Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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“To every thing there is a season, and a time to every purpose under the heaven.” These lyrics to the Byrds 1965 song Turn, Turn, Turn were taken almost verbatim from the King James version of the Bible, Ecclesiastes 3:1. So it seems there is also a season for the implied volatility of the equity market. In more than 70% of the years for which there are records there has been a seasonal low in May or June. In 22% of the years, there was either no change at all or a limited pattern match and in only 8% of the years, the pattern did not match at all. Since the seasonal high occurs in October and we are now near the expected low we will probably see rising implied volatility between now and sometime in October. These odds suggest it is time to begin adding more long volatility to the options strategy mix. In this Digest, we show the S&P 500 Index volatility chart at what could be the seasonal low. We then offer some comments, and record some adjustments made for the just completed June options expiration. We finish with a long volatility, or vega, suggestion and two new directional ideas. First, the market review.
Market Review S&P 500 Index (SPX) 921.23. SPX dropped out of the upward trending channel and turned lower by 24.98 points or 2.64% for the week. Once again, the SPX is below the upward sloping trendline from the March low. This is the third time it has declined below the redrawn trendline, not an encouraging development for the bulls. Now in order to reach the trendline again it will have to exceed the recent resistance at 950. S&P 500 Index Implied Volatility (IVXM). There were small declines in both volatility measures for the week. The VIX closed at 27.99 and our Implied Volatility Index Mean closed at 24.17. The VIX will now most likely try to retest the low set on May 20, 2009 at 26.57. This is an important level to watch since we are expecting to see the VIX begin its seasonal rise very soon. US Dollar Index (DX) 80.33. DX remains above the active downward sloping trendline and now appears to have 80 as the equilibrium point. This is suspiring given all of the recent negative comments that have been directed at the dollar in recent weeks. Could it be related to improving economic fundamentals and perhaps the expectation for higher short-term interest rates? As long as DX remains above the trendline, the downward momentum appears to be exhausted. iShares Barclays 20+ Year Treasury Bond (TLT) 91.69. TLT continued higher last week as long- term interest rates declined. It traded as high as 93.33 last Wednesday before closing at 91.84. Now it is right on the downward sloping trend line and a close above 92 ½ could come at any time and appears to be consistent with the stronger dollar. NYSE McClellan Summation Index 823.30. Our breadth indicator declined 300.36 points making it largest weekly decline since the March 6, 2009 low. The divergence we first noted last week was important and provided a clue that the market internals were beginning to weaken.
Strategy In summary, the SPX has broken its upward sloping trendline three times from the March 6, 2009 low while the VIX appears to be near a seasonal low. The market internals are now rapidly deteriorating as shown by the breadth indicator. In addition, the dollar that has been declining with the rising equities is now stable and may be ready to turn higher. The long-term treasury market appears to be supporting equities and we wonder if perhaps the Federal Reserve have been purchasing of the long-term bonds and it could be the reason for the recent rally in this market. The dollar stability will no longer be supporting crude oil and commodities both of which have helped to push equities higher. Having called for a correction several weeks ago, we are careful in doing so once again, but the evidence is mounting. Since we are expecting to see increasing implied volatility, we are now suggesting fewer positions with positive theta and negative vega, such as long Butterflies, short straddles and put sales.
Portfolio Update For the record here are trades made to unwind one and cover an assignment short position.   CBOE Volatility Index (VIX) 27.99.   The VIX short June 40 call that made up our calendar spread expired out of the money so we bought to close the long July 40 call at the close on Friday at 1.10.  An alternative would have been the sale of another VIX call, but we decided to close the calendar spread for a small gain.  We retain the long July 35/40 bull call spread. Savient Pharmaceuticals Inc. (SVNT) 12.06. Our volatility thriller from last week turned out to be not so thrilling after all.  Our two long June 12 ½ calls provided no help and our short Jun 10 call was in-the-money.  We bought 100 shares market-on- close (MOC) to deliver against our short call.  Our thriller turned into a looser so we will close it and move on while noting the continued difficulty to convert large positive volatility spreads in the Biotech and Pharmaceutical sectors into gains.  Volatility Forecast Here is the volatility chart of the SPX that we offer in support of the seasonal thesis we made above.
