« September 2010 »

IVolatility Trading Digest™

Volume 10, Issue 37
Pair Trades

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Pair Trades

While similar in concept to the pair of aces shown above, the pairs we are thinking about come from arbitrage strategies and the practice of matching a long position with a short position in two stocks in the same sector. This creates a hedge against a decline in the sector and perhaps the overall market. This could be the time for some pair trades as we explain further in the strategy section below followed by two specific pair trade suggestions and then an earnings idea and a possible takeover.



In Digest Issue 36 along with several other previous issues, we have been making the trading range case for the S&P 500 Index. However, last Monday the range idea was put in doubt when it advanced 17.12 points closing above the upper range boundary. By Thursday, it had declined and retested 1125 and then reversed upward 23.84 more points to close at 1148.67, just under resistance at 1150. As a result, several market analysts and commentators declared it had broken out above its range. This is probably right since there is little overhead resistance before the April 26 high at 1219.80. Nevertheless, before accepting this prediction we recall that the S&P 500 Index often exceeds technical analysis boundaries and then reverses. Therefore, we suggest a more cautious stance until it continues higher, closing above 1150. We should know by the end of this week and we have two pair trades ideas that will hedge sector and market risk in the event it does reverse and closes back below support at the August 9 high at 1129.24.


Gold Silver Ratio

Last week in Digest Issue 36, we suggested two silver combination ideas since silver was going up faster than gold. Now we offer a pair trade idea on the assumption that silver will continue outperforming gold, while providing a hedge in the event of a correction in the precious metals sector, which is likely at some point. On the long side, we have a silver call spread that adds to our combinations from last week and on the short side a gold put spread as a hedge.  

First the call spread.

Silver Wheaton Corp. (SLW) 26.60

With a Historical Volatility of 30.39 and an Implied Volatility Index Mean of 42.88 for an IV/HV ratio of 1.41, SLW has recently been going up even faster than SLV the silver ETF.

Silver Wheaton Corp.


Next, the hedge put spread.

Eldorado Gold Corp. (EGO) 18.25.

With a Historical Volatility of 29.64 and an Implied Volatility Index Mean of 41.38 for an IV/HV ratio of 1.40, EGO was selected for its relative weakness in the sector. By increasing the trade size, we will attempt to hedge last week’s suggestions as well.


Eldorado Gold Corp.


Since the suggestion is for two put spreads, the total debit for this side would be 1.16. Since we now have long and short positions in the precious metals sector, we are less concerned about specific prices for determining our SU (stop/unwind) levels as we are about the ratio between gold and silver. In the event the ratio declines and silver begins to underperform then we suggest closing the position.  

Consumer Discretionary vs. Consumer Staples

Going another step in the direction of pair trades here is one based upon the relationship between this classical consumer pair both with good options volume, which is important when considering multi-leg combinations.

Consumer Discretionary Select Sector SPDR (XLY) 33.70.

With a Historical Volatility of 21.02 and an Implied Volatility Index Mean of 23.72 for an IV/HV ratio of 1.13, this is the long side of the trade.


Consumer Discretionary Select Sector SPDR


Next, here is the short side.

Consumer Staples Select Sector SPDR (XLP) 28.04

The Historical Volatility is 10.72 while the Implied Volatility Index Mean is 13.18 for an IV/HV ratio of 1.23.


Consumer Staples Select Sector SPDR


Once again for our SU (stop/unwind) we are more concerned about the rate of change between to the ETFs than their individual price levels. In the event the XLY declines back below the XLP then we suggest closing the position. In addition, if the S&P 500 Index continues higher above the 1150 level as described in the strategy section above then this put spread should be closed while keeping the call spread.



Quarterly Earnings Report

Now an earnings report idea.

Family Dollar Stores Inc. (FDO) 43.40.

Family Dollar was found in the middle of an Advanced Ranker scan looking at IV/HV ratios. At 2.59, this indicates that the options prices have been pushed up relative to the underlying stock and when there is sufficient volume, it could be worth further investigation. For FDO while the options volume is not as great as we would like to see perhaps, it could be enough.

They are scheduled to report on Wednesday and the implied volatility has been rising for about a month in anticipation as the stock rose up from the 42 area. This Historical Volatility is 12.63 and abnormally low, while the Implied Volatility Index Mean is 32.76 with the calls at 32.26 and the puts at 33.25. The skew between the calls and puts suggest put buying as protection for long stock positions, which is confirmed by a high put-call ratio of 1.25 and an even higher open interest ratio of 1.33 times more puts than calls.

The analysts’ consensus estimate is for .51 per share compared to .43 for the same quarter last year.

At 17 times current and 15 times forward earnings, the stock does not appear to be in the undervalued category. With that in mind, here is one interesting put sale that appears to be safely below a recent gap between 40 and 41.


Family Dollar Stores Inc.


Unless you have a desire to increase your portfolio in the retail sector use a close back below 40, as the SU (stop/unwind).


Takeover File

Here is a new entry in the M&A takeover category.


M&A takeover category


Pride International Inc. (PDE) 29.94.

At the end of August, Bloomberg reported John Fredriksen and his Seadrill Ltd. (SDRL) 28.30 might bid for Transocean Ltd. (RIG) 60.06. The report said Seadrill already had a 10 percent stake in Pride International but it was not in a rush to increase its position due to concerns about poison-pill provisions. Since then Pride has increased in relative value more than Transocean and many of the others in the ocean drilling category. In addition, the rising price has been accompanied by rising volume, usually an indication of accumulation. While there may be concern about poison-pill provisions in the event of a hostile takeover attempt perhaps, it would be of less concern in the event of a friendly deal.

Pride is currently trades at 5 times current and 9 times forward earnings with a market capitalization of 5.82 billion.

The options data follows: Historical Volatility 32.61, Implied Volatility Index Mean 45.48, with the calls at 44.91 and the puts at 46.06, but the put-call ratio is a very bullish low of .1 and the call open interest exceeds the put open interest 3.5 times.

Based upon this, it appears Seadrill or somebody else is accumulating a position in this company.  

Consider this combination strategy.


Pride International Inc.


For a small debit and the cost of using some margin this is an interesting opportunity. Use a close back below 26 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 Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.



While the S&P 500 Index most likely broke out of its trading range last week some concern remains since it often overshoots technical analysis boundaries and reverses the prudent course to follow is to wait until it clears resistance at the 1150 level before meaningful increases in long exposure.



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In next week’s issue, we will return with a complete review of our market indicators and report the progress of the S&P 500 Index.


Takeover File Update

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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".