« October 2011 »

IVolatility Trading Digest™

Volume 11, Issue 41
60% Greek Haircut

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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European leaders will now meet twice, first on Sunday and then again Wednesday, in an effort to find a comprehensive strategy to solve the debt crisis that began in Greece. Several issues remain to be resolved including how much to reduce Greek debt. In the meanwhile, the US is in the middle of the third quarter earnings report season so both promise to keep volatility high for the near future, creating an interesting selection of trading ideas. After a few brief strategy comments, we offer several earnings report and volatility trade suggestions.




StrategyWith the details of the European rescue plan still being negotiated over the weekend including the "haircut", we expect some details will be released after the scheduled meeting on Wednesday, but think volatility will remain high until the G20 summit meeting in Cannes on November 3-4, as it seems like this is going to be the real deadline date.

As for the S&P 500 Index (SPX) 1238.25, with the breakout above the August 31 resistance high at 1230.71, it now appears less likely there will be another decline to retest 1100 as a part of a potential developing Head & Shoulders bottom pattern. However, we note the S&P 500 Index will often exceed support and resistance areas only to quickly return to them. Accordingly, unless there are some positive developments reported from Europe soon we could still see the retest.

For the VIX futures, the day weighting applied 85% to the November contract and 15% to December resulting in the average premium of .04 or .13%, compared to 4.07% last week in Digest Issue 40.
For this short-term indicator the premium to the cash is a SPX sell signal suggesting professional expectations for the cash to increase toward the futures price.

Because volatility is likely to remain elevated for some time, we suggest using option strategies that benefit from higher volatility, those combinations that have more short options, such as ratio spreads, short straddles and strangles, and put sales as long proxies.

On a relative basis, since the technology group has been doing better than the broad market averages we suggest it could be the time to consider some if the tech stocks, as they seem to have the seasonal advantage giving them a boost. We have one idea below.


Quarterly Earnings

ARM Holdings plc (ARMH) 26.88. UK based ARMH designs and licenses high performance, low-cost, power-efficient RISC microprocessors and related technology and software.

Scheduled to report earnings on Tuesday before the opening the consensus estimate is .10 per share, compared to .03, last quarter.  

The current Historical Volatility is 43.53 and 36.24 using the Parkinson's range method, with an Implied Volatility Index Mean of 62.70, up from 55.44 last week. The IV/HV ratio is 1.44 and 1.73 using the range method, with the put-call ratio at a very bearish 3.0. Friday's option volume was 22,103 contracts compared to the 5-day average of 12,070 contracts, with 8,096 November 28 puts traded which were most likely responsible the increasing implied volatility. Apparently, somebody is expecting the earnings report to disappoint.

Since they are one of the leaders in hand held device design consider this put sale back down at the previous support.



In the event to stock is below 24 on the November expiration be prepared to take it by assignment and then sell calls against the long stock position.

Netflix, Inc. (NFLX) 117.04. Netflix Inc. is the largest online movie rental subscription service in the US providing access to a library of more than 18,000 movies, television and other filmed entertainment titles.

Scheduled to report Monday after the close the consensus estimate is .96 per share and the whisper number is .99 per share.

In the last three months, this stock has declined 66% from 304.79 after announcing proposed changes to their subscription plan that was then cancelled.

The current Historical Volatility is 88.65 and 77.20 using the range method, with an Implied Volatility Index Mean of 90.06, up from 87.25 last week. The IV/HV ratio is 1.02 and 1.17 using the range method with a bullish put-call ratio of .47. Friday’s options volume was 122,626 contracts compared to the 5-day average 78,560 contacts.

Since the stock seems to have found support just above the 100 level, consider this short- term straddle combination with a long call to protect the upside.



With only four days to expiration after reporting, the implied volatility is likely to decline very rapidly. There are two break-even points, the first at 86.94 and the second at 133.06 as shown in the risk profile below. Using the ATM implied volatility of 136 the lower breakeven is well below the expected limit, while the upper is close. However, we are not expecting the stock to move at this rate after reporting.



Green Mountain Coffee Roasters Inc. (GMCR) 67.85. This company is in the specialty coffee and coffee maker business.

Scheduled to report on Wednesday, it currently sells at a price-to-earnings ratio of 66 with a forward ratio of 26 and a price-to-earnings growth ratio of 1.10 according to Yahoo! finance.

David Einhorn of Greenlight Capital recently released a 110-slide presentation as to why he thought the company was overvalued when it was near 100. It crossed our upward sloping trendline around 90 and without getting into the details presented by David Einhorn, it appears there is more downside yet to go. 

The current Historical Volatility is 67.64 and 76.65 using the range method, with an Implied Volatility Index Mean of 105.45, up from 82.00 last week. The IV/HV ratio is 1.56 and 1.38 using the range method with a bearish 1.05 put-call ratio. Friday’s options volume was 54,931 contracts compared to the 5-day average 86,770 contacts.

Consider this put spread idea.



