IVolatility Trading Digest™ Blog

Monday March 24, 2008

Volume 8, Issue 12
Spring Potpourri

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

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).

In this issue we are going to work with the Put/Call Ratio as a trade selection tool and then do some spring-cleaning by reviewing and updating some previous trade suggestions. Finally we are going to look at a low volatility strategy for the upcoming earnings season.

Market Review

In several recent issues we have expressed our view about the most likely near term course for the US equity market and for now it does not seem necessary to dwell on it further.

Strategy

In this past week there was significant selling in the commodity related groups and a good many suggestions have recently been included here. Since there is no way to know how much more selling we will experience keep the Stop/Unwind (SU) levels close at hand and be prepared to unwind spreads as necessary by selling the long side while keeping the short side. You should have written SU levels for each open position.

Volatility Index

Last week in IVolatility Trading Digest™ Volume 8, Issue 11, Ben’s Magic Show, dated March 17, 2008 we offered a suggestion for the CBOE Volatility Index (VIX) now 26.62. This was an additional suggestion and similar to the one made in IVolatility Trading Digest™ Volume 8, Issue 10, Ides of March, dated March 10, 2008. Since the VIX opened on March 17, 2008 above the SU level of 35.14 the second suggestion could not have been made according to the new plan and the first suggestion should have been closed that day on the spike to 35. As for the first suggestion the original debit was 2.575 and while we did not get the actual numbers for the closed first spread suggestion we estimate it was 6.50. What we were expecting happened and for now we would be out of this trade.

RT Options Scanner

We set up the RT Options Scanner looking for high call/put ratios as a trade selection tool. We limited our search to S&P 500 stocks and ranked the results based upon End of Day Call/Put Volume (EoD). Numbers greater than one mean more call volume than put volume. For example, a ratio of 8.47 means there was almost eight and one-half times more call volume than put volume.

With the rebound in the financial sector it was not surprising to find a few banks on the list as this group has been oversold and was likely to rebound on favorable news and short covering before the holiday weekend.

At the top of the list we have the following:

Name Symbol EoD Volume Ratio Sector

--

Marshall & Ilsley Corporation (MI) 8.47 Banking

T. Rowe Price Group, Inc. (TROW) 7.35 Investment Manager

The New York Times Company (NYT) 5.32 Newspaper

Monster Worldwide Inc. (MNST) 4.79 Online Employment

Yahoo! Inc. (YHOO) 2.58 Online Advertising

Tesoro Corporation (TSO) 2.44 Petroleum Refining

While we have previously suggested trades for four of the top six in the list above we will update our previous suggestions for three of them.

Monster Worldwide Inc. (MNST) 24.24. Monster remains in a well-defined downtrend from the October high just above 40. It could well be a takeover candidate and the call buyers think this downtrend is about over. Earning are expected April 30, 2008 and if the long calls are right here is a suggestion to consider. The current Historical Volatility is 62.72. To go with the call buyers we suggest a low risk out of the money bull call spread with a SU (stop/unwind) at 22.50.

Buy MNST Jun 35 call BSQFG .675 IV 65.82 Delta .1790

Sell MNST Jun 40 call BSQFH .30 IV 65.43 Delta -.0916
Debit .375 Position net delta .0874

Yahoo! Inc. (YHOO) 27.66. Previously we made two suggestions for YHOO and the results to date are about break-even. Since we would still be long a Jul 27 ½ call and short the Jul 27 ½ put as a synthetic long we suggest selling the near term at-the-money call. With a current 20-day Historical Volatility of 37.53 consider this call sale against the synthetic long. Use a close below 25 as the SU (stop/unwind) level.

Sell YHOO Apr 27 ½ call YHQDY 1.645 IV 48.68 Delta -.5505

Tesoro Corporation (TSO) 29.92. You may recall this is the company that Kirk Kerkorian made a $64 tender offer to buy last October. After management adopted a poison pill defense strategy he withdrew the offer and the stock has been in a defined downtrend since. Currently the concerns are about the low crack spread in the refining industry but the call buyers of this stock (and industry analysts) think it will be improving soon. Both of the previous suggestions for this stock would have been losers (pre-defined and limited) unless they were previously unwound. Since we did not provide a suggested SU (stop/unwind) level for the trades we are again reminded of their importance along with written trade plans.

