Volume 8, Issue 10
Ides of March
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Julius Caesar's assassination on March 15, 44 BC, forever marked March 15, the Ides of March, as a day of infamy. The Ides of March assumed a whole new identity after the events of 44 BC. The phrase came to represent a specific day of abrupt change that set off of repercussions throughout Roman society and beyond. In modern times the term has become a metaphor for impending doom.
Will the coming Ides of March 2008 be remembered as the time of the great stock market decline? Or perhaps it will be remembered as the time when the markets started making a bottom.
Market Review
The S&P 500 Index (SPX) 1293.37 is now just 23.32 points away from testing the January 23, 2008 low at 1270.05. It could turn upward near the previous low creating a double bottom pattern. We think the more likely outcome is its continuance to the minimum measuring objective of the Head & Shoulders Top at 1225, now 68.37 points lower.
For the CBOE Volatility Index (VIX) 27.49 it is not yet indicating that a bottom has been reached. Last August it spiked to 37.50, in November the high was 31.09 and finally on January 22, 2008 it reached 37.57. We would expect to see another high equal to the 35 level before declaring this market bottom is in place. It could come rather quickly and it should provide confirmation of the final bottom.
As for US dollar interest rates the 13-week Treasury bill now yields just 1.4% down from 4.97% this time last year. Further the Federal Reserve has continued adding liquidity to the banking system while indicating that interest rates may decline further.
The US Dollar Index (DX) cash, now 73.03 appears to be gaining momentum as it continues to decline. With low and declining interest rates and a declining dollar some Japanese yen carry trade participants may begin switching to the dollar thereby eliminating the yen currency appreciation risk. The US dollar is in the process of becoming the new carry trade currency.
The NYSE McClellan Summation Index, our favorite market breadth indicator is now once again turning lower at –217.58, a decline of 227.42 points on the week thus confirming this leg of the market decline. We can expect to see lows in the –750 area corresponding with index lows last August.
Strategy
The strategy is to stay with the shorts especially in the consumer discretionary sector until we reach the minimum measuring objective of 1225 on the S&P 500 Index. In the commodity related group we could well see some profit taking so be alert and review your stop/unwind levels in case they are needed.
Suggestions
With the downward acceleration of the S&P 500 Index (SPX) we think now is the time to return to the CBOE Volatility Index (VIX) 27.49. As we wrote in the VIX section above it could spike to above 30 with a rapid decline in the SPX. With a Historical Volatility of 83.30 here is a suggestion if you can watch the markets daily. The VIX could spike above 30 and return back to 25 in a matter of one or two days and you could miss the opportunity to close the spread at a gain.
Trade Plan
DR: This trade is being suggested as the S&P 500 Index appears to be nearing the previous low where it may attempt to reverse direction or continue lower. The expectation is the implied volatility of the index options will increase as it accelerates to the downside. It could reach the 35 objective and then quickly return to 25. The plan is to sell the spread on an intraday basis when it trades above 35.
SU: Sell or unwind this spread if the VIX fails to trade above 30 as the market declines or it if spikes to 35 and you miss the closing trade.
- Buy VIX Apr 25 call VIXDE 3.35 IV 51.39 Delta .7462
- Sell VIX Apr 35 call VIXDI .775 IV 78.32 Delta -.2150
Debit 2.575 Position net delta .5312
With good edge, the Historical Volatility is 83.30. While it would appear that the maximum gain is the difference between the strike prices less the debit this is most likely not the case as we expect the VIX will not stay above 35 very long and it would be difficult to achieve the maximum theoretical gain.
This trade requires management and should not be attempted unless you watch the markets daily and are prepared to close the spread intraday when it trades above 35.
Roll out IWM
In IVolatility Trading Digest™ Volume 8, Issue 7, Symmetrical Triangle, dated February 18, 2008 we suggested a bear put spread on the IWM, long the Mar 71 put and short the Mar 65 put. At that time the IWM was 69.87 and the indicated debit was 2.18. The current indicated value of this spread is now 4.025 which is a 85% return in 3 weeks with an initial defined and limited risk. Since it is a March spread it is now time to roll it out to the next expiration month. With a current IWM price at 65.96 and the Historical Volatility of 24.98 consider this replacement bear put spread.
