Volume 8, Issue 37
Bottom Fishing 2.0
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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In IVolatility Trading Digest™ Volume 8, Issue 14, Bottom Fishing, dated April 7, 2008, the S&P 500 Index (SPX) closed, the previous Friday, April 4, 2008 at 1256.98 and we offered some long suggestions based on the possibility that the equity market had made a double bottom on March 17, 2008. We return once again with the supposition that most of the negative news is now priced into the market. We leave the doomsday speculations to others and there are plenty available. While we remain mindful of the risks we suggest it is time to begin looking once again to the long side including a few selected financials.
In the Market Review we include a money market indicator and then offer an equity index ETF long market suggestion and trade plan ideas for three financial sector stocks.
Market Review
S&P 500 Index (SPX) 1213.27. With the low at 1133.50 on Thursday September 18, 2008 the SPX made a well defined Elliott 5th wave bottom. That does not mean it will be the final bottom but it does have all of the characteristics of an Elliott 5th wave and it does provide some comfort that the chances are improving for declaring the bottom is near. Until the VIX declines back under 30 and starts trending lower we again reserve judgment that the final bottom has been reached.
CBOE Volatility Index (VIX) 34.74. Our view of the VIX remains as we stated last week. “Now we would like to see it start declining in a normal downward slopping pattern and remain under 30 to help support the view that we have seen the bottom of the equity market for this cycle.”
US Dollar Index (DX) 76.95. We had been expecting a retracement back to 75-76 and the DX made a rapid move to the downside last Monday with a low at 75.89 and then closing at 76.15 for a 1.529 point loss. Over the course of the week it traded back upward making a classical flag pattern. Based upon this we are now looking for another point-and-one-half down from the 76.95 close to the flag measuring objective level at 75.45.
13 Week Treasury Bills (IRX) .83%. Just as the VIX is a good sentiment indicator for the equity market, The Treasury – Eurodollar Spread, called the TED Spread is a good indicator for money and fixed income markets. The London Interbank Offer Rate (LIBOR) is the rate banks charge to lend US dollars between banks. The difference between the 90-day LIBOR and the equivalent term Treasury Bills is the TED spread. In a normal market conditions this spread is about 50 to 75 bps or .50% to .75%. On Friday September 26, 2008 the TED spread closed at 2.92% an abnormally high level indicating panic buying of Treasury Bills and a lack of available funds or a lack of willingness to lend available funds in the inter-bank market, or some combination of all three. Here is the Bloomberg chart of Friday’s TED Spread.
Open 3.02, High 3.11, Low 2.81, Close 2.92.
NYSE McClellan Summation Index. Last week our market breadth indicator continued declining but at a slightly lower rate ending off 146.16 with a still negative close of -597.36, but far above the negative 1187.75 on July 18, 2008.
Strategy
One advantage of using options is their ability to establish directional positions while defining and limiting risk. While the abnormal stress in the markets may indicate opportunity we do not know with certainly conditions will improve any time soon. Therefore, if we want to take positions based upon the abnormal market conditions we should create small positions with limited and defined risk. In an abnormal market with high levels of negative sentiment it is probably too late to short the market so we suggest small positions with limited and defined risk on the long side.
IVOLopps™
Equity Market
For the equity market long consider one of our favorites.
iShares Russell 2000 Index (IWM) 70.63. This ETF tracks the price and yield performance of the Russell 2000 index. The fund invests in approximately 2000 of the smallest capitalization-weighted companies in the Russell 3000 index. It invests at least 90% of assets in the securities of the underlying index and uses a representative sampling strategy in order to track the Russell 2000 index, which measures the performance of the small-capitalization sector of the US equity broad market.
For long positions the IWM currently has the advantage of better relative strength. From the July 15, 2008 market low the IWM is up 9.5% while the S&P 500 Index ETF (SPY) is up just .7%. Part the relative strength advantage may be explained by fewer international companies with currency translation issues and fewer financials in the IWM compared to the larger companies represented by the SPY. In addition, with extremely high options volume and open interest the IWM offers very good liquidity.
With a current Historical Volatility of 33 take a look at this idea.
Trade Plan
DR: Directional trade for the equity market based upon relative strength compared to SPY.
SU: Unwind the position on a close below the last pivot at 67.16 on September 18, 2008. A close below this level indicates a likely retest the 65 level made in mid July.
- Sell IWM Oct 65 put DIWVM .90 IV 44.05 Delta .2000
At 44.05 the Implied Volatility of this is put is favorable compared to the Historical Volatility of the underlying ETF at 33. A reasonable IV forecast is for a decline back into the 25-30 range. However, if the IWM declines again to 67 we should expect to see our put selling around 1.50 where we would need to buy it back and close the short put position.
