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Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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While the dogs in this race are chasing a mechanical rabbit, we are wondering if some in the equity markets are mindlessly chasing financial rabbits. We offer a few comments on the performance chase along with a portfolio adjustment suggestion, a high-implied volatility idea and another trend continuation trade to consider. First, we update the market review.
Market Review S&P 500 Index (SPX) 1028.93. For the week, SPX added another 2.80 or .27%. On a close- to- close basis from the March 6, 2009 low at 683.38 to Fridays’ close the index was up 50.6%. For our plans we are still using the upside measuring objective at 1233.29, from the large Head & Shoulders bottom, or another 204.36 points to go. E-mini S&P 500 Future (ESU9) 1027.50. The September futures contract added 2.25 or .22%. Volume has been moderate in the 1.7 to 2 million range while open interest continues increasing. Since the expiration of the June contract, open interest has expanded almost 19% in 10 weeks for an average increase of 1.9% per week. Last week open interest expanded by 1.4%, just under the 10-week average. In order for the uptrend to be sustained, we would like to see volume and open interest continue expanding. While volume has been reasonable, we think this is probably due to seasonal considerations and as long as open interest continues to increase, our higher measuring objective remains intact. S&P 500 Index Implied Volatility (IVXM). The volatility measures were mixed last week as our Implied Volatility Index Mean added .02 to end at 21.44 while the VIX ended .25 lower at 24.76 and still below the 20-day moving average at 25.30. Comparing the Implied Volatility Index Mean to the 30-day Historical Volatility of 15.32, we see a developing a positive volatility spread indicating the options are pricing in greater future index price movement. Now looking at the September VIX futures premium over cash, we see it increased from 9.4% to 13.49%, while the October premium increased from 20% to 23.18% and the Implied Volatility Mean Index of the VIX options increased from 78.67 to 96.87 as all the risk premium measures increased again last week. US Dollar Index (DX) 78.37. The dollar index increased .33 for the week reflecting the small change in equities for the week. It is now in a range between 78 and 79 and for now will most likely continue to be inversely correlated with equities. iShares Barclays 20+ Year Treasury Bond (TLT) 96.51. Long-term bonds continued higher last week and are now testing the July 8th high at 96.81. We still claim it is range bound as long as it stays below the prior high. This should be an interesting week in the long dated Treasury bond market. NYSE McClellan Summation Index 1345.39.  Our breadth measure is back on track with the broad equity indexes as it also recorded a small gain of 42.97 and once again reduced concerns of a developing divergence. Baltic Capesize Index (BCI) 3946. The long route dry-bulk shipping index declined another 84 points last week or 2.08%. As we wrote in last week’s Digest “August is a slow period in the shipping industry, but if the BCI continues to decline in September it would be a concern as it could be indicating China’s raw material restocking has been completed as previously reported. The combination of lower equity prices in China and a continuing decline for the BCI in September would sound the alarm bells.” The time may have come to raise the yellow caution flag.
Strategy Maintaining our upside measuring objective for the SPX while carefully watching the Hang Seng and the Shanghai’s Composite equity indexes as well as the BCI describe above, we turn our attention to the unusual activity in the low priced financial stocks. There is a clearly a divergence between the high and low priced stocks in this sector. Since August 1st Citigroup, Inc. (C) 5.23 has risen 64.5%, while JPMorgan Chase & Co. (JPM) 42.92 was up 8.4% and Wells Fargo & Company (WFC) 27.30 was better by just 5.8%. The latter two money center banks are considered by many analyst to be better quality, so why such a wide divergence in price performance? According to “street talk”, the answer appears to be “chasing performance” by mutual fund managers. As we noted in the SPX section above, from the market bottom on March 6th the SPX is up by 50.6% and the iShares Russell 2000 Index (IWM) currently 58.05 is up 68.9%. Mutual Fund managers who have underperformed their benchmark indexes are at risk of losing money under management and their jobs. Accordingly, they are increasing allocations to stocks that have a chance of improving their performance numbers while paying less attention to fundamentals, but increasing risk. Could this be the same “Irrational Exuberance” responsible for Tech Bubble in 2000? If so, we will be able to measure the chasing performance phenomenon, as it will be reflected in the indexes of the smaller capitalization stocks such as the IWM and lower priced stocks beyond just the financials as they continue to outperform the large capitalization market indexes. We are still expecting to see higher market implied volatility going into the fall and we continue to suggest using strategies with long volatility or Vega. Portfolio Adjustments In IVolatility Trading Digest™ Volume 9, Issue 31, Load the Boat, dated August 10, 2009 we offered a long call spread suggestion for NVIDIA Corporation (NVDA) 14.73 when it was trading at 13.71.  Since it has broken out above resistance at 14, we return and add on to this long position with an adjustment idea.  With a current Historical Volatility of 42, consider this put sale.
