Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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This week number 5 refers to this week’s suggestion from our regular ranking feature for “Top and bottom 5 stocks based on IV Index Mean vs 30D HV”. Because options refer to numerous Greek symbols it is interesting to note that in the Greek alphabet, ε (epsilon) has a numerical value of 5. We will not use epsilon in the featured suggestion but will look in detail at an income strategy for number 5 from this week’s Top 5 based on IV Index Mean vs. 30 day Historical Volatility.

First we update our market review and offer some strategy comments.

Market Review

S&P 500 Index (SPX) 770.05. When we last visited the SPX it was holding the 800 support level and we were beginning to think there was a chance it could hold this level after finding support on five previous attempts. These thoughts were completely shattered by last week’s 56.79 point, and 6.9% decline. Now we are convinced that the long anticipated Elliott 5^th wave down is now underway and we can expect to see a new low below the November 21, 2008 key reversal low at 741.02. We are still using the downside measuring objective of 690 from the October bearish continuation pattern. In the meanwhile, SPX now appears oversold and with February options expiration now completed, we are expecting a near term bounce before it resumes the likely long and slow search for the final Elliott 5^th wave bottom.

S&P 500 Index IVXM 43.69. The Implied Volatility Index Mean (IVXM) increased 5.82 points and our IVX Monitor, using intra-day data, increased 6.10 points to 42.80. It looks as if our IVXM range forecast needs to be increased to 37-50 from the previous estimate of 37-42.

US Dollar Index (DX) 86.59. Last Tuesday DX broke out of a consolidation pattern and continued up to the previous resistance at 88 set back in mid November. Then it immediately turned lower creating a large double top. The distance from the base of the triangle to the line that connects the two tops is 10 points (88-78). Subtracting this distance from the base of the triangle at 78 would imply a minimum downside measuring objective of 68. While this seems unlikely given the recent strength of the US Dollar we note that classical bar charting technical analysis has been remarkably on target in the foreign currency markets. While DX may retest the 88 level several times, if it does not break out from 88 and trade higher then look for a reversal in DX that has the potential to go all of the way back down to 68. If so, one major beneficiary should be the gold group.

iShares Barclays 20+ Year Treasury Bond (TLT) 103.92. The objective of this ETF is to duplicate the price and yield performance of the long-term sector of the United States Treasury market as defined by the Barclays 20+ Year U.S. Treasury index.

After trading down toward the 100 level TLT has been supported three times and turned higher on each occasion. We think the 100 level will probably hold and we should consider closing the bear put spread we suggested in IVolatility Trading Digest™ Volume 9, Issue 2, Biotechnology Week, dated January 12, 2009. We will give it one more week to see if it can trade lower than the support level just above 100.

NYSE McClellan Summation Index. Last week our breadth indicator accelerated downward along with the other equity indexes. Now back into negative territory it reads -180.27 for a weekly decline of 305.79 points as once again the number of New York Stock Exchange decliners exceeded gainers by wide margins every day last week.

Strategy

It now appears that the SPX November 21^st low at 741.02 is being challenged in an Elliott 5^th wave down pattern. We continue to suggest that long positions be hedged with puts, collar or spreads. We would be more cautious with the put spreads on the lower end of the ranges until we reach the final bottom of the market. For now it appears SPX is oversold and due for a bounce. Before establishing a bearish strategy we will wait to see if there is a bounce. We also think gold and the gold derivatives along with the mining stock are overbought and due for short-term decline before proceeding higher once again.

Volatility Charts and Number 5

IVolatility.com offers the best volatility charts in the business. At our Advanced Historical Data page, you will find current volatility charts on all the traded equities, ETFs and Futures going back to 1994 or from the date options started trading. You will find the long- term charts and have the ability to narrow the time- frame down in increments of years all the way to one month. Ours is a reasonably priced Internet delivered service that we maintain so you do not have to be downloading and updating an entire database every time you want to look at volatility numbers. Just enter the symbol for the stock you want and the chart is delivered. We encourage you to try our Advanced Historical Data service for the best volatility charts in the business. This is where you find the edge.

From this week’s Top 5 based on IV Index Mean vs. 30 day Historical Volatility we look number 5 in greater detail and offer a trade idea.

A positive volatility spread is our short hand method of describing a volatility pattern. For example, a Type I Volatility pattern is one where there is a significant difference between the implied volatility and the historical volatility of the stock, which we call a positive volatility spread. What we are looking for is the relationship between HV and IV. When we make a suggestion we include the HV as a reference marker for comparison to the IVs of the spread legs. If the IV’s are higher than the HV then we would be looking to sell the IV, as it is relatively more expensive. Hence we would sell put or a covered call in an attempt to capture the pricing differential. We refer to this as the edge.

