IVolatility Trading Digest™ Blog

Monday February 25, 2008

Volume 8, Issue 8
Broken Triangle

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

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Last week in IVolatility Trading Digest™ Volume 8, Issue 7, Symmetrical Triangle, dated February 18, 2008, we made the case for a developing symmetrical triangle continuation pattern in the S&P 500 Index (SPX), now 1353.11. At the end of the week the SPX was up 3.12 points having traded sideways into the apex of the triangle destroying it. At this point anything can happen as the triangle has lost its predictive power. There is a remote chance that reversal points 3 and 4 can be relocated in subsequent trading thereby creating a new and larger symmetrical triangle. We think this is a remote possibility and we are ready to declare this symmetrical triangle continuation pattern broken.

This means the previously described Head & Shoulders Top with the measuring objective at 1225 remains the current operational pattern.

US Dollar Index (DX) 75.52 (cash) is once again moving down toward the 75 support level. As we mentioned before we are now beginning to see the formation of a bottoming pattern, perhaps a Head & Shoulders Bottom. The current retest of the 75 level is important.

Market Breadth

The NYSE McClellan Summation Index, our market breadth indicator ended the week at –65.59 a gain of 10.88 for the week, but still below zero, and the rate of increase has slowed significantly.

Strategy

While the symmetrical triangle in the S&P 500 Index seems to have been broken, there is another one that is working in the Comex April GOLD (GC/08J) 947.80. It has just broken out to the upside providing a new measuring objective for gold up at 975.

With the DX again testing the 75 level and gold trading higher once again we should reconsider some of our previous suggestions for this sector, such as Yamana Gold (AUY) 16.96 or Barrick Gold (ABX) 50.16. Bull call spreads would be a good choice considering the DX remains above the 75 level.

Others to consider for new opportunities include agricultural commodities, seasonal natural gas, equities supported by covered dividends, and some special situation takeovers.

Low Volatility Delta Neutral Straddle

Since so much of our analysis work is focused upon high volatility opportunities we thought it was about time that we should provide some low volatility suggestions as well. We set up the Advanced Ranker and searched for stocks that were near the bottom of their 52-week Implied Volatility range. Care must be taken to eliminate the many deal stocks that will show up in this group. Often their implied volatilites drop down to the lower end of the range; especially if the deals are not contested and are expected to be completed without a long delay. Next check for options volume and open interest, as you may want to eliminate those that are not actively traded. When you find one in a relative strong group you may have a candidate. Those with implied volatilites in the 20s range that have been as high as 50 in the last 52 weeks should be of interest, especially if the high implied volatility is related to earnings reports that occur quarterly. Here is one possible candidate.

Halliburton Company (HAL) 36.16. We suggested a bull call spread for this big oil oilfield service company in IVolatility Trading Digest™ Volume 8, Issue 5, Everybody Yahoo! dated February 4, 2008. Then the suggestion was to buy Apr 35 call and sell the Apr 37 ½ call with a debit of .775. With the stock now at 36.16 the spread is priced at 1.275, up .50, which is a 65% gain in 3 weeks.

This time we are interested in a low implied volatility strategy. The Advanced Ranker showed the 52 week implied volatility range as 47.02/23.56 with the current implied volatility index of 26.77. The current Historical Volatility is 29.62 and greater than the Implied Volatility Index. In addition a check of the volatility charts shows that it did trade with implied volatilites of 47.02 just before the last earnings announcement. Further it looks as if the implied volatilites rose prior to the two previous quarterly reports as well. With a lot of liquidity this is just what we want for the low volatility strategy.

For this suggestion we are going to use a long straddle, long both a call and put and we are going to adjust it to delta neutral while we wait for the implied volatility index to rise going into the first quarter report that will be announced in late April.

Trade Plan

DR: Long low volatility straddle for the next earnings report. Expect implied volatilites to rise going into the reporting period. Set up as delta neutral with adjustments using the stock to return to delta neutrality. Profits should be booked on each adjustment back to delta neutral. We are using the options with the highest gamma in order to obtain the largest change in delta for each point move in the stock.

Adjust: Adjust the position back to delta neutral on closes each 2 points higher or lower.

SU: If the stock fails to move and the implied volatility fails to rise before the expected reporting date unwind the position

Buy HAL Jul 37 ½ call HALGT 2.15 IV 28.54 Delta .4725 Gamma .0611

Buy HAL Jul 37 ½ put HALST 3.30 IV 29.05 Delta –.5353 Gamma .0618
Debit 5.45 Option position net delta -.0628.

