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Today


IVolatility Trading Digest™


Volume 9, Issue 47
Dubai and Goodbye

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).
 

Dubai and Goodbye

If the markets stay focused on the Dubai debt issue we will likely be saying goodbye to “up” Mondays to which we have become accustomed. One alternative scenario includes Dubai being shrugged off as a debt restructuring issue with no systemic risk implications. For now, we don’t think there is enough information to reach an informed conclusion, except for a likely reduction in risk exposure. The answer to extent of the risk reduction should be apparent on Monday morning with the opening of the Asian markets. While we continue to be cautious and hedged, we offer a few more long ideas to consider. First, we have our market review and a portfolio adjustment.

Market Review

S&P 500 Index (SPX) 1091.49. After another substantial up move last Monday the net change at the end of the week was .11 but once again back below the important 1100 level. Subject to revision at any time, we maintain our upside objective at 1233.29 shown in our Head & Shoulders Bottom chart in Digest issue 36.

E-mini S&P 500 Future (ESZ9) 1089.50. For the week the December E-mini future contract declined .50 after spending three days above 1100. As expected for a holiday week volume was very light but open interest expanded by another 30,248 contracts through last Wednesday. The open interest numbers that will be available on Monday morning will be an important confirmation for the market since ESZ9 was lower by 19.50 points and a large decline in open interest will be a concern for the bulls.

S&P 500 Index Implied Volatility (IVXM). Our Implied Volatility Index Mean increased 2.42 to 21.57 while the VIX was higher by 2.66 to 24.85.

For the VIX futures, December at 24.05 was a .80 discount to cash or -3.2%. At 27.15, January closed at a 2.30 premium or 9.3%. Using Larry McMillan’s day-weighted average between the first and second months, we calculated the premium to be .28 compared to 2.29 for the prior week. When the futures are selling at a premium, they are indicating a sell signal and presumably, the strength of the sell signal and the market risk increases as the premium increases. Using this short- term measure the strength of the sell signal decreased at the end of last week.

The implied volatility of the VIX call options was higher by 2.11 at 78.11 and the puts were lower by .45 at 77.95. When adjusted to the futures prices the Dec 25 call implied volatility was 90.48 and the put was 94.15. The adjustments for January produce a call-implied volatility of 123.66 and a put implied volatility of 69.51. The current Historical Volatility is 117.94.

US Dollar Index (DX) 75.00. DX cash closed the week -.66 after declining as low as 74.28 on Wednesday and a 15-month low against the euro. The reversal on Friday was attributed to risk reduction due to the uncertainty created by the news from Dubai. Once again it is back into the range between 75 and 76 ½ that we suggested in Digest issue 42. The Dubai situation will likely encourage some further risk reduction and short covering that could extend into year –end book closing. If so, this will create a strong headwind for both equities and commodities.

iShares Barclays 20+ Year Treasury Bond (TLT) 96.40. The risk reduction trade was very evident in the long Treasury bond market as TLT rose 1.28 or 1.35%. At the weekend, the yield had declined 8 basis points from 4.29% to 4.21%.

NYSE McClellan Summation Index 393.78. After two weeks of recording small gains, our favored market breadth index turned lower once again declining 21.16 points. As we suggested in Digest issue 46 this is a sign of distribution and risk reduction as money is reallocated from small companies to those that offer greater liquidity in the event they need to be liquidated quickly. We continue flying the caution flag. caution flag

Baltic Capesize Index (BCI) 6352. Our preferred Baltic dry-bulk shipping rate index for the larger ships declined 1,190 points or 16% last week. We were expecting a retracement since it had increased 84% in the last 6 weeks. The decline in the Capital Link Tanker Index was a more modest 10.63 points or .49% to 2152.81.


Strategy

Will risk reduction continue on Monday? Comparing the S&P 500 Index to the US Dollar Index, here is the recent Monday record.

Comparing the S&P 500 Index to the US Dollar Index

If the problems in Dubai cause further risk reduction, we would not expect to see a lower dollar or higher S&P 500 Index on Monday, against the odds based upon the data in the table above.

The US Dollar Index remains the center of attention. If it continues higher, it will be a problem for equities and commodities. If it is lower on Monday then we would suggest implementing hedging strategies since the recent Monday gains have been given back later in the week.

Until we have a better understanding of the additional risk imposed by the Dubai problems, we suggest caution and remain hedged.

Portfolio Adjustment

PowerShares DB US Dollar Index Bullish (UUP) 22.26.

Here is an adjustment for a suggestion made in Digest issue 43 when UUP closed at 22.62. Since we want to maintain the dollar upside hedge we will roll out our long Dec 23/24-call spread to March.

First, the trade to close the 2 December spreads.