On the theory that the call buyers are correct here is another suggestion. With Current Historical Volatility of 73.30 and with the Implied Volatility in a Type II high pattern (both volatility measures are now high and are expected to be declining) consider this put sale.

Sell TSO May 25 put TSOEQ 1.375 IV 76.06 Delta .2244

SU: In the event the stock is assigned at 25 because it closes below 25 at expiration then sell the stock at the break-even of 23.625, which is the assignment price less the put sale premium received.

IVOLopps™

News Making High Volatility

The Bear Stearns Companies, Inc. (BSC) 5.96. BSC operates as an investment bank, securities and derivatives trading and clearing brokerage. Bear vertically integrated the mortgage market from origination to the ultimate sale of mortgage back securities. This was their main business and they were unprepared to make money in a down mortgage market. If the Federal Reserve and JP Morgan Chase had not provided support they would have filed for bankruptcy thereby risking the repo securities market, the credit-default swaps market and other credit derivatives. Now the question revolves around the current valuation. JP Morgan claims they will pay 2.40 to the equity holders and not a penny more. With an irrelevant Historical Volatility at 562 and Implied Volatilities in the mid 200’s consider this bear put spread.

Buy BSC Apr 7 ½ put BVDPU 2.85 IV 243.07 Delta -.5235

Sell BSC Apr 5 put BVDPY 1.225 IV 249.54 Delta .2984
Debit 1.625 Position net delta -.2251

DR: It is unlikely there will be a higher bid for BSC.

SU: If BCS closes above 10 unwind the spread.

JPMorgan Chase &Co (JPM) 45.97. JPM is a financial holding company, providing financial services worldwide. They have six segments: Investment Bank, Retail Financial Services, Card Services, Commercial Banking, Treasury and Securities Services, and Asset Management.

If they are able to complete the Bear Stearns acquisition and if there is any value to be realized above the purchase price they would benefit. While it may take a long time to know for sure the markets are currently responding favorably.

With a current Historical Volatility of 56.34 here is a relatively low risk way to participate in this financial sector development.

Sell JPM Apr 40 put JPMPH .95 IV 60.67 Delta .1974

DR: This stock was trading around 37 before the BSC acquisition news and it may return to this level if there are any successful challenges to their bid. Be prepared to buy the stock at 40 in the event of assignment.

SU: In the event of assignment at 40 sell calls against the long stock. If the stock closes lower than 36 unwind the position and sell the stock.

Low Volatility – Earnings Reporting Starts Soon

We ran the Advanced Ranker looking for stocks in the 200 group with the highest open interest that are at lower end of their 52 week implied volatility range and that showed a regular pattern of rising implied volatility going into their earning report date.

Many companies will be reporting in mid to late April but many do not as yet have May options trading. Ideally we want to find one that has the potential for rising implied volatility as the earrings date approaches and we want our options to be in the same month in order maximize gamma, the rate of change of delta. Since the near term options have higher gamma values than deferred options we want to match the dates as close as possible.

Trade Plan

Hewlett-Packard Co. (HPQ) 46.50. HPQ provides various computer products, technologies and software solutions worldwide. The May options expire on the 16th and they are scheduled to report second quarter earning on May 15,2008. For the last four quarters implied volatility has risen noticeably (on average about 33%) prior to reporting earnings.

DR: The strategy is to buy a straddle with the highest gamma and adjust the position to delta neutral as the options gain in value from rising implied volatility. Adjustments will be made when the stock rises or declines by a value more than that represented by a one-day one-standard deviation calculated using the 10-day Historical Volatility. We do not plan to adjust for smaller daily price fluctuations. We then plan to close the position on the day before HPQ reports earnings.

SU: If the implied volatility has not risen from 35 within a week of the reporting date we will unwind the position

With a current 10-day Historical Volatility of 31.60 and a current one-day standard deviation of .92 and with 54 days to expiration consider this straddle.

Step one:

Buy HPQ May 47 ½ call HPQEW 2.15 IV 33.96 Delta .4766 Gamma .0633

Buy HPQ May 47 ½ put HPQQW 3.05 IV 35.01 Delta -.5251 Gamma .0625
Debit 5.20 Options position net delta -.0485 Position Gamma .1258

Step two:

Buy 5 shares of HPQ at 46.50
Total debit 752.50 (Options 520+ 252.50 for the stock)
Position net delta .0015
Gamma 12.58

In order to make the position delta neutral at the outset buy 5 shares of stock. This will result in a delta neutral position with a gamma of just under 13. Which means for a one-point move in the stock the position will gain or lose approximately 13 deltas requiring an adjustment purchase or sale of stock to return to neutral.

