Index objective.

More Shorts

iShares Russell 2000 Index (IWM) 68.47

In the last six months the S&P 500 Index has declined 8% while the IWM declined 13% in the same period. Since we are still expecting a further decline in the S&P 500 Index we would have an edge by using the IWM in a short position.

With options volume of 799,220 and open interest of 5,977,360 contracts this ETF has good liquidity and reasonable bid/offer spreads in most all of the option series. Currently the Historical Volatility is 25.72. Consider this bear put spread.

• Buy IWM Jun 70 put IQQRR 5.95 IV 5.95 Delta -.4982
• Sell IWM Jun 62 put IQQRJ 2.90 IV 33.59 Delta .2789
  Debit 3.05 Position net delta -.2193

The maximum gain is the difference between the strike prices less the debit, or 4.95 (8.00 -3.05). By selecting June expiration we are allowing sufficient time for the market to make a definable bottom.

Apple Sauce – The Bear Put Story

Apple Inc. (AAPL) 130.01. Apple Inc. designs, manufactures, and sells personal computers, portable digital music players, mobile communication devices and related software.

When we suggested a Apple bear put spread In IVolatility Trading Digest™ Volume 8, Issue 1, Political Risk, dated January 7, 2008, just three weeks ago the stock was trading at 180.05 now at 130.01, it is 50.04 points lower.

Here is the original suggestion:

• Buy AAPL Apr 180 put APVPP 20.10 IV 55.10 Delta -.4288
• Sell AAPL Apr 170 put APVPN 15.225 IV 55.49 Delta .3538
  Debit 4.875 Position net delta -.0750

And here are the current values:

Long AAPL Apr 180 put APVPP 50.75 IV 49.63 Delta -.9065
Short AAPL Apr 170 put APVPN 41.55 IV 49.37 Delta .8513
Indicated current debit 9.20. Position net delta -.0552

At 9.20 this represents an 88.7% gain in 3 weeks, or an annualized gain of 1,538%. Of course, we could have done better if we just bought the April 180 put, as it increased from 20.10 to 50.75. The difference is that our bear put spread had risk limited to the debit of 4.875, and we were also protected from volatility risk and time decay. On a risk-adjusted basis we have a very respectable return.

Even stocks with good fundamentals are subject to decline when the market sentiment turns, especially market leaders that had doubled in less than a year.

We now suggest closing this position at a price near 9.20.

IVOLalerts™ - Searching for a Long

Other than the QID mentioned above (which is really a short position), are there any other longs worth considering now? Let’s see.

In IVolatility Trading Digest™ Volume 8, Issue 2, Golden Fleece, dated January 14, 2008 we introduced DBA and now return after the completion of small correction.

PowerShares DB Agriculture Fund (DBA) 36.38. The PowerShares DB Agriculture Fund (Fund) is based on the Deutsche Bank Liquid Commodity Index – OptimumYield Agriculture™ and managed by DBCommodity Services LLC. The Index is rules-based and composed of futures contracts on some of the most liquid and widely traded agricultural commodities – corn, wheat, soy beans and sugar. The index is intended to reflect the performance of the agricultural sector.

Two weeks ago the price of DBA was trading at a record 3.34% premium to its Net Asset Value suggesting that a correction could be expected. Now trading much closer to its Net Asset Value we return with two suggestions. This current Historical Volatility is 30.42.

• Sell DBA Feb 34 put DBANH .775 IV 44.59 Delta .2472

And for a longer term alternative here is a bull call spread:

• Buy DBA Apr 34 call DBADH 3.60 IV 30.10 Delta .7214
• Sell DBA Apr 39 call DBADM 1.325 IV 32.02 Delta -.3718
  Debit 2.275 Position net delta .3496

Readers Market Forecast Challenge - Head and Shoulders Top

In IVolatility Trading Digest™ Volume 7, Issue 44, Merry Yuletide, dated December 17, 2007 we made the case for a developing Head and Shoulders Top reversal pattern in the S&P 500 Index. At that time we expected the index to rise back toward the 1550 level in the last week of the year to complete the right shoulder before turning lower once again.

In an effort to encourage more reader and subscriber participation we made a challenge offer for the best comment on the Potential Head & Shoulder Top. Here is what we said.

"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."

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

We were successful in obtaining a participation premium and are pleased to announce that we have created a truly spectacular package consisting of a two month subscription to Advanced Options and Advanced Historical Data plus the entire IVolatility.com Options Scanner Suite - a $229.70 value.

Further, we will be supporting the entire package right here at the IVolatility Trading Digest™, blog site, answering questions and providing comments for the full two-month period.

Here is the winning entry:

On January 8, 2008 Daniel Grill wrote:

"I love your volatility trade. The curious thing about this Head and Shoulders top is that it looks quite different between the Daily and Weekly Charts. Using line-on-close charts to remove clutter, the Daily chart shows a neckline around 1407, BELOW yesterday's close of 1416. The 1407 level is also a small resistance from March, 2007. Target on this chart is 1225-1240, as you mentioned. However, looking at the Weekly $INX, line-on-close, the neckline is at 1440, and we've already broken it. A small rally this week (1/7 to 1/11), would challenge the break down, and weakness from there will suggest a target of 1320. Note that a quick reversal to a broken neckline is extremenly common in H&S patterns. So, for the trade, I would use both charts, and look for the 1320 level first from the weekly chart, then see how the action goes and consider the 1225-1240 afterward."

We thank Daniel for his contribution and note that the neckline was retested as he suggested, just before accelerating to the downside.

Our support staff will be contacting Daniel in the next week to arrange his IVolatility.com user name and password.

Using Advanced Options and Advanced Historical Data Daniel will have access to the best volatility charts and options data in the industry.

In addition, with the IVolatility.com Options Scanner Suite he will be able identify and select the best trading opportunities, including:

• Performing real-time scans, using 20 minute delayed data
• Scan for the best Covered Calls, Naked Puts and more, using previous day close data.

We welcome Daniel to the IVolatility.com family and look forward to providing assistance.

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 bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.

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