« October 2011 »

IVolatility Trading Digest™

Volume 11, Issue 42
European Halloween Treats

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Although very popular in the US, the origins of Halloween are European. The word Halloween represents a Scottish variant of All-Hallows-Even ("evening"), that is, the night before All Hallows Day. Since the Europeans delivered what appears to be the first realistic steps in alleviating the sovereign debt crisis the equity markets are considering it quite a Halloween treat.

In this issue, we review our market indicators along with providing some ideas as to where we think the market is headed based on the improved sentiment. Then we have an update followed by two new directional ideas. 


Market Review

S&P 500 Index (SPX) 1285.09. In our last market review, we said any substantial positive news from Europe could change our expectations that we would see a retest of the 1100 support and the formation of a potential Head & Shoulders Bottom. That is exactly what happened with the news released early Thursday morning before the markets opened. In fact, we probably had an early warning the prior Friday when SPX closed at 1238.25, above its recent range. The measuring objective for a range breakout is the vertical height of the range it broke away from or about 156 points, up to 1387. Last week that seemed unlikely in the fundamental environment, however that objective now looks more realistic and SPX is likely to challenge the July 7 resistance high of 1356.48 very soon.   

E-mini S&P 500 Futures (ESZ1) 1281.00. The rapid advance last Thursday has the appearance of a flag pattern on both the cash and futures charts. If so, we would expect to see a low volume pull back for the next few days, before another quick move up to the pattern objective at 1319. Based upon the preliminary CME report Friday's volume was 1.9 million contracts, substantially below Thursdays' breakout volume at 3.2 million contracts thereby adding some validity to the potential flag pattern.  

S&P 500 Index Implied Volatility (IVXM). Since our last market review, in Digest Issue 40, the Implied Volatility Index Mean declined from 24.35 to 21.54, while the CBOE Volatility Index® (VIX) declined from 28.42 to 24.53.

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 60% to the November contract and 40% to December resulting in the average premium of 1.44 or 5.87% 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 .13%, compared to premium of 4.07% in our last market review in Digest Issue 40 based upon October 14 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 128.44 and 88.48 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 87.98, the IV/HV ratio is .68, using the range method for Historical Volatility the ratio is .99 while the VIX put-call ratio is 1.60.

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) 121.18. 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 has been acting like a contrary indicator, however it has declined from 127.99 on October 18 as the SPX challenged the range highs.

US Dollar Index (DX) 75.07. The declining dollar index from its peak on October 4 as the S&P 500 Index made a key reversal is reflecting strength in the euro that was dramatically higher on Thursday with the sovereign debt crisis news, prompting a return to "risk-on" trades as the fear of an increasing dollar faded.

iShares Barclays 7-10 Year Treasury (IEF) 102.14. The 10-year note, with a yield of 2.30, is up from 2.23% in Digest Issue 40, as IEF attempted to follow the broken upward slopping trendline higher before taking a deciding gap down on Thursday. Based upon the IEF trendline 10-year rates are headed higher.

iShares Barclays 20+ Year Treasury Bond (TLT) 111.46. After the S&P 500 Index key reversal, on October 4, the long end of the Treasury bond market declined substantially to now yield 3.35, up from up from 2.75% on October 4, and higher by 15 basis points since Digest Issue 40. After concerns about a slowing US economy, higher long-term interest rates are a sign that economic expectations are improving. Consistent with this view some technical analysts claim there is an active Head & Shoulders Top pattern on the December T-Bond chart. 

NYSE McClellan Summation Index 546.86. In the two weeks since out last Digest there has again been substantial improvement in this NYSE breadth measure, as it increased 620.86 points. This breadth measure is now higher than NYSE Index was before the July decline as breadth continues to improve faster than NYSE Index equity prices.

iShares Dow Jones Transportation Average Index (IYT) 89.62. The transports are trading in line with the S&P 500 Index both having broken out above near resistance, which is positive from a Dow Theory perspective.

iShares S&P GSCI Commodity-Indexed Trust (GSG) 33.48. In the Digest Issue 40 market review we were expecting this index to turn lower along with the SPX, but it has now made multiple closes above our downward sloping trendline on higher crude oil and gold prices reflecting dollar weakness, so will revise our plans. Accordingly, we have an energy long trade idea below.