Caution this suggestion could require a lot of trading which will require a lot of record keeping and may not be suitable for all option participants.

We intend to follow this suggestion and record the adjustments. We will report from time-to-time on its progress.

Previous Issues and Reader Response Request

Previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. 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 future 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:

I have watched and studied your option comments with some interest, although at times the advanced techniques leave me in the dust. The question that popped into my head today was this: just how profitable has your system become over the years? Would you be able to determine how much $10000 invested 3, 5 or 10 years ago would be worth if all your recos were followed exactly? Would you be willing to relate to us the average total return, standard deviation and max drawdown over that time, less commissions, slippage and taxes?

Posted by Richard on March 24, 2008 at 03:56 PM EST

Richard, Thank you for the thoughtful and articulate question about a trading record. Since we do not offer portfolio management services our activity is limited to weekly suggestions for the time being. “Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.” We would not consider all the trades suggested appropriate for everybody. Suggestions are the operative word. This is more like a menu of ideas; not all are suitable for everybody. For example some people do not have margin accounts, others may use brokers that charge commissions at a rate that would prohibit some trades that require frequent adjustments. Others may not be comfortable with short positions in stock and options. In order to establish a meaningful trading record we would need to make daily commentaries about positions closed and adjusted during the week. Further we would have to suggest each trade for a particular category and make assumptions about commission rates and available trading capital. It would require a considerable commitment to accountants and a portfolio accounting system that are beyond the scope of available resources for the IVolatility Trading Digest. Perhaps this is something we can consider doing in the future. Jacktrader

Posted by Jacktrader (66.182.123.195) on March 24, 2008 at 08:41 PM EST

I've got a question on your HPQ trade to capitalize on the rising volatility as earnings date approaches. While the puts and calls will increase in price as the IV goes up, the price also goes down due to time decay as the expiration date approaches. Since HPQ earnings date is within a day of options expiration, won't the loss in option premium due to time decay more than offset the gain in premium for the 33% increase in IV??

Posted by Jeff on March 28, 2008 at 03:30 PM EST

Jeff, Thanks for your very astute comment and question on the HPQ straddle. You have indeed identified the real risk in using near term options, which is the loss of time premium. In seeking options that have the highest gamma we are exposed to the loss of time premium. We could have chosen options in a deferred month and reduced this risk while making the straddle more sensitive to the expected increase in volatility. That would clearly be an alternative approach. The objective of this particular trade is to have the highest gamma options going into the reporting period. If the volatility of the underlying stock increases as measured by the Historical Volatility and if we are long options with the greatest gamma then we should see larger changes in delta, positive and negative as the stock price changes. Ideally we would like to see the Historical Volatility rise taking the Implied Volatility with it. As we make our adjustments to return to delta neutrality we will be counter-trend trading and booking profits on the adjustments. There is a clear trade off between the Historical Volatility, the adjustments and the time decay. If the Historical Volatility increases and we make many adjustments we should be able to beat the time decay of the long options. If the Historical Volatility does not cooperate we will close the trade early and salvage the remaining time premium. Low commissions and a lot of record keeping is required. Jacktrader

Posted by Jacktrader (66.182.123.195) on March 28, 2008 at 04:28 PM EST

Could you be a little more detailed on the Hewlett Packard trade. With the expected and admitted loss of time premium by waiting that close to expiration to unwind, is the object here to make money on the move of the net straddle intrinsic value? If that's the case, the way I see it, we only win with an upside move here. In other words, as the value of our stock goes down, the value of the straddle goes up and offsets the loss in stock keeping us relatively "even." Therefore, it seems to me that only if the stock goes up and the net straddle value goes up do we have a gain? What am I missing?