Then, buy 6 shares of HAL stock at 36.16 per share (total 216.96) to become delta neutral.

Total debit 761.96 (545 for the options + 216.96 for the stock), Initial position net delta -.0028

High Volatility Delta Neutral Trade

Returning once again to the high volatility opportunities we find a company that has just completed a merger with the intention of combining operations to increase efficiency and raise product prices. In a stable capital market they could easily refinance their debt however, but this is not a stable capital market and there are rumors that they may not be able to obtain the necessary capital to refinance their combination and continue operations.

Abitibibowater, Inc. (ABH) 16.41. AbitibiBowater produces a wide range of newsprint and commercial printing papers, market pulp and wood products. It is the eighth largest publicly traded pulp and paper manufacturer in the world. Following the required divestiture agreed to with the U.S. Department of Justice, AbitibiBowater will own or operate 27 pulp and paper facilities and 35 wood products facilities located in the United States, Canada, the United Kingdom and South Korea. They are scheduled to announce earnings and the results of negotiations for renewed credit lines with their banks on February 28, 2008. With a Historical Volatility of 82.74 consider this neutral put sale.

Trade Plan

DR: High volatility short term trade and could be over in a few days. Unwind on the earnings and credit facility announcement.

Adjust: Adjust using the stock to keep it delta neutral each 2 points higher or lower.

SU: Unwind the position if the announcement is further delayed and/or implied volatility rises further.

Sell ABH Mar 15 put ABHOC 2.45 IV 181.37 Delta .3329

Sell 33 ABH shares short
Credit 786.53 (16.41 x 33=541.53)+245, Position net delta .0029

This position requires shorting stock and may require making adjustments. It may not be suitable for everyone.

Another High Volatility Thriller

The equity market rallied last Friday on the news that a rescue package will be announced on Monday or Tuesday for bond insurer Ambac Financial. If you believe the bond insurance industry will be able to raise capital in order to keep their top credit ratings then here is a trade to consider.

Ambac Financial Group, Inc. (ABK) 10.71. The second largest US bond insurer with $524 billion of guaranteed debt as at the end of December. The implied volatility has declined from the 225% range in early January. With a Historical Volatility of 341.73 consider this put sale before the announcement.

Trade Plan

DR: High volatility short term trade. Restructuring announcement rumored any day

SU: Watch the implied volatility. If it starts rising once again before the announcement then buy back the short put or sell stock short to cover the positive delta.

Sell ABK Mar 10 put GIYOB 1.675 IV 178.40 Delta .3482

Takeover File

From the takeover file we find a calendar put spread to consider this week.

The New York Times Company (NYT) 19.03. The newspaper’s chairman Arthur Sulzberger sent shareholders a letter urging them to reject board nominations by two hedge funds, Harbinger Capital and Firebrand Partners. The letter came after Harbinger disclosed in a filing with the Securities & Exchange Commission last Thursday that it had tripled its stake in the Times to 15.6% from 5% in January.

From the options market perspective here is a takeover story very few think will get done. The Implied Volatility Index for the puts is 81.56 and the Historical Volatility is 55.58. The implied volatility was driven higher by the put buyers as the Put/Call Options Volume ratio is 5, meaning there are 5 times as much put volume compared to call volume. Since market makers short the stock when selling the puts they have driven the short interest to 31.9 million shares or 22% of the total shares outstanding. Based upon this it seems the stock price belongs back toward the 14 level where it started the year. At these implied volatility levels we also think the near term put makes a good sale. Consider this calendar spread.

Trade Plan

DR: High profile but doubtful takeover deal based upon the Put/Call ratio data. If the March put expires out-of-the –money an April put can then be sold against the remaining long put or it could be unwound. If the takeover attempt continues beyond the March expiration date the IV of the long put could rise.

SU: If the stock declines below 17 ½ the short put will be assigned. Sell the long put, and sell the stock short, which will be bought back on assignment.

Buy NYT Apr 17 ½ put NYTPW 1.225 IV 64.30 Delta -.3354

Sell NYT Mar 17 ½ put NYTOW 1.10 IV 84.35 Delta .3326
Debit .125 Position net delta -.0028

Due to the assignment risk this position requires some planning and management. The best outcome is for the March put to expire just above the strike price leaving the April long put time premium, less the debit of .125 as the profit. Another put could then be sold in April or it could be unwound and the profit booked.

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.

Comments:

Question: Could you please clarify the Adjust strategy for the Halliburton Straddle Trade Plan? "Adjust the position back to Delta Neutral on closes each 2 points higher or lower". Are you referring to $2 moves in the stock price or to changes in the Greeks? Would you adjust via stock or options?

