« September 2011 »

IVolatility Trading Digest™

Volume 11, Issue 36
Delta One

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Opportunities GaloreDespite being rocked once again by negative news from Europe, equities were somewhat better last week. While all of the details about Delta One have yet to be revealed, two thoughts come to mind. The first is, "Here we go again" followed by "Is there no adult supervision in the large banks?"

In this Digest, we review our market indicators followed by some strategy comments and then a hedge trade idea using the iShares Russell 2000 Index (IWM).



Market Review

S&P 500 Index (SPX) 1216.01. After forming a symmetrical triangle consolidation pattern that became an unusual reversal with the upside breakout on August 29, SPX is now in a range between 1136 and 1231. While we still think there is reasonable chance for it obtain the upside measuring objective from the consolidation pattern at 1258.07, we are concerned about the 1230.71 high reached on August 31, and since it is only 14.70 points away we are suggesting the implementation of an IWM hedge trade below.

E-mini S&P 500 Futures (ESU1) 1216.74. The September futures contract has now expired and based upon the preliminary CME report, the final open interest was 4.1 million contracts, compared to 3.5 million in June and 2.6 million in March. Since increasing open interest is needed to keep the trend intact this may be encouraging from a long-term trend view. The alternative explanation could be bearish since open interest has expanded since June as the market declined. We notice the high volume at both the August 9 and September 12 reversals and this support is encouraging for the bulls.

S&P 500 Index Implied Volatility (IVXM). Since our last market review, the Implied Volatility Index Mean decreased from 30.69 to 27.29, while the CBOE Volatility Index® (VIX) decreased from 33.92 to 30.98.

The table below shows the VIX Cash compared to the next two futures contracts as well as our calculation of Larry McMillan's day-weighted average between the first and second months.



For this short-term indicator the premium to the cash is a SPX sell signal indicating professional expectations for the cash to increase toward the futures price. This week at 2.86 is quite a bit more than last week at -7.40 and more than -2.05 in our last market review. It is also noteworthy that there are premiums in both front months for the first time in 7 weeks.

Readings above 20% have generally been a good indication of increased professional hedging in anticipation of an immediate decline while negative readings suggests complacency about protecting long stock positions by buying VIX futures contracts. While the current reading is not as high as we have seen in the past it is noteworthy for being the first positive premium since July 22 right before the recent dramatic decline.

Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium is always available. 

VIX Options

With a current 30-day Historical Volatility of 216.33 and 145.21 using Parkinson's range method, the table below shows Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon the closing option mid prices on Friday along with their respective month's futures prices.



Using the IV Index Mean of 84.98, the IV/HV ratio is .39, using the range method for Historical Volatility the ratio is .59. The VIX put-call ratio was .63.  

All of the Implied Volatilities along with the Historical Volatilities and Greeks for the VIX options based upon the Futures prices can be found on our Advanced Options page by clicking on the "market close" link shown near the top of the page.

CBOE S&P 500 Skew Index (SKEW) 123.27. When out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase. From our perspective, the SKEW continues to act more like a contrary indicator. 

US Dollar Index (DX) 76.54. The big change in the dollar index came on September 6 with the breakdown of the euro pushing the dollar higher and closing up 1.20 and above its range since April. DX now appears to have stopped its long decline and may be in the early stage of turning higher. If so and if recent correlations remain unchanged, a higher dollar will present a challenge for both equities and commodities, with precious metals being especially vulnerable.

iShares Barclays 7-10 Year Treasury (IEF) 103.99. The 10-year note, with a yield of 2.07 % appears to have broken the upward slopping trend line from the July 29 breakout. On Thursday, it gapped lower closing off .78 and below the trendline.

iShares Barclays 20+ Year Treasury Bond (TLT) 112.24. Now with a yield of 3.34%, the decline at the long end was not as noticeable as the 10-year note and Fridays close is right on the upward slopping trendline from the July breakout.  

