Volume 8, Issue 21,
Crude Oil Bubble
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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On Tuesday May 20, 2008 the US Senate Committee on Homeland Security and Governmental Affairs held a hearing and took testimony on Index Speculators in the commodity futures markets from Michael W. Masters. For the rest of the week there was considerable discussion and controversy in the financial media and in financial blogs about a potential bubble in the crude oil market. Anyone who has an interest in the financial markets, crude oil, and inflation should take some time to read and consider this testimony.
Without getting into the details of the controversy we are going to consider some hedging ideas for the equity market and the oil and gas sector. Then we will look at the results of an earlier low volatility trade suggestion and review the current status of the calendar spreads we suggested last week.
Market Review
S&P 500 Index (SPX) 1375.93. On Wednesday May 21, 2008 the SPX crossed and closed below the three point 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. We can now expect to see it decline back toward the March 17, 2008 low at 1256.98.
The CBOE Volatility Index (VIX) 19.55. The VIX turned higher as excepted with a decline in the SPX. Last week we noted the high level of VIX call buying and call open interest that continued early into the week with the call open interest reaching in excess of 1 million contracts. Then when the index turned lower both the call volume and open interest declined. Once again the high level of call open interest gave an early warning of the SPX decline. However, now we have a divergence, as the index would be expected to continue lower having broken the upward sloping trendline, but the call open interest is now back in neutral territory at about 690K contracts. Now the VIX call options buyers are not convinced the SPX will continue lower. So far they had been right – will they be right once again?
The US Dollar Index (DX) 71.89. The DX continued lower closing below the 72 level for the first time in a month. This renewed dollar weakness may help to explain the strength in the crude oil market. We now expect the DX to trade back down and test the low at 71.
Our market breadth indicator, the NYSE McClellan Summation Index turned lower with the equity market declining 37.20 points for the week, closing at 389.65.
Strategy
As yet we have not seen any meaningful seasonal weakness in the energy complex and gold is not responding very well to the DX turning lower once again. It seems most of the dollar hedging enthusiasm has been directed to the crude oil market.
With the SPX turning lower once again we suggest hedging strategies for equities and since the seasonal weakness is now due we would begin extending hedging strategies to the oil and gas sector as well. Crude oil futures and the oil and gas sectors appear overbought and we think some hedging is now prudent.
IVOLopps™
CBOE Volatility Index (VIX) 19.55. With a further expected decline in the equity market we would expect to see higher market implied volatility of the SPX. With a current Historical Volatility for the VIX of 74.18 consider this bull call spread suggestion.
- Buy VIX Aug 25 call VIXHE 2.375 IV 105.45 Delta .4210 Gamma .0384
- Sell VIX Aug 27 ½ call VIXHY 1.700 IV 101.02 Delta -.3367 Gamma -.0374
Debit .675 Position net delta .0843 Position net gamma .0010
The maximum gain is the difference between the strike prices of 2.50 less the debit of .675, or 1.825. While there is no edge it is the best of those available and provides sufficient time to produce the desired results if the SPX declines further from the current level. We suggest unwinding the spread if the VIX moves sideways and the SPX turns higher once again closing back above the recent three point trendline.
UltraShort S&P500 ProShares (SDS) 58.90. After a long decline from the March 17,2008 high, corresponding to the SPX low, this ETF crossed above and closed above the downward sloping trend line on Wednesday May 21,2008. The SDS should rise twice as fast as the SPX declines. With a Historical Volatility of 31.35 take a look at this bull call spread as an equity market hedge or a limited risk equity market short.
DR: A leveraged inverse index for the SPX based upon the trendline break of the SPX.
SU: Unwind the spread on a close below the downward sloping trendline or about 55.
- Buy SDS Sep 58 call SDSIF 5.85 IV 40.61 Delta .5733 Gamma .0290
- Sell SDS Sep 64 call SDSIL 3.90 IV 43.77 Delta -.4193 Gamma -.0268
Debit 1.95 Position net delta .1540 Position net gamma .0022
The position has reasonable edge with a limited and defined risk, while the maximum gain is 4.05 (the difference between the strike prices of 6 points less the debit of 1.95).
UltraShort Oil & Gas ProShares (DUG) 28.47. This ETF is the inverse of the long Ultra Oil & Gas ProShares (DIG) and will increase in value if the share prices of the companies that comprise the DJ US Oil and Gas Index decline. With a Historical Volatility of 46.31 consider this bull call spread as a hedge against long oil & gas positions.
DR: The sector appears overbought and this is the seasonal period when they are expected to start declining.
SU: Unwind the position on a close below the downward sloping trendline or 26.
- Buy DUG Oct 30 call DZGJD 4.10 IV 64.88 Delta .5381 Gamma .0343
- Sell DUG Oct 39 call DUGJM 2.00 IV 68.48 Delta -.3115 Gamma -.0288
Debit 2.10 Position net delta .2266 Position net gamma .0055
With good edge and plenty of time the position has a maximum potential of 9 points less the debit of 2.10, or 6.90 more than three times the reward to the defined and limited risk. If we approaching a seasonal decline then this would be a good hedge for the oil & gas sector.
