Volume 8, Issue 1
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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As we begin this election year in the US it seems fitting to take some time and consider how to incorporate the upcoming election into our investing and trading strategies. Investopedia defines political risk as “The financial risk that a country’s government will suddenly change its policies.”
Historically election years are bullish as the incumbent administration attempts to influence the outcome by any number of stimulate fiscal measures in an effort to gain the favor of the voting public. Here are some considerations:
- The US economy could now be entering into a housing induced recession.
- The consumer is being squeezed by higher energy costs and declining house values.
- The current president may well have the lowest approval rating in history.
- The 2008 election will be the first since 1952 when a member of the current administration will not be on the election ballot.
Based upon this there is a good chance that we could be facing political risk in the US during 2008 and the markets may now be reflecting this uncertainty.
The volatility indexes declined into the holiday period as expected then reversed to the upside with the tragic assignation news from Pakistan. By the end of the week another volatility uptrend was apparent. For the IVX Mean we could now again see the 26 level, 30 for the VIX and 33 for the QQV.
As for interest rates the 10-Year Treasury Note and 30-Year Treasury Bond yields declined to 3.85 and 4.36 respectively while at the short end the 90-day Treasury Bill rose in yield to close at 3.12%. The one-month LIBOR rate also declined to 4.52 narrowing the spread between the Treasury bills and LIBOR to 140 basis points from 220 basis points when we last reported on December 17, 2007. Apparently the new Federal Reserve credit facility is working as the spread between Treasury bills and LIBOR, called the TED spread, has narrowed.
The news from Pakistan abruptly ended the year-end dollar rally as measured by the US Dollar Index (DX) 75.79. It now appears that we will retest the 75 level in the next few trading days. As expected higher gold prices followed the lower dollar with Comex cash gold having trading as high as 868.85 on Thursday January 3, 2008, closed the week at 859.83 thus reestablishing the uptrend from the 642.25 low on August 16, 2007.
The NYSE McClellan Summation Index, our market breadth indicator ended the week with a reading of –336.53 after a brief rise going into the year-end. Now, however it is resuming a downward path corresponding with the market decline.
Head and Shoulders Top
In IVolatility Trading Digest™ Volume 7, Issue 44, Merry Yuletide, dated December 17, 2007 we made the case for a developing Head and Shoulders Top reversal pattern in the S&P 500 Index. We expected the index to rise back toward the 1550 level in the last week of the year to complete the right shoulder before turning lower once again. As often happens, fundamental events in the real world alter the development of ideal technical patterns. This appears to be the case as the bearish sentiment associated with the developments in Pakistan cut short the final rise of the right shoulder. For the week the
S&P 500 Index (SPX) closed at 1411.63 and below the neckline of the H&S Top formation thus setting off the pattern for the decline to the minimum measuring objective of 1225.
Shorts and hedging is the most likely strategy to produce positive results for the near future. While there are still a few positive sectors most will be declining with the broad market. Some of the exceptions include gold, crude oil and solar energy.
There is a good chance that the expected market decline will come rather quickly and will be accompanied with higher market implied volatility. In this situation it may be better to trade the expected rise in volatility using options on the CBOE Volatility Index (VIX) 23.94.
The rise in volatility associated with the decline in the S&P 500 Index can be traded as there are listed VIX options. We would seek an options strategy best suited for a rapid bullish upward move.
A call ratio backspread is a hedged directional trade that will profit from a rapid upward movement in the VIX as the S&P 500 Index declines. The trade is constructed by shorting the near-the-money option (calls), and buying a greater number of out-of-the money calls. The position is net long options and will benefit from a rising VIX and from rising market implied volatility of the options. The sale of the more expensive near-the-money call pays for the purchase of the less expensive out-of-the-money options. If our strategy is wrong and the VIX declines rapidly both options will expire worthless. In addition the short leg of the spread reduces time decay concern. The risk would be a small rise in the VIX. In this event we should close the position.
VIX Call Ratio Backspread Trade Plan
DR: The reason we are doing this trade is our expectation that the S&P 500 Index will continue lower now that the Head & Shoulders Top pattern has been set off. Further we expect the decline will occur rapidly and rising implied volatility should accompany the decline. We have a hedged credit spread that will benefit from increased market implied volatility.
