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Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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According to Investopedia, a Symmetrical Triangle is an easily recognized chart pattern used in technical analysis with a distinct shape created by two converging trendlines. Drawing two trendlines that connect a series of sequentially lower peaks and a series of sequentially higher troughs creates the symmetrical triangle. Both trendlines seem to act as limits preventing the price from heading higher or lower, but once the price breaches one of these levels, a sharp movement often follows.
Market Review
In the world of classical bar charting the symmetrical triangle is a continuation pattern that leads to the continuation of the prevailing trend about 75% of the time. Using the Investopedia illustration above as a guideline here are the numbers for the S&P 500 Index (SPX) now 1349.99 and labeled above as S&P 2-15-08 now on the lower trendline. Here are the S&P 500 Index values corresponding to the labeled points shown in the illustration above.
|
S&P 500 Index |
Date |
| Reversal 1 |
1270.05 |
1-23-08 |
| Reversal 2 |
1396.02 |
2-1- 08 |
| Reversal 3 |
1320.32 |
2-11-08 |
| Reversal 4 |
1369.23 |
2-13-08 |
The measuring objective for this continuation pattern is from the upward-sloping trendline to reversal point 2, which in this case is 1300 to 1396.02, producing a minimum measuring objective of 96.02 points. This value is applied to the point where the price crosses below the upward-sloping trend line taking it down to the 1250 area. This would be just below the January 23, 2008 low at 1270.05. In previous IVolatility Trading Digest™ issues we calculated the minimum measuring objective of the S&P 500 Index Head & Shoulders Top to be 1225.
In the event the S&P 500 Index now trades sideways and does not cross the lower trendline before reaching the vertex of the triangle then the continuation pattern will be in doubt. The most likely outcome is a continuing decline to at least 1250 and most likely to the Head & Shoulders Top minimum objective of 1225.
US Dollar Index (DX) 76.10 (cash) continues trading above the 75 support level. We are now beginning to see the formation of a bottoming pattern and we need to start considering the implications of the dollar turning higher. Last Thursday the Commerce Department reported that the trade deficit dropped to $711.6 billion last year, a decline of 6.2%, with the December trade deficit at $58.8 billion a decline of 6.9% for the month. This is quite an achievement with oil prices stuck above $90 a barrel.
Strategy
Until we reach the downside objective for the S&P 500 Index we continue to favor the short side of the market. Some exceptions include agricultural commodities, seasonal natural gas, equities supported by covered dividends, and perhaps special situation takeovers.
Favorite Shorts
Because we think the pace of the downside decline is about to accelerate once again we are going to update and increase some of our favorite shorts.
iShares Russell 2000 Index (IWM) 69.87. Since the IWM declines faster than the S&P 500 Index and since we are still expecting a further decline in the S&P 500 Index we would have an edge by using the IWM in a short position.
In IVolatility Trading Digest™Volume 8, Issue 4, Rogue Trader, dated January 28, 2008 we suggested a bear put spread. Long the June 70 put and short the June 62 put.
Now we return with another suggestion. With a current Historical Volatility of 27.97 consider adding this bear put spread.
DR: Until reaching 1225 we expect further declines in the S&P 500 Index. Since we appear to be completing a symmetrical triangle continuation pattern and expect the decline to accelerate we are suggesting an additional position.
SU: If we see S&P 500 Index closes above 1425 we would unwind the position.
- Buy IWM Mar 71 put DIWOS 3.10 IV 29.88 Delta -.5422
- Sell IWM Mar 65 put DIWOM .92 IV 32.91 Delta .2156
Debit 2.18 Position net delta -.3266
The maximum gain is the difference between the strike prices less the debit, or 3.82 (6.00 –2.18). We are expecting downside acceleration soon.
Shorting the Qs Again
We are returning to the Qs for the short side once again.
Most of the Short and UltraShort ETFs do not have listed options and the few that do have limited volume and open interest, the exception is the QID the UltraShort on the QQQ with fairly good options volume and open interest.
UltraShort QQQ Proshares (QID) 50.85. UltraShort QQQ ProShares seeks daily results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the NASDAQ-100 Index®.
Using the QID gives us an addition to our “Options Upside Down” series that we started last week in IVolatility Trading Digest™ Volume 8, Issue 6, Good Credit, dated February 11, 2008
With a Historical Volatility of 54.72 consider this bull call spread that will rise in value as the NASDAQ-100 Index declines. There is a well-defined upward sloping trend line off of the December 26, 2007 low at 36.10.
DR: The QID is a leveraged 2 times to the NASDAQ – 100 Index. Until the S&P 500 Index reaches its minimum downside objective of 1225 this bull call spread will benefit from the decline while providing protection against increasing volatility, time decay and interest rate declines. This is a downside direction trade with limited risk. Because it is leveraged to the Index it requires close attention.
SU: The spread should be unwound if the QID closes below the 45 support area, which could occur very rapidly in the event of a short covering rally in the stocks comprising this Index.
- Buy QID Mar 50 call QIDCX 3.70 IV 49.24 Delta .5994
- Sell QID Mar 57 call DYMCE 1.575 IV 57.14 Delta -.3042
Debit 2.125 Position net delta .2952
The maximum upside is the difference between the strike prices less the debit, or 4.875 (7.00-2.125) and with a defined 2.125 downside risk providing a good risk reward ratio.
Lululemon Athletica Inc. (LULU) 32.06. LULU is a yoga-inspired athletic apparel company that creates components for people to live longer, healthier and more fun lives. By producing products that keep people active and stress free, lululemon believes that the world will be a better place. Using technical fabrics and functional designs, lululemon works with yogis and athletes in local communities for continuous research and product feedback.
While a cool sounding company the forward price -to -earnings ratio, according to Yahoo! Finance is a not so cool or stress free 43.92. In a difficult consumer-spending environment it is hard to justify a price-to-earnings ratio at this level.
Here are the volatility and price charts.
The noticeable increase in Implied Volatility shown as the orange line in the top chart above corresponds with the price decline in late December. After a three-week rally that saw the price increase from 25 to over 35 it now appears to be turning lower once again. In a declining market environment this stock will most likely retest the 25 low set on January 23, 2008 and the Implied Volatility will most likely rise once again. With a Historical Volatility of 70.24 consider this bear put spread.
DR: High multiple consumer discretionary stock in a declining market.
SU: A close above 35 would be the level to unwind the spread.
- Buy LULU Mar 35 put QLNOG 4.850 IV 78.15 Delta -.5926
- Sell LULU Mar 25 put QLNOE . 925 IV 95.97 Delta .1597
Debit 3.925 Position net delta -.4329
With the downside limited to the debit and with a good edge the maximum gain is the difference between the strike prices less the debit or 6.075 (10.00-3.925).
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. 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.
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