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Today


IVolatility Trading Digest™


Volume 10, Issue 45
Volatility Lingo

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).
 
Volatility Lingo

Since the term volatility is being more frequently encountered these days in the financial media and since it has been awhile since we reviewed how the terminology is used we are going devote some space in this Digest to volatility. It should be helpful for our newer readers. Then we cranked up our rankers and scanners and found six trading ideas, four relative strength, one trend continuation and two takeovers. First, a brief strategy comment.

Ben Delivered QE2

 

 

As we suggested last week in Digest Issue 44 counter trend corrections have a tendency to reverse quickly to the upside. The S&P 500 Index closed well below the 1197.96 support level before making a pivot last Tuesday at 1173. It has a tendency to overshoot technical objectives before reversing and once again, this could be case. While it appears to have turned up, one more day with a higher high and higher low is needed before declaring the breakout correction is complete. In addition, some caution is still justified due to the lagging advance-decline line and the resulting divergence. Ideally, the advance-decline line as measured by the NYSE Summation Index should turn higher along with the index.

Accordingly, we suggest cautious optimism using special situations for new positions while keeping a close eye on rising long-term interest rates, which are a concern.

 

Volatility Lingo

Since the word volatility is often used to mean several different things, we are going to review a few of the basics.  

Implied Volatility

What do they mean when they say volatility is rising? In general, they mean options prices, also called premiums are increasing. By entering options prices into an options pricing model, often the standard Black-Scholes model premiums are converted into a volatility measure. This measure, called Implied Volatility (IV), is the value determined by the pricing model by imputing the known variables and solving for the unknown variable volatility. Therefore, for media purposes, rising volatility means options prices are rising and the less frequently mentioned declining volatility, means options prices are declining. However, venturing beyond the headlines we find it is somewhat more complicated.

Implied Volatility Index Mean

Since the actual options prices are subject to the forces of supply and demand in the marketplace the inputs into the model reflect expectations regarding future movement of the underlying, be it a stock, index, ETF or a futures contract. Each option contract has a unique level of Implied Volatility, which changes over time as the demand rises or falls. By combining several individual implied volatility values, an index of the implied volatility for the underlying can be created and then used to make some general observations about the options values. We call these combined options values the Implied Volatility Index Mean (IVXM).

Historical Volatility  

The second important volatility measure is called Historical Volatility (HV), it also called Statistical Volatility (SV) or Realized Volatility, all refer to the past price movements of the underlying asset, and hence the term "Historical" seems to remain the most popular. Historical Volatility is defined as a one standard deviation price change, computed from close-to-close price data, annualized. A frequently used alternative computation method, referred to as Parkinson’s Historical Volatility, includes the price range for each observation in the calculation thereby better reflecting intraday price movements into the Historical Volatility calculation.

Forecasted Volatility  

From the perspective of an options trader or strategist, forecasted Implied and Historical Volatilities are the most important and the least publicized. Since option premiums rise when market participants expect greater underlying price movement and when the Historical Volatility is high, there is a tendency for the market to drive option premiums high as well. Implied Volatility is forecasting the expected future Historical Volatility and like many other forecasts it can be wrong due to unknown and unforeseen circumstances. However, some useful observations can be helpful when attempting forecast volatility, one of the most important is that volatility is mean reverting, both measures tend to return to "normal" levels after reaching extremes, either high or low. Therefore, a strategist will look to sell volatility when it is perceived to be high and buy volatility when it is perceived to be low. 

IV/HV Ratio

Since Historical Volatility is a one year, one standard deviation price change of the underlying it can be compared to the Implied Volatility and their differences used as the basis for trading plans by determining if the current option prices are expensive or cheap relative to the movement in the price of underlying asset. We often mention IV/HV ratios, comparing the Implied Volatility to the Historical Volatility and refer to a positive volatility spread when the Implied Volatility Exceeds the Historical Volatility.

More Volatility Terms  

If this is not confusing enough, here is another way volatility is used by the media. Since rising Implied Volatility is synonymous with increasing options prices and since options are frequently used for hedging then Implied Volatility is the cost of hedging, and volatility is often used in periods of increasing uncertainty to express the rising cost of hedging.

In addition, there are two more terms often encountered, Volatility Skew, also called Volatility Smile and Volatility Surface, an example is the volatility surface image for the S&P 500 Index appearing above.

Since our space and time is limited and we want to offer some specific trading ideas in this Digest we will review Volatility Skew and Surface in a future issue. For those who cannot wait the information can be found in our educational material by using the search box at the top of our home page.

 

IVOLopps™

After what appears to have been a brief correction from the QE2 breakout by the S&P 500ndex it is often instructive to look for stocks and sectors that did not correct and are showing relative strength. Here are three such ideas.