Low Volatility Strategy Report
In IVolatility Trading Digest™ Volume 8, Issue 12, Spring Potpourri, dated March 24, 2008, we suggested a low volatility strategy for the upcoming first quarter earnings season. In the prior four quarters the implied volatility of the options on Hewlett-Packard Co. (HPQ) 44.96 rose on average about 33% prior to the earnings report. The suggested strategy was to buy a straddle while the implied volatility was low, make periodic adjustments to keep the position delta neutral and then close it while the implied volatility was high just before the earning announcement. The challenge is to balance the declining time premium with the rising volatility. If the straddle is too far out in time the total gamma will be fairly low and the adjustments returning to delta neutral will be small. Since the adjustments are counter-trend we expect to book gains each time we adjust to neutral and they are an important part of the total return. If the straddle is too close to expiration then the rapid decline in time premium of the long options will cost more than the gains from the adjustments. However, if there is no increase in implied volatility the likely result will be a loss.
On March 24, 2008 we booked the purchase of the May 47 ½ call and the May 47 ½ put for a total cost of 5.05. At the same time we sold short 13 shares HPQ at 47.93 to make the position delta neutral. Over the next 5 weeks we made a total of 6 adjustments returning the position to delta neutral. It was then closed early on May 8, 2008 when we concluded that the implied volatility of the options was not going to follow the expected pattern nor was the historical volatility going to rise enough to help with the adjustments, while the time decay was now accelerating. This was a volatility position that needed volatility to increase and it did not. We booked the sale of the options for a 240 loss but we offset that will the gains from the adjustments of 112.15, resulting in a net loss of 127.85.
On May 13, 2008 HPQ pre-announced earnings of .80 per share and announced their intention of acquire EDS and neither the implied volatility nor the historical volatility responded to these developments. The market greeted HPQ’s announcement with a yawn, as there is little interest in the technology sector. Even though we had a small loss our decision to close this position early was correct.
Calendar Spreads
In last week’s IVolatility Trading Digest™ Volume 8, Issue 20, Golden Divergence, dated May 19, 2008 we suggested two calendar spreads on Anheuser-Busch Companies Inc. (BUD) 56.61. Then the stock last traded at 51.73 and we noted large moves in the underlying stock are detrimental since the gamma of the near term short options are considerable higher than the long options. Now it seems the Financial Times reported that InBev is going to approach BUD with an offer.
Here is the first suggested calendar spread.
- 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
This is the current status.
BUD Dec 55 call BUDLK 5.25 IV 25.21 Delta .6114 Gamma .0366
BUD Jun 55 call BUDFK 3.75 IV 44.84 Delta - .6204 Gamma -.0532
Debit 1.50 Position net delta -.0090 Position net gamma -.0166
And here is the original 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
Current status:
BUD Dec 55 call BUDLK 5.25 IV 25.21 Delta .6114 Gamma .0366
BUD Jun 60 call BUDFL 1.40 IV 41.73 Delta -.3375 Gamma -.0549
Debit 3.85 Position net delta .2739 Position net gamma -.0183
We can see from the first spread above the near term June options were correctly pricing a higher volatility than the December options as the subsequent takeover developments justified a higher near term price. Comparing the IVs we see 34.21 compared to 24.14 and this is the difference that we found with the original scan. We also see in the current status this differential has increased even more with the takeover news rising to 44.84 from 34.21. Since this spread is now showing a .075 loss it should be unwound by buying back the short June 55 call at 3.75. We will then still be long the December 55 call. The final result will depend upon the takeover developments and we have until December.
On the second spread we have a different result as it is showing a 1.65 gain. This can be explained by comparing the gammas of the two short calls. The June 55 was -.0636 while the June 60 was -.0336 meaning the short June 55 call gained deltas twice as fast the short June 60. We now suggest keeping this spread and waiting for further takeover developments.
Be careful if the short call is in-the-money at expiration since it will be called away creating price risk the next day since you would be short the stock. One technique to mitigate this risk is to buy to stock represented by the short call on the last trading day with a market-on-close order. Your long stock will then offset the stock called away eliminating the next trading day price risk.
As for BUD the large move did hurt the first spread but not the second as we are now showing a gain of 1.65. We paid a bit more for the second spread and we slanted it toward the potential event, however if the move in the stock had been large enough even this spread would have been in trouble from the increasing delta of the short call.
In summary, calendar spreads are often found in scans and make tempting targets for selling the near term high premium but they take some careful planning and a good bit of management.
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.
Posted by David McCorquodale on May 28, 2008 at 02:14 PM EDT
Posted by Jacktrader (66.182.123.195) on May 29, 2008 at 12:27 AM EDT