« March 2010 »

IVolatility Trading Digest™

Volume 10, Issue 12
Bond Market Vigilantes

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Bond Market Vigilantes

After a long absence, there was some evidence last week that the “Bond Market Vigilantes” are indeed alive and once again expressing their anxiety and displeasure with the endless supply of sovereign debt offered, including US Treasury Bonds. While the bond market is beginning to show signs of being underwater equities continued higher as volatility turned somewhat higher. After a brief strategy update we offer a few trading ideas for consideration.


S&P 500 Index (SPX) 1166.59. Last week SPX continued cautiously higher but the expected retracement back down to the previous January 19, 2010 high at 1150.45 was not completed. In order to continue higher it will need to make an effort to retest the breakout and so far, there is little evidence of the retest.

The VIX futures weighted premium now reading 15.23%, down from 20.09% in the previous week suggests less VIX hedging despite the expected retest of the breakout. For reference, the calculated futures premium over the cash was 21.7% on January 8, 2010 just before the last major top.

Once the retest is completed SPX is expected to continue to our upside measuring objective at 1233.29 described in Digest Issue 1 dated January 11, 2010.

As implied volatility now appears to be increasing, the strategy is to use positions with long volatility on the expectation it will continue increasing. Long volatility examples include positions with more long options than short options, such as call and put ratio backspreads, straddles, strangles, and even spreads with net long vega. In addition, since quarterly reporting will soon begin increasing volatility is likely.


Long Euro

Last week’s suggestion for a long euro position was a week too soon. Now that a support package for Greece appears to have been completed chances are the euro should rebound somewhat. Here is a replacement euro long call spread idea.

CurrencyShares Euro Trust (FXE) 133.80. The Historical Volatility is now 9.55.


Use a close below the last pivot at 132.37 as the SU (stop/unwind).


Las Vegas Sands Corp. (LVS) 21.89. The firm Sanford C. Bernstein increased their price target to $24 from $22 while maintaining an “outpeform” rating. We last suggested LVS, in Digest Issue 6, when it was 16.81. The current Historical Volatility is 57.90 and the Implied Volatility Index Mean is 59.06 with a put-call ratio at a moderately bullish reading of .5.

On the Bernstein upgrade, the stock broke out above 20 and is now subject to a pull back and retest of the 20 level. One alternative is to wait for the pull back to be completed the other is to use options with enough time before expiration for the pull back to be completed. Since the pull back could be quick, we suggest there is very little risk in opening the position now while reducing the change of missing the rebound from a quick pull back.

Consider this combination of a long call spread and a short put.


The long call spread part of the trade at a debit of 1.17 is reasonably priced at 33% of its maximum 3.50 value. Since we are selling a call with a lower implied volatility than the call we are buying we are giving up some edge, but we offset it with the short put, which has a higher implied volatility. In addition, the short put gives the trade some positive time value to offset the negative time value of the long call spread. While the position indicates it could be done with a net credit, there is an estimated initial margin requirement of $623.

Since trade plans should include stop level we will set the SU (stop/unwind) at a close back down below 18, a level that has provided support on several previously occasions. However, in the event this stock closes below 18 at the June expiration we may want to take the stock by assignment and then sell calls against the long stock since the options should continue to have an attractively high-implied volatility.


Lockheed Martin Corporation (LMT) 84.24. After trending upward from about 75, LMT has pulled back from the 87.50 level. The calls along with others in defense group were active Friday perhaps on the news about the sinking of the South Korean Naval Ship, Cheonan, off the coast near North Korea.

Currently the Historical Volatility is 14.31 and the Implied Volatility Index Mean is 22.80 up from 20.00 in the last week.

In the event to implied volatility remains high on Monday consider this put sale with a positive volatility spread between the Historical Volatility and the Implied Volatility.


Use a close back below 82.50 as the SU (stop/unwind).

Cliffs Natural Resources Inc. (CLF) 71.26. Cliffs continues to trend higher in anticipation of a new quarterly iron ore pricing system being discussed. The new pricing has yet to be determined, but they most likely to be considerably higher than the current contract price of $60 per ton and could be closer to the spot market price of $143 per ton.

With a current Historical Volatility of 78.46 and an Implied Volatility Index Mean of 52.16, the current put-call ratio is a bearish 1.5, suggesting hedging activity.

Consider these put sale ideas with strike prices a good way below the current price.


Use a close back below the 60 level as the SU (stop/unwind).

High IV/HV Ratio

Delcath Systems Inc. (DCTH) 7.26. In the high IV/HV ratio category we find an emerging market medical device maker, that is developing a regional treatment system for cancer in the liver. Their Percutaneous Hepatic Perfusion (PHP) technology allows physicians to deliver significantly higher doses of existing chemotherapy drugs to the liver without exposing each patient's entire body to the anti-cancer drugs, representing an better solution that promises to increase the effectiveness of approved anti-cancer drugs while reducing systemic side effects. They are expecting important study results to be released sometime in April.

The current Historical Volatility is 47.37 with an Implied Volatility Index Mean at 176.25 and a bullish put-call ratio of .30. Consider this long call spread and short put combination.


This is also an event trade so there is little reason to set a stop since the stock will make most of its move at one time when the test results are announced. In the event the results are unfavorable, the only real effective risk management tool available is to limit the position size.

Takeover File

Takeover File

RadioShack Corp. (RSH) 23.65.

