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Market Review – January Barometer

While the US equity markets continue their rebound from the January 23, 2008 lows we checked the record and calculated the numbers for the January Barometer. According to Yale Hirsch at the Stock Trader’s Almanac January’s close up or down determines the likely direction of the S&P 500 Index for the year. On December 31, 2007 the S&P 500 Index closed at 1468.36 and at 1378.55 on January 31, 2008 for a decline 89.81 points or 6.1%. According to Hirsch there have been 21 down Januarys since 1953 with 16 closes lower and only 5 higher. According to this indicator there is a 76% probability for a lower S&P 500 Index close this year.

Head & Shoulders Top Update

For the week the S&P 500 Index (SPX) closed at 13395.42, up 64.81. While the gain is impressive it is still below the neckline and now has the appearance of developing into an Elliott 4th wave. Closes above 1425 would be required to change the current outlook. For now we are we still expecting a decline to a minimum measuring objective of 1225, now 170 points lower. We think it is unlikely that the S&P 500 Index has made a V bottom and will not retest the 1270.05 low made on January 23, 2008.

Dollar Index

US Dollar Index (DX) 75.45, (cash) has returned once again to the 75 support level. Failure to hold this level will be significant and immediately reflected in the price of gold and the gold mining stocks. Keep an eye on DX this week. Will it bounce off of the 75 support level or continue lower?

Market Breadth

The NYSE McClellan Summation Index, our market breadth indicator ended the week with a reading of –255.12, for a one-week gain of 245.46 points. The upward slope now makes this indicator more positive but it remains below the zero line.

Strategy

Even though we know the probabilities suggest a lower market in the near term we think a bottom will be forming and would now start selectively looking for a few more long opportunities.

Yahoo!

Yahoo! Inc. (YHOO) 28.38. Yahoo provides Internet services to users and businesses worldwide. It also owns 39% of Alibaba, the Chinese B2B web portal.

Our last suggestion for Yahoo was in IVolatility Trading Digest™ Volume 7, Issue 37, Yellow Light, dated October 29, 2007. At that time Yahoo was 33.63 and we suggested a bull call spread. Long the Jan 32 ½ call and short the Jan 37 ½ call, with a 1.94 debit. We set the stop and/or unwind at a close below 30. Yahoo made a high of 34.08 on October 29, 2007 and did not look back, closing below 30 on November 6, 2007, just 7 trading days later. Following our trade plan we would have closed this position for a small loss.

With Friday’s news of the unsolicited bid by Microsoft Corporation (MSFT) 30.45, the stock gapped up 9 ½ points returning Yahoo! once again to the option opportunity list. There are a good number of hurdles to overcome in order for this deal to be completed and it will most likely take longer than most people expect. For example, they will require the approval of the European Union and it has not been very friendly to Microsoft in the past. The process could become long and drawn out testing the patience of shareholders. In the meanwhile, we expect the options market implied volatilites will be rising with each new report expressing uncertainly or doubt. Following the higher price the Historical Volatility rose to 126.49 and while it will now begin to decline we expect rising implied volatility to follow.

We suggest strategies that are long more options that short in order to benefit from the expected rise in implied volatility. We do not suggest the outright sale of longer dated options, as they will be more sensitive to rising implied volatility. Selling shorter dated options would allow the possibility to renew the sale in the next period at higher volatilites. Spreads and synthetics would provide some volatility protection and can be used in combinations.

Here is one example using a synthetic long and near term call sale. First the synthetic:

• Buy Yhoo Jul 27 ½ call YUQGY 3.575 IV 38.60 Delta .6198
• Sell Yhoo Jul 27 ½ put YHQSY 2.455 IV 40.19 Delta .3864
  Debit 1.12 Position net delta 1.0062

Then against this position,

• Sell Yhoo Feb 30 call YHQBF .61 IV 52.76 Delta -.3252

Net debit .51 Overall position net delta .6810

We have created a position that costs around a half- a-buck that has the equivalent of 68 long shares with the opportunity to renew the February sale in the event it expires in two weeks. We would then sell a March call against our long synthetic at a higher expected implied volatility than we received for the February call.

As an alternative for those who may be uncomfortable selling puts, buy 100 shares of YHOO and then sell the same February 30 call shown above.

We think there will be many option opportunities in the coming Yahoo! contest and it could last for a long time. We should be able to find interesting new strategies every week.

Agriculture

PowerShares DB Agriculture Fund (DBA) 37.25 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. According to Investor’s Business Daily it holds only corn, wheat, soybeans and sugar futures divided equally. The index is intended to reflect the performance of the agricultural sector and does not have stock price risk.

With a current Historical Volatility of 29.79, consider adding this bull call spread.

• Buy DBA Mar 36 call DBACJ 2.55 IV 32.98 Delta .6473
• Sell DBA Mar 40 call DBACN .85 IV 33.10 Delta -.3115
  Debit 1.70 Position net delta .3358

The difference between the strike prices defines the maximum value of the spread. In this case it would be 4 points. From that we subtract our debit of 1.70 to calculate the maximum gain of 2.30. This represents a good return on a position with a defined and limited downside. On a DBA close below 34 we would unwind this spread.