The mid price for this put on Friday was a credit of .70 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .63 as shown above in the “E Price” column.  The “Greeks” are based upon Friday numbers, before the position is established – they will be reversed when the put is sold and the delta and theta will then both become positive.  Use the delta as shown above to adjust for any change in the stock price when placing the order.  Use a close below 13 as the new SU (stop/unwind) adjusting up from the previous SU at 12. IVOLalerts™ Citigroup, Inc. (C) 5.23. As we mentioned at the close of last week’s Digest we intended to add Citigroup to the suggestion list this week, but it is now clearly overbought so the best we can do is to add it to our alert list along with our copper favorite Freeport-McMoran Copper & Gold Inc. (FCX) 65.48. A possible overbought strategy would be to buy the Citigroup September 5 puts, but since we prefer not to trade against the trend, we will just wait for the inevitable pull back and then prepare a strategy suggestion. In the meanwhile, we have placed it on the alert list waiting for a correction.   IVOLopps™ From Friday’s Top 5 stocks based on IV Index Mean vs 30D HV list of positive volatility spreads, here is number two at 3.50 (IV is 3.5 times HV).  Allos Therapeutics, Inc. (ALTH) 7.48. Allos is a biopharmaceutical company developing small molecule drugs for the treatment of cancer. The FDA Oncologic Drugs Advisory Committee will hold a meeting September 2, 2009 on the application for Pralatrexate, an antifolate under Phase II trial, for treating patients with relapsed or refractory peripheral T-cell lymphoma. A final decision on whether to approve the drug is not due until September 24, 2009. With a current Historical Volatility of 49.28 and with the Implied Volatility Index Mean at 172.51 the implied potential movement for the stock is very large. The September ATM volatility of 182 implies a one standard deviation potential move would be between 4.39 on the downside and 10.53 on the upside. For October, the ATM implied volatility of 167 implies the downside is 3.38 with an upside of 11.43. Since the implied volatility is likely to remain high until the September 24th final decision date we suggest using October options for a high volatility high risk trade. Since the 5-price level has acted as support for the last year, we suggest selling an October 5 put knowing that there is a chance the stock could be assigned on a close below 5.
The mid price for this put on Friday was a credit of .95 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .90 as shown above in the “E Price” column. The “Greeks” are based upon Friday numbers, before the position is established –  they will be reversed when the put is sold and delta and theta will then both become positive. Use the delta as shown above to adjust for any change in the stock price when placing the order. The only effective risk control for this trade is to keep the position size small. Trend Continuation In IVolatility Trading Digest™ Volume 9, Issue 24, Seasonality in Volatility, dated June 22, 2009 we suggested a bull put spread for Medtronic, Inc. (MDT) 38.67 when it was 35.47.  After testing the 32 support level on July 9th the stock has been a well defined uptrend uninterrupted by the earnings report on August 25th.  We think there is a good chance it will continue to go higher, but we suggest allowing enough time in the plan for a correction. With a current Historical Volatility of 17.89 and an Implied Volatility Index Mean of 25.36 take a look at this long call spread with long Vega that benefits from rising implied volatility that we are expecting in October.
The mid price for this spread on Friday was a debit (Dr) of .65 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 change in price of the underlying or use the net spread delta for spread orders. Use a close below the current support at 36 as the SU (stop/unwind). Another Bookstore Idea Here is a reference guide we often use to help pick options strategies.  It helps to define how and when to use option strategies along with defining the risks.
Author: Author: Cohen, Guy, Item #: 3320009, ISBN: 0131710664, Publisher: Financial Times Prentice Hall, Hard Cover, Publish Date: May 31, 2005. You can find it at our bookstore, page two, item number 10, at a special discounted price of just $44.41 plus shipping and handling.
Visit us on twitter for more ideas from our scanners and portfolio updates, including positions closed or unwound during the week.
In next week’s issue, we plan to review the preliminary results of our high volatility event trade suggestion for ALTH and offer a few more trend continuation ideas as well.

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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