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This October we are going to devote more effort into finding a congenial German Beer garden and forget all about the financial markets. We recall what a famous American writer and philosopher once said about October.

“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, and February.” (Mark Twain)

It seems like to only side of this market to be on is the short side. Despite apparent values and bargains nothing seems to be working on the long side as the hedge funds continue unwind.

If the world economy is going to slow down as much as the pundits are declaring we think crude oil prices will continue following other commodities lower. We will offer an option strategy suggestion in the event it does and then use the cool and soon to be released IVolatility.com Profit and Loss Calculator to help explain the details.

Then after the Market Review we offer one more short idea to consider.

Market Review

S&P 500 Index (SPX) 1099.23. From the long perspective it has been a rough time for equities as the SPX closed out the week on the low and 34.27 lower than on September 18, 2008. We are now beginning to doubt the bottom of this market cycle is anywhere near. Our best indicator is the VIX and it still remains very high. Until the VIX declines back under 30 and starts trending lower we suggest overweighing on the short side.

CBOE Volatility Index ( VIX) 45.14. With the market decline on Monday the VIX reached what appears to be an all time high at 48.40. If there is a previous higher high we did not find one. It exceeded the October 1998 high at 45.74 and the September 2002 high at 45.65. At least the previous highs have all come in either September or October and perhaps we have also seen the high for this year. In the meanwhile, until the VIX starts trending lower the right side for the equity market is the short side.

US Dollar Index (DX) 80.31. The flag pattern that we described last week was totally destroyed with the .52 gain on Monday following the large equity market decline. For now the dollar appears to be the only safe sanctuary with 90-day Eurodollar deposits yielding 5.125%. Why take risks in equities if you can earn 5.125% in short-term deposits?

TED Spread 3.87. The difference between the 90-day LIBOR and the equivalent term Treasury Bills is the TED spread. In normal market conditions this spread is about 50 to 75 bps or .50% to .75%. Here is Friday’s updated Bloomberg chart of the TED Spread.

Open 3.61, High 3.88, Close 3.87

NYSE McClellan Summation Index. As we expected our market breadth indicator continued declining and was lower by 185.91 for the week at -783.27. It now looks as if we will continue seeing breadth deterioration.

Strategy

Last week we suggested bottom fishing using small long positions with defined and limited risk. We now suggest unwinding most longs and replacing them with shorts. Since the market sentiment is already so negative we recognize it may be late in the game to be looking for short opportunities, but we do not think longs are worth the risk. Perhaps the best place to be for now is 90-day Eurodollar deposits and the PowerShares DB US Dollar Index Bullish (UUP) 24.78.

Short Crude Oil

United States Oil (USO) 75.25. This ETF reflects 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.

With a Historical Volatility of 58 consider this combination of a put ratio backspread and a bear call spread for a low cost short USO position.

Part one.

• Buy 2 USO Nov 69 puts UNAWQ 3.20 (2 X 3.20 = 6.40)
  IV 56.16 Delta -.2965 (2 X .2965 = -.5930)
• Sell USO Nov 75 put UNAWW 5.80 Delta 54.27
  Debit .60 Position net delta -.1411

Part two.

• Sell USO Oct 75 call UNAJW 3.40 IV 55.07 Delta -.5284
• Buy USO Oct 80 call UNAJB 1.525 IV 54.67 Delta .3045
  Credit 1.875 Position net delta -.2304
  
  Combination net credit 1.275 net delta -.3715

With considerable volume and open interest the USO is a good ETF for options strategies. With the help of the soon to be available IVolatility.com Profit and Loss Calculator we can create a visual image of the position and stress test it for changes in implied volatility and time decay. Using the Black-Scholes Model the Profit and Loss Calculator gives us theoretical values not including commissions.

Here is the position profit and loss graph based upon Friday’s closing data.

The closing price was 75.25 and this is a close as we were able to set the price marker. We think there is a reasonably good chance that the USO will decline to 70 in the near future. If so our position will gain in value by a theoretical 197 as indicated above. We started with a net credit of 1.275. The first half of this position is a put ratio backspread, which is a put credit spread with an extra long put. Since the extra long put will have time decay we added a bear call spread. If USO closes below 75 on the October expiration then both legs of the bear call spread will expire worthless and we book the entire premium of 1.875 as a gain. This offsets the time decay for our put ratio backspread and gives us the next two weeks to see if USO is going to decline further.

SU: From the graph above you can see the curve goes negative right at the 75 level and at 80 the theoretical loss would be 163. This gives us a good place to set the stop/unwind at close of 80 or above.

In the event USO declines as we expect and the implied volatility increases by 5% from 55 to 58, which seems likely if USO declines further then our gain would be a theoretical 242.

Here is the Profit and Loss profile using Fridays’ closing numbers and modeling for the expiration of the bear call spread on the October options expiration in 14 days.

If USO is below 75 on the October options expiration as indicated in the graph above as +14 days, then we book the entire initial credit and our theoretical gain at the 70-price level is 199. If we also have an increase in implied volatility we would have a theoretical again of 245.

Unless we are seeing a rapid decline in the price of USO we will close the position on the October options expiration since we will have unhedged time decay from the extra long Nov 69 put as shown above.

With the help of the IVolatility.com Profit and Loss Calculator we are now able to better explain some of the more complicated strategies. We welcome the addition of this new tool that will soon be available to our subscribers.

One More Short Idea

Here is another short idea; this one is in the technology sector.

EMC Corporation. (EMC) 11.58. EMC is in the information infrastructure technologies and solutions business. Its Information Storage segment offers networked information storage systems, networked attached storage, content addressed storage, or direct attached storage environment. The current trailing 12 month price-to-earnings ratio is 15 with an indicated forward ratio of 13.

There is good options volume and open interest and with a Historical Volatility of 50 take a look at this bear put spread suggestion with a nice edge.

• Buy EMC Nov 12 put EMCWN 1.205 IV 58.46 Delta -.5156
• Sell EMC Nov 9 put EMCWI .225 IV 70.40 Delta .1315
  Debit .98 Position net delta -.3841

This is bear put spread with good edge in a sector that is under pressure. Use a close back above 13 as the SU (stop/unwind).

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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