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Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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In this Digest, we return once again to the Top 5 list in the Rankers and Scanner section on our home page with three suggestions from Friday’ s list. First, we have two positions to close and the report on a third that was closed early in the week. Then we have another trend continuation idea. We also briefly mention one of the books at our bookstore. First, the market review.
Market Review S&P 500 Index (SPX) 979.26. By the end of last week, the SPX gained 38.80 or 4.1%. The importance of the gain was not the numbers of points, but their location. On Thursday, it gapped above 950 opening at 974.33 removing doubt about a potential double top formation. This was a “bell ringer.”  From the longer-term perspective, the long awaited right shoulder of the larger Head & Shoulders (H&S) bottom now appears to have been formed with the July 10 low at 872.81. The neckline drawn from the January 6 high at 943.85 to the June 6 high at 956.23, when extended, goes through the gap created at the opening on Thursday confirming the breakout and setting off the H&S pattern. We have now calculated the minimum upside measuring objective at 1233.29. In addition, we checked the volume and open interest of the E-mini S&P 500 future contracts traded on the CME and confirmed that they both expanded with the breakout thus providing additional confirmation. S&P 500 Index Implied Volatility (IVXM). The implied volatility measures continued lower last week with the breakout in the SPX. Our Implied Volatility Index Mean was lower by 1.48 at 21.05 and the VIX declined by 1.25 at 23.09. The September VIX futures premium over cash declined .70 and is now at 23.3% while the October declined to 25.6%. With the breakout, the VIX is likely to continue declining so we will close our VIX bull call spread. See the details in the Portfolio Adjustment section below. US Dollar Index (DX) 78.84. The dollar along with the Japanese yen both declined as investors continued adding to riskier alternatives. For the week the decline was .51 or .64% and it is now about the retest the 78 level made in early June. If equities continue higher, as we expect, the dollar will mostly likely continue lower. iShares Barclays 20+ Year Treasury Bond (TLT) 91.45. Now in a tight range below the prior uptrend, TLT was up .21 for the week as the focus shifted to the equity markets. NYSE McClellan Summation Index 855.41. Confirming the SPX and the S&P 500 E-mini futures our breadth indicator gained upside momentum rising 321.23 points, the best since the last week of March as advancers led decliners every day on the NYSE.
Strategy With the breakout, the strategy changes to favor more long positions with less hedging activity. We favor stocks and ETF’s that have broken out with the broad market , and continue to express some caution for those that still have potential double top formations including our copper indicator, Freeport-McMoRan Copper & Gold Inc. (FCX) 59.82. Our other indicator, for shipping, the Baltic Capesize Index (BCI) 5170, declined 787 points. The ideal strategy after a breakout is to wait for the reversal of the pull back to initiate new long positions. Of course, there is a risk the pull back will not occur anytime soon and potential upside gains can be missed. The continuing premium of VIX futures over cash for September and October suggests insurance is still being bid higher for these traditionally weak months. Until then, we expect to see equities continue higher as they move up toward the Head & Shoulders bottom minimum measuring objective at 1233.29.
Portfolio Adjustments With the breakout our VIX bull call spread suggested last week in IVolatility Trading Digest™ Volume 9, Issue 28, Whipsaw, dated July 20, 2009 is no longer required as we expect options implied volatility to continue declining as the SPX rises.  Here are the closing trades for Monday.
The mid price for this spread on Friday was a credit of 1.55 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be about the same as the time decay is offset by the spread and is shown above in the “E Price” column. Use the deltas for each leg to adjust for any price change in the underlying or use the net spread delta for spread orders. In IVolatility Trading Digest™ Volume 9, Issue 22, More Hedge Trimming, dated June 8, 2009 we suggested a call ratio backspread for Alcoa, Inc. (AA) 11.02, when it was 10.94. The suggestion was based on a favorable put call ratio and takeover rumors. Since the stock declined below its upward sloping trend line and has not shown good upside momentum we now suggest closing. Here are the trades for Monday.
The mid price for this spread on Friday was a debit (Dr) of .53 as shown in the “Price” column above.  Adjusting for time decay the estimated price on Monday should be .54 as shown above in the “E Price” column.  Use the deltas for each leg to adjust for any price change of the stock.
Portfolio Update Last Monday we closed the Yahoo! straddle in accordance with the plan in Digest issue 28.  The October call was 2.20 and October put was 1.205.  The total proceeds after commissions were 338.50, compared to our original basis of 361.50 for a net loss of 23.  The implied volatility rose as expected, but not enough in an environment of declining implied volatility of the broad market.
