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Last week after making the technical case for the continuation of the bull market, this week, we join the controversy about the speed of its advance. We think there is a good chance for an equity market correction within the context of the continuing bull market. We offer some thoughts about a possible correction, and then suggest two current portfolio adjustments, a natural gas wildcat speculation and a possible takeover. First, we review our market indicators.
Market Review S&P 500 Index (SPX) 1068.30. Last Monday SPX made a low below the prior Friday’s low thereby validating that Friday’s key reversal. It then proceeded to advance for the second week by more than 2.5%. At the current rate, it is advancing at 130% a year. If measured from the September 2nd low at 991.97 to the high last Thursday at 1071.52, or 11 trading days, it gained 8%, at an annual rate of 186%. We think this is unsustainable, it has come too far too fast, and we should expect a correction at any time. We still maintain our upside measuring objective at 1233.29, from the large Head & Shoulders bottom that we explained last week in detail, but there is likely to be meaningful correction before reaching the objective. E-mini S&P 500 Future (ESZ9) 1061.00. With the expiration of the September contract, we now are using December and it was up 23.75 points, or 2.3% for the week. Open interest continued expanding through last Wednesday and then decline modestly on Thursday. After the September expiration, we will once again begin tracking new open interest numbers. The totals decline after each quarterly expiration and we will have to watch carefully for signs that open interest is not resuming its former rate of increase before the September expiration. For the bull market to continue we need to see increasing volume and increasing open interest with the advance. S&P 500 Index Implied Volatility (IVXM). The volatility measures are not yet fully reflecting our concern about a possible market decline. Our Implied Volatility Index Mean was up just .38 at 21.28 while the VIX declined .23 to 23.92. The VIX 20-day moving average, our hedge indicator is our now 25.10, still above the current VIX. The October VIX futures premium over cash, declined 2.87 to 11.83%, the November premium increased 1.13 to 18.52% and December increased 1.12 to 16.85%. The November futures premium continues to be the highest. The Implied Volatility Mean Index of the VIX options declined from 95.52 to 85.59, but this is misleading since there is a wide disparity between the at-the-money call and puts. The implied volatility of the October 25 call is 118.60 while the put is just 13.81. The November 25 call is 123.32. In the future, we will use the at-the-money call. Using these measures, the highest premiums are being paid for November downside protection from rising implied volatility. US Dollar Index (DX) 76.43. DX continued lower testing 76 before rebounding slightly by the end of the week. If this was the driving force behind the rise in gold and silver then they could have problems if the dollar continues rebounding. Since DX now looks oversold, we expect it will attempt to continue higher. iShares Barclays 20+ Year Treasury Bond (TLT) 95.76. TLT declined .94 for the week. Long bonds continue to trade near the upper portion of the 90- 97½ range. We are watching 97.68, the high made on September 11, 2009, as the upper resistance. NYSE McClellan Summation Index 1476.72.  The breadth indicator increased once again, this time by 247.88 points, the highest since the March low at negative 950.67. The new high here adds to the concern that perhaps the equity market has risen too far too fast. Baltic Capesize Index (BCI) 3008. Turning our attention to the one indicator that is clearly not with the program we see our long route dry-bulk shipping index declined another 531 points, or 15% last week. This could be the indicator to watch for the start of a market correction. We understand charter rates were weak in August, but they should have rebounded by now if raw material shipping activity has resumed. Since it has not we assume China has slowed the importation of some raw materials. Until we see this indicator turn higher, this caution flag continues flying.
Strategy If the Chinese stopped buying copper and perhaps other raw materials then we need to look elsewhere for some possible answers as to why prices remain at the current high levels. For copper we see from the new CFTC Disaggregated Commitments of Traders Report, dated September 15, 2009 that Swap Dealers were net long 38,325 contracts or 958,125 pounds of copper. Since this is the newly revised format the significance of their net long position is unclear, but what is clear is the declining shipping rates reflected by the Baltic Capsize Index. We suggest using collars or put ratio spreads to hedge positions in the copper miners and other raw material producers. For new ideas, we suggest looking for sectors that have yet not participated such as natural gas producers, transporters and processors, but remember there is a late October seasonal high that should to be included in any trade plan. As for the S&P 500 Index, and our long iShares Russell 2000 Index (IWM) 61.91 portfolio position we do not yet have sufficient justification to implement a hedging strategy, but we could see it develop this week. If it starts before the end of this week will post a tweet on twitter.