The high for the IV Index Mean was 76.67 on October 27, 2008 while the high for the Historical Volatility occurred on November 21, 2008 at 80.47. Currently the IV Index Mean is 24.17 while the Historical Volatility is 23.86. Most of the seasonal lows are made in May and June while the seasonal highs are made in October. We are not suggesting this chart represents our expectations for this year, but only to illustrate we are more likely to be near the bottom, especially if a market corrections begins in the near future as the deteriorating market internals may be now be indicating. IVOLopps™ Since we are expecting implied volatility to begin rising, we want to look for strategies that have long volatility or long vega, such as straddles or vertical spreads. Here is a straddle idea to consider. Yahoo Inc. (YHOO) 15.80. Yahoo has recently been in a well-defined uptrend and is now testing the upward sloping trendline. They are expected report second quarter earnings on July 21, 2009, after the July options expiration. Going into the past two earning reports the implied volatility rose substantially and we are expecting this to happen once again. We suggest using a long October 16 straddle as the strategy for increasing implied volatility.
The mid price for this straddle on Friday was a debit of 3.41 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be 3.38 as shown above in the “E Price” column. Use the deltas for each leg to adjust for the change in prices of the underlying or use the net delta for straddle orders. The plan is to hold the straddle until the day before the earnings report, which would be July 20, 2009 unless they report early. Our risk is volatility does not increase and both legs lose time value between now and the earnings report date. If we are right about the increasing market volatility then we think there is a good chance we will see a substantial increase in the implied volatility of Yahoo as they near the earnings report date. Improving Medical Condition In the event the equity market continues to rotate out of the former banking, crude oil and commodity leaders without a substantial market decline we should participate in this rotation but we want limited exposure to direction and the potential rising volatility risk. Here are two ideas we think fit the bill. Cerner Corp. (CERN) 59.67. Kansas City, Missouri based Cerner provides healthcare information technology solutions and healthcare devices. With good strength relative to the market, it could be a beneficiary of the proposed changes to the health care system. Here is a suggestion that will benefit if this stock continues higher, but with a small initial delta and vega risk. The put call ratio is a bullish .3, the current Historical Volatility is 27, the put implied volatility is 40.16, and for the calls, it is 37.52. Consider this bullish put spread for a continuation of the uptrend.
The mid price for this spread on Friday was a credit (Cr) of .65 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .60 as shown above in the “E Price” column. Use the deltas for each leg to adjust for the change in prices of the underlying or use the net spread delta for spread orders. This position is an out-of-the-money put sale with a purchased put at a lower strike price for downside price protection. In addition, because the short put has negative vega the purchased long put provides some protection against rising implied volatility by reducing the negative vega from -5.20 to -2.61as shown in the table above. Use the upward sloping trendline as the first warning indicator and then a close below the short put strike price of 55 as the SU (stop/unwind). Medtronic, Inc. (MDT) 35.47. Minneapolis based Medtronic manufactures and markets medical devices such as pacemakers and implantable defibrillators. It also appears to be benefitting from the rotation into the health care sector. The stock recently crossed below the upward sloping trend line and then turned back up from support at 32. If we were buying pullbacks this is where we would initiate a new long. However, we will again use a limited delta and vega risk strategy. The put call ratio is a positive .5 with a Historical Volatility of 35. Consider this bull put spread.
The mid price for this spread on Friday was a credit (Cr) of .775 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .78 as shown above in the “E Price” column. Use the deltas for each leg to adjust for the change in prices of the underlying or use the net spread delta for spread orders.  This position is once again an out-of-the-money put sale with a purchased put at a lower strike price for downside price and upside vega protection see the table above. Set the SU (stop/unwind) at a close below the previous pivot at the 32 support.

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.