Volume 8, Issue 27
Bears and Oil
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Since the last issue at the end of June the markets have changed dramatically. Equities appear to have bottomed as crude oil and natural gas turned lower. Even though we switched to the long side in IVolatility Trading Digest™ Volume 8, Issue 26, Right Side, dated June 30, 2008 we had been expecting the crude oil correction, as it was long overdue. This is not the first time, nor will it be the last, when we reversed our position near a top or bottom only to realize that it was too late.
Even though we expect a retest of the lows before very long, using our indicators we will tell you why we think equities have now most likely made a bottom thereby marking the end of this bear market. At the risk of being labeled a “flip-flopper” we suggest unwinding long positions in crude, natural gas and selected overbought commodities. We will provide some specific suggestions along with some new ideas, and a brief takeover review including at least one where the terms have been agreed.
Market Review
S&P 500 Index (SPX) 1260.68. The SPX and the other US equity indexes appear to have bottomed. On Tuesday July 15, 2008 the SPX traded as low as 1200.44 before closing at 1214.91. In IVolatility Trading Digest™ Volume 7, Issue 44, Merry Yuletide, dated December 17, 2007 we identified and defined a potential Head & Shoulder Top from the October 11, 2007 high at 1576.09. At that time we wrote that we expected to see the SPX trade down to a minimum measuring objective of 1225. Now that this objective has been achieved we suggest closing short equity positions while starting to look for long opportunities. Reaching the downside-measuring objective of this most reliable classical bar chart pattern is the first reason for declaring a bottom in the SPX.
The CBOE Volatility Index (VIX) 24.05. The VIX continued higher early in the week making an intra-day high of 30.81 on Tuesday July 15, 2008 with the bottoming of the SPX. We expected to see at least 30 for the VIX at the bottom and we got it. For comparison, the prior relevant VIX highs corresponding to index lows for this decline are:
37.50 on August 16, 2007
37.57 on January 22, 2008
35.60 on March 17, 2008
Since the VIX reached 30.81 on this decline of the index and then retreated as the index turned higher is the second reason for declaring the bottom of the equity market.
The US Dollar Index (DX) 72.19. The DX returned once again to successfully test and hold the 72 level. For now the focus is on crude oil and equities while the DX appears to be on the sideline.
NYSE McClellan Summation Index. Our market breadth indicator continued accelerating to the downside reaching –1218.42 on July 16, 2008, before recovering to close at –1187.75 by the end of the week. Here is what the experts say at the McClellan Financial Publications Website. “Among the most significant indications given by the Summation Index are the identification of the end of a bear market and the confirmation of a new bull market. Bear markets typically end with the Summation Index below -1200. A strong rise from such a level can signal initiation of a new bull market.” This index declined below –1200 giving us the third reason for declaring a market bottom.
In addition to market breadth, market sentiment as measured by Investors Intelligence which uses the net difference between the bullish percentage and the bearish percentage was at an extreme low under 20, a level associated with good buying opportunities and providing the fourth reason to declare the market bottom.
Strategy
We suggest closing or hedging positions in the oil and gas sectors along with agricultural commodities and or commodity ETFs. The recovery in the SPX was directly related to the decline in the crude oil futures market on Wednesday July16, 2008 as crude oil came down, tested and then closed below the operative four point upward sloping trendline that starts from the April 2, 2008 low at 98. This long overdue seasonal decline in crude oil and natural gas could last until the end of August providing support for equities in general and oversold equities in particular including financials. Therefore, we now also suggest closing any remaining open positions in UltraShort Financials ProShares (SKF) 138.00.
The decline in crude oil and natural gas is our fifth reason for declaring a market bottom.
IVOLopps™
United States Oil (USO) 104.44. This ETF reflects 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.
Here is a new put spread to replace the ones that may have been prematurely closed based upon the suggestions in IVolatility Trading Digest™ Volume 8, Issue 26, Right Side, dated June 30, 2008 or closed on a SU (stop/unwind) below 105 from prior trade plans.
With a Historical Volatility of 44.29 consider this bear put spread for USO.
DR: Expecting a seasonal decline in crude oil that could last until the end of August.
SU: Unwind on a close above the upward sloping trend line, now about 123.
- Buy USO Oct 100 put IYSVV 8.50 IV 53.52 Delta -.3758
- Sell USO Oct 95 put IYSVQ 6.40 IV 54.06 Delta .3197
Debit 2.10 Position net delta -.0561
This spread with a maximum potential value of 5 should have enough time for the completion of the expected seasonal decline. With a cost of 2.10 the maximum gain potential is 2.90.
UltraShort Oil & Gas ProShares (DUG) 34.20. 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 58.58 consider these suggestions.
- Sell DUG Aug 30 put DZGTD 1.025 IV 71.76 Delta .2303.
This index rises with a decline in the value of the oil and gas stocks and this put sale has good edge.
In addition consider this bull call spread.
- Buy DUG Oct 30 call DZGJD 6.70 IV 66.92 Delta .7137
- Sell DUG Oct 37 call DUGJK 3.75 IV 70.78 Delta -.4846
Debit 2.95 Position net delta .2291
The difference between the strike prices defines the maximum value of the spread. For this position it is 7 points and with a cost of 2.95 there is a potential gain of 4.05 for a risk to reward ratio of .73, or the potential gain is 1.37 times the defined and limited risk.
