IVolatility Trading Digest™ Blog

Monday April 14, 2008

Volume 8, Issue 15
Momentum Waves

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).

Sometimes called buying high and selling higher momentum is a strategy that attempts to capture gains by buying "hot" stocks and selling "cold" ones. As more market participants have adopted this style it has created waves of investment capital flowing from sector to sector attempting to quickly identify the next hot sectors and then quickly exit. Usually associated with bull markets this momentum sector rotation is alive and well even during this market correction. By remaining focused solely on the market averages you may have missed the upward momentum activity. We are going to offer some option suggestions for a few stocks currently in favor and a few that have the potential to return to favor shortly.

Market Review

S&P 500 Index (SPX) 1332.83. By the end of the week the recent upside bounce was in retreat renewing our call once again for the Head & Shoulders Top measuring objective down at 1225. There is a chance it will attempt to stop short of the objective thereby forming a new Head & Shoulders Bottom. If so, look for the next reversal to occur at the 1270 level. Again we think the more likely outcome is the attainment of the original measuring objective at 1225.

The CBOE Volatility Index (VIX) 23.46 is now looking stable in the 22-24 area. Although the market declined Friday the VIX did not seem to reflect a rush of protective call buying. We will be watching this index as the number of earning reports increase this week.

The US Dollar Index (DX) 71.90 traded along the 72-price level for the week. If the commodity group is going to continue higher it will require the DX to continue lower. For now both appear stable. We continue to think this is the single best indicator to watch for the commodity-related groups.

Although our market breadth indicator, the NYSE McClellan Summation Index improved 122.69 for the week by Friday it appeared to be running out of gas with a reading of –162.78.

Strategy

We are going to continue the portfolio review we began last week. Although the market continues to decline and we expect a somewhat lower level before the final bottom in place we think it is likely that most of the decline is behind us and we should now focus on sectors and stocks that are already trading higher. In this momentum driven market we increasingly run the risk of establishing positions just as the momentum reverses. Currently some upside momentum favorites are steel, coal, railroads, domestic exploration and drilling, ocean tankers and agricultural chemicals. Some of ones that continue to have favorable fundamentals yet are out of favor include China and the bulk shippers. The commodity group including gold and silver may have also seen their highs but the US Dollar Index (DX) will be the deciding factor.

IVOLopps™

In order to devote more space to suggestions we are going to shorten our format somewhat by eliminating the specific references to the determining rationale DR and the stop/wind SU. Both are and important part of the written trade plan and we continue to encourage them to be a part of process.

Upside Momentum

AK Steel Holding Corporation (AKS) 66.68. AKS sells flat-rolled carbon steel products primarily to automotive manufacturers and customers in the appliance, industrial machinery and equipment, and construction markets. Up from 35 in January this steel stock along with others is one red-hot group. The risk here is the momentum could be withdrawn at any time. In the prior four quarters earning have been better than expected and the next report is due on April 22, 2008. With reasonable support at the 50 trendline and with a current Historical Volatility of 68.67 consider this put sale suggestion.

Sell AKS May 55 put AKSQK 1.475 IV 73.17 Delta .1649

Good edge here. If assigned take the stock and then sell calls.

Alpha Natural Resources Inc. (ANR) 46.66 produces, processes, and sells steam and metallurgical coal in the United States. The company's steam coal is used as fuel for electricity generation, while the metallurgical coal is used to make coke for steel. Up from the January low at 22 ½ this coal stock along with others is following the steel sector higher and as with the steel stocks there is momentum risk. The quarterly earnings report pattern has been mixed with many not meeting expectations. The next report is due May 6, 2008. With a well defined upside trendline and with a current Historical Volatility of 84.10 (should decline) consider this suggestion.

Sell ANR May 40 put ANRQH 1.475 IV 74.55 Delta .2138.

Currently 6.66 above the strike price at 40. If assigned the basis would be 38.525 and near support at 37 ½. In this event sell calls against the long stock.

McMoRan Exploration Co. (MMR) 21.29 is pursuing natural gas exploration and development opportunities in the Gulf of Mexico and the Gulf Coast region, primarily high-risk, high-potential, deep exploration prospects considerably below 15,000 ft. in the shallow waters on the shelf of the Gulf of Mexico. In addition, they are developing MPEH™, the offshore LNG gas terminal at Main Pass. There continues to be more insiders buying as we reported about this time last year when the stock was around 13. Having just broken out above 18 it is clearly in the momentum group and subject to selling at any time. The earnings report is due Thursday April 17, 2008. With a Historical Volatility of 58.90 consider these ideas:

Sell MMR Apr 20 put MMRPD .50 IV 89.64 Delta .2842
Or
Sell MMR May 20 Put MMRQD 1.625 IV 87.77 Delta .3542

While the suggestions above have assignment risk here is a spread suggestion with limited and defined risk as well as having the advantage of eliminating volatility and time decay risk.