Posted by Donald on April 06, 2008 at 03:51 AM EDT

Donald, Thanks for questioning the HPQ straddle. Some trades work better than others and at the moment this one is not showing the volatility we would like to see. It is still early; the earnings report is due May 15, 2008. We think the volatility will start picking up soon. You are not missing anything and have the analysis right with respect to the decaying time value of the options. The other part that we have not as yet made very clear is the adjustments. This trade is relying on a material increase in volatility, both implied and historical going into the earnings report. We are basing this upon its activity for the last few reporting periods. We think there is a chance the pattern will repeat itself again this quarter. If it works according to the plan the increase in implied volatility will more than offset the loss of time premium on the options. Then if the historical volatility rises above 34 (the implied volatility of the options we bought) we will have an edge as we make our adjustments to remain neutral. That is, if the underlying stock starts moving faster than was priced by the implied volatility at the time of the options purchase then we should be able to gain an edge with the adjustments. We add up all the gains from the adjustments (assuming good volatility) and it becomes a part of the total accounting for the trade along with the options valuation. It all depends upon the volatility hence this is volatility trade. Jacktrader

Posted by Jacktrader (66.182.123.195) on April 07, 2008 at 03:14 AM EDT

I posted an answer here 2 weeks ago and no acknowledgement was offered. Was it lost in cyberspace? Thank you. Jackie G. L.

Posted by JackieGL on April 10, 2008 at 05:33 AM EDT

JackieGL Thanks for letting us know about the posting two weeks ago. If you will provide some more details we will look into it. At this point we have no idea what you are referring to. Jacktrader

Posted by Jacktrader (66.182.123.195) on April 11, 2008 at 12:28 AM EDT

Looks like it was lost in cyberspace then. In essence I meant to say to Richard that "yes" the system seems profitable. I had made a small but elaborate report of all the propositions you have posted since November 2007. And it added to a gain of ~ 10375$ Cheers!

Posted by JackieGL on April 14, 2008 at 04:10 PM EDT

JackieGL, Thanks for the report on the suggestions since November. You must have spent a good deal of time preparing it. Keep in mind not all suggestions would be appropriate for any one portfolio or risk tolerance. Thanks for the effort, this is indeed a detail business required a lot of record keeping. Jacktrader

Posted by Jacktrader (66.182.123.195) on April 14, 2008 at 11:23 PM EDT

It is not much time ! Really ! I always paper trade your suggestions in a yahoo portfolio assuming 10 contracts on each trades. JGL

Posted by JackieGL on April 21, 2008 at 09:50 AM EDT

JackieGL, Thanks for the comment on the trade record keeping. How do you handle closing them? If we have not included a SU and it goes the wrong way what action are you assuming? What commission rate are you including? Keep up the good work. Jacktrader

Posted by 66.182.123.195 on April 21, 2008 at 01:21 PM EDT

Jacktrader For simplicity wise I never mind the Stop/unwind you provide. For options: Spreads : I always figure 10 contracts for the buy and 10 for the writing. Naked Puts: I always write 10 contracts. Covered calls would be the same: 1000 shares and 10 written calls. For commission : I allocate 45 $ buying and 45 $ selling for each batch of 20 contracts.on a spread. The assignment of 1000 shares on a naked PUTs will also be 45$ charge and the same goes for the selling of the1000 shares when they are called away. I close/end the contracts on the Monday before the last day of the contract when they profit and I closed them after a loss of 10% if they don't. When assigned the 1000 shares of a stock from naked PUTS I sell these shares at the opening the day after. I hope I am clear. -Jacqueline

Posted by JackieGL on April 21, 2008 at 02:18 PM EDT

Jacqueline, Thanks for these details. Yours seems like a very reasonable approach. So you are using a 10% stop on trades that don’t work. As for the commission charges, there are brokers out there charging .50 per option contract, so for a twenty lot it would total $10. For stock the number is .005 per share. Have you considered keeping the assigned stock from puts sales and then selling calls? Jacktrader

Posted by Jacktrader (66.182.123.195) on April 21, 2008 at 05:40 PM EDT

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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".

IVOLopps^TM
In this section which we call IVOLopps^TM (IVolatility Opportunities) we will focus on recommendations that should be made now, or Action Now! For many event driven opportunities volatility will be abnormal for very short periods of time so action is recommended without delay. Our assumption is the trade will be made the next day.

IVOLalerts^TM
Our next section we call IVOLalerts^TM (IVolatility Alerts). These recommendations require some additional time before being made. Often we will be waiting for confirming fundamental or technical developments before making these trades.