- Buy IWM Apr 67 put DIWPO 3.45 IV 31.57 Delta -.5422
- Sell IWM Apr 62 put DIWPJ 1.475 IV 34.75 Delta .2841
Debit 1.975 Position net delta -.2581
You can sell the March spread and buy the April spread above or you can combine the spread orders into a new combination that will give you the same results when completed. Compare the pricing of each and then select the one that is most advantageous. Remember you may have to be willing to give up .05 or even .10 to get them executed.
Here are the two alternative spread orders to enter to roll this spread out to April.
| Buy IWM |
Apr 67 |
put DIWPO |
3.45 to open |
| Sell IWM |
Mar 71 |
put DIWOS |
5.20 to close (first leg of the Mar spread) |
| Credit 1.75 |
| Buy IWM |
Mar 65 |
put DIWOM |
1.175 to close (second leg of the Mar spread) |
| Sell IWM |
Apr 62 |
put DIWPJ |
1.475 to open |
| Credit .30 |
To check the prices compare the current value of the original spread to the indicated debit of the replacement spread which is 2.05 (4.025-1.975) this difference should be the same as the total of the credits in the alternative order, again 2.05 (1.75 +.30).
Roll out the Upside Down QID
The second March spread from Issue 7 that we suggest rolling out is the upside down OID. The original QID suggestion was long the Mar 50 call and short the Mar 57 call with an indicated debit of 2.125 when the QID was 50.85. With the QID now at 55.47 the current indicated value of the spread is now 4.10 showing a 93% return in 3 weeks. With the current Historical Volatility of 40.75 consider this suggestion for the roll out.
- Buy QID Apr 54 call QIDDB 4.60 IV 54.05 Delta .5827
- Sell QID Apr 60 call DYMDH 2.575 IV 58.76 Delta -.3741
Debit 2.025 Position net delta .2086
Compare the pricing for selling the March spread and then buying the April above or use these combinations if they will result in better pricing.
Here are the two alternative spread orders to enter:
| Buy QID |
Apr 54 |
call QIDDB |
4.60 to open |
| Sell QID |
Mar 50 |
call QIDCX |
5.80 to close (first leg of the Mar spread) |
| Credit 1.20 |
| Buy QID |
Mar 57 |
call DYMCE |
1.70 to close (second leg of the Mar spread) |
| Sell QID |
Apr 60 |
call DYMDH |
2.575 to open |
| Credit .875 |
To check the pricing numbers compare the difference between current value of the original spread to the indicated debit of the replacement which is 2.075 (4.100-2.025) this difference should be the same as the total of the credits in the alternative order, again 2.075 (1.20 + .875). You may have to give up .05 or .10 to get each trade completed.
Strange as it seems
In the middle of the IVolaility.com home page we have an Options Data Analysis section that includes two charts for two suggested stocks. One is Stock Sentiment Analysis and the other is Best Calendar Spread. Since we have commented on numerous times about the Best Calendar Spread this time we are going to take a look at the Stock Sentiment Analysis and the current selection BMC.
The Stock Sentiment Analysis tab is located on the Stock Sentiment page accessed from the menu selections in the left column of the home page or by clicking on the volatility chart directly from the Options Data Analysis section.
Stock Sentiment Analysis uses a number of indicators to rank stocks in the database according to a bullish ranking index. The indicators include trading volume, put/call ratios (or call/put ratios in this application), exponential moving averages, 14-day Relative Strength and the 21-day Chaikin Money Flow.
In a declining market you would expect to see only stocks that are involved in merger and takeover activity included in the bullish index rankings. But used in a declining market this index could find some most unusual situations and strange as it seems we have selected as number one, a mainframe software company that is making a comeback.
BMC Software Inc. (BMC) 33.83. BMC develops software for systems and service management solutions for the large enterprises competing with IBM and Hewlett-Packard. Analysts credit new software offerings and good acquisitions for a 39% earnings gains in the third quarter that was better than expected, exceeding estimates by 14%. Operating margins are 30% up from less than 10% in 2005. The lower dollar may also be helping them with international sales. Nevertheless this relative strength in a declining market environment is noteworthy. We suggest you do the fundamental homework to see if this contrarian suggestion, which we call “strange as it seems”, may be of further interest. If so, then here is an options suggestion to consider.
Trade Plan
DR: The rising stock price in a weak market environment is the basis for this suggestion. This is a limited and defined risk long-term fundamental turn around in the competitive software sector. The declining dollar is likely helping with improved results. If so, they could continue improving.