RadioShack returns after being included in the Takeover File in Digest Issue 10 when it was 22.87. The volatility has increased somewhat on speculation that Best Buy Co. Inc. (BBY) 43.16 may have an interest in the company. The April 25 call was active and there was some buying of the May 25 call but there was not much activity in the other months or strikes. The lack of significant option volume in May is not very encouraging for those who speculate a deal may be announced soon.

The put-call ratio has improved to a more bullish reading of .5 as the Historical Volatility increased to 45.76 as the stock gapped open on Friday. The Implied Volatility Mean Index is now 49.42 compared to last week’s 39.87. If a deal was close to being agreed we would expect to see a higher level of implied volatility. Nevertheless, an implied volatility above 40 is usually worth considering.

Consider this put sale suggestion to add to the long call spread suggestion made in Digest Issue 10.


Use a close back below the support at 21 as the SU (stop/unwind).

The Talbots Inc. (TLB) 11.48.

Talbots is currently in the process of being merged with BPW Acquisition Corp. (BPW) 11.14.

With a current Historical Volatility of 33.93 and an Implied Volatility Mean of 83.61 along with a bullish put-call ratio of .58, the options should be selling for less unless there are concerns that the deal may not be completed in its current form. Indeed trading in the Apr 12.5 and 14 calls indicates speculation that a higher price is expected.


While the merger arbitrage business is difficult, the elevated level of implied volatility and options activity suggests there is more to this story even though it appears to be in the late stages of being completed. Here are two put sale idea for those who may want to try some merger arbitrage.


Use a close back down below 10 as the SU (stop/unwind), although if the deal looks like it is going to fall apart it may not help much since the stock would most likely decline rapidly back to about 6 making an exit difficult. Therefore, as an added risk management precaution we suggest keeping the trade size small.


While waiting for the S&P 500 Index to complete a retest of the breakout there are some special situations worth considering. As the second quarter earnings reports begin, volatility is likely to begin increasing.

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In next week’s issue, our detailed market review will update the status of the S&P 500 Index and its progress in retesting the breakout above 1150.

Previous Issues and Reader Response Request

Finding Previous Issues and Our Reader Response Request

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Any idea what the SPX will be retesting before it continues to 1233.29?


Posted by Richard Emerson on March 29, 2010 at 10:44 AM EDT


Posted by graziano on March 31, 2010 at 04:04 AM EDT
Website: http://graziano.pierini@virgilio.it

I bought a bull call spread on MTG when the stock was at 8.45. The stock is now at 11.14 and both legs of the spread are in the money.

What is a suitable *exit* strategy for a Long 7.50 Short 10 April bull call spread ?

Posted by emthree on April 01, 2010 at 09:33 PM EDT


Thanks for the SPX question. It should retest the breakout high of 1150.45 that is made on January 19, 2010. However, it could continue up to 1233.29 before making the retest.


Posted by Jacktrader ( on April 03, 2010 at 01:59 PM EDT

G. Raziano,

Thanks for the comment.


Posted by Jacktrader ( on April 03, 2010 at 02:02 PM EDT

EM Three,

Thanks for the MTG question.

After to referring to your original trade plan consider that you now have realized 90% of the potential gain based upon the mid prices of the options. For most trades this is good enough to unwind the position. Of course if you sell it you will have to contend with the bid/ask spread that will reduce your gain. Depending upon your fundamental or technical viewpoint you may want to leg out of the trade in an effort the keep as much of the gain as possible. This will expose you to some price risk. If you think MTG will continue higher for the next two weeks you may want to wait for the Friday before expiration. There is just a bit more time premium in your short call compared to your long based upon the mid prices. On expiration, the in-the-money 7.5 call will be exercised and the stock delivered against the short 10 call. Check with you broker to make sure of the costs involved and if the process is automatic or if it requires notice.


Posted by Jacktrader ( on April 03, 2010 at 02:28 PM EDT

Thanks for the suggestions on the MTG Vertical Bull Call Spread. I managed to sell it for 2.40 which is 96% of the 7.50/10 spread.

Page 76 of 'McMillan on Options' says; "If the underlying is volatile, then he should not be queasy about having to pay for the time value premium on an in-the-money option - it is probably worth it" as the implied and historical volatilities are most likely closely in line".

Looking at how some of your ideas like LVS and DCTH have performed recently, do you think ITM calls are a better alternative to ATM Bull Call spreads to capture upside price movement ?
It would be good to see some such suggestions in future issues of your trading digest.

Posted by emthree on April 09, 2010 at 11:33 AM EDT

EM Three,

Thanks again for your comment and the question comparing ITM call to a bull call spread. It really depends upon the pricing of the alternatives. In general, an ITM call will have a higher delta and will move more with the underlying stock and due to the degree of skew may be at bit more expensive in implied volatility terms than at-the-money or out-of-the money calls. Compare the implied volatilities to determine the skew, or look at our skew graph in Advanced Options. In addition, with a vertical spread where you are long one call and short the other, you offset, to some degree, the time decay and volatility risk, leaving direction as the primary objective. Therefore, you will seldom see outright long options suggested in the Digest. A synthetic long will often provide the same risk hedge, since the position is long a call and short a put, with a combined delta near .90 or better.


Posted by Jacktrader ( on April 09, 2010 at 02:00 PM EDT

"A synthetic long will often provide the same risk hedge, since the position is long a call and short a put"- Jack, the important difference is that a synthetic call has far more downside risk where as the risk in the ITM call is limited to the premium paid.

Posted by emthree on April 09, 2010 at 08:30 PM EDT

EM Three,

You are right; direction risk is usually the most important.


Posted by Jacktrader ( on April 14, 2010 at 06:37 PM EDT

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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".