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Contango is a term used in the Futures Markets to describe the relationship between the prices of current month contracts to the deferred months. Contango is when the deferred month is more expensive. It is also called a “normal carry market” since one would naturally expect the deferred to be more expensive to allow for storage and insurance costs. When a shortage of a commodity exists and the near term contracts are more expensive than the deferred month the condition is described as backwardation. Since July of last year the crude oil futures contracts traded on the New York Mercantile Exchange have been in backwardation. This has been beneficial to the commodity index funds that buy the current month and then roll them over each month, selling the more expensive contract and replacing it with the new cheaper one. However, when the market reverts to contango this advantage disappears and becomes a disadvantage. Since crude oil futures have now reverted to contango we have the first real evidence that this market may be about ready to correct. In the past these corrections have been large and fast.

In this issue we offer a limited and defined risk options strategy for a potential crude oil futures correction. Then we add another shipping company to the suggestion list and finally we make a new addition to the takeover file with a look at the current number one positive volatility spread and offer some suggestions on how to trade it.

Market Review

S&P 500 Index (SPX) 1400.38. The four-day rally brings the SPX back to the 1400 level once again. We continue to expect a further decline back toward the March 17, 2008 low at 1256.98.

The CBOE Volatility Index (VIX) 17.83. For the week the VIX was lower with the rising SPX Index which was confirmed by call open interest declining to 800K contracts. With recent call open interest rising above 1 million contracts they would now need to return once again to this level in order to indicate an imminent short term rise in the VIX and a decline in the SPX. At this current level of call open interest we conclude the VIX call option buyers are about neutral.

The US Dollar Index (DX) 72.88. The DX bounced off the 72 level and traded up to 73 inflicting considerable pain on the gold bulls as the August Gold Futures contract lost 33.80 for the week closing at 891.50. We had expected the DX to trade back down toward the 71 level but it continues to be well supported at 72 and we are beginning to doubt the widely predicted lower dollar scenario. Continued dollar strength here would not be good for the commodity bulls.

Our market breadth indicator, the NYSE McClellan Summation Index declined 30.34 points in a quiet week, closing at 359.31.

Strategy

IVOLopps™

With the recent subtle but nevertheless important change in the crude oil futures market we suggest some hedging or short positions. Consider this put ratio backspread suggestion.

United States Oil (USO) 103.06. This ETF seeks to reflect the performance of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund invests in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil.

Since July of last year the crude oil futures market has been in backwardation providing an opportunity to gain on the roll of the futures contract, as the deferred month being purchased was less expensive that the current month being sold. Over the course of year this could have accounted for as much as 10% of the USO price gain. Now that the market is in contango and the deferred month is more expensive this will result in losses as the current months contracts are rolled forward.

With the crude oil market appearing overbought and entering a seasonal weak period along with the contract rolling gains no longer available we think a leveraged bear put has merit.

With a current Historical Volatility of 31.52 and with the Implied Volatility Index at 41.68 skewed toward the puts consider this put ratio backspread suggestion.

DR: Overbought crude oil market that has changed from backwardation to contango creating the conditions for a substantial and rapid decline with increasing implied volatility.

SU: Unwind the position on a close above the recent high at 108 and/or if the implied volatility does not rise.

• Buy 2 USO Oct 93 puts IYSVO 5.65 IV 42.48 Delta -.5764 (2 x -.2882)
• Sell 1 USO Oct 103 put IYSVY 10.30 IV 42.76 Delta .4338
  Debit 1.00 (2 x 5.65= 11.30 less 10.30) Position net delta -.1426

This is a leveraged low cost trade for a decline in USO. If the implied volatility does not rise this position will show a small loss if USO is in the range between 89.53 and 104. With a 10% increase in implied volatility the entire risk profile shifts into positive territory. The position has unlimited upside with a decline in the USO and the return is enhanced with an increase in implied volatility which is likely with a rapid decline.

Another Dry Bulk Shipper

Since the dry bulk shipping market remains very strong and some of the stocks have recently completed a small correction we think this is a good time to suggest one more shipping company.

Diana Shipping Inc. (DSX) 34.99. Athens based DSX transports dry bulk cargoes, such as iron ore, coal, grain, and other materials with a fleet of 13 Panamax dry bulk carriers and 6 Capesize dry bulk carriers with a combined carrying capacity of approximately 2 million dwt. Currently selling at 12 times earnings with a dividend of almost 10% at the current rate.

DR: Dry bulk shipping rates remain very strong as a result of several factors, including limited fleet expansion capacity due to financing concerns, the availability of ship yard space and the limited availability of major components such as main engines and generators for new ships.

SU: We would consider unwinding the position on a close below the last pivot at 32 ½.

With a current Historical Volatility of 49.93 consider this put sale.

• Sell DSX Jul 30 put DSXSF .85 IV 55.45 Delta .1934

As a longer-term directional alternative consider this combination:

• Buy DSX Sep 35 call DSXIG 3.65 IV 48.60 Delta .5689 Gamma .0466
• Sell DSX Sep 40 call DSXIH 1.90 IV 48.61 Delta -.3606 Gamma -.0432
• Sell DSX Sep 30 Put DSXUF 2.05 IV 54.44 Delta .2737 Gamma .0324
  Credit .30 Position net Delta .4820 Position net gamma .0358.

This direction trade combination is a long-term bull call spread and a short put. We sell the put with a good edge and then finance the purchase of the bull call spread that does not have volatility edge. If DSX continues higher as we expect this position will give us a very high return on investment with a low margin requirement.

Takeover File Update

Here is number one at the top of our list of 5 stocks based on IV Index Mean vs 30D HV, which defines the largest positive volatility spread between the Historical Volatility and the Implied Volatility.

Huntsman Corp. (HUN) 21.93. Salt Lake City based HUN manufactures and markets specialty chemical products worldwide. Early last summer they were the subject of a bidding contest that resulted in their acceptance of an offer from a private equity company to combine with their subsidiary at $28 per share. The offer has been extended until July 4, 2008 while they attempt to resolve antitrust concerns with the FTC. With a current Historical Volatility of 19.79 and with an Implied Volatility Index of 58.12 consider these suggestions:

• Sell HUN Jul 20 put HUNSD 1.425 IV 73.06 Delta .3191

Or this safer yet more expensive (in IV terms) alternative.

• Sell HUN Jul 17 ½ put HUNSW .775 IV 81. 45 Delta .1853

Another possibility is this calendar spread.

• Buy HUN Nov 25 call HUNKE 1.60 IV 44.12 Delta .3981
• Sell HUN Jul 25 call HUNGE .80 IV 57.20 Delta -.3021
  Debit .80 Position net delta .0960.

The calendar spread has good edge but will require more management as the near term options expire and will need to be replaced. The likelihood of a large move to the upside is limited to the defined sales price of 28 while the downside is estimated at around 20, the price before the bidding began last summer, making this a good calendar spread candidate.

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.

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