Volume 8, Issue 35
Collaring Income
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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We are now beginning to see equity prices in some sectors offer good fundamental value and attractive yields so we are going to take a somewhat different track in this issue.
We will make a few suggestions for buying high yielding dividend stocks for income and then because of the continuing uncertainty that the final bottom may not have been made in these sectors we explain how to use collars to protect the downside risk.
We start with our Market Review and then a suggestion from last Friday’s Stock Trend Analysis selection on our front page followed a few comments about the agony in the financial sector with a caution on Friday’s Best Calendar Spread also on the front page.
Market Review
S&P 500 Index (SPX) 1251.70. While the SPX is making a well defined double bottom we can not say the same for all of the major indexes. While this double bottom may be it for this cycle, for now we hesitant to declare that we have seen the final bottom.
CBOE Volatility Index (VIX) 25.66. On a weekly close-to-close basis the increase in the VIX from 23.06 to 25.66 hardly seems significant. However, looking at the chart revels that the daily trading ranges rose all week and are now poised to attack the 30 level, which we think is likely. For those that watch the markets daily and can unwind positions intra-day we would once again suggest a bull call spread as it may trade above 30 and then close the same day back under 25.
US Dollar Index (DX) 78.97. Thursday September 11, 2008 the DX traded and closed above the 80 resistance level. Then Friday it abruptly reversed closing on the low at 78.97 with a loss of 1.18 points. Many traders must have been waiting for a close above 80 to pull the sell trigger and take some profits after this extraordinary up move. Sure enough their opportunity came right on cue as this resistance at 80 was expected. We are now looking for a retracement back to 75-76.
NYSE McClellan Summation Index. Last week our market breadth indicator slowed its ascent and then began a modest decline ending off 42.07 and closing at -237.63. This, the first decline in 8 weeks, seems to correspond with the rising VIX index.
Stock Trend Analysis
As a regular feature in the Rankers & Scanners section on our front page we show the result of the Stock Sentiment Ranker based upon the short term market trend, HV term structure, call/put ratio, exponential moving average, 14 day RSI (relative strength index), and the 21 day Chaikin Money Flow. Here is Friday’s selection with a trade idea.
Pepsi Bottling Group Inc. (PBG) 32.47. In an uptrend since July 15th the Pepsi Bottling Group, Inc. bottles and distributes Pepsi-cola beverages. At the current price it is just under 14 times trailing twelve month earnings with a 2% yield. They are expected to announce earnings of 1.04 on September 30th. With a current Historical Volatility of 34 consider this put sale suggestion with some edge for this relatively safe consumer staple stock currently in an uptrend.
- Sell PBG Oct 30 put PBGVF .625 IV 40.47 Delta .2407
Financial Sector Agony
On Friday the top four places in the “Top 5 stocks with greatest IV change from yesterday” ranking were all financials. Take a look below.
The percent changes in the IV (Implied Volatility) Indexes for AIG, GE, MER, and UYG (see the last column) all reflect the great sense of uncertainty in this sector. Nobody seems to know what the real risk level is and they don’t want to take a chance that their stock will be next to fall.
Best Calendar Spread
Our RT Spread Scanner found this idea on Friday. It is based upon the differential between relative implied volatilities and does not consider fundamental sector or other market risk criteria.
Morgan Stanley (MS) 37.23. Since Morgan Stanley is a financial and they are expected to report earnings and perhaps more write downs on Wednesday September 17, 2008 we suggest the prudent action is to avoid this calendar spread selection. However, if you believe MS has less risk than those shown above and want to participate in speculating about the earnings report we suggest a short straddle strategy as an alternative.
Trade Plan
DR: Short term short volatility trade for the earnings report next Wednesday. Expect a material decline in implied volatility after the earnings report. Options expire on Friday so the trade will be short lived. Since the IV will most likely rise further before Wednesday we suggest implementing this trade on Tuesday however, be aware that news from Lehman Brothers (LEH) 3.65 over the weekend could change the sentiment for the sector.
SU: Close the position after the earnings report announcement and/or if it trades above or below the breakeven on either side (above 41.45 or below 32.55).