Portfolio Adjustments If equities are currently overbought then the same is true for gold and silver. If the US Dollar index is due for a bounce then gold and silver will see a correction. Our portfolio had four positions is this sector ,but one September short put position in Market Vectors Gold Miners ETF (GDX) 45.92 expired leaving three longs. Based upon “too far too fast” here are two more we suggest closing Monday. iShares Silver Trust (SLV) 16.70. This long Jan 14/17 call spread is from Digest issue 33 when SLV was 13.92. The details to close it follow.
The mid price for this spread on Friday was a credit (Cr) of 1.75 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. Silver Wheaton Corp. (SLW) 12.51, The SLW position is a combination from Digest issue 35 consisting of a short Oct 11 put and a long October call ratio backspread. Here are the details to close the ratio backspread while retaining the short put in the event SLW closes below 11 at the October expiration we will be assigned stock.
The mid price on Friday was a debit (Dr) of .075 shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .13 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in the stock price or use the net spread delta for spread orders. IVOLopps™ Natural Gas Wildcatter Here is one we first suggested in IVolatility Trading Digest™ Volume 7, Issue 15, May Expiration Review and Looking for More Deals, dated May 21, 2007 and then again, in IVolatility Trading Digest™ Volume 7, Issue 24, Infrastructure, dated July 23, 2007.
InterOil Corp. (IOC) 41.69. InterOil Corp. engages in the exploration and production of oil and gas properties in Papua New Guinea. It owns four exploration licenses and two retention licenses in Papua New Guinea covering approximately nine million acres; and a 15% working interest in petroleum prospecting license 244 located offshore in the Gulf of Papua. The stock price rises and falls with the drilling reports of a natural gas well they are trying to bring into production to provide natural gas for a LNG processing facility to export natural gas to the nearby Asian markets. Finally, more than two years later they may have hit the big one. Last Thursday the company said drilling at the Antelope-2 well found the top of a natural gas reservoir 345 feet higher than expected, leading them to believe it is much bigger than originally expected. A Morgan Stanley analyst said it represents sizable upside potential for the company and assigned a $65 price target for the company. We will attempt to structure a trade with limited and defined downside risk while participating in the upside in the event the Morgan Stanley analyst is correct. With a current Historical Volatility of 78 and with the Implied Volatility Mean Index of 80.72 consider this call ratio backspread.
The mid price for this spread on Friday was a credit (Cr) of .20 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .26 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. Note on the buy side we have indicated the ratio with B2, for buy two to open while on the sell side it is S1 for sell one to open. This is credit spread with long delta and negative theta or time decay from the extra long call, but has, using Friday’s prices, an initial margin requirement, of $986. We will not set a price SU (stop/unwind) because if it declines substantially we will let all the options expire and keep the net credit. However, in order to gain we need it to move higher quickly since there is negative time value working against it. The plan is to adjust the position at the October expiration since it will then have an upside breakeven at 53 and will require unwinding or perhaps adding a short put to offset the negative time decay. Takeover File This week for the Takeover File here is another old favorite that began with Digest issue 12 and was then included in Issues 14 , 15, and 16. Dendreon Corp. (DNDN) 29.20. Seattle based Dendreon, is a biotechnology company engaged in developing Provenge, a vaccine for treatment of prostate cancer. It plans to resubmit its application for FDA approval in the fourth quarter of this year. In addition, they have several other experimental cancer drugs in development. Last week there was rumor of a $40 bid for from a European company. Dendreon confirms they are looking to find a partner for the non-US distribution of Provenge. With a current Historical Volatility of 53.77 and with an Implied Volatility Index Mean of 100.51 and rising again, the options are very active with good volume in several expiration months. Here is a combination with a short October put and a November long call spread to consider. First the Put Sale:
The mid price for this put sale on Friday was a credit (Cr) 1.39 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be 1.25 as shown above in the “E Price” column. The other “Greeks” are also based upon Friday numbers, before the position is established, and will reverse when the put is sold. Use the delta as shown above to adjust for any change in the stock price. Next, the Long Call Spread:
The mid price for this spread on Friday was a debit (Dr) of 1.58 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be 1.57 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in the price of the stock or use the net spread delta for spread orders. Use a close below the last pivot at 22 ½ as the SU (stop/unwind).
Visit us on twitter for more ideas from our scanners and portfolio updates, including positions closed or unwound during the week.
IVolatility.com Bookstore. In addition to the vast number of articles and information on our web site, browse in our bookstore for more reference information and material. In next week’s issue, we should have a good idea if there is going to be a market correction and will offer some hedging ideas in the event they are required.

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