Volume 7, Issue 36
Bear Care
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Market Review
What a difference a week makes. Equity markets were mostly negative all week, with downside momentum accelerating on expiration Friday. In an apparent flight to safety equities were sold and Treasury notes and bonds were bought as interest rates declined. Noticeable interest rate declines in both the 10 and 30-Year Treasuries on Wednesday gave the first clues of the increasing downside momentum. Equities were attempting to push above the July highs and this is a serious setback. Once again we appear to be making a reversal pattern. Perhaps we now have a double top or we are in the process of building a Head & Shoulders top formation.
The The US Dollar Index (DX) 77.41, basis cash, is now at another all time low.
After making a new low on October 1, 2007 it rebounded for 6 days and then turned lower once again making a new
low on Friday. As we noted in IVolatility Trading Digest™ Volume 7, Issue 33, Dollar Dilemma, dated October 1, 2007, the declining dollar will make it difficult for the Federal Reserve to lower interest rates once again and without another reduction equity holders will express their disappointment by selling.
Further evidence of selling can be seen in our market breadth indicator, the McClellan Summation Index 280.84, down 140.55 with the first decline in 8 weeks.
If the week’s activity was entirely options expiration related then the equity markets should rebound and continue higher. If however, there is more selling activity ahead we should focus once again on hedging and increasing short positions.
Strategy
Due to this week’s equity market deterioration we suggest fewer long positions and more shorts.
On the long side look again at the gold producers. The Market Vectors Gold Miners ETF (GDX) 46.80,
traded as high as 49.74 last Monday and does not appear to be declining with the market.
Barrick Gold Corp. (ABX)
41.60 looks attractive. On the short side use the homebuilders, mortgage finance companies and banks with mortgage
exposure along with consumer discretionary retail, such as Harley Davidson (HOG) 48.30. Keep an eye on the takeover list as we can expect Canadian, Australian and European buyers to be shopping for US based companies.
Bear Put Spread
IWM Hedging Strategy
iShare Russell 2000 Index (IWM) 79.09.
When the DJ Industrials and the S&P 500 were briefly trading above their July highs the IWM did not show the same relative strength and was stopped short of a new high at the 85 level. With fewer large multi-national companies the IWM does not have the translation advantage of lower dollar exchange rates. With more domestic exposure this relative weakness is understandable and should also be reflected in a market correction.
Using a put spread will reduce the probability of overpaying for expensive puts and will offset time decay of the long put with time decay of a short put. The current Historical Volatility of the IWM is 22.59 and the IV Index for the puts is 30.53.
Consider this Bear Put Spread:
DR: Downside Hedge
SU: On a close back above 84 the spread should be unwound or closed entirely.
Buy IWM Dec 80 put IQQXB 4.225 IV 28.65 Delta -.4926
Sell IWM Dec 75 put IQQXW 2.425 IV 31.82 Delta .3115
Debit 1.80 Position net delta -.1811
The risk is the debit of 1.80 while the gain is limited to the difference between the strike prices of five points, less the debit. This means we are risking 1.80 to make 3.20, which is a good risk reward ratio for a trade with defined and limited downside risk. With substantial volume and good bid/offer spreads the IWM makes a good hedging tool.
Featured Calendar Spread
The Calendar Spread, also called a Horizontal Spread, featured on the Home Page Friday follows:
Buy AMZN Apr 90 call ZQNDR 14.125 IV 53.16 Delta .5973 Gamma .0116 Vega .2468
Sell AMZN Nov 90 call ZQNKR 6.475 IV 63.51 Delta -.5387 Gamma .02446 Vega .1005
Debit 7.65
The prices indicated above are the mid prices between the bid and offer with a debit of 7.65 and with a position net delta of .0586.
Amazon.com Inc. (AMZN) 89.76, operates retail Web sites and provides programs that enable third parties to sell products on its Web sites. The company sources and sells a range of products to its customers. It offers Amazon Marketplace and Merchants programs, which enable third parties to sell their products on its Web sites.
Third quarter earnings are scheduled to be released Tuesday after the close. Operating earnings are expected to be 170% higher compared to the third quarter last year. Analysts are looking for $108 million or .18 per share on revenue of $3.14 billion.
In early April the stock was trading at $45 and has since doubled. On each of the last two earnings reports the stock gapped up about 10 points. Now near 90 is seems unlikely that the analysts could have it wrong again by such a wide margin.
The April and July earnings report events are easily seen in the both the volatility and price charts above. On both occasions Implied Volatility declined after reporting. For the third quarter the implied volatility is now higher than in July. Based on this, it seems reasonable to expect Implied Volatility to decline back toward the 40 level next week.
