IVolatility Trading Digest™ Blog

Monday April 21, 2008

Volume 8, Issue 16
More Income

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Traditionally a model-balanced portfolio would include a certain percentage of growth stocks, income stocks and/or bonds, perhaps gold and some cash allocated in a manner that attempts to maximize its value over time. Today a more contemporary portfolio might add options in the stock category, futures and options on the futures along with foreign exchange. It may also attempt to maintain some short positions as well as the more traditional long only exposure. Since we have been devoting a lot of our effort to long and short suggestions in the growth stock category we are going to start highlighting some additional income suggestions as well. After all, a more predictable income stream might reduce stress levels while providing more time for alternative activities like going to the beach.

Market Review

S&P 500 Index (SPX) 1390.33. It is becoming increasingly difficult to continue supporting the Head & Shoulders Top thesis with its the measuring objective down at 1225. The SPX continues to trade above the current downward sloping trend line and it now looks as if we should once again declare that the double bottom formed on March 17, 2008 at 1256.98 is the final bottom.

The CBOE Volatility Index (VIX) 20.13 continues lower and is now back to the levels made before the January sell off that formed the left side of the double bottom on January 23, 2008 at 1270.05. Since the VIX call buyers have recently been one of the better leading indicators we included a chart of its status supporting the hypothesis that we have now most likely seen the bottom for the SPX. Before the March 17, 2008 decline the call open interest had increased to in excess of 800,000 contracts. See the chart from Advanced Historical Volatility below and notice the decline in open interest on March 17, 2008 as the longs liquidated on the market decline and the accompanying increase in implied volatility. The call open interest began building again on March 31, 2008 and again rose above 800,000 contracts going into last week. This time the long liquidation occurred at the low of 1324.55 on the pivot made on April 15, 2008 as the SPX turned higher once again.

The call open interest is now just above 600,000 having declined about 200,000 contracts for the week. This decline in call open interest along with the decline in the implied volatility of the VIX options and the broken downward slopping trend line would seem to support the view that the SPX wants to continue higher for the time being.

The US Dollar Index (DX) 72.01 declined back toward the 71 level once again before turning higher on Friday with the market rally. This makes the second test of the 71 level for DX over the last month. If the commodity group is going to continue higher it will require the DX to continue lower and for now the DX looks like it wants to follow equities higher. This combination would make for tough going in the gold and commodity group.

Our market breadth indicator, the NYSE McClellan Summation Index continues to improve last week adding 97.13 and now reading just –65.65. With the zero line and positive territory fast approaching thereby adding further support to the market upturn supposition.

Strategy

Last week in IVolatility Trading Digest™ Volume 8, Issue 15, Momentum Waves, dated April 14, 2008 we mentioned some of the current momentum favorites including steel, coal, railroads, domestic exploration and drilling, ocean tankers and agricultural chemicals. Last week China’s Sinofert Holdings Ltd. agreed a new $576 price for potassium compounds used in fertilizer, representing a $400 per ton increase up from $176 per ton. This good news could mark the turning point for the momentum traders in the agricultural chemicals group which includes Potash Corp. (POT) 204.67 now selling at 60 times trailing 12 month earnings, Mosiac Co. (MOS) 135.25 at 42 times 12 month trailing earnings and Agruim Inc. (AGU) 88.04 at 27 times trailing 12 month earnings.

In IVolatility Trading Digest™ Volume 8, Issue 11, Ben’s Magic Show, dated March 17, 2008 we suggested a bull call spread for Potash Corp. (POT) when it was trading at 160.46. Long the June 160 call and short the June 170 call with an indicated debit of 4.40. The spread is now priced at 7.80 representing a one-month gain of 77%. The spread has a maximum value of 10 so there is potentially more to go on the upside, but we would suggest that you watch this stock very carefully and use a trendline or stochastic indicator for a signal to unwind this spread. These stocks along with some in the steel and coal group look to be entering into momentum madness.

Low Volatility Straddle Report

In IVolatility Trading Digest™ Volume 8, Issue 8, Broken Triangle, dated February 25, 2008 we included a suggestion for a Halliburton Company (HAL) 47.43. The suggested straddle was long both the July 37 ½ call and the 37 ½ put with an indicated debit of 5.45. The closing price on the following trading day at 5.10 established our basis. The trade plan was made for the expected rise in implied volatility going into the next earnings report scheduled for Monday April 24, 2008. We recorded the daily price changes and the adjustments required to return the position to delta neutral. On April 8, after the stock broke out above 40 we sold the July 37 ½ straddle and replaced it with the July 42 ½ straddle.

We have now closed the book on the position, as they will report earnings on Monday before the opening. The anticipated rise in implied volatility did not occur, as the volatility measures remained stable for the last week as the stock began trending higher.

