« January 2012 »

IVolatility Trading Digest™

Volume 12, Issue 5
Cat Watch

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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As a single cyclical indicator for the global economy, it would be hard to find one better than the sales, earnings and stock price of Caterpillar (CAT) 111.28. Despite continuing negative news from Europe, CAT reported much better than expected earnings along with positive comments about improving business conditions such as "The 2011 increase in sales and revenues was the largest percentage increase in any year since 1947, and much of it was driven by demand for Caterpillar products and services outside of the United States."

In this Digest, we offer our Market Review followed by a brief strategy comment along with updates for last week’s suggestions and then an Amazon earnings trade idea. Before starting, we want to mention the 2011 Digest Issues have been added to the website Table of Contents where, starting in the middle of the page, links are available to all Digest Issues since 2008.


Market Review

Review Notes Clip ArtS&P 500 Index (SPX) 1316.33. While still not above the neckline of the larger potential Head & Shoulder Bottom suggested in Digest Issue 48, there is well-defined three-point upward sloping trendline that we are calling the October trendline for the current advance; currently SPX is comfortably 7% above it.

E-mini S&P 500 Futures (ESH2) 1312.50. Since the middle of December, volume has been light, averaging around 1.5 million contracts, with just a few days exceeding 2.0 million while the open interest is flat around 2.6 million contracts. Since expanding open interest is needed to confirm the uptrend, the e-mini is not providing much support for the current advance.

S&P 500 Index Implied Volatility (IVXM). Since our last market review, in Digest Issue 3, the Implied Volatility Index Mean declined from 18.09 to 16.06, while the CBOE Volatility Index® (VIX) declined from 20.91 to 18.53.

The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan's day-weighted average between the first and second months.



The day weighting applied 60% to the February and 40% to March resulting in the average premium of 2.44 or 13.17% shown above. An alternative volume weighting between February and March results in a 12.94% premium.

For this short-term indicator the premium to the cash is a SPX sell signal suggesting professional expectations for the cash to increase toward the futures price. Last week the premium was 21.21% compared to premium of 14.51% in Digest Issue 3, our last market review based upon January 13 closing prices. Last week we noted the premium had risen above 20%, which has been the crucial level in the past. With last week's minor correction the premiums have returned to the normal range, suggesting the pressure has been reduced. 

Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium or discount is always available. 

VIX Options

With a current 30-day Historical Volatility of 66.63 and 66.59 using Parkinson's range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon the closing option mid prices on Friday along with their respective month's futures prices, since the options are priced from the futures.



Using the IV Index Mean of 71.54, the IV/HV ratio is 1.07, using the range method for Historical Volatility the ratio is also 1.07 while the VIX put-call ratio is low at .45 suggesting there was considerable call activity on Friday, which is usually associated with hedging activity using VIX calls.   

All of the Implied Volatilities along with the Historical Volatilities and Greeks for the VIX options based upon the Futures prices can be found on our Advanced Options page by clicking on the "market close" link shown near the top of the page.

CBOE S&P 500 Skew Index (SKEW) 121.50. When out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase. In Digest Issue 4, last week we noticed this index had risen to 129.24, near the upper end of its range since it began trading on February 24, 2011. With the minor correction, it declined back to the center of the range confirming the lower VIX futures premium above.  

CurrencyShares Euro Trust (FXE) 131.63. Since our last Market Review in Digest Issue 3, FXE made an abrupt reversal and is now trending higher. Unless unexpected news from Europe changes the outlook, it looks as if FXE will continue higher until reaching the next resistance at 135. The put spread suggestion made in Digest Issue 2 would have been closed Wednesday, based upon the trade plan, for a loss. The euro strength reflects dollar weakness, supporting both equities and gold.

NYSE McClellan Summation Index 1050.00. This indicator, used as a measure for the number of advancing issues compared to declining issues on the New York Stock Exchange, advanced another 431.82 points since Digest Issue 3 on based upon January 13 data. Last week's 239.10-point advance was the best positive momentum week since last October 21. The continuing display of upward momentum is creating a positive divergence as the advance decline line is accelerating faster than the index, as the Summation Index now exceeds the March 4, 2011 high at 778.11.

iShares Dow Jones Transportation Average Index (IYT) 95.38. As a confirming indicator, the transports are now 3% above its upward sloping trendline from the October 4, 2011 low at 70.82. From a Dow Theory perspective, it is another encouraging positive momentum indicator for the bulls.



StrategyAlong with gold, equities are following the euro higher, reflecting dollar weakness as much as euro strength. A portion of CAT’s excellent 4Q and 2011 earnings were attributed to currency gains. Caterpillar's Chairman and Chief Executive Officer, Doug Oberhelman said. "In addition to volume, sales were higher as a result of currency impacts from a weaker U.S. dollar, and price realization improved."