As for the Calendar Spread this would be about right as long as we do not get a large move in the stock price. A large up move would create an assignment risk and we will have to buy in the stock for delivery against our short Nov 90 call. If the analysts have it right we should not see another large gap up.
Now take a look at the 30-day Put/Call ratio chart, found in Advanced Historical Data.
It appears that the recent rise in the Implied Volatility is associated with put buying for price decline protection as we see the ratio is above 1.5.
Assuming the options market has AMZN right the risk appears to be is to the downside.
We expect our short Nov 90 call to decline as a result of the expected decline in Implied Volatility but we are also long volatility with the Apr 90 call. The Vega numbers shown above give the theoretical values for the change in volatility. The Vega for the Nov 90 call is .1005 while for the Apr 90 call it is .2468. If we are forecasting a decline in Implied Volatility back to 40 then we can forecast the value of our Calendar Spread, assuming no price change. The IV of the Nov 90 call would decline 23.51% points (63.51-40.00) and each one is worth .10 for a total decline of 2.35. For the Apr 90 call the decline would be 13.16% points (53.16-40.00) with each point decline worth .25 for a total decline of 3.29. So it seems our short call would decline to 4.125 (6.475- 2.35) while the long call would decline to 10.835 (14.125-3.29). Now, if we compare these forecasted Calendar Spread values to the current value we can see that the result would be a disappointment. The current debit is 7.65 and our forecasted theoretical debit would be 6.71 (10.835-4.125) or a loss of .94. Using this forecast it appears we would need something else to make this trade profitable.
Based upon our forecast assumptions, the options market seems to have the Implied Volatility numbers about right and if the put buyers are right about the direction then we will have to rely upon future call sales against our long Apr 90 call to come out positive on this trade.
We will return to AMZN next week after the earnings report to summarize this trade idea and make some follow-up suggestions.
Guided Down
ValueClick Inc. (VCLK) 25.98, provides online advertising campaigns and programs for advertisers and advertising agency customers. Recently our old friend VCLK has been active. On October 8, 2007, Jim Cramer of Mad Money fame recommended the stock as a takeover suggesting it could fetch a big premium. Then on the 16th the company issued a warning that the third quarter earnings will come in on the light side saying revenue was hurt by “continued weakness in lead generation”. The result was a round trip from 25 to 30 then back again to 25. Interestingly the stock was up 1.02 points on Friday when the DJ Industrial Average was off 367 points.
With a current Historical Volatility of 75.45 and sold support at the 20 level consider one of these put sale suggestions:
Sell VCLK Nov 25 put QCSWE 2.125 IV 91.89 Delta .3858
Or
Sell VCLK Nov 22 ½ QCSWX 1.05 IV 89.50 Delta .2387
In the event of assignment the Nov 22 ½ put would result in a stock cost of 21.45, just above the 20 support level – less risk, but with less reward in the event the stock closes above 25 at the November expiration.
Reader Response Request
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 futures issues. If you have questions or comments just let us know. Use the blog response at the bottom
of the IVolatility Trading Digest™ page on the IVolatility.com Website.
Is the Put/Call ratio based on VOLUME for a moment in time; an average for the week, month, etc.?
OR
Is the Put/Call ratio based on OPEN INTEREST for a moment in time; an average for the week, month, etc.?
If it IS VOLUME--wouldn't this figure also be taking into account positions that are being opened AND CLOSED?
Maybe i'm getting confused...
Thx, Bob
Posted by Bob on October 26, 2007 at 03:35 PM EDT
Again thanks for another excellent question. A quote directly from our IVolatility Education section on the Put/Call ratio will help us defined this indicator.
“The put-to-call ratio is computed as the total number of puts traded each day divided by the total numbers of calls. It is one of the best measures of market sentiment and it helps to determine whether option buyers are predominantly bullish or bearish and whether that relative bias is intensifying or diminishing. It can be applied to an individual stock, an index, or exchange. A rising ratio suggests a bearish attitude; a falling ratio indicates a bullish attitude. The greatest value of a put-to-call ratio is at extremes, similar to an overbought/oversold oscillator. It is then used as a contrary indicator.”
From the above we that it is a measure of volume and that it is sentiment indicator, with greatest values at the extremes. The obvious problem is that we don’t know for sure when the extreme is at the maximum or if it will continue. You are right by suggesting that the complementary analysis is to look at the open interest. In Advanced Historical Data we offer the charts for both measures. I often refer to the 30 days charts for both. I also suggest that the options market often has it right and to be careful when using these measures as contrary indicators.
Jacktrader
Posted by Jacktrader (130.13.240.126) on October 27, 2007 at 12:03 AM EDT