NYSE McClellan Summation Index -205.22. Since our last market review, this NYSE breadth measure improved 84.90 points, with 101.64 points of the gain in the last week as breadth continues showing signs of slow improvement.   

iShares Dow Jones Transportation Average Index (IYT) 84.23. The transports are in the same pattern as the other major indexes and near the upper end of the current range where we think it is prudent to hedge.

iShares S&P GSCI Commodity-Indexed Trust (GSG) 33.40. GSG our proxy for the CRB Index is now up against the downward sloping trendline. If the dollar is about to turn higher along with dollar interest rates as we suggest above then this energy heavy commodity trust will have problems breaking out above the downward sloping trendline. See the chart below.






To complement our comment above about the UBS Delta One trading issue, here is a statement attributed to the Americans for Financial Reform, the incident "once again highlights a central problem with our financial system - that the largest banks have grown so big and so complex that even their own management cannot fully understand or control the risks they take."

While it may always seem to be the case, there are a few things in particular to be watching next week, including commodities, especially gold since it could be about to decline below its upward slopping trendline.

There are several events scheduled that should keep implied volatility high for the next two weeks.

Federal Open Market Committee is scheduled to meet on Tuesday and Wednesday and there has been much commentary about the possible implementation of "operation twist", the plan to sell short dated treasuries and buy longer dated issues. We think the rise in equities and short-term interest rates this week could be a case of buy the rumor and sell the news. Therefore, we suggest adding an equity hedge using an unleveraged equity ETF. 

Reuters reports the long-awaited commodity position-limits plan that was proposed to be voted upon by the CTFC on Thursday September 22, has been rescheduled for October 4

Back to Europe, on September 29, the German Bundestag or Parliament will vote on the European Financial Stability Facility and presumably, the rules and conditions Germany will impose for further debt support for European countries.

Due to fundamental economic uncertainty primarily in Europe, but also in the US we think volatility will remain high as reflected by the CBOE Volatility Index® (VIX®) for the next few weeks. Consequently, we suggest using options strategies that are short more options than long whenever possible to benefit as implied volatility declines.

Hedge the News

Based upon the theory that equities increased last week partly due to anticipating the Federal Reserve announcement on Wednesday after the FOMC meeting, and since they are back near the top part of the recent range, we suggest using another hedging strategy to insulate other long positions from the possibility they will sell off on the news. Further, we note our VIX day-weighted premium is positive for the first time in seven weeks and as we explain above, positive readings are SPX sell signals.  

iShares Russell 2000 Index (IWM) 71.52.

The current Historical Volatility is 54.13, while the range method Historical Volatility is 41.83, the Implied Volatility Index Mean is 37.99, down from last week at 45.59. Our near term forecast for IV is around the 30 level. The current IV/HV ratio is .70 and the put-call ratio is 2.50, but since it is used extensively for hedging, the put-call ratio is usually in the 2 to 4 range. Friday's option volume was 830,924 contracts with a 5-day average of 777,860 contracts however; Friday was options expiration so more volume could be expected. Since the bid/offer spreads are very narrow this is a good underlying to trade. Consider this put spread as a hedge idea.



With a reasonable volatility edge, the spread is 28% of the distance between the strike prices for a 2.6 to 1 risk to reward ratio, as the maximum risk is defined by the debit and the maximum gain is the difference between the strike prices, less the debit. The risk can be further minimized by setting a stop and for this trade we suggest setting the SU (stop/unwind) at 75, to allow some room in the event it exceeds the August 31 resistance at 73.89 and then turns lower to retest the lower end of the recent range.  

The suggestion above is based upon last Friday's closing prices using the mid price between the bid and ask. On Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.


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The FOMC meeting is most likely to be the highlight of the week and we think there is a good change any good news is already in equity prices. Further, the stronger dollar is creating weakness in commodity prices while gold is testing its uptrend.


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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".