UUP

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 about .04 as shown above in the “E Price” column. The prices and Greeks shown above are based upon a single option so the values will be doubled for the call spreads. Use the deltas for each leg to adjust for any change in price of the underlying ETF or use the net spread delta for spread orders.

Then, the 2 March replacement trades.

UUP

The mid price for this spread on Friday was a debit (Dr) of .20 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be about the same as the time decay is offset by the spread and is shown above in the “E Price” column. The prices and Greeks shown above are based upon a single option so the values will be doubled for the two long call spreads. Use the deltas for each leg to adjust for any change in price of the underlying ETF or use the net spread delta for spread orders.

Use a close below the last pivot at 22 as the SU (stop/unwind).

IVOLopps™

Here is an idea that should be less sensitive to the dollar and the market direction.

Origin Agritech Limited (SEED) 11.00. Beijing based SEED received approval for of the world’s first genetically modified phytase corn seed.

The stock gapped up 1.64 at the open last Monday on 45.5 million shares and the Implied Volatility Mean Index rose to 114.57 from 66.14 last week. The rising volatility created a rush to buy stock and sell calls with higher implied volatility. One alternative we favor is to start the process by selling a put with higher implied volatility. If it closes below the strike price on expiration the assigned stock is then used to sell covered calls.

With a current Historical Volatility of 209.02 and the Implied Volatility Mean Index at 114.57 and now likely to decline, consider this put sale as step one of the process.

SEED

The mid price for this put sale on Friday was a credit (Cr) of 1.05 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .96 as shown above in the “E Price” column. The other “Greeks” are also based upon Friday numbers, before the position is established, and will reverse when the put is sold. Use the delta as shown above to adjust for any change in the stock price.

Conditional Put Sales

Here are two more put sale ideas, but these are more sensitive to the dollar and the market direction. If we have another weak dollar on Monday with another substantial market gain, we suggest waiting until later in the week for a likely pull back before implementing these suggestions.

IAMGOLD Corp. (IAG) 18.68. IAG is a Toronto based mining company exploring for and producing gold, silver, zinc, niobium, diamonds, precious metals, and copper. The company holds interest in seven operating gold mines, a niobium producer, a diamond royalty, and exploration and development projects located in Africa and the Americas. The stock recently rose from 13 when they reported earnings on November 4, 2009 and then pulled back Friday on the Dubai news and risk reduction activity.

With a current Historical Volatility of 70.42 and with an Implied Volatility Mean Index of 65.16 consider these put sale ideas. Since we are in period of seasonal strength for gold, we suggest any open gold position be closed on the first sign of weakness in late December. The first suggestion is a December put and it will expire before the end of the seasonal strength period, but the second should be closed when the stock begins to show signs of weakness.

Here is the December suggestion.

IAG

The mid price for this put sale on Friday was a credit (Cr) of .625 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .56 as shown above in the “E Price” column. The other “Greeks” are also based upon Friday numbers, before the position is established, and will reverse when the put is sold. Use the delta as shown above to adjust for any change in the stock price.

Here is the January alternative.

IAG

The mid price for this put sale on Friday was a credit (Cr) of 1.175 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be 1.13 as shown above in the “E Price” column. The other “Greeks” are also based upon Friday numbers, before the position is established, and will reverse when the put is sold. Use the delta as shown above to adjust for any change in the stock price.

We suggest using a close below the support at 16 as the SU (stop/unwind). In late December, we suggest using the first signs of weakness to close the January short put. This could be done using a trendline, short term moving average, or even a relative strength or stochastic indicator.

Mercadolibre, Inc. (MELI) 48.59. Based in Buenos Aires, MELI hosts online commerce and payments platforms in Latin America. With a current P/E ratio of 72 and a forward P/E of 44 this is a momentum stock not likely to be favored by value investors. In the last quarterly report, their earnings accelerated from .12 to .22 and the stock increased from 35 to almost 50. Friday on the Dubai news, it sold off by .79 providing an entry point.

With a current Historical Volatility of 59.40 consider this put sale as a trend continuation trade

MELI

Here is the January alternative.

MELI

The mid price for these put sales on Friday are shown in the “Price” columns above. Adjusting for time decay the estimated prices on Monday should be as shown above in the “E Price” columns. The other “Greeks” are also based upon Friday numbers, before the positions are established, and will reverse when the puts are sold. Use the deltas as shown above to adjust for any change in the stock price.

Use a close below the support at 42 ½ as the SU (stop/unwind).

Summary

In light of the Dubai developments, risk reduction could become the predominant consideration replacing the need for performance going into year-end. Since we do not think Dubai will be resolved quickly and if the markets perceive systemic risk (unlikely), the affect could linger. Until we have a better understanding on how the markets will react, we suggest caution and hedging is the game plan. Monday will give us a better reading of the market sentiment.



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In next week’s issue, we will continue evaluating the struggle between year-end performance and risk reduction.

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.

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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".