With a current Historical Volatility of 55 and with the Implied Volatility Index Mean at 76.82 take a look at this short straddle alternative idea.
- Sell MS Sep 37 call MSIK 2.40 IV 103.80 Delta -.5481
- Sell MS Sep 37 put MSUK 2.15 IV 103.65 Delta .4522
Credit 4.45 Position net delta -.0959.
In this environment this is a risky trade for a stock in the financial sector. We could add some downside protect by buying a Jan 30 put MSMF at 2.75 with an Implied Volatility of 71.90 and -.2387 delta, but it would alter the results if the stock trades between 32.55 and 41.45 after reporting. If so, the put could then be sold with a likely loss but could be considered as the cost downside insurance.
IVOLopps™
Collaring Income Stocks
A collar is a covered call with an additional long put to protect the downside of the long stock. If we buy a stock because it pays good dividends our objective is income. One reason the dividends could be attractive is the result of an abnormal decline in the stock price causing the dividend rate to rise. If the fundamentals remain intact then the dividend rate could be unusually attractive. However, in order to take advantage of the temporary stock price decline we are faced with the dilemma of buying a stock that has been going down in price and may not have yet stabilized or begun to turn higher. A collar is one way to go ahead and buy the higher paying dividend stock and protect the downside risk. The collar is created by selling an out-of-the-money call and then using the proceeds to purchase an out-of-the-money put. Ideally, the call sale will cover most or all of the put cost. If the stock stays within bounds of the collar we keep the stock and collect the dividends. If the stock rises above our sold call price we will loose the stock by assignment at expiration, but make a gain on the stock sale price. If the stock declines we have downside protection from our long put.
Currently there are at least two sectors that are not financials, offering such opportunities, shipping and pipelines. We offer some suggestions for your consideration.
Frontline Ltd. (FRO) 49.96. Highly leveraged with a debt to equity ratio of 5 FRO claims to be the worlds largest Tanker Company with a fleet of 77 oil tankers, including oil/bulk/ore (OBO) carriers ranging in size from 135K dwt to 311K dwt. In the past 12 months FRO paid dividends of 12.84 at an annualized rate of 25.7%. During the good portion of that time VLCC freight rates were near $150,000 per day, but in the recent weeks they have declined to under $50,000 per day. While we are expecting rates to rise again between now and year-end we do not expect to see the dividend rate remain at this level. In fact, we currently estimate the annual dividend rate for the next twelve months at 6.00 making the estimated forward dividend rate 12%. In order to capture this expected dividend rate we may have to buy the stock now even though it still appears to be in a downtrend.
With a current Historical Volatility of 72 and likely to decline when the stock turns higher consider this suggestion.
- Buy 100 shares of FRO at 49.96
- Sell FRO Nov 55 call FROKK 2.15 IV 44.55 Delta -.3581
- Buy FRO Nov 45 put FROWI 2.30 IV 53.08 Delta -.2798
Option debit .15 Option net delta -.6379
Position net debit 50.11 Position net delta .3621
We expect the next dividend will more than pay for the cost of the collar. If the stock turns higher and exceeds 55 at the November options expiration we will loose our stock by assignment but the position will have gained in value. We have downside protection from the long Nov 45 put.
Diana Shipping Inc. (DSX) 24.18. With a very conservative debt to equity ratio of just .237 DSX transports dry bulk cargoes, such as iron ore, coal, grain, and other materials with a fleet of 13 Panamax dry bulk carriers and 6 Capesize dry bulk carriers with a combined carrying capacity of approximately 2 million dwt. Now selling at a forward price to earning ratio of 9 and a current yield of 12% that we expect will be maintained at this level since they have already chartered out their ships until the end of the year. The stock price has declined over the last few weeks as iron ore shipments have rapidly declined but we expect them to recover before much longer as China restarts its economy after the Olympics and Para-Olympics. With a current Historical Volatility of 59 consider this collared stock purchase for income.
