« May 2012 »

IVolatility Trading Digest™

Volume 12, Issue 22
Bear Slide

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Last week in Digest Issue 21, we laid out the bear market case and made some suggestions about where it might end. Here is another thought to keep in mind as the bear slide progresses.

"Never buy anything until the whole market has
demonstrated its ability to ignore bad news."
Fred C. Kelly, How Shrewd Speculators Win, 1932

Usually there are few exceptions such as takeovers or special situations and this is our focus along with a put spread idea for gold.



StrategyS&P 500 Index (SPX) 1317.82. While not implying a multi-year bear market that would take the major indexes below their March 2009 lows we do think there is a good chance SPX will test 1200 before this decline is over. In the meanwhile, we update the takeover file and look for some new ideas.

First, to get a sense of what the professional hedgers are doing here are the VIX futures premiums.

S&P 500 Index Implied Volatility (IVXM). Last week, the Implied Volatility Index Mean declined from 22.28 to 19.39, while the decline for the CBOE Volatility Index® (VIX) was from 25.10 to 21.76.    

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 June and 32% to July resulting in the average premium of 3.29 or 15.10% shown above. Our alternative volume weighting between June and July results in a 15.35% premium, both are slightly higher than last week readings of 12.33% and 12.88%. 

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. In the past premiums in excess of 20%, have usually preceded corrections, although not a precise timing tool it does appear to be a good way to measure professional hedging sentiment. On this decline, the VIX premium indicator has been failing miserably, especially since SPX closed below our trigger point on May 9.



Takeover File

While there have been several new deals announced in the last few weeks most are not very good option strategy candidates since the options volume is low and the implied volatilities are not suggesting prices are rising. This is usually a sign that the deals are uncontested and will likely close at the initial announced price. However, for two there have been new developments.

Amylin Pharmaceuticals, Inc. (AMLN) 27.96. Amylin seems to have successfully put itself up for auction after rejecting the initial offer by Bristol-Myers Squibb. There were reports saying both Sanofi (SNY) and Merck (MRK) have put in first round offers that were are least 25. In addition, more offers are expected from Takeda Pharmaceuticals and Pfizer (PFE). As a result, this one looks alive and well.

The current Historical Volatility is 54.76 and 35.76 using the Parkinson's range method, with an Implied Volatility Index Mean of 50.93 down from 64.57 last week. The IV/HV ratio is .93 and 1.42 using the range method to calculate the HV. Friday's put-call ratio was bullish at .50 while the volume was 51,796 contracts traded compared to the 5-day average volume of 19,850 contracts. The rising volume confirms the renewed confidence that a higher offer could be made.

Originally suggested in Digest Issue 14 and updated in Digest Issue 18 here is a put sale idea to decrease the cost of the two outstanding call spreads from the previous suggestions.



With a good implied volatility edge and since it could still take quite some time for this to be finally resolved this put sale should help to reduce the cost of the spreads and assuming the final deal is for more that 27 the results will be favorable. The risk is a close below 25 at the July expiration. In that event, be prepared to receive the stock by assignment.

Human Genome Sciences Inc. (HGSI) 13.61. As we detailed in Digest Issue 18 the options are not showing much enthusiasm for a higher price after HGSI rejected GlaxoSmithKline's offer to acquire the company for 13 per share in cash and this continues to be the situation.

The current Historical Volatility is 198.68 and 28.56 using the Parkinson's range method, with an Implied Volatility Index Mean of 54.48 up from 48.88 last week. The IV/HV ratio is .27 and 1.91 using the range method to calculate the HV. Friday's put-call ratio was bullish at .27, but the volume was only 2,992 contracts traded compared to the 5-day average volume of 11,570 contracts, which hardly suggests there was a rush to get positions on last Friday.

If you believe from a fundamental viewpoint, as at least one analyst does, that GlaxoSmithKline (GSK) will increase its offer modestly to get this deal done here is another put sale that will further reduce the cost of the June 15/16 call spread suggested in Digest Issue 18.



While there is a good implied volatility edge in this put sale, if Glaxo withdraws the offer this stock is likely to decline quickly to at least 10, so the only real risk management technique available is to limit the position size.

Ariba Inc. (ARBA) 45.22. SAP AG (SAP) announced it intends to acquire this online B2B e-commerce company for 45 per share or 4.3 billion, an 18% premium. SAP says it expects to close in Q3 and be accretive to earnings in 2013.

The current Historical Volatility is 66.19 and 49.62 using the Parkinson's range method, with an Implied Volatility Index Mean of 9.88 down from 47.07 last week. The IV/HV ratio is .15 and .19 using the range method to calculate the HV. Friday's put-call ratio was bullish at less than .30, and the volume was 11,253 contracts traded compared to the 5-day average volume of 10,020 contracts.

While most of the activity was in the June and July 45 calls there was very little volume in the 50 calls and since the implied volatility has collapsed from 47.07 to 9.88 this looks like an uncontested deal that will most likely close on the terms announced.

While we don't have an options suggestion, we included it as an example of what the options data looks like for a deal that is likely to close. Notable is the lack of call buying at a higher price and the dramatic decline in implied volatility from 47.07 to 9.88.  




SPDR Gold Shares (GLD) 152.68. The SPDR Gold Trust, issues SPDR Gold Shares, representing units of fractional undivided beneficial interest in and ownership of the trust holding gold.

The euro is declining and the dollar is rising due to problems in Europe. As a dollar alternative, gold declines as the dollar rises. If the European problems continue, which now seem very likely gold should continue declining.  

From a technical perspective, the recent price bounce from just below 150 to 155 and then the retracement to 152 appears like the formation a symmetrical triangle continuation pattern implying it is likely to continue lower after completing the pattern by closing below point 3 on the triangle at 148.84.

Therefore, assuming it continues lower we want to use a put spread such as this one.



Without a significant implied volatility edge, the debit is 30% of the distance between the strike prices providing a risk to reward ratio of 2.4 to 1. Use a close back above 155 as the SU (stop/unwind). 


All of the suggestions above are based upon last Friday's closing prices using the mid price between the bid and ask. On Tuesday, the option prices will be somewhat different due to the time decay over the weekend and any price change.


"Options data with predictive qualities - Nobody does it better!"

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After the oversold bounce last week equities along with gold appear to be in the process of forming symmetrical continuation patterns implying there is more downside yet to come as the prices break below the lower pattern boundaries. Accordingly, we suggest more hedging of long positions and more shorts.


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In next week's issue, we will review all of our market indicators and report on the progress of the continuation patterns working in the equity and gold markets.


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. Another way to find them is the Table of Contents link in the blog section of our website.

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




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".