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Today


IVolatility Trading Digest™


Volume 9, Issue 38
Oil Bears Return

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).
 
Too Far Too Fast?

On average, the seasonal peak in crude oil prices usually occurs in the middle of October. However, last week the US Energy Department reported crude oil inventory numbers increased twice the amount expected by the analysts and crude oil prices immediately turned lower. This year the seasonal decline may have arrived early. After two portfolio adjustments, we offer a short crude oil suggestion and then a bearish solar put spread idea. First, a quick market review.

Market Review

S&P 500 Index (SPX) 1044.38. SPX made another key reversal last Wednesday after the Energy Department released the crude, gasoline and heating oil inventory numbers. If energy prices are headed lower it will most likely take the SPX lower since there are a good number of energy industry companies included in the SPX. For the week, the decline was 23.92 points or 2.24%, about the same as the previous week’s gain. Last week we suggested the SPX had risen too far too fast, now we consider if the correction has been enough. The current active upward sloping trend line from the low on July 10th at 872.81 crossing at the low of 992.25 on September 3rd positions Friday’s closing price exactly on the trendline. Thus, from the trendline perspective a continuation lower is inclusive. However, since crude oil has broken its upward sloping trendline the odds are SPX will continue lower for now.

We still maintain our upside measuring objective at 1233.29, from the large Head & Shoulders bottom previously explained in Digest issue 36, but first the current correction in context of the bull market needs to be completed.

E-mini S&P 500 Future (ESZ9) 1041.00. The December E-mini future contract declined 20 points, or 1.89% last week. At the September contract expiration on the 18th total open interest declined 815,794 contracts compared to 1,004,862 at the June expiration. It then began increasing again on Wednesday while making a key reversal. For the bull market to continue the E-mini needs to turn up from the trendline with increasing volume and increasing open interest as it advances. This will be difficult with declining crude oil and energy product prices.

S&P 500 Index Implied Volatility (IVXM). Our Implied Volatility Index Mean was up 1.47 at 22.75 while the VIX increased 1.69 to 25.61. The VIX 20-day moving average, our hedge indicator is our now 24.93 and now below the current VIX at 25.61.

The October VIX futures premium over cash declined 6.40 to 5.43, the November premium declined 7.04 to 11.48 and December declined 6.10 to 10.70. The significant decline in these premiums suggests less concern about a continuation of the market decline and indeed suggests the decline will reverse at the upward sloping trendline. We will soon have the answer.

The implied volatility of the VIX October 22 ½ calls declined to 115.17 from 141.04 and the October 25s declined to 99.83 from 118.60. The November 22 ½ calls are now 126.72 while the November 25s are 109.85 also down from last week’s 123.32. These declines confirm the declining risk premium in the futures contracts.

US Dollar Index (DX) 76.81. DX rebounded and then retested 76 before rebounding slightly by the end of the week, closing up .38. From the middle of November 2007 to early February 2008, DX traded in a 75 to 78 range centered on 76 so it is not surprising that it again found some support at this level, but the rebound is creating problems for commodities, gold and silver. We said last week, DX looked oversold and we expected it would attempt to turn higher as it has.

iShares Barclays 20+ Year Treasury Bond (TLT) 97.98. The increase of 2.22 for the week is important as it closed above the prior resistance high made on September 11th at 97.68. There is now a defined upward sloping trendline to follow from the double bottom low made on August 10th at 90.41. Rising long bond prices are consistent with declining equities, so this upward trendline is not good news for equity bulls.

NYSE McClellan Summation Index 1426.13.  We expected to see a declining breadth indicator with the lower equity market and we were not disappointed as it declined 50.59 for the week. Last week we were concerned about the new high for this indicator and our concern was confirmed as equities corrected and the breadth declined.

Baltic Capesize Index (BCI) 2677. Our long route dry-bulk shipping index declined another 463 points, or 15% by last Wednesday, before recovering 132 points on Thursday and Friday to finish the week off another 11%. We think this is one of the better indicators of slowing economic activity as it reflects slowing importation of some raw materials to China. For comparisons, this index was as low as 830 on December 3, 2008 and 1972 on April 7, 2009. Now that it turned higher, we need to see it continue and establish an uptrend. Until then, this caution flag continues flying. flag


Strategy

Last week, we expressed concern that the equity markets had risen too far too fast and were due for a correction. The correction is underway and now the question is how much lower it goes. The S&P 500 Index is right on the upward sloping trendline while our risk VIX futures and options premium indicators show less concern suggesting the trendline will hold and equities turn higher once again. We have doubts since crude oil broke its trendline and looks like it will continue lower. If so, the SPX will not hold this level and will follow crude oil lower.

On Friday, we sent a twitter tweet about closing our long iShares Russell 2000 Index (IWM) 59.83 long November 59/66 bull call spread. Since we are still expecting to see a higher high later in the year and because this correction could be brief, we decided not to attempt a hedging strategy deciding instead to close or rollout positions at risk .


Rollout Adjustments

Here are two positions in the current portfolio that could be at risk if the correction extends very far into October. We suggest closing these current positions and opening new ones further out in time.

Mylan, Inc. (MYL) 16.06. Mylan is the world’s third-largest generic drug maker.

From Digest issue 30 we were short a September 12 ½ put that expired worthless. The stock is uptrending off the low on July 27th at 11.66 and it looks as if it will continue higher. We still have the long October 15/17 ½ call spread, but want to rollout it out to November providing some more time in the event the market correction continues. Here are the closing trades.