Posted by John Byrne on February 25, 2008 at 05:39 AM EST

What do DX DR and SU stand FOR IN THE NEWLETTER?

Posted by lee on February 25, 2008 at 11:22 AM EST

For the trade discussed on Feb 4th, the DBA bull call spread has moved very nicely. Assuming continued upward movement, what would your thoughts be now for this?

Posted by David Linton on February 25, 2008 at 12:06 PM EST

Would you explain what the acronyms DR AND SU mean in your trade discussions that I receive via Email? Thankyou

Posted by Paul Seifert on February 25, 2008 at 02:09 PM EST

When you discuss the following statement: - Buy HAL Jul 37 ½ call HALGT 2.15 IV 28.54 Delta .4725 Gamma .0611 - Buy HAL Jul 37 ½ put HALST 3.30 IV 29.05 Delta .5353 Gamma .0618 - Debit 5.45 Option position net delta -.0628. Then, buy 6 shares of HAL stock at 36.16 per share (total 216.96) to become delta neutral. How do you determine how many shares to buy to bring delta to neutral? Thanks

Posted by Landon on February 26, 2008 at 12:49 AM EST

John, Thanks for the Adjustment question on HAL. We are suggesting adjusting each two point move in the stock price. If it moves up 2 points we would sell stock to get neutral. If it then moves down 2 points we would buy stock to get neutral once again. We would use the Greek, delta to determine how much stock to sell and then buy again using this example. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 26, 2008 at 01:45 AM EST

Lee, Thanks for asking for clarification on DX, DR and SU. You will find DX in the text of the Digest. It is the trade weighted US Dollar Index, listed on the NY Board of Trade. The DR as we explain in the footnotes is the Determining Rationale (DR), or why we are doing this trade. We write it out before we enter the trade while we are still relatively objective. Later when we have a position and our objectivity may now be somewhat impaired we can refer back to the DR and see if it’s still valid. Is the reason we entered the trade still valid or have circumstances changed? SU is our shorthand for the Stop. We use SU because we may have a spread that can change direction by lifting a leg, or adjusting the option position, or unwinding. Therefore we use SU or “Stop and/or unwind” Jacktrader

Posted by Jacktrader (66.182.123.195) on February 26, 2008 at 01:58 AM EST

David, Thanks for the comment on DBA. Find another entry point and add another bull call spread. DBA has gone up just about 5 points and the spread has doubled in value in three weeks. This is a good return on investment considering we started with a defined and limited downside risk. If you look at the chart you will notice when DBA gaps up it usually pulls back for 3 days before resuming the uptrend. You can estimate how much the pull back will be by comparing the closing price to the Net Asset Value of DBA available at the AMEX web site, in the ETF section. When they come back in line then add another spread. Use the April or July options, with about 4-5 points difference and see if you can identify some edge, by selling one that is more expensive in IV terms than the one you buy. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 26, 2008 at 02:31 AM EST

Paul, Thanks for the DR and SU question. The DR as we explain in the footnotes on our web site is the Determining Rationale (DR), or why we are doing this trade. We write it out before we enter the trade while we are still relatively objective. Later when we have a position and our objectivity may now be somewhat impaired we can refer back to the DR and see if it’s still valid. Is the reason we entered the trade still valid or have circumstances changed? SU is our shorthand for the Stop. We use SU because we may have a spread that can change direction by lifting a leg, or adjusting the option position, or unwinding. Therefore we use SU or “Stop and/or unwind” Jacktrader

Posted by Jacktrader (66.182.123.195) on February 26, 2008 at 02:39 AM EST

London, Thanks for the question on the neutrality computation on the HAL straddle. The net delta position of the options is what we want to make neutral. In the example, it is shown as -.0628. Each option is for 100 shares so move the decimal point two places to the right and you see the net short is –6.3 deltas or shares. Therefore, to get neutral we need to buy 6 shares of stock. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 26, 2008 at 02:52 AM EST

I suppose that: Sell ABK Mar 10 put GIVOB 1.675 IV 178.40 Delta .3482 was meant to be Sell ABK Mar 10 put GIYOB 1.675 IV 178.40 Delta .3482 Jackie from the «gotcha» brigade !

