« October 2008 »

IVolatility Trading Digest™

Volume 8, Issue 41
Brothers Grimm

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).

The Brothers Grimm are two twin fictional comic book supervillains, owned by Marvel Comics. They are also two German academics who published “Rumpelstiltskin”, “Snow White”, “Sleeping Beauty”, “Rapunzel”, “Cinderella”, and “Hansel and Gretel.”

Our Brothers Grimm are our old favorites VIX and TED that we have been visiting with and writing about for the last few weeks. While certainly not causing the current unpleasent market conditions they are nevertheless appropriate symbols of its gloom.

We update VIX and TED in the market review section below and then give some additional details about using the IVolatility.com Profit and Loss Calculator using another bear put spread as an example. Then we will update our current short oil position and take a look at an interesting idea in the Takeover File.

Market Review

S&P 500 Index (SPX) 876.77. For the week the SPX lost 63.78 points at the close. The low of the day was 852.85 and is now close to the low made on October 10, 2008 at 839.80. Given the current sentiment it is hard to make a case that 839.80 will hold. Although currently oversold, from a momentum perspective it looks to be going lower.

CBOE Volatility Index (VIX) 79.13. On a closing basis our brother VIX was 8.80 higher at the end of the week, but that is not the whole story. Consider these intra-day highs last week.

Wednesday   10-22   81.45
Thursday   10-23   96.40
Friday   10-24   89.53

Going back to May our chart below does not do justice to the VIX since it does not show the intra-day highs. One thing is for sure it remains very high providing a grim to bleak appraisal for the bulls in the near term.

Open 67.80, High 89.53, Low 67.80, Close 79.13, up 11.33 on the day.

US Dollar Index (DX) 86.44. The US Dollar broke out above the 84 level and continued higher closing the week up 4.03 for a 4.7% gain. Continuing risk aversion and hedge fund position unwinding are being cited for the strength. We don’t see anything that will change this outlook in the near term and certainly not until after the US elections on November 4th.

TED Spread 2.67. Our second brother TED showed some improvement last week. The TED spread is difference between the 90-day LIBOR (London Inter-bank Offer Rate) and the equivalent term Treasury Bills. In normal market conditions this spread is about 50 to 75 basis points or .50% to .75%. Since the US Government guarantees Treasury Bills and Eurodollar deposits have bank risk the TED spread give us a way to measure the current perceived risk in the Eurodollar market. Here is the updated Bloomberg chart showing a further decline of .96 for the week.

Open 2.57, High 2.76, Low 2.55, Close 2.67

NYSE McClellan Summation Index. The rate of decline of our market breadth indicator slowed considerably last week. Now at -1.514.11 the decline for the week was just 17.82 points. Since history tells us that bear markets end when the Summation Index is below –1,200 we are still looking for an inflection point to confirm the change in direction of the NYSE Index.


As we wrote last week that high options implied volatility provides opportunities to sell expensive options. We cautioned about using straddles and strangles and since we are in the middle of earnings reporting extra caution is needed with specific stocks unless they have already reported. Then we have one suggestion in the Takeover Section below that seems to be in a special category. Otherwise look for opportunities using bear put spreads or other negative delta trades until we get some confirmation that the market has stopped going lower.


Sears Holdings Corporation (SHLD) 47.67. A broad-line retailer in the United States and Canada. The company operates three businesses: Kmart, Sears Domestic, and Sears Canada.

When we last suggested a bear put spread on SHLD it was 105.51. See IVolatility Trading Digest™ Volume 7, Issue 42, Dim Green Light, dated December 3, 2007.

SHLD came to our attention once again because of its number one position in the IVolatiity.com Ranker for Top 5 stocks based on IV Index Mean vs 30D HV. With an Implied Volatility Index Mean of 108.53 and a current Historical Volatility of 61.52 it’s at the top of this week’s list with an IVIndex/HV ratio of 1.76.

Now at 47.67 it has clearly broken the previous support area at 70 and is gaining momentum to the downside. The rising options implied volatility along with current retail environment provides further support for this thesis. Consider this bear put spread idea.

To help us better understand and visualize this suggestion we refer again to the soon to be released IVolatility.com Profit and Loss Calculator.

The table below shows the profit and loss at several levels.