SU: Sell or unwind the spread on a close below 30.
- Buy BMC Aug 35 call BMCHG 2.825 IV 35.05 Delta .5100
- Sell BMC Aug 40 call BMCHH 1.15 IV 33.20 Delta -.2776
Debit 1.675 Position net delta .2324
We are suggesting an OTM bull call spread with a good risk reward ratio and enough time to weather to current negative market environment. The Historical Volatility is 30.52, but the spread has no implied volatility edge. All of the potential gains will have to come from stock appreciation.
One word of caution is in order. The August options are thin so be careful with the order entry. You may have to leg into the spread in order to get a net debit near the one indicated above.
Previous Issues and Reader Response Request
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.
Great stuff.
Considering the current QID bull call spread:
a) How did you decide on the 54 / 60 set among the many Apr calls available? I suspect it is some combination of largest net delta, greatest reward / risk ratio, most edge, and other factors (?), but how how much weighting on each factor?
b) The prior play from the 2/18/08 issue had a net delta of .2952. As you point out, price went up $4.63 suggesting a trade value of initial debit 2.125 plus delta of 1.37 = 3.48. That is a long way from the 4.10 realized. What are the main components of the difference?
Thanks
Posted by David on March 10, 2008 at 03:57 PM EDT
Thanks for the question on upside down QID. The April calls were selected based primarily on edge, the implied volatility differential between the call sold and the one purchased. The second is the important Greek called Gamma. This is the rate of change of delta. This measures how much delta will change as the price of the underlying changes. As the price of the ETF increased the net delta of the spread increased. This is also called curvature, as the delta increases at an accelerating rate. At the Advanced Options page Gamma is the next column to the right from Delta. You will notice the Gamma of the ATM is higher than for the OTM and ITM options. Delta and Gamma, like two peas in pod.
Jacktrader
Posted by Jacktrader (66.182.123.195) on March 10, 2008 at 07:36 PM EDT
In an earlier post you mentioned that calendar spreads are not for stocks that are involved in takeover talks. How are calendars riskier than other spreads when it comes to takeover stocks? Aren't all debit spreads at risk of losing net time premium if the underlying is bought out?
Thanks,
KB
Posted by KB on March 13, 2008 at 05:18 PM EDT
Thanks for the question. A calendar spread is an income strategy that produces its best return when the stock price is fairly stable and not subject to large moves which is usually not the case for takeover stocks. We find calendar spread candidates based upon the higher implied volatility in the near term month compared to the deferred month. Often we are tempted to sell this higher implied volatility reasoning that the higher implied volatility of the near term options is wrong. In more cases than not the higher implied volatility in the near term options is right and they are higher for a good reason. The good reason being that they are expecting a large move in the underlying and it is justified. Large moves in the underlying will hurt the calendar spread while they are most beneficial to a debit bull call spread or a debit bear put spread without exposure to volatility risk or time premium decay.
Jacktrader
Posted by Jacktrader (66.182.123.195) on March 14, 2008 at 01:00 AM EDT
It is likely the upside price objective of 35 for the the April VIX Call Spread will be achieved on Monday (I am writing this on Sunday night).
Assuming this does happen and assuming the index does quickly reverse from these levels as it did in Aug/07 and Jan/08, is there an opportunity to sell April Call credit spreads to capture that reversal ? If so, how to select the 2 strikes and set a price limit ?
Is there a better way to capture this expected reversal in the VIX ?
As always, thanks for the interesting ideas discussed in the weekly digest.
Emthree.
Posted by Emthree on March 16, 2008 at 11:59 PM EDT
Thanks for the VIX question. The volatility relationships in the VIX are unlike most other options. There is no market for the underlying so this eliminates arbitrage opportunities. The second is tendency for it to take on a range bound limit on the upside, which skews the implied volatility numbers. I would not suggest a April call credit spread, but would look at bear put debit spread, perhaps buying the April 35 put and selling the April 30 put. Look at the implied volatility numbers to make the selection and be prepared to act intraday. As for a stop/unwind level if we see sustained VIX numbers above 35 think in terms of adjusting the bear put spread up to the next higher strike prices.
Posted by Jacktrader (66.182.123.195) on March 17, 2008 at 03:31 PM EDT