Here are the results: In addition, to the roll-up of the strike price we booked 17 adjustments returning to delta neutral. The net gain after commissions from the adjustments totaled 77.63. From the options, including the roll-up the net was 322.50. Added together the total is 440.13. The maximum margin requirement plus the cash cost of the initial straddle was 1,305. The return on investment was 33.7% in 7 weeks. If the implied volatility had expanded as planned we would have seen an even better return.

In the meanwhile we still have the long HAL July 45/47 ½ bull call spread that was added on the breakout as a suggestion in IVolatility Trading Digest™ Volume 8, Issue 15, Momentum Waves, dated April 14, 2008. While the initial debit was .85, the current indicated price is 1.425. We also now suggest other HAL bull call spreads be considered after the earnings report is fully priced into the stock price.

IVOLopps™

Top IV Index Mean vs. 30 Day Historical Volatility

While we usually find hard to evaluate biotech companies at the top of the list but this week we have a venture capital emerging green energy technology company in the number one spot.

Medis Technologies Ltd. (MDTL) 9.76. This New York based development company is attempting to bring to market a portable liquid fuel cell power supply for mobile handsets and portable consumer electronics. Problems in the capital markets over the last 6 months have raised questions about the ability of this company to continue financing its negative cash flow requirements. They have been loosing money at in increasing rate and while the product concept is timely and exciting this company has all the problems and delays associated with a start-up development company.

They are expected to report first quarter earnings about the second week of May. With a Historical Volatility of 57.97, and with twice as many calls as puts outstanding, with a low put/call ratio of about .5 and with a wide positive volatility spread consider this somewhat risky put sale income strategy.

Sell MDTL May 10 put MRUQB 1.45 IV 120.96 Delta .4584

If assigned stock from the short put the basis would be 8.55, somewhat lower than the current support at about 9. In this case the plan would be to sell calls against the long stock. The risk here is their ability to finance further development costs. Failure could mean the company is either sold or liquidated. Not the sort risk usually associated with the ordinary income portfolio. We suggest you read the fundamental research reports, listen to the last earnings call and visit their web site before making a commitment. If you like venture capital this one could be for you.

Takeover File Update

Now we are going to combine the takeover file update with more income suggestions using our old favorite Yahoo!

Yahoo! Inc. (YHOO) 28.43. A total of 8 suggestions have been included in six recent Digest issues starting with IVolatility Trading Digest™ Volume 7, Issue 30, Waiting for Godot, dated September 10, 2007. The tally is four gains and two losses for a net gain of 120. In addition we still have the synthetic long (long Jul 27 ½ call – short July 27 ½ put) on the books with a current value of 1.125 equal to the original basis February 4, 2008.

From Advanced Historical Volatility here is the current volatility graph.

The implied volatilites are in the 50-55 range with the historical volatility now at 37.51 making for a nice positive volatility spread of about 13-14 points. If we use the Parkinson’s range method for calculating the historical volatility we get 26.85 making the positive volatility spread even better.

Yahoo! reports second quarter results on Tuesday April 22, 2008 and the implied volatilites remain fairly constant with just a little skew to the put side. The Implied Volatility Index for the calls is 50.97 and for the puts it is 51.57.

This is a good opportunity to employ income strategies. The stock price is not likely to increase very much and there is enough uncertainty in from the takeover negotiation to keep the implied volatility fairly high for quite some time.

As for income strategies there are many to consider including covered calls, covered short straddle, covered short strangle, naked put sale, bear call spread, long iron condor, long iron butterfly, and a call calendar spread.

We have posted in the Ranker & Scanners section on our home page the Best Calendar Spread. Here are the volatility numbers for this suggestion.

Buy YHOO Jan 27 ½ call VYHAY 3.950 IV 32.67 Delta .6331

Sell YHOO Jul 27 ½ call VYQGY 3.035 IV 43.39 Delta .6162
Debit .925 Position net delta .0169

And here are two alternatives. The first is a naked or cash covered put sale and the second is a bull put spread.

Sell YHOO May 25 put YHQQE .68 IV 65.03 Delta .2102
Or
Buy YHOO Oct 25 put YHQVE 1.665 IV 42.91 Delta -.2691
Sell YHOO May 25 put YHQQE . 68 IV 65.03 Delta .2102
Debit .9850 Position net delta -.0589

With a good edge this position would allow for multiple subsequent put sales as the May expires worthless. Of course the risk is the deal collapses and you would be assigned stock. We think the more likely scenario is the deal will get done but because of multiple regulatory approvals it will take a long time to complete even after they come to terms.

This should make for a relatively stress free summer allowing some time for the beach.

