« November 2011 »

IVolatility Trading Digest™

Volume 11, Issue 46
Thanksgiving Week Record

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Usually when the financial media mentions record events, they refer to new highs or other positive developments. However, last week it was to draw attention to the worst Thanksgiving week on record for equities. Once again, the culprit was Europe and the news S&P lowered Belgium's credit rating and that Greece is demanding private investors write off more of their sovereign debt. While Europe is a never-ending saga of negative news, we have a somewhat abbreviated update of our market indicators and then offer two new trading ideas.


Market Review

S&P 500 Index (SPX) 1158.67. We wrote last week "the break down below the consolidation triangle creates a new downside-measuring objective at 1163, which could become the missing right shoulder of a Head & Shoulders Bottom that we had been expecting in the later part of October." Since the objective has been reached, the logical question is what to expect now that the potential Head & Shoulders Bottom is in place. First, we should mention the triangle-measuring objective of 1163 was a minimum. Second, market sentiment needs to decline further before we are likely to see the market reverse and turn higher. We have an estimate in the Strategy section below.    

S&P 500 Index Implied Volatility (IVXM). Since our last market review, in Digest Issue 44, the Implied Volatility Index Mean increased from 25.60 to 31.44, while the CBOE Volatility Index® (VIX) increased from 30.04 to 34.47.

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.



The day weighting applied 68% to the December contract and 32% to January resulting in the average premium of .38 or 1.11% shown above. An alternative volume weighting between December and January results a 1.07% premium.

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. Last week it was also a premium of 1.62%, compared to premium of .93% in Digest Issue 44, our last market review based upon November 11 closing prices. The relatively low premium level probably reflects a lack of enthusiasm to push the VIX futures higher for portfolio protection.

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

VIX Options

With a current 30-day Historical Volatility of 159.24 and 86.05 using Parkinson's range method, the table below shows the 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, since the options are priced from the futures.



Using the IV Index Mean of 101.29, the IV/HV ratio is .64 using the range method for Historical Volatility the ratio is 1.18 while the VIX put-call ratio at 1.00 is bearish for the S&P 500 Index.

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) 114.77. When out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase. It seems as SPX declines into what could become a right shoulder the SKEW would be increasing, but for now it is declining. From our perspective, the SKEW continues to act as contrary indicator.

US Dollar Index (DX) 79.69. If this were the only measure available to reflect the "risk-off" sentiment of the market due to European debt agony, it would do a good job of showing the flight out of the euro that began on October 31. In a more normal environment, technical analysts would now be expecting a reaction near the former October 4 high at 79.84, but since European events are the driving forces many of the usual technical tools are not very helpful.

The Treasury note and bond prices are also being whipped around by cash moving into "risk-off" then "risk-on" positions and then back to "risk-off”"once again.   

NYSE McClellan Summation Index 296.30. After painting an improving picture for equities in our last Digest, the NYSE breadth has materially deteriorated, declining 451.33 points reflecting once again the sudden return to "risk-off". 



StrategyUsing a weekly chart of the S&P 500 Index here is the long-term trend update from the March 2009 low.  


From a trend perspective, using the upward sloping trendline from the March 2009 low the S&P 500 Index remained in positive territory until the August 2 decline. It then attempted to return to the trend rising to 1292.66 on October 27 before retreating once again. If it finds support above 1100 in the next few weeks then the stage will be set for a potential Head & Shoulders Bottom. Of course, there is always the risk more negative European news will take it below 1100 so this next leg down to test 1100 will be very important. 

One way to measure when the current decline could be ending is to look at the sentiment indicators and compare them to those at the October 4 low that could become the potential Head of the Head & Shoulders Bottom. There are several services offering sentiment data, including the Investors Intelligence weekly survey of independent newsletter editors. Another good source that is available without a subscription is the weekly AAII Investor Sentiment reading. The most recent AAII reading as of November 23, was 32.7 bullish and 38.3 bearish for a negative spread of -5.60. On the closest date before the October 4 reversal the reading was 32.51 bullish and 46.79 bearish, for a negative spread of -14.28. Based upon this the negative sentiment should increase before a reversal could be expected.

Another sentiment measure that is available daily is the NYSE Bullish Percent Index. Now at 44.50, at the October 4 low the reading was 17.03. See the chart below with our estimate indicted by the line at 30 for the minimum expectation.



If a Head & Shoulders Bottom pattern is to develop we would expect the see the bullish percent begin improving before reaching the October 4 low at 17.03 shown above. Based upon the shape of the potential Head & Shoulder Bottom pattern it appears a sentiment reversal around the 30 level would be about right.

Quarterly Earnings Report

Another notable earnings report is due on Wednesday before the opening.

SeaDrill Limited (SDRL) 31.14. Hamilton, Bermuda based Seadrill is an offshore drilling contractor, providing offshore drilling services to the oil and gas industries worldwide. As of March 31, 2011, the company owned and operated 54 offshore drilling units, consisting of drill ships, jack-up rigs, semisubmersible rigs, and tender rigs for operations in shallow and deepwater areas, as well as in harsh environments. With Norwegian management, they are active in the North Sea.

The consensus estimate of .72 per share would produce a price-to-earnings ratio of approximately 11 with a price-to-earnings growth ratio of one.  

The .75 quarterly dividend rate annualized yields a 9.6% return at the current stock price and there are no indications the current dividend rate will be reduced. However, with indications that the global economy is slowing management comments and guidance on Wednesday will be closely scrutinized.  

The current Historical Volatility is 36.71, while the Parkinson's range Historical Volatility is 24.48. The Implied Volatility Index Mean is 44.71 for an IV/HV ratio of 1.22 and 1.83 using the range method. The put-call ratio at .29 is bullish. 

Since the rising implied volatility appears to be higher along with the market more than due to the upcoming earnings report we think this could be an opportunity for straddle. 



For this report, the strategy is to be long on both sides. If there is a surprise, it is more likely to be on the downside. By using the January options, we reduce the amount of implied volatility loss that will occur when they report. We suggest closing the position by Friday after the report as any price adjustment will likely be quick. 

Short Idea

Since the market is not currently in an uptrend as defined by our upward sloping trendline described above we are willing to consider short ideas. Here is one.

Diamond Foods, Inc. (DMND) 27.04 processes, markets and distributes snack food products.

While Diamond is attempting to complete the acquisition of Pringles from P&G accounting issues and even possible fraud are in the news raising many questions. For those who are inclined to sell whenever they hear accounting issues here is an idea.

The current Historical Volatility is 104.98, while the Parkinson's range Historical Volatility is 62.85. The Implied Volatility Index Mean is 140.36, up from 96.03 last week for an IV/HV ratio of 1.34 and 2.06 using the range method. The put-call ratio at 1.50 is bearish.



Use a close back above 35 as the SU (stop/unwind).

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. 

Since the holiday season is approaching, we are again offering special discounted rates on our data services. Here is more information about how to acquire your customized data service to help find those special volatility events and other advantageous trading ideas. 


IVolatility’s Holidays Special Offer



Although the usual technical indicators are being whipped around by developments in Europe, it does appear equities could be in the process of making a bottoming formation. The process would be greatly accelerated if there were any positive developments reported from Europe in the next few weeks.


IVolatility.com Bookstore  In addition to the vast number of articles and other information on our web site, take a browse through our bookstore for more reference information and material.

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In next week's issue, we will review our market indicators and offer some more option trading ideas.


Finding Previous Issues and Our 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.

Next week’s 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 us to look at a specific stock, ETF or futures contract, 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".