MYL

The mid price on Friday was a credit (Cr) of 1.20 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be 1.18 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in the stock price or use the net spread delta for spread orders.

Here is the replacement.

MYL

The mid price for this spread on Friday was a debit (Dr) of .875as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .86 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in the price of the stock or use the net spread delta for spread orders.

Use a close below 15 as the SU (stop/unwind).

Sprint Nextel Corp. (S) 3.95. From Digest issue 35 this stock will most likely need more time to reach our objective. In addition, there continues to be takeover speculation that may have merit, but the October expiration is too soon. Here are the closing trades.

S

The mid price on Friday for one spread was a credit (Cr) of .20 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .18 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in the stock price or use the net spread delta for spread orders. The above table is for one spread and since we will be closing 5 spreads the total should be about .90.

Here is the replacement.

S

The mid price for one spread on Friday was a debit (Dr) of .30 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .31 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in the price of the stock or use the net spread delta for spread orders. Once again, this table is for one spread and since we will open 5 spreads, the total should be 1.55.

Use a close below 3.50 as the SU (stop/unwind).

IVOLopps™

United States Oil (USO) 34.00. The purpose of this ETF is to reflect the performance of the spot price of West Texas Intermediate (WTI) light, sweet crude oil by buying exchange traded current month futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels. When the futures prices are said to be in contango, meaning the deferred months are priced higher than the front month, the ETF is disadvantaged by the deferred month carrying cost as they roll the contracts forward near the expiration. Since the future price equals the spot price at expiration, the premium is always decreasing creating an advantage on the short side while the futures are in contango.

Crude oil is about ready to begin a seasonal decline and since it has closed below the active upward sloping trendline, we suggest a short call spread with a short put backspread combination as follows:

Part 1, the short call spread.

USO Part 1, the short call spread.

The mid price for this spread on Friday was a credit (Cr) of .72 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .68 as shown above in the “E Price” column. Use the deltas for each leg to adjust for the change in prices of the underlying or use the net spread delta for spread orders.

Part 2, the put ratio backspread.

USO Part 2, the put ratio backspread.

The mid price for this spread on Friday was a credit (Cr) of .05 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .11 as shown above in the “E Price” column. Use the deltas for each leg to adjust for the change in prices of the underlying or use the net spread delta for spread orders. Note the buy side is for 2 Nov 31 puts indicated by B2 or buy 2, so the prices and “Greeks” have been doubled in the table.

Use as close back above 36 as the SU (stop/unwind).

RT Spread Scanner

This next suggestion comes from our real time spread scanner set up to find vertical put spreads with a positive volatility advantage, defined as a lower implied volatility for the option purchased and higher implied volatility for the option to be sold.

Energy Conversion Devices, Inc. (ENER) 11.99. Energy Conversion Devices, Inc. is in the photovoltaic (PV), or solar energy business. The stock has been in a downtrend since April and will not likely find much support with declining crude oil prices. Here are the details from the scanner.

(ENER) details from the scanner.

The scanner results are based upon the ask price for the Oct 11 put purchased and the bid price for the Oct 10 put sold for a debit of .25 (.40-.15). When there is reasonable liquidity, some price improvement may be possible. As a spread order guideline, use the ask price for the option bought and then use half the differential between the bid and ask for the option sold, in this example it would be .175 reducing the debit to .225. Since these prices are based upon the Friday closing numbers the estimates for the Monday prices considering 3 more days of time decay can be calculated by using Theta shown in the table above. For the Oct 11 put the reduction is .05 to .35 (1.54 x 3) and the Oct 10 put is .03 to 14 (1.13 x 3) making our adjusted new spread price .21. In order to adjust for any change in the price of the stock use the deltas for each leg or use the net spread delta of -13.36 for spread orders.

For our portfolio record, we will record the purchase of 5 put spreads using the closing prices on Monday.

Use a close back above 14, the last pivot as the SU (stop/unwind).

Twitter Visit us on twitter for more ideas from our scanners and portfolio updates, including positions closed or unwound during the week. 

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In next week’s issue, the focus will remain on the technical condition of the S&P 500 Index and crude oil prices. In addition, we will begin considering the upcoming third quarter earnings reports.

Previous Issues and Reader Response Request

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. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com.

Comments:

price and e-price for the Part 2, the put ratio backspread. of uso are wrong. they are at least the double. thanks

Posted by JackieGL on September 28, 2009 at 10:18 AM EDT

I don't understand the USO Nov put ratio backspread, please elaborate. thanks much!

Posted by nathan on September 28, 2009 at 12:50 PM EDT

Nathan, Thanks for the request to clarify the USO put ratio backspread. For the Nov backspread, we are selling the Nov 34 put and buying two Nov 31 puts. On Friday, each Nov 31 put was prices at 1.20 so for two they total 2.40. Now about an hour before the close they are 1.025 so two total 2.05. The Nov 34 is 2.175 so our credit would be about .125. With the extra long call the position had negative Theta or time decay exposure so we will want it to go in our direction without a lot of time delay. Our negative theta is offset by the positive Theta in the short call spread in Part 1. If USO begins to accelerate to the downside then our positive Vega will also help as implied volatility rises. Jack

Posted by Jacktrader (72.193.214.145) on September 28, 2009 at 03:58 PM EDT


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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".