There is an important difference between the Implied Volatility and the Historical Volatility as they are measuring different things. If the Implied Volatility is consistently higher than the Historical Volatility there is a statistical advantage that we refer to a Positive Volatility Spread that provides an edge to the option seller. Here is Friday’s Number 5 as an example.

Boston Scientific Corporation (BSX) 8.18. Natick, MA based BSX develops medical devices and interventional medical specialty products. The company and Angiotech Pharma (ANPI) .37 filled an application for Premarket approval (PMA) with the FDA on February 5, 2009 for two TAXUS (Liberate Atom & long) drug-eluting coronary stents (DES) with a decision expected by year-end. PMA is the FDA process of scientific and regulatory review to evaluate the safety and effectiveness of Class III medical devices.

We found BSX in the number 5 spot from last Friday’s Top 5 based on IV Index Mean vs. 30 day Historical Volatility. With an Implied Volatility Index Mean of 88.07 and a current Historical Volatility of 49.23 the ratio is 1.79. With implied volatility being higher by a ratio of 1.79 over the stock’s Historical Volatility.

Look at this favorable and increasing positive volatility spread. The IV Index Mean is orange and the Historical Volatility is blue.

After identifying the volatility spread we want to know if the implied volatilities are being bid higher by call buyers expecting some good news or by put buyers with long stock positions and are seeking downside protection. At Advanced Historical Data we discover that put volume increased significantly on February 17, 2009 from about 2,000 to over 15,000 contracts. While put open interest has exceeded call open interest for quite awhile the latest put buying appears to be responsible for bidding up the options implied volatility, creating the wide spread that we found with our ranker. At the end of the week the put/call ratio was a bearish 1.5. With this data we will look for some puts to sell.

With the current Historical Volatility of the stock at 49.23 consider this calendar put spread income strategy.

• Sell BSX Mar 7 ½ put BSXOU .50 IV 90.41 Delta .3193 Vega .0082
• Buy BSX Aug 7 ½ put BSXTU 1.15 IV 68.21 Delta -.3316 Vega .0211
  Debit .65 Position net delta -.0123 Net Vega .0129

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the debit Monday should be about .67 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change. If the stock price is higher the spread net debit will be less by about .01 per point since the delta is negative at -.0123. If the stock price is lower the spread will be more by about .01 per point since the delta is negative at -.0123.

The spread will reach is maximum value if the stock closes exactly at 7 ½ on the March expiration since the March will expire, but since we are still long the August we will next sell the April 7 ½ put.

Notice the net Vega, or the amount an option price changes per a one- percentage change in implied volatility, shown above at .0129. This means if implied volatility increases it will benefit the position. If implied volatility declines it will be detrimental. In the fundamental information above we see that a decision on their stent PMA application is not expected until year end. With a long August 7 ½ put we could have an opportunity to sell 7 ½ puts at least 4 more times before the August expiration and if implied volatility continues rising as indicated in the chart they could be sold for higher prices in the subsequent months. In addition, notice the difference between the implied volatility of the Mar 7 ½ put at 90.41 that we are selling and the August 7 ½ put at 68.21 that we are buying. This is a good edge and we hope it can be maintained in the subsequent months.

In the meanwhile, with a Historical Volatility at 49 the stock is not moving fast, and looking at a stock chart, it appears to have considerable support at 8 having tested this level multiple times since last October.

On the downside there is risk if the stock rises too far too soon. In this instance we don’t think it is likely that stock will rise before they get nearer to the expected approval date. In the event the stock declines below 7 ½ on the March expiration there will be a management issue with respect to the assigned stock from the short put. In this event, we will want to sell stock short with a market on close order (MOC) just before the options expire on the last Friday in order to be flat the following Monday after the stock is assigned. The alternative would be to sell the long put, but we would be giving up the time value in the long put. A better solution is to keep the long put and sell another put creating another calendar put spread.

Since the position is long Vega, or the amount an option price changes per a one- percentage change in implied volatility, another risk is declining volatility as the long term put will decline in value more than the near term put. Again referring to the volatility chart above we think it is more likely that implied volatility will be increasing as the expected PMA approval date gets closer.

Although more complicated to explain and with more position management issues to consider a calendar spread such as this one that has the potential for 4 more spread opportunities and could be very rewarding.

Since this is a fairly complicated trade suggestion that could last for several months we will set up a trading record and follow its progress using the next day closing prices. Therefore, for this record we will be using Monday’s closing prices. We will report back on the progress when there are noteworthy developments or at least monthly when we set up the next monthly calendar spread.

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. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com.