Posted by JackieGL on February 26, 2008 at 07:42 AM EST

JackieGL, Thanks for the ABK Mar 10 put correction. You are right it should be GIYOB and not GIVOB. Keep up the good work. Jacktrader

Posted by jacktrader (66.182.123.195) on February 26, 2008 at 11:53 AM EST

Hi Jacktrader, You mentioned that "We are using the options with the highest gamma in order to obtain the largest change in delta for each point move in the stock". Since the HAL long straddle was designed to capture the expected volatility increase, shouldn't we buy options with highest vega? Thanks!

Posted by Newoption on February 26, 2008 at 10:46 PM EST

Newoption, Thanks for the comment. You are right if our primary objective was an increase in implied volatility we should focus on vega. We are planning to adjust this position back to delta neutral in 2 point stock increments, so for this trade we were specifically looking for the highest gamma. It also has the highest vega for the July options. If our primary objective was just an increase in volatility we would suggest a straddle with a longer time to expiration and with higher vega values than the July option series. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 27, 2008 at 01:59 AM EST

You commented that with the dollar looking down and gold looking up, a bull call spread might be good on AUY or ABX. For AUY, I got both the Mar08 and Apr08 (did not know how to decide) spreads buying 16 and selling 17.5 calls. The Mar spread seems to be working ok and better than the Apr. Should I have expected this? Also, you wrote 'good choice considering the DX remains above the 75 level'. Are you suggesting that DX < 75 would hurt this play?

Posted by David on February 28, 2008 at 05:47 PM EST

David, Thanks for the comments and question on DX and AUY. Comparing the March 16/17.5 call spread to the April 16/17.5 call spread, we can see that the Mar has a net delta of .1899 while the Apr is .1370 (using closing data 2-28-08). This explains why the Mar is more responsive to the price rise. We suggest you compute these numbers and make them a part of your written trade plan, either before or concurrent with the trade. If you did you would have seen the delta differences in the two spreads and you could have expected it to rise quicker. Also look at the IVs for the legs. Ideally you want to buy the less expensive in IV terms and sell the more expensive in IV terms. As for the DX above the 75 level this was a reference to the uncertainty that the DX would be able to hold the 75 level. If it had held then the spread would give you a position with less risk than an outright long call, for example. I was not suggesting that a decline below 75 would hurt this play, to the contrary it would be beneficial. Now that we know DX is going lower we can increase our positions in this sector. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 29, 2008 at 12:47 AM EST

Jacktrader Thanks for your response. Your IVolatility Trading Digest is great. I think I am finally starting to get a bit of a handle on options. I looked on the web site to see your net delta and IV info and found that the 16 calls do not show on the main page. Is there a link somewhere? Will the near term spread always have the better net delta? Will the more ITM strike always have the lower IV? During the day, the delta and IV can move a lot with the option prices. Is there a way to enter the trades based on limit net delta and / or limit net IV? Thanks again.

Posted by David on February 29, 2008 at 09:54 AM EST

David, Thanks again for the questions. In order to get a good understanding we suggest you subscribe to our Advanced Options and Advanced Historical Volatility services. There are a lot of variables influence options pricing. This is the best place to get started. You can subscribe to real time data if you are an active day trader. With spreads you can calculate the position net delta at the close and then use this delta computation for the next days pricing. Using the next days price change apply the delta from the previous day to see the new theoretical value for the spread in the current day. You can use the same method to calculate the new values for each of the legs as well. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 29, 2008 at 12:17 PM EST

IVOLATILITY SUGGESTION: 02/29/08 YHOO BEST CALENDAR SPREAD LONG 10 OCT 08 27.50CALL @ 3.55 SHORT 10 APR 08 27.70CALL @ 2.13 30 days HV= 124.7% IV index mean= 45.89& QUESTION: You have suggested a call calendar spread. If yhoo has had such a change in volatility to the downside, wouldn´t it be better to set up a put calendar spread instead? Please advice pretty confused..

Posted by Carl on February 29, 2008 at 04:07 PM EST

Carl, Thanks for the Yahoo calendar spread question. Using the closing prices on 2-29-08 lets take a look at the IV numbers. For the Apr 27 ½ call the IV is 49.67 and the put IV is 49.49. Since we want to sell the near term option we would select the call since it is more expensive in IV terms than the put. For the Oct 27 ½ call the IV is 35.38 and 38.71 for the put. Since we are buying the Oct we would want the cheaper one, again the call, in IV terms. The best trade would be to sell the Mar 27 ½ call with an IV of 53.74 and buy the Oct 27 ½ call with an IV of 35.38. Since it is the ATM call you would have to be concerned with assignment of the short call if Yahoo closes higher than 27 ½ at the March expiration, which seems very likely. While the IV has declined in the last month it has risen in the last week. A best guess estimate for IV would be a 40-50 range with spikes higher on fundamental news about the merger battle. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 29, 2008 at 08:18 PM EST

Jacktrader:Thank you for your response to my YHOO best call calendar of 02/29/08 question. My technical analysis indicates me that YHOO is bearish. Would the call calendar be preferred over a put calendar? You explained before that the short call is more expensive than the short put and therefore we would enter as a call calendar for a larger credit. Wouldn´t it be the long put that would make us profit assuming that the belief in my bearish trend is right eventhough we don´t have a higher volatility for the short put?