Oil Service

Many of the oil service stocks have corrected from the October highs. Here is an interesting one that looks oversold with good value and a new strategy.

Halliburton Company (HAL) 33.73. This big oil oilfield service company has restructured by spinning off KBR, the construction subsidiary that caused so much controversy over contracts in Iraq and Afghanistan. In addition, they relocated headquarters to Dubai in order to be closer to and focus on their customers in the Middle East, Africa and Russia. HAL thinks their future growth is in the international arena and they are making a major commitment to the strategy.

With a Historical Volatility of 28.31 consider this bull call spread.

• Buy HAL Apr 35 call HALDG 1.375 IV 29.89 Delta .4326
• Sell HAL Apr 37 ½ call HALDT .60 IV 28.78 Delta -.2416
  Debit .775 Position net delta .1910

With two and one-half points between the strikes the gain is limited to 1.725, but with a defined and limited risk of .775.

Small Cap China Growth

American Oriental Bioengineering Inc. (AOB) 10.20. Shenzhen, China based American Oriental Bioengineering, Inc., engages in the development, manufacture, and commercialization of plant-based pharmaceutical (PBP) and plant-based nutraceutical (PBN) products. It is a play on alternative medicine that has recently seen major contributions from its over-the-counter business segment, which includes a form of ginseng designed to soothe the nerves.

According to The Motley Fool’s January 22, 2008 article,

Insiders own 22% of company, this is good.
Sales growth is 62%, this is extraordinary.
EPS (earning per share) growth is 51%, most unusual.
Net Margins (what they make after expenses) of 27%, most extraordinary.
ROE (Return on Equity) 19%, quite good.

Yahoo! Finance shows the forward Price to Earnings Ratio (PE) at 12.91 and the Price to Earnings Growth Ratio (PEG) at .55.

While some continue to be skeptical of Chinese accounting and doubtful that the numbers reported are comparable to US, European or International Accounting Standards, they are nevertheless truly impressive.

AOB peaked above 14 with the October market high and then pulled back below 9. It is now back above 10 and appears to be making a bottom. With a Historical Volatility of 41.91, take a look at this put sale.

• Sell AOB Mar 10 put AOBOB .975 IV 74.10 Delta .4126

With a nice positive volatility spread there is a chance the stock will again trade lower and retest the 9 area. In this event be prepared to take in the stock and then write calls against the long stock position. Remember to size you position accordingly. If you would not be comfortable long this stock then do not make the trade or limit the size to a number where you would be comfortable. We further suggest a stop/unwind be set at the 8 level.

More Interesting Small Caps

Concho Resources, Inc. (CXO) 21.48. Midland, Texas based Concho Resources, Inc. engages in the acquisition, development and exploration of oil and natural gas properties in the United States. Concho drills in proven areas that don’t have the political risk associated with the Middle East or Africa.

With a Historical Volatility of 47.77 consider these put sales.

• Sell CXO Feb 20 put CXOND .475 IV 62.24 Delta .2689

Or

• Sell CXO Mar 20 put CXOOD 1.225 IV 62.35 Delta .3336

If you want exposure to the domestic oil business this is one to consider with a nice positive volatility spread. As with other put sales remember to size the position and be prepared to take in the stock in the event it closes below 20 in February or March depending upon the series selected. In this event be prepared to take in the stock and then sell calls against the long stock position.

US Shipping Partners LP (USS) 12.68. U.S. Shipping Partners L.P. is a leading provider of long-haul marine transportation services, principally for refined petroleum products, in the U.S. Jones Act, domestic "coastwise" trade. U.S. Shipping Partners L.P. is also involved in the coastwise transportation of petrochemical and commodity chemical products. The Partnership's existing fleet consists of eleven tank vessels: six integrated tug barge units; one product tanker; three chemical parcel tankers and one articulated tug barge unit ("ATB"). The Partnership has embarked on a capital construction program to build additional ATBs and, through a joint venture, additional $1 billion worth of tank vessels that upon completion will result in the Partnership having one of the most modern fleets in service.

The stock price declined from just below 20 in October and now with a Historical Volatility of 49.68 consider one of these alternatives.

• Sell USS Feb 12 ½ put USSNV .825 IV 67.38 Delta .5409.

With a good positive volatility spread be prepared to take on the stock and then sell calls in the event it closes below 12 ½ on February 15, 2008.

As an alternative consider this buy-write.

• Buy 100 shares of stock and then,

• Sell USS May 15 call USSEC .575 IV 55.85 Delta -.3060.
  Debit 12.105 Position net delta .6940.

Since USS pays a .45 quarterly distribution the annualized yield would be 14.87% at the current rate. If the May 15 call expires you would have the opportunity to sell another call against your long stock further reducing your cost basis and increasing your return on investment. Set the stop/unwind below the 10 level.

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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