Buy MMR May 20 call MMRED 2.65 IV 74.94 Delta .6542

Sell MMR May 25 call MMREE .85 IV 77.77 Delta -.2961
Debit 1.80 Position net delta .3581

In the event of a sudden loss of group momentum there is a good chance that this spread will still have some value that could be realized. As for the put sales you would most likely have to take the stock and sell calls as was the case for the suggestions we made for MMR about this time last year.

Halliburton Company (HAL) 43.52

In IVolatility Trading Digest™ Volume 8, Issue 8, Broken Triangle, dated February 25, 2008 we suggested a low volatility straddle strategy for this big oil services company. At that time the stock was 36.16 and since then we have adjusted the straddle to delta neutral 16 times and have adjusted the strike prices up one level as the stock began to trend upward. As we have now broken out above 40 we suggest adding a bull call spread to the existing straddle position. The earnings report is due next Monday April 21, 2008 and so far the options Implied Volatility has not yet risen.

Buy HAL Jul 45 call HALGI 2.255 IV 31.10 Delta .4624

Sell HAL Jul 47 ½ call HALGW 1.380 IV 30.62 Delta -.3301
Debit .85 Position net delta .1323

In the event that the momentum fades after the earnings report we still have sufficient time for the stock to recover. In the meanwhile the risk is defined and limited and we have offset the volatility and time decay risk as well.

Now Lacking Upside Momentum

Next we look at a few suggestions for stocks that continue to have good fundamentals but are currently out of favor with momentum traders. Unless the fundamentals deteriorate the momentum could return at any time as the wave rolls out of the overvalued and into the next perceived undervalued group.

DryShips, Inc. (DRYS) 65.41 DryShips is the owner of 35 dry bulk carriers comprising 5 Capesize, 27 Panamax, 1 Handymax, and 2 newbuilding Panamax vessels with a combined deadweight tonnage of approximately 3 million, carrying dry bulk commodities, including coal, iron ore, and grains, bauxite, phosphate, fertilizers, and steel products. DRYS charters its ships in the riskier and usually more profitable spot cargo market.

In IVolatility Trading Digest™ Volume 7, Issue 42, Dim Green Light, dated December 3, 2007 we suggested the sale of a December 80 put at 2.90. Since the stock closed at 71.18 on the December expiration this stock would have been assigned and the basis would have been 77.10. The opportunity to exit the long stock position came in the middle of February as the stock again traded above 80. If a January or February call had been sold the basis would have been further reduced providing for a reasonable return on investment.

We return once again and this time the stock is trading just above the 60-support area, but the implied volatility is not high enough to consider a put sale. With the next earnings report due on May 29, 2008 and with a current Historical Volatility of 88.00 take a look at this bull call spread as a way to be ahead of the momentum traders if and when they return to DRYS as we think they will.

Buy DRYS Jun 70 call DQRFN 6.75 IV 74.89 Delta .4855
Sell DRYS Jun 75 call DRQFO 5.05 IV 73.86 Delta -.3995

Debit 1.70 Position net delta .0860

This out-of-the-money position gives us sufficient time with a low and defined risk.

Genco Shipping & Trading Ltd. (GNK) 58.43. New York based GNK transports iron ore, coal, grain, steel products, and other drybulk cargoes with a fleet of 28 drybulk carriers consisting of 5 Capesize, 6 Panamax, 3 Supramax, 6 Handymax, and 8 Handysize drybulk carriers, with an aggregate carrying capacity of approximately 2,020,000 deadweight tons. Currently selling at just over 7 times 2008 earnings with a 6% dividend it reports quarterly earnings on May 7, 2008. We think there is a good chance the momentum crowd will be returning to the bulk shippers and here is another suggestion to be there before they arrive. With a current Historical Volatility of 68.35 consider this bull call spread.

Buy GNK Jul 65 call GNKGM 3.85 IV 53.63 Delta .3964

Sell GNK Jul 70 call GNKGN 2.525 IV 52.85 Delta -.2923
Debit 1.325 Position net delta .1041

This out-of-the-money spread expires after the next earnings report with a low, defined and limited risk.