With a reasonable volatility edge and at 29% of the distance between the strikes it represents a good risk to reward ratio. Use a close back above 80 as the SU (stop/unwind).


Takeover File Update

Yahoo! Inc. (YHOO) 16.12. YHOO is a digital media company in the process of reorganizing or perhaps being sold. The stock price is up on news that Jack Ma and others including Microsoft may be interested in the company as they explore the possibility of selling their interest in Yahoo Japan.

Better than expected earnings of .21 were reported on October 18 and the stock initially sold off, only to quickly recover.

For those who may be wondering why we are repeating this suggestion for the fourth time it is because it keeps coming up in our active call scan as one of the stocks with the highest call activity. Then on Saturday AP reports Google is exploring the possibility of helping to finance a possible deal by others to acquire the company according to a report published report by the Wall Street Journal.

The current Historical Volatility is 47.87 and 43.21 using the range method. The Implied Volatility Index Mean is 57.98, down from 70.44 last week, for an IV/HV ratio of 1.21, but 1.34 using the range method. The put-call ratio is extremely bullish at .27 as there were 3.75 times more calls traded than puts and there were 15 call strikes with more than 2,000 calls traded. Friday's volume was 236,563 contracts compared to the 5-day average of 262,250 contracts.

Here is another call spread combination updated for the higher prices, but otherwise similar to the ones suggested in the previous four Digest issues.



Use a close back below the last pivot at 13 as the SU (stop/unwind) or be prepared to take the stock by assignment in the event it closes below 15 on the November expiration. If so, then the plan is to sell calls against the stock position. If the November put expires out-of-the-money then sell the December 15 put and then once again in January reducing the call spread cost each time. If the stock gaps up on Monday due to the recent Google news then it may be necessary to adjust the spread strikes higher in order to obtain a ratio near 30%.

Here is another idea from one of our contributing authors that takes a somewhat different approach to high volatility trading.

Dave's Corner

High HV/IV Ratio

Morgan Stanley Volatility Looks Attractive Ahead of the EU Summit.

The binary nature of the capital markets has made it difficult to pick solid individual equities or commodities in the face of the EU summit on Sunday.

The EU has set a self-imposed date, to come up with a grand solution on how to deal with the peripheral countries debt and this headline risk in the past week has made directional trading very difficult.

The banking sector seems to have been most affected by the uncertainty as many banks have substantial exposure to European sovereign debt. In some European countries, restrictions have been implemented to disallow shorting of these stocks, which has spilled over into US financial institutions. If Europeans are unable to short their bank stocks, they can still short banks in the US markets.

Some US banks have been beaten down based on low earnings expectations, some of which were released during the past week. Investment banks, Morgan Stanley and Goldman Sachs both beat expectations after being reduced significantly earlier in the third quarter.

Since volatility is likely to remain high and premiums are significantly higher than their historical long-term averages, we want to find an opportunity with some protection against volatility, while maintaining the trade potential. One way is to use an instrument where movement of the underlying is greater than the implied option price.

When the 30-day historical volatility is greater than the implied volatility, there is an opportunity to make money by delta hedging the position as the market chops up and down.

Morgan Stanley (MS) 17.02.

After reporting better than expected earnings of 1.14 last Wednesday, the implied volatility has declined in line with many of the other financial institutions. The current level near 64% is relatively high when compared to the longer-term moving average near 45%. Despite the relatively high IV the historically volatility of the stock is even higher, with the current 30-day historical volatility near 90%. This means a delta hedger could have earned back most of the premium during the past 30 days. The low implied volatility to historical volatility ratio makes MS an interesting long straddle candidate.

With MS is at the upper end of its recent trading range here is a delta neutral idea. Purchase a straddle using the November 17 strike, buying both the call and put. Using the offer prices quoted, the straddle settled at 2.41.  





If MS breaks through the highs, look to delta hedge near 18. If it breaks down, buy shorts back near 14.75. If implied volatility breaks through the 55% level on the downside, stop out of the trade. Look to take profit on implied volatility near 80%. 

All of the suggestions above are 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.



The combination of an uncertain outcome to the summit meetings in Europe along with a large number of earnings reports scheduled to be released this week is likely to keep volatility high as the S&P 500 Index tries to sustain its breakout from the recent trading range.


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In next week's issue, we will review all of our indicators and update the status of the S&P 500 Index breakout.


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nflx has not trade at 117.04 since aug 1 don't know what you mean. good call on armh

Posted by eric on October 27, 2011 at 11:29 AM EDT

Eric, Thanks for the NFLX comment. I went back and double-checked the chart and it sure looks as if it closed at 117.04 on October 21. However, the suggested trade will likely result in a loss when the options expire on Friday if closed out. However, if the short 90 put is kept and assigned this will mean a long stock NFLX position with a basis of 86.79, about 5 points lower that the current price. In this situation look for a place to sell an out-of-the-money call against the long stock. ARMH should do better with some seasonal help and improving market sentiment. Jack

Posted by Jacktrader ( on October 27, 2011 at 03:09 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".