From the P& L Calculator here are the spread price and option characteristics.

Comparing our suggested data to the calculations we notice some differences. First we assumed a mid price for the spread at 5.05 as usual. We see the P&L summary also gives the BID and ASK price. Other differences are due to calculating them based upon either the bid or ask price not mid prices as we assume. We show the net delta as -.1599 and above it is -15.45. The P&L summary has also made the adjustment for the position size of a one lot by multiplying the delta by 100 to get -15.45. We have the gamma as .0032 and the summary shows it as .32. Theta is also the same after adjusting for the position size at -.83 our number above is -.0083. While there is a slight difference between the vega of .0121 and 1.13 after adjustment for position size. Here is the graph of the suggested position.

Referring to the table above we can see that at 40 the theoretical price gain would be 129.81. We can also change the volatility and time to expiration assumptions. For example, if the implied volatility increases by 5.36% as the stock declines to 40 and when there is 26 days to expiration the price gain will be 150.86 based upon a one-lot position (not shown). We also note that with a negative theta of .83 it means the time value of our spread declines .83 cents every day. Since we calculated it based upon Friday values with 56 days to expiration we can adjust our price for Monday by subtracting 2.53 from our price making it 5.0247 or 502 to 503.

The additional capability we have using the P&L Calculator provides easy and more accurate estimates while giving us the ability to model various assumptions.

Short Crude Oil Update

United States Oil (USO) 53.00. This ETF reflects the spot price of West Texas Intermediate (WTI) light, sweet crude oil. For this week it declined another 6.37 in addition to last week’s 7.13 while the prior week’s decline was 8.75. This week the Implied Volatility Index Mean increased from 69.46 to 82.73 up 13.27. The mid price of our existing long November 60, short November 55 bear put spread has increased from 1.375 to 3.30 in two weeks. Our current position cost is a credit or net gain of 6.10 or $610 since the initial combination suggestion three weeks ago.

Takeover File

Anheuser-Busch Companies Inc (BUD) 56.93. From St Louis, BUD makes and distributes beer in the United States and internationally. The domestic beers are Budweiser, Michelob, Busch, and Natural brand names.

BUD is in the process of being acquired by Belgian-Brazilian InBev at 70 in a deal that was agreed in July. Originally they expected to close before year end. Now, despite the management of both companies continuing to confirm the deal will close as expected, the stock price has declined and the option implied volatility is rising.

Some analysts speculate there are problems in the financing while others are saying the stock is declining simply because investors are under pressure resulting from other losses and need the cash.

This week BUD is number two in our in the IVolatiity.com Ranker for Top 5 stocks based on IV Index Mean vs 30D HV. With an Implied Volatility Index Mean of 73.53 and a current Historical Volatility of 46.48 it has an IVIndex/HV ratio of 1.58.

Based primarily upon the assumption that the current stock price is a function of the current market condition and not because the deal is in trouble here are two put sale suggestions.

If the stock declines below 50 at the December expiration the first suggestion would mean a basis in the stock at 45.80 and about at the price it was before the InBev rumors began. If it were to decline below 45 at the December expiration the basis in the second suggestion would be 41.90 and a long way below the stock price low for the last 52 weeks.

The prices above are based upon Friday’s closing so the Monday prices will be .15 less just from the loss in time decay assuming no price change in the stock so adjust you prices expectations accordingly.

While the Dec 45 put is more expensive in Implied Volatility terms it is also the safest although it does yield a slightly smaller credit. Assuming there are no financing problems with the deal this appears to be an unusual opportunity.

Even if we do have a recession will people stop drinking beer? Who knows, perhaps beer will even regain market share that it lost to wine.

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.