Yucheng Technologies Limited (YTEC) 16.62. Beijing, China, based YTEC is a leading IT service provider to the Chinese banking industry. It has more than 1,700 employees serving its banking clients nationwide with subsidiaries and representative offices in eleven cities. YTEC provides a comprehensive suite of IT solutions and services to Chinese banks including channel-related IT solutions, such as web banking and call centers, business-related processing solutions, such as core banking systems, foreign exchange and treasury management, and management-related IT solutions, such as risk analytics and business intelligence. It is also a leading third party provider of POS merchant acquiring services in partnership with banks in China. Here is a beneficiary as China makes the transition from cash to credit cards. The forward price to earnings ratio is 15 with a price to earnings growth ratio of .74. With YTEC you get a rapidly growing company in an out-of-favor country in an out-of-favor industry sector. With a current Historical Volatility of 79.76 consider this put sale with edge.

Sell YTEC May 15 put TXEQC 1.15 IV 95.78 Delta .3079

Takeover File Update

Cameco Corp. (CCJ) 36.76. Saskatoon, Canada based CCJ explores, develops and mines uranium ore to produce uranium concentrate. It operates four mines in Canada and the United States, and has two mines under development, one each in Canada and Central Asia.

We are adding CCJ to the takeover file as a result of the report last week that China National Nuclear had indicated an interest in Canadian acquisitions or joint ventures. With the report came expanded stock and option volume landing it about in the middle of our volume ranking on Friday with 19,790 contracts traded compared to the average volume of about 7,600.

Even if we discount the China National Nuclear report there is no denying that the uranium/nuclear story is out of favor with momentum traders. The conjecture here is that is about to change as CCJ is near the bottom of its 35 to 55 range. In April last year the stock was about 36 and by July it had peaked at just above 55 and by August it was back at 35. Regardless of China’s interest we could be seeing the start of annual momentum move in CCJ. The next earnings report is due May 13, 2008.

With a current Historical Volatility of 49.84 consider these suggestions.

Sell CCJ Apr 35 put CCJPG .60 IV 61.38 Delta .2770.
Or
Sell CCJ may 35 put CCJQG 1.825 IV 58.96 Delta .3558

As an alternative consider this bull call spread with limited and defined risk

Buy CCJ Jun 35 call CCJFG 4.30 IV 51.48 Delta .6380

Sell CCJ Jun 40 call CCJFH 2.15 IV 51.43 Delta -.4069
Debit 2.15 Position net delta .2311

Previous Issues and Reader Response Request

All 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:

want to read previous issues

Posted by daniel peretz on April 14, 2008 at 01:42 AM EDT

Daniel, Thanks for the request for the previous issues. While we mention their location at the bottom of each issue in the Previous Issues and Reader Response Request section we can expand on the instruction. Open any issue of IVolatility Trading Digest™. At the top right side of the first page just above the issue title you will see a small calendar. Each date that we have published a Digest is underlined in blue. For example, today there are two dates underlined, April 14, for today’s issue and April 7 for last week’s issue. Click on the link represented by the blue underline and you are taken to the selected issue. For issues in the prior months scroll the calendar back by using the small back arrows also underlined in blue at the top of the calendar just to left of the respective titled month. You can find all of the IVolatility Trading Digest™ Issues all the way back to the first one, which was Volume 7, Issue 1 on February 5, 2007. Jacktrader

Posted by Jacktrader (66.182.123.195) on April 14, 2008 at 12:50 PM EDT

To; JackTrader I have some questions about how to use the tools at iVolatility.com to find the information I need. Assume I already have my selection of stocks and their expected direction and duration of the move (usually within 1-2 months). I only need help w/ the strike price selection for option spreads that can capture that expected move. 1) Are Debit spreads the best way to avoid time decay and volatility ? If so; a)What are the general guidelines for the IV levels of the bought option and the sold option in a debit spread ? Does it matter if both strikes are similarly high or similarly low ? b)Should spreads usually be only 1 strike apart ? If not, how to pick the 2 legs of the spread ? c)If I set a limit order to exit the spread - where to set that limit ? Spread difference + how much (for remaining time premium etc.)? For instance; where would you set the exit limit order for the this weeks CCJ example ? I am in Asia and do not watch the market intraday. d)If I want to exit a bull spread that is profitable but the share price is not yet reached the maximum profit level, then how to set a limit order to exit such a trade before expiry ? e)At what IV level would you avoid buying a Debit spread ? f)Why would you choose to buy spreads on high dividend stocks ? 2)An "edge" in a put option sale means the option IV is higher than IVX of the stock, yes ? 3)What are the useful scans to run with Spread Scanner ? How often ? Thank you for reading all these questions.