Relative Strength

NVIDIA Corporation (NVDA) 13.75.

After reporting better than expected earnings of .15 on November 11, interactive graphic chipmaker NVDA gapped up, corrected and now appears to be headed higher once again.

With a current Historical Volatility of 31.08 and an Implied Volatility Index Mean of 39 for an IV/HV ratio of 1.25 and a bullish
put-call ratio of .3 take a look at this combination idea.

 

NVIDIA Corporation

 

Use a stop back below the last pivot at 12.50 as the SU (stop/unwind). 

Fluor Corporation (FLR) 57.71.

Originally suggested in Digest Issue 43, FLR the international engineering management company gapped higher after reporting earnings on November 4 of .02 per share, better than the expected -.26 per share consensus estimate. In addition, they reported a backlog of $33 billion, an 18% increase, and the second consecutive quarter of backlog expansion. Here is another relative strength selection.

With a current Historical Volatility of 38.27 and an Implied Volatility Index Mean of 33.54 with an IV/HV ratio of .88 and a bullish
put-call ratio of .3, consider this bull call spread.

 

Fluor Corporation

 

Use a close back down below 50 as the SU (stop/unwind). 

McMoRan Exploration Co. (MMR) 17.60.

With no specific news, this shallow Gulf of Mexico oil and gas exploration and development company appears headed higher once again.

The current Historical Volatility is 57.84 with an Implied Volatility Index Mean of 88.12, up from 74.08 last week for an IV/HV ratio of 1.52, a very favorable volatility spread, and a bullish put-call ratio of .25, muse over this combination idea.

 

McMoRan Exploration Co.

 

Use a close back down below 16 as the SU (stop/unwind)

Trend Continuation

Las Vegas Sands Corp. (LVS) 49.39.

While casino operator LVS pulled back with the broad market it has quickly made a pivot and appears to be resuming its uptrend, but like the S&P 500 Index one more day with a higher high and higher low would greatly improve the chances.  

With the current Historical Volatility at 51.46 and an Implied Volatility Index Mean of 56.36 along with an IV/HV ratio of 1.10 and a moderately bullish put-call ratio of .42 consider this idea for improving the odds.

 

Las Vegas Sands Corp.

 

Use a close back down below the last pivot at 44.10 as the SU (stop/unwind).

 

Takeover File

Now for two additions to the already bulging takeover file.

Walter Energy, Inc. (WLT) 105.91.

On Thursday, this metallurgical coal producer was up more than 2 points with heavy volume on the news it was making a $3.3 bn bid to buy Western Coal of Canada, then of Friday it was up another 9 points with even higher volume on a buy recommendation from Dahlman Rose & Co.  Since it is unusual for the company making a bid to rise on a takeover announcement, it suggests the combination will add immediate value, along with other possible explanations including the brokerage upgrade.

With a current Historical Volatility of 44.66 and an Implied Volatility Index Mean of 57.25, up from 47.45 last week, for an IV/HV ratio of 1.28 and a favorable put-call ratio of .4; consider this put sale with good edge.

 

Walter Energy, Inc.

 

Use a close back down below the recent support at 90 as the SU (stop/unwind).

Mylan, Inc. (MYL) 19.85.

Branded generic and specialty pharmaceuticals maker MYL was higher on significant volume Friday, along with increasing implied volatility in the December options. It was also our Calendar Spread suggestion that we offer as a regular feature in the Rankers & Scanners section of our home page.

Calendar Spreads are always problematic since often the higher implied volatility is justified by events underway making the near term options priced correctly. The relatively high front month implied volatility was the clue to look for the underlying story pushing the options prices higher. In this case, it was unsubstantiated takeover rumors according to strategists at Susquehanna International Group LLP. If there is more to the story than just a rumor a calendar spread is not the best strategy choice, as it will most likely be hurt with a large move in the underlying. For an alternative, consider this put sale as a way to take advantage of the higher near-term implied volatility.

The current Historical Volatility is 21.19 and the Implied Volatility Index Mean is 45.68, up from 30.44 last week, for an IV/HV ratio of 2.15 and number 3 on our Top 5 list, with a bullish put-call ratio of .3.

 

Mylan, Inc.

 

Use a close back below the November 17 pivot low of 18.82 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.

 

Summary

Although some diversions remain to be resolved, it appears the S&P 500 Index is resuming its uptrend after correcting from the QE2 breakout. Confirmation should come early this week.  

 

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

 

Twitter Follow us on twitter for more ideas from our scanners and other developments.

 

 

In next week's issue, we will return with our complete market review along with more interesting trading ideas.

 

Volatility Lingo

 

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.

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".