- Buy 100 shares DSX at 24.18
- Sell DSX Dec 30 call DSXLF .80 IV 53.30 Delta -.2469
- Buy DSX Dec 20 put DSXXD 1.325 IV 60.90 Delta -.2526
Option debit .525 Option net delta -.4995
Position net debit 24.705 Position net delta .5005
The stock price is driven by the Baltic Cape Index for dry freight that has recently declined. We expect a recovery soon; in the meanwhile we have downside protection from the long Dec 20 put.
Atlas Pipeline Partners LP (APL) 29.55. APL engages in the transmission, gathering, and processing of natural gas with an extensive gas-gathering infrastructure serving the heart of the most active region of Marcellus shale formation. With a current dividend of 12.7% they have already guided to a higher dividend rate for the balance of the year and advised that the dividend will be covered 1.3 times by the available cash flow. Further they guided 2009 distributions to 4.25 to 4.50 for a current rate of almost 15%. Insider open market purchases are always a good indicator – the Chairman & CEO bought 10,000 shares of stock on August 12, 2008 at 33.47.
With the current emphasis on the growing role of natural gas as a transportation fuel being promoted by
T.&nbpsBoone Pickens and others this appears to be a good opportunity without exploration and production price risk.
With a current Historical Volatility of 36 consider this collared stock purchase for income.
- Buy 100 shares APL at 29.55
- Sell APL Nov 35 call APLKG .25 IV 32.44 Delta -.1166
- Buy APL Nov 25 put APLWE .40 IV 32.90 Delta -.1507
Options debit .15 Options net delta -.2673
Position net debit 29.70 Position net delta .7327
We suspect commodity related hedge fund selling for the recent excessive decline in this sector, but expect the price should now stabilize and turn higher before very long. In the event it continues lower the position is protected to some degree by the long Nov 25 put.
Delayed Responses to Comments from Previous Issues
We apologize for the delay in responding to some of the comments made in a few of the previous issues over the past few weeks. It seems our response notification system had some problems.
Previous Issues and 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. 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.
Posted by dan on September 16, 2008 at 06:16 PM EDT
Thanks for the observation and question on the Frontline collar suggestion. Although the Frontline dividend announcement dates have been somewhat inconsistent in the past your suggestion is a good one and would improve this idea.
Jacktrader
Posted by Jacktrader (68.109.71.202) on September 17, 2008 at 11:24 AM EDT
Posted by ron gordon on September 19, 2008 at 05:36 PM EDT
Thanks for your question about the put ratio backspread suggestion on Dendreon Corp. (DNDN) that we made in IVTD V8 34 on September 8, 2008. The rationale for the trade is in the last paragraph and perhaps we should have used our regular trade plan format that would have done a better job explaining why we were making the suggestion. The basis of this suggestion was more on the expectation of rising options implied volatility and not on the difference between the implied volatility and the historical volatility that we frequently use as a basis for suggestions. In addition, we were expecting the stock to move down in price and the options implied volatility to rise with the decline in price. The actual result was a dramatic rise in price from 5.66 to 6.50 about a 15% move and not what we were expecting. We did, however get the rise in implied volatility that more than offset the price rise. Our two long Oct 5 puts options increased in value by .05 each as the implied volatility rose from 169 to 202 or 20% despite the stock rising in price by 15%. Then the short Oct 7 ½ put declined in value by .415 or 15%, but the implied volatility rose from 191 to 233 or 22%. The result was in decline in value of the spread from .935 to .42 for a gain of .515 or 55%. Since this was a credit spread we keep the theoretical indicated difference as we buy back (debit) the spread to close it. We were wrong on the direction, but right on the volatility. We now suggest closing this trade and booking any gain we can make after paying the commission(s) and the bid/offer spreads that could take away a good portion of the indicated gain. Since we now have a better forecast of the likely price direction we can look at the now very positive volatility spread (IV 223 and HV 58) for a put sale. We would go after the same puts that we were previously long, the Oct 5 puts UKOVA at .955 with an IV of 202.
This is a real good example of being wrong in price direction but being right on volatility. After updating the fundamentals we can now make the adjustment and hopefully get the direction right.
Jacktrader
Posted by Jacktrader (68.109.71.202) on September 20, 2008 at 12:34 PM EDT