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This Issue combines Bull Call Spreads with inverse ETFs creating easy to manage hybrid short suggestions both for hedging long positions and for taking short direction positions. We offer suggestions for the VIX and two UltraShort Indexes that move inversely to their respective Indexes.

While there were several reasons cited for the market decline last week including the rise in the unemployment numbers and rising crude oil prices we think the more likely culprit was the European Central Bank’s statement that they may raise interest rates. The dollar immediately dropped and crude oil futures rose in response. It seems higher interest rates for anything other than the dollar means higher oil prices and lower equities. At issue is the value of the dollar and crude oil futures are now the preferred instruments to hedge the dollar risk.

Market Review

S&P 500 Index (SPX) 1360.68. The SPX closed under 1375 setting off a complex Head & Shoulders Top from the May 19, 2008 high of 1440.24. Over the near term we expect the SPX to decline further as we now have a defined downside measuring objective at 1300. We continue to have the view that the SPX is making a larger bottoming pattern and the current decline is a part of that developing pattern. With the expected decline back down to 1300 the SPX would have the look of a large Head & Shoulder Bottom.

The CBOE Volatility Index ( VIX) 23.56. For the week the VIX rose substantially with the SPX decline. While call open interest rose above 800K contracts it did not rise as much as we had expected. Therefore we are now revising this indicator and returning to 800K as the critical level once again. Previously we concluded that when rising call open interest reaches 800K contracts we can expect the VIX to rise in response to a decline in the SPX. Currently we estimate call open interest at 825K contracts. A 3-month graph from Advanced Historical Data of the VIX options volume and open interest follows.

The Call Volume and Open Interest is shown in blue above. When the call open interest rose above 800K contracts, shown above at 1-4 large declines in the SPX followed. After rising above 1 million contracts (see 3 above) it appeared that this level would be required to indicate another expected large decline in the SPX but that proved not be the case. Once again, as with the previous examples, 800K contracts of call open interest was a good leading indicator of the decline.

The US Dollar Index (DX) 72.39. Early in the week the DX was rising upward toward the 74 level on positive comments from the US Federal Reserve about dollar support. This was abruptly reversed by the ECB comments suggesting higher Euro interest rates in response to inflationary pressures. Ironically the inflationary pressures are being caused in part by the weak dollar. The DX will now likely decline back down and test previous support at the 72 level and perhaps even to the 71 level. Here is the DX chart showing the large declines on Thursday and Friday.

NYSE McClellan Summation Index. As we would expect with a large market decline our market breadth indicator, the NYSE McClellan Summation Index also declined 105.33 points ending the week, at 253.98. The last inflection point was at 427 on May 16, 2008.

Strategy

Once again for the third week we write, “Crude oil futures and the oil and gas sectors appear overbought and we think some hedging is now prudent.” We suggest extending these strategies once again and would include other commodity-related issues including gold.

For this next week or so we think the equity market will continue lower and we suggest hedging long positions with selected short ETFs. When the SPX reaches the measuring objective at 1300 we suggest lifting the hedges and increasing long positions in the sectors with relative strength that are not overbought.

IVOLopps™

In IVolatility Trading Digest™ Volume 8, Issue 21, Crude Oil Bubble, dated May 26, 2008 we suggested a bull call spread for the VIX. Here is another idea.

CBOE Volatility Index (VIX ) 23.56. With a further expected decline in the equity market we would expect to see higher market implied volatilites for the SPX options. Due to its responsiveness the VIX is one of the better ways to hedge a broad market decline. With a current Historical Volatility for the VIX of 107 consider this bull call spread suggestion.

• Buy VIX Jun 25 call VIXFE 1.25 IV 107 Delta .4189 Gamma .0855
• Sell VIX Jun 30 call VIXFF .575 IV 136.59 Delta -.1981 Gamma -.0477
  Debit .675 Position net delta .2208 Position net gamma .0378

This suggestion has good edge and a favorable risk to reward ratio. The difference between the strike prices is 5 points and is the maximum potential value of the spread. Our cost is .675 so we have a potential gain of 4.325, six times the amount at risk. However, there are two concerns. First the options expire in two weeks, so the gamma is high and rising, and secondly the VIX could go to 30 or even higher on an intra-day basis and close lower.

This position requires daily management and should be closed intra-day when the VIX trades above 30. In the event the VIX declines and closes back under 20 unwind the position.

Here is another idea from Issue 21 with a new bull call spread suggestion.

UltraShort S&P500 ProShares. (SDS) 59.80. 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 27.46 take a look at this bull call spread as an equity market hedge or a limited risk equity market short.

DR: Leveraged inversely to the SPX based upon the trendline break and the newly defined Head& Shoulders Top for the SPX.

SU: Unwind the spread on a close below 55.

• Buy SDS Sep 60 call SDSIH 5.20 IV 40.91 Delta .5421 Gamma .0304
• Sell SDS Sep 65 call SDSIM 3.95 IV 46.14 Delta -.4201 Gamma -.0265
  Debit 1.25 Position net delta .1220 Position net gamma .0039

The position has a good edge with a limited and defined risk, while the maximum gain is 3.75 (the difference between the strike prices of 5 points less the debit of 1.25).

Based upon the expected downside-measuring objective of the SPX at 1300 (see above) we expect the SDS to reach 67 when the SPX reaches 1300.

UltraShort Financials ProShares (SKF) 122. This ETF seeks daily results corresponding to twice the inverse of the daily performance of the Dow Jones U.S. Financials Index. The fund normally invests 80% of assets in financial instruments with characteristics that should be inverse to those of the index. The Dow Jones U.S. Financials Index is broad based and includes 286 banks, insurance companies, investment management, mortgage companies and REITs.

New regulatory proposals along with rumors of lingering mortgage related problems with major financial companies are once again raising concerns about this group. We think pressure will likely continue until the broad market has made a conclusive bottom and there is some improvement in house prices.

With a current Historical Volatility of 54.20 and with 24,000 call open interest compared to 15,000 put open interest consider this bull call spread.

DR: Problems in the financial sector are likely to continue until the equity market turns higher along with the US dollar and there is some improvement in house prices.

SU: Unwind this position on a close below 110.

• Buy SKF Jul 125 call SKFGR 9.80 IV 65.72 Delta .5069
• Sell SKF Jul 130 call SKFGU 9.05 IV 72.69 Delta -.4528
  Debit .75 Position net delta .0541

Since there are 5 points between the strike prices it defines the maximum value of the spread. With a debit of .75 there is a potential gain of 4.25, which is more that 5 times the defined and limited risk.

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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