« February 2012 »

IVolatility Trading Digest™

Volume 12, Issue 8
Hedging with VIX

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).


Even though the equity markets are in low volume uptrends now may be the time to add a hedge strategy for some downside protection. We offer some reasons for caution in the strategy section below.

Then we offer a VIX hedge idea along with an earnings report update and look at the results of our latest Advanced Ranker scan for more trading ideas.



StrategyAlthough the major indexes are still trending higher, signs are beginning to appear that a correction is overdue and should now be included in trading plans.

Last week in Digest Issue 7, we noted the CBOE SKEW Index (SKEW) 129.54 was at a level consistent with past corrections although our day-weighted VIX premium indicator remained in the normal range at 12.41%. However, Friday the VIX premium increased to 28.59% while the volume-weighted premium was 30.15%. In the past when the premium levels were above 20%, corrections usually followed very soon.

We also updated the weekly Investors' Intelligence survey of financial newsletter writers. As of February 15, the current reading was 54.8% bullish and 25.8 bearish for a bull/bear spread of 29%. Although not at the 35% extreme seen before the market top last April it does suggest a correction is due at any time.

Another sentiment indicator we watch is the NYSE Bullish Percent Index, currently at 77.71. While not yet above 80, a level associated with previous declines, we note declines have occasionally begun from lower levels as well.   

Special attention should also be given when market leaders begin to experience selling, such as last Wednesday's key reversal by market leader Apple Inc. (AAPL) 502.12. After spiking above 525 and then reversing the momentum is now down sending a cautionary signal to the entire market.


VIX Hedge

Here is an update for the conditional strategy we suggested in last week's Digest. We sent a tweet last Thursday that the VIX premium had reached 20% and that it was time to implement the hedge. Here is the updated trade suggestion.

CBOE Volatility Index® (VIX) 17.78.

The current Historical Volatility is 80.10 and 77.83 using the Parkinson's range method, with an Implied Volatility Index Mean of 84.56, down 87.54 last week. The IV/HV ratio is 1.06 and 1.09 using the range method to calculate the HV. Friday's put-call ratio was .45, bullish for the VIX, but bearish for SPX, with 347,592 contracts traded compared the 5-day average volume of 461,270 contracts.

If the VIX continues rising the spread between the near term option and the deferred should narrow.



Although there is no apparent volatility edge, the spread should narrow if the VIX continues higher as the long March contract should increase faster than the short April contact.






Last week in Digest Issue 7, we suggested an earnings report strangle idea for MercadoLibre, Inc. (MELI) 96.16, scheduled to report 4Q earnings on February 22 after the close, with a consensus estimate of .51 per share.

The stock was up 2.70 by the time we booked the position on Monday February 13, so the long March 97.5 call was entered for 4.85 and long March 85 put was 2.08 for a total debit of 6.93. As we anticipated, the implied volatility increased by about 10 percentage points up into the 60 range. The mark-to-market value on Friday was 5.80 for the call and 2.23 for the put, totaling 8.03.

Here is the updated options data. The current Historical Volatility is 30.64 and 35.99 using the Parkinson's range method, with an Implied Volatility Index Mean of 59.69, up from 47.71 last week. The IV/HV ratio is 1.95 and 1.66 using the range method to calculate the HV. Friday's put-call ratio was at .79 was bearish bullish, with 2,093 contracts traded compared the 5-day average volume of 3,560 contracts.

Now the plan is to close the long strangle on Tuesday and replace it will a call calendar spread shown below.



When they report, we estimate the March implied volatility should decline about 15 percentage points, while the June will also decline, but it should be less. While calendar spreads are always problematic when the underlying makes a large move we estimate the breakeven levels to be 80 and 128 with the decline in implied volatility.


Advanced Ranker Scan

Recently in Digest Issue 6, we explained how to set up our Advanced Ranker to find more than the Top 5 that we regularly display from the link on our home page. This time we slightly modify the settings to search for options with the greatest increase in implied volatility.  

The Advanced Ranker is a scanning tool allowing the user to specify the universe of stocks, indexes or ETFs to be used for the scan. It provides the capability to search several criteria and quickly find results such as opportunities with high-implied volatility or the ones with the greatest implied volatility change.

Since we are interested in finding stocks that are active for various reasons we selected the Top 200 (Options Volume) with stocks priced above $5, as the group to scan as shown below.



Next, we set the ranker to scan based upon "Implied Volatility as a % change from yesterday's IV" the second selection from the five in the list above. In the second column, "IV Index", we selected Mean, the mean value between the calls and puts. Next, for the "IV Term" we have selected 30, which is the 30-day calculated implied volatility. In column four, "HV Term", we specified the Historical Volatility term to be 30-days. Then for "Quantity of stocks to be viewed" in column five, we chose 20 in order to get a good selection from this active options group displaying the Top ranked results.

Here are all 20 results from Friday.



We are interested in increasing implied volatility and the results shown in column four above are listed in that order from Kinder Morgan at 53.72% to Cheniere Energy with a .89% increase.

Although Kinder Morgan increased 53.72%, the implied volatility is still only 19.33, so it is not very attractive as a candidate if we are looking for options to sell. Two better ones for selling would be either Nokia or Fusion-io, with implied volatilities of 56.35 and 82.00, shown in column two above.

Fusion-io Inc. (FIO) 28.30 looks interesting so we click on the symbol FIO and we go to the Basic and Advanced Options page sections of IVolatility.com for further volatility details and analysis of this specific stock.



The large increase in IV to 82 from 73.61 last week is shown at the arrow in the in the volatility chart above, along with the options volume of 55,940 contracts at the arrow in lower volume chart. The stock closed up 3.37 at 28.30, also on a large volume increase. This is Interesting!

After some digging through the news releases, we found a reference to a rumored takeover by Intel. However, when we looked at the options pricing in Advanced Options we noticed an unusual skew with the puts priced considerably higher than the calls, suggesting the implied volatility and volume was coming not from call buying, but call selling and put buying. Apparently, options participants are not giving the takeover rumor very much credibility.  

Back at the scan results above, we note many of the increases are related to upcoming earnings releases, while others may be related to other events, and with some additional research, the reasons for increasing in implied volatility can usually be quickly determined. This scan is an excellent place to being looking for trading ideas and since it is using the top options volume group they will have good liquidity, which is ideal for multiple leg combinations. We frequently use this scan to find Digest suggestions.

For those companies reporting earnings in the next few days, the near term options implied volatility is often elevated compared to the deferred months offering calendar spread opportunities such as MercadoLibre, Inc. (MELI) above. However, keep in mind if there is a large stock price move a calendar spread will result in a loss since the near term short option has higher gamma and will move more than the deferred long option.  

The suggestions above are based upon last Friday's closing prices using the mid price between the bid and ask. On Tuesday, the option prices will be somewhat different due to the time decay over the long weekend and any price change.


The powerful IVolatility Advanced Ranker  

E-mail support@IVolatility.com



While equities are in a low volume uptrend we are seeing several signs detailed in the strategy section above that the market is overbought and a correction should be expected on the next important negative news event.   


IVolatility.com Bookstore  In addition to the vast number of articles and other information on our web site, take a browse through our bookstore for more reference information and material.


Twitter Follow us on twitter for more ideas from our scanners and other developments.


In next week's issue, we will return with a review of our market indicators with special emphasis on the VIX futures premium.


Finding Previous Issues and Our 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. They can also be found from the Table of Contents link in the blog section of our website.

Next week’s 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 us to look at a specific stock, ETF or futures contract, 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




IVolatility Trading DigestTM Disclaimer
IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.

Our purpose is to offer some ideas that will help you make money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".