Since housing remains an important part of the US economy, now representing 2.3% of the GDP, compared to 4.4% in 2000, according to the McKinsey Global Institute's January 2012 report, we suggest adding SPDR Homebuilders (XHB) 19.20 to the economic watch list. If the current uptrend stalls, it will create a drag on the economy and hinder higher equity prices. Accordingly, we offered a trend continuation idea in Digest Issue 3

This week we are tracking all of the suggestions made last week in Digest Issue 4. For record keeping purposes, the prices are based upon the next day closing prices. Here is a post game review of last week's ideas.

Baker Hughes (BHI) 49.31. While the stock price is now almost unchanged it was down 1.55 on Monday January 23, when we booked the suggested call ratio backspread. The plan was to close it, by the end of the week, if between 50 and 53. On the earnings report, the stock continued lower and then recovered by Friday. Wednesday we sent a tweet update, to close the position while it was ahead by .56.

Apple Inc. (AAPL) 447.28. For Apple we suggested a calendar spread based upon the implied volatility differential. The result was a reminder that often the higher implied volatility in the near term options are justified and that any large move in the underlying will result in a loss. In this example, the stock increased 26.87 or 6.4% by the end of the week creating a 2.24 loss.

SanDisk Corporation (SNDK) 46.70. As for SanDisk, we suggested selling a Jan 27 50 put that we booked for 1.01. After reporting earnings, the stock gapped lower, closing the week with a 5.79 loss. Subtracting our 1.01 credit from the 50-strike price the assigned stock is now booked at 48.99. Since we are now long stock, the position remains open offering the opportunity to sell a call. Using the February 48 call priced at .91, this would reduce our loss to .08 in the event it was called away on the February expiration. If it does not close above 48 at the February expiration, we would have the opportunity to sell another call thereby further reducing our cost basis. An alternative plan would be to wait for a rebound before selling the call, but this increases the risk in the event it continues lower, which does not seem very likely.

Netflix, Inc. (NFLX) 100.24. For Netflix we again suggested selling a Jan 27 85 put that we booked for 2.82. For the week, the stock closed 23.55 higher and the 85 put expired worthless, so we booked the 2.82 gain, more than offsetting the loss on Apple above.

Southern Copper Corporation (SCCO) 35.14. Once again, for Southern Copper we suggested a put sale this one was the March 30 put. Their earnings report was scheduled for Friday after the close, but so far, we have not seen the report, however they did declare a .19 per share dividend and a .0107 share stock dividend, which is not likely to be received favorably since the last dividend was .70 per share. We booked the put sale for a credit of .35 and by the Friday close, it was .30 for a .05 gain, but this one is still open.

Williams Companies, Inc. (WMB) 28.84. For Williams the plan was a call spread short put combination using May options. We booked the position for a .24 debit and the Friday closing mark-to-market value was .07 for an unrealized loss of .17. This one is still open and has a good bit of time remaining until expiration.  


Quarterly Earnings Report Idea

Amazon.com Inc. (AMZN) 195.37. In Digest Issue 2, we suggested a possible trend change idea using a long January 190/200 call spread. We booked it on Monday January 9 with a .63 debit. At the close on Friday, it was 5.33 for a 4.70 gain.

They are schedule to report 4Q earnings on Tuesday January 31 with a consensus estimate of .16 per share and a whisper estimate of .20 per share. Since the stock price has risen from 183 in the last week, it appears to have a lot of good news in the stock price.

Here is the option data.

The current Historical Volatility is 31.08 and 29.81 using the Parkinson's range method, with an Implied Volatility Index Mean of 43.43, up from 42.00 last week. The IV/HV ratio is 1.40 and 1.46 using the range method to calculate the HV. Friday's put-call ratio was almost bearish at .60 with 104,102 contracts traded compared the 5-day average volume of 69,800 contracts.

Here is another call ratio backspread to ponder using weekly options.



The Feb 3 210 calls were 2.76 on Friday and they have been reduced to an estimated 1.88 each for the expected time decay by Monday, before any stock price change. The 3.76 shown above is for both long calls. The Feb 3 195 call was 7.90 on Friday and is estimated to be 6.80 on Monday before any stock price change. This is a good position in the event of a large price increase. The plan is to close it shortly after the report.

The suggestion above is based upon the estimated options prices on Monday considering the loss of time value over the weekend using last Friday's mid price between the bid and ask.



Unless derailed by an unexpected European sovereign debt event equities should continue rising along with the euro for this week and next.


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In next week's issue, we will return with a review of the January Barometer and more suggestions from our ranker and scanner tools.


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.

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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.

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