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Today


IVolatility Trading Digest™


Volume 10, Issue 3
Hedging Once Again

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Hedging Once Again

Once again, we think it is prudent to consider looking after the hedge. There is a good chance this decline is about over, but with all of the recent news we want to hedge our market risk in the event it continues lower. First our market review and then we offer four hedging suggestions below.

Market Review

S&P 500 Index (SPX) 1091.76. The 21.56-point decline last Thursday looked like a retest of the 1120 support level, but since it continued lower on Friday with another 24.72-point decline the picture changed. Now watch 1080 since a close below this level means it has taken out the recent trading range between 1080 and 1120. The decline that began on October 21st lasted for nine trading days resulting in a 71.98-point decline or 6.54% from the high to the low on November 2, 2009. Since the decline from the high on Tuesday the 19th to Friday’s low was 60.27 points and assuming this decline will be similar to October we can expect to see another 10 to 15 point decline, to just below 1080. Based upon this assumption there is a good chance of a reversal in the next few days. However, if SPX continues lower we suggest implementing hedging strategies on Monday. We offer some suggestions in the Strategy section below.

E-mini S&P 500 Future (ESHO) 1091.00. Since our last Market Review the March E-mini futures contract declined 50.50 points. Last Thursday the decline was 23 points and the volume at 3.4 million was the highest we have seen for some time. In addition, open interest expanded by 55K contracts due to shorting activity, which confirms the decline. We will get Friday’s volume and open interest numbers on Monday morning. We can expect to see another large volume day and another increase in open interest due to increased short selling. When the shorts begin covering, watch for a reversal day with a lower low and a higher close. Open interest will decline and because the data is delayed until the next day, it will confirm the short- term bottom.

S&P 500 Index Implied Volatility (IVXM). Since our last Market Review, and with the recent rapid SPX decline, our Implied Volatility Index Mean has increased 6.87 and is now 22.82. The increase for the VIX was 9.18 ending the week at 27.31. The Historical Volatility increased 2.61 to 14.09.

The table below shows the VIX Cash compared to the next two futures contracts as well as Larry McMillan’s day-weighted average between the first and second months.

Larry McMillan’s day-weighted average

Larry suggests that buy signals are given when the futures are selling at a discount as they are now. For example, on October 30, 2009 the November futures closed at a discount of -2.84 or 9.25 % and the December futures were at a discount of -2.99 or 9.74%. The Next Monday November 2, 2009, SPX made a key reversal ending the October correction. Since the discounts are comparable, it suggests this correction could be nearly over.

With a current Historical Volatility of 101.39, the next table shows the adjusted Implied Volatility (IV) of the at-the-money (27.5) VIX calls and puts based upon Friday’s closing mid prices for the options and the respective month’s futures prices.

adjusted Implied Volatility (IV)

US Dollar Index (DX) 78.28. Since our last Market Review DX increased .81 points, after declining for the past two weeks. The reversal up on Tuesday January 19th did not immediately impact SPX since it set a new high of 1150.45. On the second day of the increase, SPX declined 12.19, then on Thursday, the third day, DX reversed closing unchanged as the bottom fell out of SPX on what appears to have been caused by fundamental news. In this instance very little of the SPX decline can be attributed to the rising US Dollar Index.

iShares Barclays 20+ Year Treasury Bond (TLT) 92.00. TLT has risen for the last 8 trading days as long term interest rates declined 18 basis points. So rising interest rates do not appear to have caused the rise in the US Dollar Index or the sharp decline in the equity indexes. Two weeks ago, we mentioned to possibility of a possible double bottom for TLT and that now appears to be underway.

NYSE McClellan Summation Index 930.85. As could be expected the NYSE breadth indicator declined along with the NYSE Composite Index and is now back below the 1000 level. Interestingly the shorter-term NYSE McClellan Oscillator indicator at -75 is at the same level where it was at the bottom of the October correction. The previously noted divergence between this indicator and the NYSE Composite Index once again served as a good leading indicator of the overbought index levels. For now, we will continue flying this caution flag. caution flag  

Baltic Capesize Index (BCI) 4161. For the past two weeks, our preferred Baltic dry-bulk shipping rate index for the larger ships recovered somewhat closing up 428 points or 11.47% and now appears to be moving sideways without trend. In the tanker segment, the Capital Link Tanker Index declined an additional 175.72 points or 7 % to 2336.78 and looks to be going lower. Weakness in the tanker segment is reason to continue flying the caution flag. caution flag

Strategy

If the current equity market correction is comparable to the one we experience in October then we anticipate a reversal of the decline in the next few days. If so, we would expect to see the Implied Volatility rise one or two more days, and then begin to decline. For example, if it rises to the October level then we can see it at or above 25, or another 3 points higher on the IV Mean Index before turning lower. See the volatility chart below. The comparable level for the VIX would also be about 3-4 points higher, taking it to the 31-32 area.

HV and IVIndex vs Price

Looking at the Put/Call Options Volume ratio for the S&P 500 Index, we notice the 3 pervious peaks at or over 3.5 (more puts than calls), including the October correction. Compare that to the current reading of 2 as shown below. Up to now there does not appear to be rush into puts, but that could change on Monday. On interpretation for this lack of put buying response could be the expectation that this market correction is near completion.

In the event the index does not turn higher, but continues lower and approaches the 1040 level before find support, is exactly the reason to implement a defined risk options hedge on Monday. If the S&P 500 Index turns higher, as the VIX futures discount indicates it will, then the hedge can be removed with a small and limited loss.

IVIndex vs VolumePut/VolumeCall

Hedging Suggestions

Since the S&P 500 Index ETF, the SPDRs (SPY) 109.21 and the iShares Russell 2000 Index (IWM) 61.73 have been trading together in percentage terms since the middle of December, either could be use for hedging. They both have significant volume and open interest and hence good liquidity and trade with reasonable bid/ask spreads.

We suggest long put spreads or put ratio backspreads using March options.

As for the SPY, look at the Mar 107/105 put spread with an indicated mid price debit on Friday of 1.28.

For the backspread, consider buying 2 Mar 105 puts and selling 1 Mar 110 put for a .82 debit.

Here are two alternative ideas using the IWM.

Buy Mar 61/58 put spread with an indicated mid price debit on Friday of .90.

For the backspread, consider buying 2 Mar 58 puts and selling 1 Mar 62 put for a debit of .125.

The prices will be somewhat lower on Monday after adjusting for the weekend time decay. In addition, the price will need to be adjusted for changes in the price of the underlying ETFs on Monday.

We think there is a good chance SPX will decline more on Monday and then attempt to turn higher. Watch the 1080 level as a likely turning point. The plan is to close the hedges on as soon as the VIX makes a defined spike and turns lower.

Many other combinations could be used for hedging including the ETFs for crude oil, gold and the financials. The plan is to have the hedges in place in the event equities continue lower.


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In next week’s issue, we think it is likely we will once again be looking for more upside trading ideas. If not we will be looking to augment our hedges.

Previous Issues and Reader Response Request

Finding Previous Issues and Our Reader Response Reques

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.

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.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.

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