Posted by Carl on February 29, 2008 at 09:33 PM EST

Carl, With respect to a bearish view on Yahoo, it is better to use a tool that is best suited for the purpose. If you wanted to saw a board in half you would not want to use a drill. If you are bearish on Yahoo, then use a bear put spread and not the calendar spread. Go out to Jul or Oct and pick the puts using the same volatility criteria previously discussed. Buy the less expensive and sell the more expensive in IV terms. Jacktrader

Posted by Jacktrader (66.182.123.195) on February 29, 2008 at 09:51 PM EST

Hello Jacktrader, Thank you for your answer to my vega question about the HAL straddle. Another question about it. How to adjust the position. Let's suppose that the price of HAL decrease for $36.16 to $34.14 after we enter the trade, call option delta decrease accordingly to 40 and put option delta increase to -60, net delta become -14. At this time, how do we adjust? Buy another 14 shares? If doing that, no profit will be realized. Thanks!

Posted by Newoption on February 29, 2008 at 09:59 PM EST

Newoption, Thanks for the adjustment question on HAL. For the suggested trade plan in IVTD V8 Issue 8 for HAL we bought 6 shares on the first trade in order to become neutral at the time we bought the straddle. Now, when we add up the deltas and find we are –14 then we need to buy 8 shares more to get neutral once again. Profits and losses come from two sources, one from adjusting the stock and the other from the change in value of the straddle. If, for example IV rises as a result of a rapid decline in the stock price then the value of our straddle will also rise. The other source of profit and loss is the adjustments we make in the number of shares we hold. It is probably best to keep two separate records, one for the options and the other for the stock. Using your HAL numbers as an example, on the next price rise we will sell stock, say the same 8 shares at the then higher price and book the gain. If you find that you are not making adjustments narrow the required price move. In the suggested plan we used 2 points and this may be too much. A one-day one-standard deviation move is a possibility to consider. To fully understand it does require a lot of record keeping. Jacktrader

Posted by Jacktrader (66.182.123.195) on March 01, 2008 at 12:13 AM EST

Thank you so much, your blog is the best. I have been reading some books/websites about the option trading. But your blog is the one that really stands out with it real-world guidances and detailed explanation. Thank you for the great work and can't wait for the next issue.

Posted by Newoption on March 01, 2008 at 09:21 AM EST

Newoption, Thanks for your kind words of encouragement. We think real time examples will help to understand some of the more complicated nuances of this options biz. Please pass the word to your friends. Jacktrader

Posted by Jacktrader (66.182.123.195) on March 01, 2008 at 11:12 AM EST

On the HAL trade, I understand the tactics you are using to achieve and maintain delta neutrality. My question is why is that important here?

Posted by Donald on April 06, 2008 at 04:02 AM EDT

Donald, Thanks for the question on HAL. A delta neutral long straddle is a package deal. We buy the straddle when we think Implied Volatility will be rising with the objective of increasing the value of the long options. For example, the IV of HAL has risen from 27.44 to 33.91 since the inception of the trade. The value of the options have risen from 5.10 to 6.465. In addition, we have made 14 adjusting trades, eleven of which are closed booking 189.51 in gains. The current short position, marked to market would add another 78.64. The options cost 510 and the maximum long stock was 1,129.88, while the current short is –1.822.15. Putting it all together we are have 504.65 in gains, realized or indicated on an investment of 1,421 (cost of the options + the margin of 50% on the maximum short of 1,822) in 5 weeks. The percent gain is 36% and the annualized gain is 369%. The current position is still long Jul 37 ½ call and short the Jul 37 ½ call with a short position in the stock of 46 shares. Position net delta .4 of one share long. Thanks for asking, it was about time to do the accounting and as you can see it requires quite a lot. Jacktrader

Posted by Jacktrader (66.182.123.195) on April 07, 2008 at 02:40 AM EDT

Permalink Comments [28]

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IVolatility Trading Digest^TM Disclaimer
IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.

Our purpose is to offer some ideas that will help you make money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".