« October 2011 »

IVolatility Trading Digest™

Volume 11, Issue 40
German Bank Haircut

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Just as the markets were starting to hear about the outline of a credible debt-restructuring plan for the Eurozone, news began leaking that Germany wants a 50% to 60% write down of the debt held by the private banks after they had previously agreed to a 21% haircut on their Greek debt holdings. The final plan is expected at the G-20 leaders meeting in Cannes November 3-4. Anticipating a solution equity have made an impressive run in the last nine days, but since they are now at resistance levels, we think a hedge is in order. After reviewing our market indicators, we offer an interesting hedge suggestion.



Market Review

S&P 500 Index (SPX) 1224.58. After breaching 1100 on October 4, SPX made another classic key reversal, like the one it made on August 9, and returned to the range that is now defined by the August 31 high at 1230.71 and the new low of 1074.77. Now only 6 points away from the August resistance high we think another test of the 1100 area will begin soon. Technical analysts will also start anticipating the formation of a Head & Shoulders bottom on the next test of the 1100 support, which should be completed before the market starts to discount the expected news from the November G-20 meeting in Cannes. Of course, any substantial positive news from Europe could change this scenario so watch for closes above the August 31 high at 1230.71 as an indication that a revised plan is needed.

E-mini S&P 500 Futures (ESZ1) 1219.25. Volume on the October 4 key reversal was a substantial 4.2 million contracts and high volume is needed to validate the key reversal. The open interest expanded by 25,014 contracts. For the last eight trading days, the volume has been moderate to low with open large open interest contractions on up days suggesting short covering. However, on Friday, based upon the preliminary CME report, open interest expanded by 84,007 contacts and if this number is not materially revised on Monday, it suggests shorts could have been hedging into the rising market.

S&P 500 Index Implied Volatility (IVXM). Since our last market review, the Implied Volatility Index Mean declined from 38.42 to 24.35, while the CBOE Volatility Index® (VIX) declined from 42.96 to 28.42.

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 10% to the October contract and 90% to November resulting in the average premium of 1.15 or 4.07%, shown above.

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. Last week it was also at a premium of 1.24%, compared to a discount to the cash of -5.98% in our last market review in Digest Issue 38 based upon September 30 closing prices.

Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium or discount is always available. 

VIX Options

With a current 30-day Historical Volatility of 112.06 and 85.68 using Parkinson's range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon the closing option mid prices on Friday along with their respective month’s futures prices, since the options are priced from the futures.



Using the IV Index Mean of 88.88, the IV/HV ratio is .81, using the range method for Historical Volatility the ratio is 1.04. The VIX put-call ratio is .70.

Since the spread between the October and November VIX futures declined from 4.40 in Digest Issue 38 to .40 on Friday, we have a trade idea based upon the narrow spread below.  

All of the Implied Volatilities along with the Historical Volatilities and Greeks for the VIX options based upon the Futures prices can be found on our Advanced Options page by clicking on the "market close" link shown near the top of the page.

CBOE S&P 500 Skew Index (SKEW) 121.90. When out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase. From our perspective, the SKEW continues to act more like a contrary indicator.

US Dollar Index (DX) 76.62. The inverse, or negative correlation between the dollar and equities was clearly demonstrated when the dollar peaked on October 4 as the S&P 500 Index made a key reversal suggesting increased "risk-on" activity.

iShares Barclays 7-10 Year Treasury (IEF) 102.38. The 10-year note, with a yield of 2.23 % broke the upward slopping trendline for the second time, after closing for a yield of 1.78% on October 4, the important key reversal day.  

iShares Barclays 20+ Year Treasury Bond (TLT) 113.95. After the S&P 500 Index key reversal, on October 4, the long end of the Treasury bond market declined substantially to now yield 3.20%, up from 2.75% on October 4, raising some questions about when the results of "operation twist", will be seen in long interest rates.

NYSE McClellan Summation Index -74.00. With a gain of 266.26 points, there has been a substantial improvement in this NYSE breadth measure, since our last market review in Digest Issue 38, which could have been expected with the equity market key reversal. Using this measure, breadth is now improving faster than NYSE equity prices.

iShares Dow Jones Transportation Average Index (IYT) 84.02. The transports are trading in line with the S&P 500 Index and both are near resistance, for the IYT it is the August 31 high of 86.22, just 2.20 points higher. We are expecting another retest to around 75.   

iShares S&P GSCI Commodity-Indexed Trust (GSG) 32.72. Along with equities, this commodity index also made a key reversal on October 4 and has now risen back up to close just below the upward sloping trendline described in Digest Issue 32. If we are right about equities making another test of 1100 then we think this index will also turn lower soon. In the event it makes multiple closes above our downward sloping trendline, we will revise our plans.



StrategyWith the details of the European rescue plan still being negotiated, including the "haircut", we are expecting volatility to remain high until the G20 summit meeting in Cannes on November 3-4.

If we are right about the S&P 500 Index being in the process of forming a Head & Shoulders bottom another decline to retest test 1100 would be a part of the developing pattern and if so, chances are good it will come from the overhead resistance at the August 31 high at 1230.71, now only 6 points away. 

Accordingly, we have a hedge strategy suggestion below using the CBOE Volatility Index® (VIX).


Chart of the Week

As a part of our hedge strategy suggestion, here is the chart of the VIX showing its close below 30 for the first time since August 3. Since the S&P 500 Index is near resistance and we are expecting another retest of 1100, then chances are VIX will soon reverse.



CBOE Volatility Index® (VIX) 28.24.

In Digest Issue 38, we suggested a calendar spread, long the November 40 call and short the October 40 call. At the close on Monday October 3, we booked the options spread for a credit of 1.15 as the futures spread between to October and November widened to 4.50 from 4.40 the previous Friday.

Last Friday around mid day we sent out a tweet saying that we were booking the close of the spread for a .97 credit as the difference between the October and November futures had declined to .25 as the VIX declined below 30.

Adding the initial credit of 1.15 to the closing credit of .97, we booked a total gain of 2.12 in two weeks.

Now however, we think the chances are good that VIX will go the other way so we will open a new spread that should gain in value as the futures spread widens as the VIX rises.

Since the last trading day for the October VIX options is Tuesday, we will select November for the long call and December for the short call as November will be the front month on Wednesday and should rise more rapidly if the VIX turns higher.

On Friday the November futures contract was 29.35 while the December was 28.90 for a difference .45. If the VIX turns higher, we expect the difference will increase, as the November will gain in price faster than the December. Consider this calendar spread.



In the event the S&P 500 Index continues above the August 31 high at 1230.71 and the VIX continues lower, we suggest using a close below 25 as the SU (stop/unwind). Presuming it works as planned use a close back up above 42 as the closing price target.

The suggestion above is 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.


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After making a key reversal and then an eight-day run the S&P 500 Index is near resistance at the August 31 high of 1230.71 where we are expecting it to turn lower and retest the 1100 level once again. Volatility should remain higher until the G-20 summit in early November.


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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".