Posted by Wimal Samarasinghe on April 16, 2008 at 06:58 AM EDT

Wimal, Thanks for the questions about the debit spreads. As for offsetting time decay and changes in volatility spreads, both debit and credit will accomplish the objective. Further any combination that includes long and short options will achieve this objective to varying degrees depending upon the structure of the trade. Ideally, for a debit spread the strike price of the option bought should have Implied Volatility less than the strike sold. While this is not always possible, if the direction decision is correct, it will alter the pricing and the ultimate net profit on the trade. If both strike prices are high (or low) then the long on one will be offset by the short on the other. The important relationships are the current Implied Volatility measures, the current Historical Volatility measures and how they are both forecasted to change over the period of the trade. Volatility both high and low are mean reverting, so if we can establish a trade at either extreme then we have an advantage. There is no requirement leg strike prices to be one strike apart. This distance will define the maximum potential for the spread and change the cost accordingly. Pick them based upon the available implied volatility, the net debit and the desired net delta of the spread. For stocks at important turning points it may be desirable to use spreads with a lower net delta to provide a margin of safety in the event the turning point fails. For stocks that have completed pivots and are now trending higher net delta spreads could be used. Another measure that we can use is the rate of change in the deltas of the two strike prices since they are not the same. This measure is referred to as gamma and it is located just to the right of delta in Advance Options. This is the second derivative of price change, the rate of change. With a long debit spread we would ideally want our long leg to have a higher gamma than our short leg gamma. As the stock price rises our long option will gain delta faster then the short option is losing delta. As for the exit pricing we know the maximum value of the spread is the difference between the strike prices. As the options go in-the-money the spread will reach its maximum theoretical value representing the difference in the strike prices. As a practical mater in order to close the spread and realize the gain we may have to give up some pricing otherwise nobody would buy the spread. With actively traded options this difference could be as small as .05. For less liquid options it will be more. Using CCJ as the example, The strike prices are 5 points apart so the maximum value of the spread will be 5, less the original debit of 2.15 representing a gain of 2.85. Since the options of CCJ have not been consistently traded in high volume we might well conclude that 4.90 is the most we could hope to realize from this trade. We could enter an order to sell it on a limit order for 4.90. That would result in a 2.75 gain on an investment of 2.15 in just over two months. A limit order could be placed as the options go in-the-money and there would not be a requirement to watch it on a daily basis. There is no theoretical maximum limit on the volatility of the spread legs. As a practical matter they will find a limit, so refer to the volatility charts found at Advanced Historical Volatility, as these are trade selection keys. Remember the most important volatility measure is the forecasted volatility for the time period of the trade. If you expect a dividend paying stock to trend you could use a debit spread. If the dividend is large and unpredictable it can create some challenges as you would not want to be short an in-the-money option as it may be exercised for the dividend leaving you long an option on a stock that will trade lower by the amount of the dividend. As for the theoretical edge we want to compare the Implied Volatility of the option to the Historical Volatility of the stock. So for a put sale the IV of the put to be sold is higher than the Historical Volatility of the stock. IVolatility.com offers scanning capability from easy to complex, from few to many scan criteria. We have the Strategist Worksheets, which are easy to use for finding put selling and covered call opportunities. The Spread Scanner can be used for multiple spread combinations using defined templates. Finally the RT Scanner offers the capability to refine the search criteria to very specific requirements. You can do as many trades as you have money in your account and the time to select and mange the trades. As a guideline about 40% of the task is the initial trade and strategy selection along with the preparation of the trade plan. About 40% is the management of the trade after its made and finally about 20% needs to be devoted to accounting in order to understand what has happened. Since experience is the best teacher we suggest you start with one and get some experience. As we suggest in the digest start with one-lot trades and do them until you understand them well.

Posted by Jacktrader (66.182.123.195) on April 17, 2008 at 01:25 AM EDT

Permalink Comments [4]

« Volume 8, Issue 14
Bottom Fis...hing | Weblog | Volume 8, Issue 16
More Incom...e »

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.