If we are right on the market timing then we should also consider adding a bull call spread as the second part of this long trade.
- Buy Dec 73 call IQQLU 3.40 IV 28.82 Delta .4653
- Sell Dec 75 call IQQLW 2.565 IV 28.11 Delta -.3898
Debit .835 Position net delta .0755
The combination of both trades results in a credit of .065 with a net delta of .2755. This is an example of long market position with good potential upside. While the downside for the bull call spread is defined by the debit of .835 there is a small margin requirement for the short October 65 put but the SU (stop/unwind) needs to be carefully watched to preclude a greater loss in the event the IWM does not continue higher in the next two weeks.
Financial Sector
If a government rescue package is agreed over the week-end these suggestions may change when the markets open on Monday. If so, use the position net deltas to adjust for the new option position prices. With this in mind we start with one of the more controversial financials.
Wachovia Corporation (WB) 10.00. It has been reported that Charlotte, NC based WB has been talking with Wells Fargo & Co., Banco Santander SA., and Citigroup Inc. If the government rescue package is agreed soon there may be less pressure on this bank to do something right away. On Friday the stock declined on speculation that the rescue package will be delayed and WB may be forced into an asset sale and ending up like WaMu last Thursday with no stock value. With that in mind here is a credit call ratio back spread that would benefit from an upside move. With a current Historical Volatility of 235 consider this limited risk idea.
- Sell WB Oct 10 call WBJB 3.30 IV 245 Delta -.6196
- Buy 2 WB Oct 15 calls WBJC 2.45 (2 X 1.225 each = 2.45) Delta .7116 (2 X .3558)
Credit .85 Position net delta .0920.
If the stock does not turn higher soon there will be a loss of time premium on the second long call but if the position expires with both legs out-of-the money the credit will be maintained. More problematical will be the short Oct 10 call if the stock quickly rises since it will be in the money and the stock will have to be bought in before expiration in order to be flat when the stock is called away.
JPMorgan Chase & Co (JPM) 48.24. From the market reaction to their new $10 billion stock offering it looks like JPM is going to be one of the winners from the financial sector turmoil. They did a good job of risk management with their Bear Stearns assets purchase and now appear to have done the same or better with the acquisition of the WaMu assets. The management of this bank seems to have remembered the 1907 financial panic and is following the same astute strategy.
With a current Historical Volatility of 107 and now declining consider this put sale.
- Sell JPM Oct 40 put JPMVH 1.05 IV 85.80 Delta .1756
This is an opportunity to sell nice premium in a well managed company. In the event it declines below 40 at the October expiration be prepared to take in the stock by assignment and then sell calls.
Interactive Brokers Group, Inc. (IBKR) 24.19. Greenwich, Connecticut based IB serves both institutional and individual customers offering automated global electronic market making and brokerage services. It engages in order routing, executing and trade processing for equities, futures, and foreign exchange instruments on 70 electronic exchanges and trading venues worldwide. It provides bid and offer quotations on approximately 420,000 securities and futures listed on multiple electronic exchanges. They also offer an order management, trade execution, and portfolio management platform to access multiple asset classes, such as stocks, options, futures, foreign exchange, and bonds.
They have just raised their guidance and are now forecasting third-quarter earnings to be .55 - .65 when the announce on October 23rd, well above the market estimates of .47, and have said they will buy back 8 million, or 20 percent of their outstanding stock. Yahoo finance shows their trailing twelve month price to earning ratio at 11.51 with a forward price to earnings ratio of 10.52 and with an attractive price to earnings growth ratio of .57. The total debt to equity ratio is 1.81 with an appealing return on equity of 21%.
While the current Historical Volatility is 84 and now declining and with an Implied Volatility Index Mean of 72.04 and declining we expect to see the implied volatility back into the 55-60 range soon.
Consider this combination trade to benefit from the value and growth prospects of this online brokerage company.
- Sell IBKR Nov 20 put QBOWD .925 IV 72.65 Delta .2048
In the event the stock closes below 20 on the October expiration be prepared to take the stock by assignment and then sell calls. In that event the basis in the stock would then be 19.075 about equal to the last pivot and before they announced higher earrings guidance and the stock buy back.
Next, consider this bull call spread.
- Buy IBKR Dec 25 call QBOLE 2.80 IV 65.75 Delta .5329
- Sell IBKR Dec 30 call QBOLF 1.05 IV 59.27 Delta -.2814
Debit 1.75 Position net delta .2515
While this spread does not have an implied volatility edge there is long gamma since the Dec 25 has a gamma of .0518 while the Dec 30 gamma is .0488 meaning the delta of the long call will increase faster than the delta of the short call when the stock price increases.
Combining the two trades produces an attractively priced combination with a net debit of .825, a net delta of .4563 with good upside potential and with an acceptable and manageable 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.