Hello IVolatility, In a bear put spread per the Sears holding example is the investor required to actually own the stock in a portfolio? Thank You Ron

Posted by RonCivil on October 29, 2008 at 02:59 PM EDT

Ron, Thanks for your excellent question about owning the stock as a prerequisite for a bear put spread. In general, there is no requirement to own the stock to have a bear put spread or to be short the stock in order to have bull call spread. There are some requirements at the brokerage firms for the types of trading that is allowed in various accounts. Check with your brokerage firm for more details of their requirements. Jack

Posted by Jacktrader ( on October 29, 2008 at 04:20 PM EDT

Hello Jacktrader, Thank you for the reply to my question. I am just starting out in options and have spent the last 2 months reading and learning. Is there a portfolio summary of what returns or how the trades turned out per the suggestion in the above and past blogs? Thank You again Ron

Posted by RonCivil on October 30, 2008 at 07:19 AM EDT

Ron, Thanks for your question about a trading record. Since we do not offer portfolio management services our activity is limited to weekly suggestions for the time being. “Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.” We would not consider all the trades suggested appropriate for everybody. Suggestions are the operative word. This is more like a menu of ideas; not all are suitable for everybody. For example some people do not have margin accounts, others may use brokers that charge commissions at a rate that would prohibit some trades that require frequent adjustments. Others may not be comfortable with short positions in stock and options. Further, we could have short suggestions and long suggestions in the same issue. When you have a long bias you would be more interested in the long suggestions while ignoring the shorts. The initial trade selection ideas we offer here are only about 40% of the task. The other 40% are adjustments and trade management while the remaining 20% is accounting and record keeping. Daily updates we would require a considerable commitment to a portfolio accounting system. Perhaps this is something we can do in the future, but for now our options trading suggestions are just the starting point in the process. Jack

Posted by Jacktrader ( on October 30, 2008 at 01:48 PM EDT

I have a question about a strategy I occasionally use. I call it a 'covered call spread.' Suppose I own 2000s of XLY, the consumer discretionary spider, and I want to earn some premium income but not pass up the entire possibility of gains in the event of big price surge. With the current price at 20, let us say, I might decide to write twenty calls strike 21 at $1.20; and buy twenty calls with a 22 strike at $0.85, pocketing the .35 as a credit. On 2000 shares this is $700. I am essentially trading $2000 in future gains--the bird in the bush---for $700 income now, the bird in hand. I am a conservative investor and live low on the hog, with the need to supplement my meager income with some premium income; but do not want to forego big gains in the event of a big market pop, which is a very possible event at this time. What do you think of this strategy, overall? cyclingscholar

Posted by Gary on October 31, 2008 at 10:42 AM EDT
Website: http://www.cyclingscholar.com

Gary, Thanks for your question about the covered call strategy using the XLY. The position you describe would probably be described as a covered bear call spread. The best outcome for a bear call spread is for the stock to decline or remain unchanged so that both of the options will expire worthless so you keep the .35 credit. However, you are long by virtue of the long stock position. Based upon your example you would probably be delta long about 1760. The two positions are in conflict. In addition, there is another problem with the XLY because the wide spread between the bid and ask of the options, which are very wide. For example, the November 23 calls are .65 bid, 1.75 ask and the November 24 calls are .25 bid, .80 ask. If you usually have long stock positions we suggest you look for a stock that pays a good dividend and then sell out-of-the money calls. Look for stocks with good options volume that have narrow bid/ask spreads and one where you can sell expensive calls against your long stock as determined by the Implied Volatility of the options in relationship to the Historical Volatility of the stock. The objective is to sell expensive calls. At this time of high options volatility there are currently many available. Jack

Posted by Jacktrader ( on October 31, 2008 at 11:56 PM EDT

Hello Jack In the above example from Gary - Cycling Scholar, if he is writing calls on the XLF position, couldn't Gary lose his (2000 shares) long stock position in XLF? Thank You Ron

Posted by RonCivil on November 03, 2008 at 09:13 AM EST

Ron, Thanks for the question about loosing the underlying stock or ETF from covered call sale. You are correct if you sell calls against the stock and it rises to become in-the-money you will have the stock called away. If you can find expensive out-of-the-money calls to sell on good quality stocks that pay a good dividend then you greatly increase to odds of making money. If the stock should rise you gain from the appreciation of the stock between the original price and the strike price of the call sold. In addition, you keep the premium for the sold call. When you add these together it could be a nice return on investment. If the stock does not rise to the strike price then you keep the premium from the sold call and collect the dividends from the long stock position. Because Implied Volatility is now high there any many opportunities for this strategy using good quality stocks. Jack

Posted by Jacktrader ( on November 03, 2008 at 12:46 PM EST

Permalink Comments [8]

IVolatility Trading DigestTM Disclaimer
IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.

Our purpose is to offer some ideas that will help you make money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".