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Volatilities and Trading Ranges

By Scott "The Strategist" Fullman
February 6, 2002

Since reaching the highs set in the beginning of January, the major market benchmarks have been in a negative trend. Bond prices have been little changed, and for the first time in a long time we are seeing strength in the precious metals, especially gold. Investors appear to be in a battle to decide which is more important-the economy, earnings, or accounting problems. This is leading to a conflict in confidence as well, resulting in a stagnation of market movements versus severe punishments on the stocks of companies that were naughty.

As most investors and traders are aware, rallies that have begun since the beginning of January have lacked follow-through and momentum. This has caused the three major benchmarks, as well as other indices that we follow, to drop back below their respective 200-day moving averages, indicating that the markets may be in for some tough fights during the months ahead. There has been a slight drop in trading volume, indicating a rotation factor. We also note that the internal market indicators, which we follow closely, have been deteriorating.

Most of the oscillations that we have seen in the markets have been tied to the readings of the implied volatility indices. For example, as the chart below illustrates, each time the implied volatility level on the S&P 500 Index (SPX) dropped to near 17.7%, the market sold off. Conversely, each time that level neared 20%, the market rallied. This confirms the theory that more people become nervous near bottoms. This chart also indicates that the implied volatility levels have generally been good oscillators since the start of the year.

Figure I - Daily price, implied volatility, and historical volatility chart on the S&P 500 Index (SPX) from January 7, 2002 to February 5, 2002. Volatility levels supplied by

In overseas trading this morning, gold prices shot sharply higher, breaching the $300 per ounce level. This follows the strength of the stocks of companies in the precious metals mining business. The benchmark index for this group, the PHLX Gold/Silver Index (XAU) began a positive trend on November 27, when the index broke above the $50 level. Since that time, the index has been very strong and closed at $67.83 yesterday. There have been several false starts since the index hit a high of $92.72 in September 1999. However, the rise in gold prices during the past two weeks is giving more credence to the movement. It is important to note that gold has also had several rallies that have failed during the past few years.

The sharp rise in gold stocks has resulted in an anomaly. Option premiums for puts and calls have fallen, even as interest has risen. Implied volatility levels for XAU have decline, even as the movement of gold futures has become more volatile. This is illustrated in the chart below, showing a significant rise in the volatility levels. Also note the rise in trading volume and open interest.

Figure II - Daily chart on implied volatility, historic volatility, option volume, and option open interest on the PHLX Gold/Silver Index (XAU).

In order to take advantage of periods when volatility levels rise, conservative investors should consider the use of the covered call writing strategy as an attractive alternative to purchasing shares alone. Given the current environment, industry group and stock selection are extremely important. users should look at the Strategist category and utilize the covered-call-writing scanner for help in selecting candidates that meet your needs.

The collapse of the Enron Corp. empire has resulted in concerns about the accounting practices of other companies. One of the major victims has been Tyco International (TYC), whose shares have dropped more than 60% since the end of 2001. Implied volatility levels on this stock have jumped just over 27% since last November to 165% yesterday. The highest volatility levels can be found in the current expiration month, as illustrated on the volatility skew chart shown below. This chart shows the implied volatility level based on days to expiration for puts and calls that are at-the-money.

Figure III - Volatility skew chart on Tyco International.