StrategyWhen the European banks accepted a "voluntary" 50% haircut on their Greek sovereign debt it cleared, away one of the main sticking points to the European rescue plan setting off euro strength and a dollar decline as "risk-on" resumed. More details are expected this Thursday and Friday at the G20 summit meeting in Cannes on November 3-4.

The CBOE Volatility Index® (VIX) 24.53 is now well below the 30 support line and with improving fundamentals is now likely to trade in the 20-25 range once again. Since the implied volatilities of some individual equities may take some time to decline, there may still be some opportunities to sell some put premium. However, since we no longer see an opportunity for an expanding spread between the November and December VIX futures we suggest closing the call spread we offered in Digest Issue 40.   

With substantial breakouts last Thursday along with the potential flag patterns, we suggest using the next few days while the flag pattern consolidates to establish long directional positions in quality companies, especially those in the technology, energy and materials sectors. We have two ideas below.


Trade Suggestion Update

Here is an update to a trade idea we made in Digest Issue 41 last week.

Netflix, Inc. (NFLX) 84.14. Netflix Inc. reported 1.16 per share last Monday compared to the whisper number of .99 per share, but guided substantially lower. On Tuesday, the stock closed at 77.37, off 41.47 points.

Our suggestion was to sell a short-term strangle expiring last Friday with upside protection as a volatility trade. In the suggestion we mislabeled it as a straddle, but since the call and put had different strike prices it was actually a strangle combination.

The stock price moved more than expected and more than suggested by the implied volatility exceeding our lower break-even level of 86.79, after booking it using last Monday's closing prices for a credit of 3.21.

Although not explicitly defined in the plan the downside included accepting the stock by assignment on a close below 90. As a result, we are long stock with a basis of 86.79 with a current price of 84.14. Next, the plan is to sell a call option against the long stock. Since there is little difference in the implied volatility between November and December, we will select the earlier one as we prefer to release our margin requirement on the long stock as quickly as possible.



Based upon this premium we would add a credit of 4.87 to the initial credit of 3.21, book the stock at 90 and then sell it as 85, presuming it is above 85 on the November expiration. This would result in a gain of 3.08. In the event the stock turns lower once again use the new break-even of 81.92 as the SU (stop/unwind).


Long Technology

Since the seasonal tendency favors technology here is a long idea to consider.

PowerShares QQQ (QQQ) 58.94. This ETF holds all the stocks in the Nasdaq-100 index, which consists of the largest non-financial securities listed on the Nasdaq Stock Market.

The current Historical Volatility is 27.95 and 23.89 using the Parkinson's range method, with an Implied Volatility Index Mean of 23.12, down from 28.05 last week. We expect it to decline fairly soon to around 20. The IV/HV ratio is .83 and .97 using the range method, with the put-call ratio at a bearish 1.15, however it is used for hedging so a higher ratio is expected. Friday's option volume was 330,848 contracts compared to the 5-day average of 463,310contracts.

Consider this combination idea.



With a reasonable volatility edge, use a close back below 56 as the SU (stop/unwind)

Dave's Corner

Skew Makes XLE Risk Reversal Attractive

Energy Select Sector SPDR (XLE) 73.04

October has been an amazing month for equities, as the major averages as well as, numerous specific sectors has showed exceptional returns. The energy patch has seen nearly a 29% rally from the lows seen on September 30, but still 15% off the recent highs seen in July 2011.

Conoco Phillips (COP), Exxon (XOM) and Chevron (CVX) have all reported earnings that were better than expected.

One way to take advantage of further upside in the Energy patch is to use a position that benefits from further upside using a risk reversal.



This trade takes advantage of the volatility skew, generating a long position using relatively inexpensive calls while selling expensive puts.

Look to take profit the risk reversal on a close of XLE above $78. Use a stop if XLE closes below $68.

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.

From time-to-time, we like to remind our readers about our complementary options data service. Here is a link to a Digest Issue that explains its extensive capability in detail.


Complementary Options Data

My Favorites

Digest Issue 9



After the rapid upward advance last Thursday, chances are now very good that the S&P 500 Index will challenge the July 7 resistance high of 1356.48 very soon as "risk-on" returned. Technology, energy and the material sectors are all attractive long candidates once again.


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

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In next week's issue, we will use our ranker and scanner tools to find more trading ideas.


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.

Next week’s 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".