SU: Our stop/unwind criterion has two parts. If the S&P Index recovers and trades back above the neckline and appears to be turning higher or if there is a minimal increase in the VIX. Either outcome would require closing the position. Remember the position is short a near-the-money option that settles for cash at expiration.
- Sell VIX Feb 22 ½ call VIXBX 4.10 IV 99.81 Delta -.6438
- Buy 2 VIX Feb 27 ½ calls VIXBY 1.975 each =3.95 IV 94.45 Delta .4096 each = .8192
Credit .15 Position net delta .1754
Hedging (or Short) Strategy - Comparing the FXY to the IWM
In IVolatility Trading Digest™ Volume 7, Issue 44, Merry Yuletide, dated December 17, 2007, we suggested considering a bullish call spread on the CurrencyShares Japanese Yen Trust (FXY) 92.11
and a bearish put spread on the iShares Russell 2000 Index (IWM) 72.09.
We suggested the FXY would make a more efficient hedge for a market decline than the IWM.
The debit for the FXY spread was 1.725 with .3158 delta, while the IWM had a debit of 1.875 and a delta of –. 1461. Our conclusion was based on the somewhat lower cost and more delta for the FXY spread compared to the IWM. The result is:
The FXY increased 4.6% from 88.04 to 92.11 while the spread closed at 2.15, up from 1.725 representing a .425 three-week gain of 25%.
The IWM declined 3.9% from 75 to 72.09 while the spread closed at 2.235, up from 1.875 representing a .36 three-week gain of 19%.
Previously we wrote that the IWM has a beta greater than one for the S&P 500 Index and now it seems that the CurrencyShares Japanese Yen Trust (FXY) is even more sensitive to price changes in the S&P 500 Index than the iShares Russell 2000 Index (IWM). While the advantage would appear to be with the FXY, it should be noted that there is considerably less liquidity and hence greater bid/offer spreads trading the FXY compared to the IWM. This reminds us what Milton Friedman said, “There is no such thing as a free lunch”.
This is a hedged position on a rising VIX (declining S&P 500 Index) with edge as the long calls have a lower implied volatility than the short call.
Consumer Discretionary SPDR (XLY) 30.84 This ETF includes companies from automobiles, consumer durables, apparel, hotels, restaurants, leisure, media and retailing. Holdings include Amazon (AMZN), Home Depot (HD), Lowes (LOW), McDonalds (MCD), Time Warner (TWX), Walt Disney (DIS) and others. On Friday January 4, 2008 the XLY gapped below 32 on the disappointing employment report and reflecting recession concerns. With a Historical Volatility of 24 consider this defined risk bear put spread.
- Buy XLY Mar 32 put XLYOF 2.025 IV 26.59 Delta -.5811
- Sell XLY Mar 29 put XLYOC .875 IV 31.57 Delta .2907
Debit 1.15 Position net delta -.2904
This spread offers reasonable edge since the option we are selling has an IV of 31.57 while the option we are buying has a lower IV of 26.59. It has a reasonably good risk reward ratio for a defined risk position of 1.61 (3.00 –1.15=1.85)/1.15.
Apple Inc. (AAPL) 180.05. Apple Inc. designs, manufactures, and sells personal computers, portable digital music players, mobile communication devices and related software.
It is hard to make the case that consumer electronic sales will hold up if we enter a recession. We are already seeing many consumer-related stocks being sold. Since Apple has more than doubled since April of last year and was likely marked up to 200 for year-end statement purposes, the most likely direction is now downward along with others in the tech and consumer electronics sectors. If and when mutual funds begin selling to meet redemptions they will be forced into selling the winners with big gains along with the losers as they scramble to raise cash. We see support at 150 from last July and would use this as the target. With a Historical Volatility of 36.83 consider this directional bear put spread.
- Buy AAPL Apr 180 put APVPP 20.10 IV 55.10 Delta -.4288
- Sell AAPL Apr 170 put APVPN 15.225 IV 55.49 Delta .3538
Debit 4.875 Position net delta -.0750
DR: Consumer electronic stocks will not be immune from selling if we enter into a recession.
SU: Unwind the position if AAPL holds and rallies from the upward sloping trend line off of the August low at 120.
This position has a reasonable risk reward ratio and this stock has some potential downside distance to travel.
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