IVOLopps™  For ideas, we often look at the top 5 stocks based on IV Index Mean vs 30D HV located in the Rankers and Scanner section on our home page at the   Top 5 stocks by implied volatility change. In the first section, we list the Top and bottom 5 stocks based on IV Index Mean vs 30D HV.  Here are three selections from the Top 5 list last Friday. Sequenom Inc. (SQNM) 5.58.  Sequenom’s business is industrial genomics, specifically single nucleotide polymorphisms.  The Implied Volatility Index of 138.07 and a current Historical Volatility of 89.82 puts it in the number two place on the list with a ratio of 1.54.  While this would seem to make a good covered call candidate, we could start the process by doing a put spread with the intention of being assigned stock for the later covered call.
The mid price for this spread on Friday was a credit (Cr) of 1.05 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be about 1.06 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any stock price change or use the net spread delta for spread orders. Use a close below the lower put strike at 4 as the SU (stop/unwind). If the implied volatility remains high consider taking the stock by assignment and then selling covered calls. USEC Inc. (USU) 6.03. USEC supplies low enriched uranium (LEU) for commercial nuclear power plants worldwide. At number five on Friday’s list, it has an Implied Volatility Index of 108.5 and a Historical Volatility of 74.79. Two weeks ago, the Implied Volatility Index was near 140 and is now declining. Since it appears to be in a 5 to 7 range, consider an iron condor, selling an OTM call spread and an OTM put spread using the relative expensive options. They are scheduled to report earnings on August 5th. First the call spread.
Next the put spread.
The mid prices for the spreads on Friday are shown as Credits in the “Price” columns above.  Adjusting for time decay the estimated prices on Monday should be about as shown above in the “E Price” columns.  Use the deltas for each leg to adjust for any stock price change or use the net spread delta for spread orders. Here is the estimate for the combination on Monday.
Use the upper and lower range boundaries as the SU (stop /unwind) levels, below 5 or above 7. Wal-Mart Stores Inc.(WMT) 48.94. Number 4 on our Top 5 ranking list last Friday, WMT is scheduled to report earnings on August 13th, a week before the August options expire. The Implied Volatility Index is 20.67 and the Historical Volatility is 14.02 for a 1.47 positive volatility spread ratio. WMT usually shows a seasonal tendency to rise during the summer and it appears to be right on schedule rising up off the 48 support level. Of course, the risk is it will decline again after reporting and we think in this event, chances are good that the 48 support will hold any post reporting sell off. Look at this put sale suggestion
Use 47 ½ as the SU (stop/unwind) or take the stock by assignment in the event it closes below 47 ½ at the August expiration. Trend Continuation This week’s trend and continuation selection is one we suggested in IVolatility Trading Digest™ Volume 9, Issue 5, Takeover File Update, dated February 2, 2009. Coach Inc. (COH) 29.31.  Coach designs and markets premium leather hand and travel bags.  Currently selling at 14 times current earnings with very little long-term debt, 21 % profit margins and 46% return on equity.  They are scheduled to report Tuesday before the opening so this one can be done on Monday anticipating the current uptrend will continue if they report better than expected earnings, or wait to see the results if there is doubt about the earnings report.  For our record, we will be booking the trade as of the close on Monday.  We suggest using a September bull call spread to allow enough time for a recovery if the earnings report disappoints expectations.   The Implied Volatility Index Mean is 45.64 with a Historical Volatility of 43.58.
The mid price for this spread on Friday was a debit (Dr) of .925 as shown in the “Price” column above.  Adjusting for time decay the estimated price on Monday should be about .92 as shown above in the “E Price” column.  Use the deltas for each leg to adjust for any change in price of the underlying or use the net spread delta for spread orders. Use a close back below the last pivot at 22 ½ as the SU (stop/unwind).  Bookstore Selection In the past, we have been asked to recommend reference books in addition to the vast material found at our web site.  For those who do not want to spend all their study time in front of a computer screen a recently released update by one of our favorite authors should be of interest.
Author: Natenberg, Sheldon, Item #: 6091437, ISBN: 159280344X, Publisher: Marketplace Books, Soft Cover, Publish Date: March 26 2009. It is item number 18 at our bookstore, with a special price of just $34.41 plus s&h.   In next week’s issue, we will focus on the breakout of the S&P 500 Index and offer some ideas for the pull back that will most likely follow.

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.

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