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:

You report that the bull call spread for Potash Corp. (POT) would show a profit of 77% At writing the prices of both PYPFL.X and PYPFN.X are respecttively 48.41 and 42.00 ; so me don't have the same basis to calculate the percentage. JGL

Posted by Jackie on April 21, 2008 at 09:18 AM EDT

Jackie, Thanks for the POT comment. What you say is understandable since we used the mid closing prices as of Friday, which were PYPFL 49.75 and PYPFN 41.95, which is a difference of 7.80. Since both options are deep in the money one would expect that in order to get the trade done as a spread (without legging out and the price risk associated with that practice) you would have to give up some portion of the difference, perhaps even .10 in order to get the spread sold. So depending upon when you get the price quote and what commission you incorporate into the numbers the ROI could vary somewhat. Jacktrader

Posted by Jacktrader (66.182.123.195) on April 21, 2008 at 05:29 PM EDT

On the HAL trade you note:"...we booked 17 adjustments returning to delta neutral. The net gain after commissions from the adjustments totaled 77.63..." What is your criteria for adjusting your delta? You obviously don't do it every day. Every week? After a percentage move in the underlying? Any change of delta by more than x? Thanks. Craig

Posted by Craig on April 27, 2008 at 10:13 PM EDT

Craig, Thanks for the insightful question about adjusting back to neutral. This is a good question about an important part of the strategy. There are several choices available. It could be a specific number of points up or down, such as 2 points. In the initial plan this is what we proposed. One point could have been chosen and in hindsight this would have been a better choice. The better alternative and the one we actually used was a bit more complicated and was based upon the 10-day Historical Volatility of the stock. On each adjustment we calculated a one-day one-standard deviation price move and used it as the upper and lower boundary for the next adjustment. When the stock was quiet and not moving the adjustments were few and far between. When the historical volatility of the stock starts increasing we will have more adjustment events. Since we are recording the 10-day HV daily we can see when it starts changing. When the boundary was exceeded, up or down, we made the adjustment returning again to delta neutral. Ideally we would like to see the implied volatility of the options increase meaning we are making money on our straddle and we would like to see the historical volatility increase even faster meaning more adjustment events and more opportunity to book adjustment gains. We don’t often find the ideal combination but by using the volatility charts in Advanced Historical Volatility we try to find the stocks that have the right characteristics and the potential to produce real good numbers. It does require a lot of record keeping and the focus shifts from concern about direction to concern about the implied volatility and historical volatility. Jacktrader

Posted by Jacktrader (66.182.123.195) on April 28, 2008 at 02:40 AM EDT

Question on the YHOO calendar spread where you sell the MAY 25 puts and buy OCT 25 puts. I was doing some charting of possible outcomes as of the May expiration date to see what range of YHOO stock prices will likely result in this trade yielding a positive outcome. It looks like I can widen the range of YHOO prices yielding postive outcomes (as of May expiration) by doing the calendar spread at multiple strike prices. For example with YHOO stock currently around 27, doing the calendar spreads for 25, 27.50 and 30 looks like it gives me a wider range than doing just one. The tradeoff being that the maximum profit is now somewhat lower. Does this analysis make sense to you? Or am misunderstanding something? Thanks.

Posted by Jeff on April 30, 2008 at 12:22 PM EDT

Jeff, Thanks for the Yahoo put spread question. If I understand correctly you are asking about doing three calendar spreads Long the October and short the May using the 25, 27 ½ and the 30. Your analysis makes sense. One of the interesting things about options is the ability to create many combinations for many purposes. In the case of Yahoo the implied volatility of both the call and puts is now rising rapidly, the calls are 68.91 and the puts are 70.30. But the IV of the May 25 put is 93.19 while the October is 48.03. The options market seems to be reflecting greater uncertainty about this deal as MSFT says they are prepared to walk away. This could just be posturing but it raising the risk and that is reflected in the options. Keep in mind that calendar spreads are hurt by a big move in the stock. With this much difference in implied volatility we must ask ourselves if perhaps the options are right and there could be a large move in the stock. We suggest you look at risk profile for the stock at 22 and then decide how many you want to do. Jacktrader

Posted by Jacktrader (66.182.123.195) on May 02, 2008 at 01:03 AM EDT

Why does increased Call buying in your Vix analysis suggest a possible market decline ?

Posted by Leonard Makin on May 19, 2008 at 07:05 AM EDT

Leonard, Thanks for the VIX question. Declining markets are associated with increased implied volatility. A trader who expects the market to decline buys calls to benefit from the increased implied volatility. Recently we have observed that increasing VIX call open interest has been a good indicator of short-term market declines as the traders have correctly called the market direction and their calls values have risen along with the implied volatility of the S&P 500 Index as it declined in price. Jacktrader

Posted by Jacktrader (66.182.123.195) on May 20, 2008 at 12:27 AM EDT

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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.