Freeport-McMoRan Copper & Gold Inc. (FCX) 103.24. Freeport-McMoRan, engages in the exploration, mining, and production of copper, gold, and silver. It holds interests in the Grasberg open pit and the Deep Ore Zone mines in Indonesia and others including Phelps-Dodge. In addition, it smelts and refines copper concentrates, and markets refined copper products.
We last suggested the sale of a FCX July 110 put in a put in IVolatility Trading Digest™ Volume 8, Issue 24, Takeover Update, dated June 16, 2008. Since this put is in the money we will be assigned stock at 110 making our cost in the long stock 106.60. With the current a Historical Volatility at 40.84 and the Implied Volatilites in the mid 70s calls sales against the long stock is now an attractive opportunity. From our Advanced Historical Data service take a look at the volatility chart below:
It is somewhat unusual to see a quality company selling with such a large positive volatility spread. Since we do not consider copper to be in the overbought commodity category this represents a good opportunity.
Here is a suggestion for the covered call against the assigned long stock.
- Sell FCX Aug 115 call FCXHC 4.075 IV 70.71 Delta -.3330.
In addition, consider these put sales.
- Sell FCX Aug 85 put FCXTQ 1.825 IV 74.19 Delta .1482.
- Sell FCX Aug 90 put FCXTR 2.990 IV 73.52 Delta .2192.
- Sell FCX Aug 95 put FCXTS 4.60 IV 73.11 Delta .3031.
Previously there was speculation that FCX would be the target of a takeover bid by the Brazilian mining giant Companhia Vale do Rio Doce (RIO) 29.13. Rio has just completed a new stock offering raising $11.5 billion, part of a new strategic acquisition plan. Although RIO management has denied it the volatility chart of FCX looks as if the options buyers have not completely dismissed the possibility that FCX could be included in RIO’s plan.
Financial Sector
Take a look at this suggestion from Friday’s list of our Top 5 stocks based on IV Index Mean vs 30D HV. With an Implied Volatility Index of 124.77 and a current Historical Volatility of 71.07 perhaps the time has come to consider a financial stock.
American Capital, Ltd. (ACAS) 21.11. Bethesda, Maryland based ACAS, formerly known as American Capital Strategies, Ltd., is a principal investment firm specializing in management and employee private equity buyouts, acquisitions, recapitalizations, mergers and acquisition, add-on acquisitions, securitizations, special situations, growth capital investments in middle market companies. Included among its many investments is a REIT that intends to buy residential mortgages and the related controversial securitized products.
If you believe the sell off in financials is overdone and you can manage the risk, one of these put sale suggestions (with considerable edge) may be of interest.
- Sell ACAS Aug 15 put DQSTC .95 IV 155.44 Delta .1576
Or
Sell ACAS Aug 17 ½ put DQSTW 1.575 IV 142.17 Delta .2504
Emphasis should be placed on risk management so investigate this company and read about the portfolio valuation issues they have before taking a position. One of the better risk management techniques is to limit the size of the initial position.
From Friday’s Options Data Analysis Section
Stock Trend Analysis
Danaher Corp. (DHR) 82.37. This Washington, DC based conglomerate reported better that expected earnings last Thursday and then raised guidance for the third quarter and full year. It appears much of their growth is related to acquisitions and currency valuation. If a growing conglomerate with good fundamentals is of interest then consider this bull call spread. With an improving equity market and having just gapped up on the earnings report it is likely to pull back before challenging the prior November/December highs at 90.
- Buy DHR Dec 85 call DHRLQ 5.05 IV 26.86 Delta .4916
- Sell DHR Dec 90 call DHRLR 3.025 IV 25.63 Delta -.3546
Debit 2.025 Position net delta .1370
Best Calendar Spread
Yahoo! Inc. (YHOO) 22.45. As we expected, this takeover saga continues to generate near term implied volatility higher than the deferred months, generating calendar spread opportunities. We have included many suggestions for YHOO in recent issues, here is one more from the Best Calendar Spread selection in Fridays’ Options Data Analysis Section. With the current Historical Volatility at 57.76 here are the details including the implied volatility numbers that help explain this suggestion.
- Buy YHOO Jan 22 ½ call YHQAX 3.325 IV 50.64 Delta .5858
- Sell YHOO Aug 22 ½ call YHQHX 1.93 IV 76.70 Delta -.5426
Debit 1.395 Position net delta .0432
Takeover File
And now from the takeover file some updated details on a deal that seems to be agreed.
Anheuser-Busch Companies Inc. (BUD) 67.11. 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.
On July 14, 2008 InBev and Anheuser-Busch announced that they reached a friendly deal at 70. This is the model that takeovers should follow, two offers and then a friendly agreement.
Reviewing our previous suggestions, we took a 5.225 credit with the adjustment of the first calendar spread. This resulted in a new Dec/Jul 55 calendar spread that was then closed on Friday at .80. The total net credit was 6.025 while the initial debit was 2.20. The resulting gain was 3.825
In addition we suggested the sale of the July 60 put for .85 in IVolatility Trading Digest™ Volume 8, Issue 26, Right Side, dated June 30, 2008. Since BUD closed at 67.11 on Friday this put expired and we added .85 to the credit column for a total of 4.675 or 112.5% return in two months, before considering the margin requirement for the short put.
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To InBev we say well done and …this Buds for you.
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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.
