Volume 8, Issue 20,
Golden Divergence
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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In this issue we are going to suggest a trade for the divergence between gold and crude oil. Then we will look at two high volatility trades and a long-term trend idea. Finally we will close with a review of the calendar spread on our home page. First a look at the equity market.
Market Review
S&P 500 Index (SPX) 1425.35. For now the SPX is holding above the upward sloping trend line off of the March 17, 2008 low at 1256.98 passing just under the April 15, 2008 pivot at 1324.35 and the most recent pivot on May 9, 2008 at 1384.11 creating a well defined three point trendline. If it fails and the SPX closes below this trendline it could trade back down toward the 1300 level once again.
The CBOE Volatility Index (VIX) 16.47. The VIX continued lower confirming the rising SPX. However, call buying continued higher with the open interest reaching 945K contracts while the options implied volatility almost doubled to 130 from last week’s 64 level. In the recent past rising call volume and open interest has been a leading indicator of a short-term market decline. So far, the VIX call options buyers are not yet convinced the operative short-term upward trend line shown in the graph above will hold.
The US Dollar Index (DX) 72.84. The DX traded along the 73-price level most of the week but took a turn down on Friday on reports of weaker than expected consumer sentiment. It is now back under the previous resistance, which is now support at 73.194 gaining some downward momentum and confirming the recent strength in crude oil prices and a gold rally. Stay focused on DX as it trades back down near the low at 71.
Our market breadth indicator, the NYSE McClellan Summation Index confirmed the higher equity market adding 144.46 points for the week, closing at 462.85.
Strategy
With the US Dollar Index (DX) turning lower once again the divergence with rising commodity prices lead by crude oil and natural gas appears to be resolved for the time being. This is what we said last week, “Seasonally we would expect to begin seeing some weakness in the energy complex that would now be supportive for the dollar and equities. As yet, this is not the case and we advise some caution until it is resolved. If the dollar begins to breakdown and starts trading back down toward the lows around 71 we would expect to see continuing commodity price strength. Since gold has now corrected almost 17% from the March 17, 2008 high at 1,038.60 basis Jun and is now lagging other commodities there could be a catch up opportunity if the dollar turns lower once again.”
With the DX weakness on Friday June gold closed up 19.90 at 899.90 breaking the downward sloping trendline from the March 17, 2008 high at 1,038.60. If the dollar continues lower we could expect to see 950 gold again very quickly.
We continue to see relative strength in the ocean transport sector and continue to suggest new positions in some of the stocks that have been lagging. We think this sector will continue to be strong for the next few months.
Gold/Oil Ratio
On March 17, 2008 gold reached a high of 1,038.60 basis June and closed at 1007.10 while crude oil closed at 103. Gold subsequently declined to 858 on May 2, 2008 before recovering somewhat and closing at 899.90 on Friday May 16, 2008. In the meanwhile crude oil continued higher closing at 126.29 on Friday. In the past there has been a fairly predictable relationship between gold and crude oil as they both moved in the same direction. However, since March 17, 2008 there has been a divergence as crude continued higher, gold turned lower. As we suggest in the Strategy section above with renewed weakness in the US Dollar Index (DX) gold may attempt to catch up with crude once again. If so, here is a suggestion.
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Yamana Gold Inc. (AUY) 15.03. Toronto based Yamana is a gold and copper miner with properties in Brazil, Argentina, Honduras, and Nicaragua. This is a growth mid-tier copper and gold producer that will be producing 1.5 million ounces of gold per year by 2009 and 2.2 million ounces by 2012. Although based in Canada all of its mining operations are in countries with significantly lower labor costs.
We suggested Yamana in IVolatility Trading Digest™ Volume 8, Issue 9, Dollar Breakdown, dated March 3, 2008 and in IVolatility Trading Digest™ Volume 8, Issue 11, Ben’s Magic Show, dated
March 17, 2008.
Based upon the SU (stop/unwind) in the trade plans the second spread would have been closed on March 19, 2008, just two days later for a 1.57 loss as the stock closed at 16.60. The first spread would have been closed for a .67 loss April 22, 2008 as the stock closed at 13.93.
As the usually reliable relationship between gold, oil and the dollar broke down we closed the trades according to our trade plan. Now, however it could be the time to test these long-term relationships once again.
With a current Historical Volatility of 50.32 consider this bull call spread.
DR: This trade will test the observation that oil and gold move in the same direction and inversely to the dollar index. Currently there is a divergence and if the long relationships remain valid then either gold increases or oil declines or perhaps a combination of both.
SU: Close the position on a close below 14.
- Buy AUY Oct 15 call AUYJC 2.10 IV 53.43 Delta .5804 Gamma .0770
- Sell AUY Oct 20 call AUYJD .725 IV 53.64 Delta -.2678 Gamma -.0632
Debit 1.375 Position net delta .3126 Position net gamma .0138
Our last two attempts to trade gold direction using Yamana were stopped out and that could well happen once again so size the position accordingly and remember if the stock closes below the SU limit it can be unwound by selling the long call while keeping the short call. While the short call will then require margin it is an alternative to closing out the position and immediately booking the loss.
IVOLopps™
From our Advanced Ranker sample list, found on the home page, for the “Top 5 stocks based on IV Index Mean vs 30D HV” we find this suggestion listed as number four.
NetEase.com, Inc. (NTES) 24.96. Beijing, based NTES operates an interactive online and wireless community in China. It provides Chinese language content and services through its online games, wireless value-added services, and Internet portals. The online games business focuses on massively multiplayer online role-playing games by selling prepaid point cards to the end customers who may use the points on such cards for online game services provided by the company. It distributes prepaid point cards through wholesalers, Internet cafes, software stores, supermarkets, bookstores, newspaper stands, and convenience stores.
They are scheduled to report first quarter earnings on Wednesday May 21, 2008 after the close. The expected earnings are .31 compared to .29 for the same quarter last year. With the IV Index Mean at 58.20 and the Historical Volatility at 31.19 consider this put sale.
- Sell NTES Jun 22 ½ put NQGFX .65 IV 54.06 Delta .2389
With a positive volatility spread the stock is currently trending upward from the March low with support at 22. If the stock sells off on the earnings report be prepared to take in the stock and sell calls.
Next we return to the home page list again for the “Top 5 stocks with greatest IV change from yesterday” we find this suggestion at number three as the result of an increase in the IV Index Mean to 126.83%.
Solarfun Power Holdings Co., Ltd. (SOLF) 22.84. Headquartered in Qidong, the People's Republic of China Solarfun Power Holdings Co., Ltd., through its subsidiary, Jiangsu Linyang Solarfun Co., Ltd., engages in the development, manufacture, and sale of photovoltaic (PV) cells and PV modules primarily in the People's Republic of China. It offers monocrystalline silicon cells and modules, and multicrystalline silicon cells and modules to system integrators, as well as through third party distributors.
The story here is a large short interest representing 35% of the float and an earnings report due before the opening on Wednesday May 21, 2008. The estimates are 1.12 compared to a loss of .01 for the same quarter last year. With rising raw material costs the shorts have driven this stock down from 40 at the first of the year. The stock advanced 4.37 points Friday on what appears to be short covering and rumors of a short squeeze.
With a current Historical Volatility of 85.08 consider one of these put sales.
- Sell SOLF Jun 15 put QFGRC .525 IV 125.78 Delta .1022
Or
Sell SOLF Jun 17 ½ put QFGRW 1.175 IV 126.81 Delta .1910
With a positive volatility spread there is a good bit of risk in this stock, as the shorts may have it correct, so size the position considering that you could be assigned the stock at expiration. From this perspective the June 15 looks best since it is 7.84 points out-of-the money and there is considerable support at 15.
Trending Direction Suggestion
iShares MSCI Emerging Markets Index (EEM) 155.10. This ETF seeks results corresponding to the price and yield performance of the MSCI Emerging Markets index. The fund generally invests at least 90% of assets in the securities of its underlying index or in ADRs and GDRs representing such securities. Developed by Morgan Stanley Capital International (MSCI) this index is an equity benchmark for the emerging markets. With a Net Asset Value of 154.22 it is currently priced at a .5% premium. From the March double bottom the EEM is in a defined uptrend having just cleared the resistance at the 150 level. The double bottom minimum measuring objective is at 170. With a current Historical Volatility of 21.58 consider this idea.
DR: Long term uptrend with a defined upward sloping trend line. In a positive equity environment we would expect the uptrend to continue and reach the minimum measuring objective of 170.
SU: Close or unwind the spread on a close below the upward sloping trendline now at 150.
- Buy EEM Sep 160 call EEMIL 7.25 IV 23.94 Delta. .4678 Gamma .0182
- Sell EEM Sep 165 call EEMIM 5.325 IV 23.68 Delta -.3808 Gamma -.0176
Debit 1.925 Position net delta .0870 Position net gamma .0006
By using a bull call spread we can participate in the direction trend of the emerging markets without a substantial investment since we are long just the difference in the strike prices. The maximum value of the spread is 5 and we have a good risk to reward ratio for this position with a limited and defined risk without volatility and time decay concerns.
Calendar Spread
In the Options Data Analysis section of the home page you will see two volatility graphs that correspond to the details in the Rankers & Scanners section below. The first is a Stock Trend Analysis and the second is a Calendar Spread. The Scanner finds the calendar spreads based upon the difference in the implied volatilites of the legs. Since we know that large moves in the underlying stock will hurt a calendar spread we need to do some further investigation before making the trade. Often the differences in the implied volatilites are justified and correctly reflect the pricing of the differences in risk. Ideally we would like to find large volatility discrepancies in stocks that do not move very quickly.
Here is the second chart from the Options Data Analysis section for the current Calendar Spread suggestion.
Then in the next section, Rankers and Scanners we find the details as follows:
As you can see this suggestion is based upon a position size of 10 contracts.
Now here are the additional details to complete this idea.
Anheuser-Busch Companies Inc. (BUD) 51.73. From St Louis, BUD makes and distributes beer in the United States and internationally. The domestic beers are Budweiser, Michelob, Busch, and Natural brand names. The current Historical Volatility is 18.90 and the Implied Volatility Index is 34.06.
- Buy BUD Dec 55 call BUDLK 2.625 IV 24.14 Delta .4219 Gamma .0419
- Sell BUD Jun 55 call BUDFK 1.050 IV 34.21 Delta .3108 Gamma -.0636
Debit 1.575 Position net delta .1111 Position net gamma -.0217
And here is an alternative calendar spread with more edge, greater delta and gamma.
- Buy BUD Dec 55 call BUDLK 2.625 IV 24.14 Delta .4219 Gamma .0419
- Sell BUD Jun 60 call BUDFL .425 IV 40.02 Delta .1363 Gamma -.0336
Debit 2.20 Position net delta .2856 Position net gamma .0083
This looks like a good calendar spread. The recent price increase along with the increase in implied volatility has been attributed to buyout rumor talks between BUD and InBev SA. While a sale to European buyers makes sense from a currency value perspective at least one analyst does not think a deal will happen any time soon. This should give us the opportunity to sell OTM calls for several months against our long Dec 55 call.
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.
