« March 2012 »

IVolatility Trading Digest™

Volume 12, Issue 13
VIX Futures Pressure Relief

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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While last week's minor correction in the S&P 500 Index seemed to relieve some of the apparent overbought pressure that had been building in the VIX futures premium we are not convinced it was enough. We make the case for an additional decline in the market review and strategy sections below. As a result, we offer another hedge suggestion and then review all the trade suggestions made last week in our update section.


Market Review

Review Notes Clip ArtS&P 500 Index (SPX) 1397.11. Last week the second long anticipated correction began after reaching a new high of 1414 on Monday, it followed by making lower lows and lower highs for the next four days, although Friday's close was higher than Thursday's the trading range on Friday was lower. We think there is good chance it will continue lower to retest support at 1378.04 from February 29, which would also be support from the upward sloping trendline that began with the November 28, 2011 low at 1169.29. We think a retest of the upward sloping trendline is likely. The next support is then 1370.58, the previous high made on May 2, 2011. A close below this second support level would put the current uptrend in serious doubt. 

E-mini S&P 500 Futures (ESM2) 1394.00. With the expiration of the March contract, June the new front month expires on June 15. After the normal contract rollover volume surge open interest is now back into the normal range with Thursdays' open interest reported at 2.7 million contracts as trading volume remained low all week.

S&P 500 Index Implied Volatility (IVXM). Since last week the Implied Volatility Index Mean increased from 12.54 to 12.84, while the CBOE Volatility Index® (VIX) increased from 14.47 to 14.82. 

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 applies 85% to April and 15% to May resulting in the average premium of 2.66 or 17.95% shown above. Our alternative volume weighting between April and May results in a 21.55% premium, still above the 20% caution mark.

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. Premiums declined with last week's correction, the day-weighted declined from the highest premium recorded to date last week at 46.26%, to 17.95%, while the volume weighted also declined from 33.22% to 21.55%. As a further indication that the hedging pressure declined to some extent, the open interest also declined from Monday at 355,393 contracts to 320,215 on Thursday.

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 100.22 and 82.43 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 81.80, the IV/HV ratio is .82, using the range method for Historical Volatility the ratio is .99 while the VIX put-call ratio was .95.

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

CBOE S&P 500 Skew Index (SKEW) 122.98. The purchase of out-of-the money S&P 500 Index puts for downside protection causes this index to increase in value. Last week in Digest Issue 12, we noted three days when it increased above the previous all-time high range of 130, indicting active index put buying. Now back below the previous cautionary high range between 128 and 130 this indicator also suggests some pressure relief for the S&P 500 Index, although it remains in the upper half of its range since beginning on February 23, 2011.

CurrencyShares Euro Trust (FXE) 132.07. After it looked like the next stop for the euro was 126, it found support at 130 and turned higher. Now it looks as if it will attempt to return and test the upward sloping trendline defined by the 126.33 low on January 13 and the 129.53 low on February 16. A failure at that level would be the signal to expect a retest of the 126 low. In the meanwhile, the euro rebound last week helped equities and crude oil.  

NYSE McClellan Summation Index 765.80. As a further confirmation that the current correction is not complete, our NYSE advance-decline indicator continued lower again with another 146.60 point loss since we last reported in Digest Issue 11 as the downside momentum accelerated again last week. As we have noted several times the divergence between the NYSE Composite Index and the number of advancing issues compared to the number of declining issues has been a good leading indicator of trend changes. While it is too soon to declare the current correction will turn out to be a change in trend, we continue to urge watching this indicator carefully.

iShares Dow Jones Transportation Average Index (IYT) 93.19. The transports have been having trouble since February 10 when the IYT closed below our upward sloping trendline from the low last October. When FedEx reported better than expected earnings their shares declined -3.5% because they also said they were lowering their worldwide economic growth forecast to plus 2.3% for the year, down from the previous forecast of +2.9%. Unless they get some help from declining crude oil and gasoline prices, which is unlikely since this is the seasonally strong time of the year for energy prices the transports will continue to be a drag on the major equity indexes, clearly a concern from a Dow Theory perspective.

SPDR Homebuilders (XHB) 21.23. With the new high made on March 16 at 21.87, we have a new upward sloping trendline from the October 4 low at 12.21. Friday's lower low and lower high along with along with lower close on extremely high volume suggests it will soon test the new upward sloping trendline at 20. We have more in our KB Home (KBH) 10.29 update below.

StrategyWhile watching the current correction develop over the last few weeks, we would like to say that the correction has run its course, but that would be contrary to the evidence. Until crude oil prices decline, we believe further advances in equities will be constrained and the risk is to the downside on any negative macro news event. In the meanwhile, we suggest additional hedging and we offer another VIX hedge below.

Hedge Suggestion 

CBOE Volatility Index® (VIX) 14.82. Since the pricing of the VIX options are from the futures and the April futures closed at 17 the most straight forward hedge is to buy the April 17 VIX call option. Accordingly, here is the hedge idea unencumbered with any attempt to use a spread or ratio strategy. Since the near term future contract is the most responsive the changes in the prices of the VIX here is the suggestion.



The April VIX futures expire on April 18 with the last day of trading on April 17. Use a close of the S&P 500 Index above the March 19 high of 1414 as the SU (stop/unwind).




As we mentioned in last week's Digest we booked all of the trade ideas using the closing prices on Monday and since two used weekly options, we closed them on Friday and marked the other two to market. In the order presented in the Digest Issue 12 last week, here are the updates and commentary.

Oracle Corporation (ORCL) 28.55. On Tuesday March 20 after the close, they reported 3Q net income of 2.5 billion, or .49 per share, compared with 2.12 billion, or .41 per share, for the year-earlier period. Revenue was 9.04 billion, up from 8.76 billion. Analysts were expecting .56 cents per share on revenue of 9 billion, while the whisper estimate was .57 per share.

After initially trading higher, the shares declined and closed off 1.19 for the week.

We booked the weekly March 23 straddle sale using the 30 strike prices for the sale of the put and call on last Monday's close for a 1.77 credit as the implied volatility climbed to 70.50. On Friday the 30 call expired worthless and the 30 put was 1.46 at the close. The net result on the implied volatility decline to 19.78 was a .31 gain.

thinkingNext the long hedge side of the suggestion, the April 30 straddle purchased at Monday's closing prices for 2.21 with implied volatility of 31.16. Friday's closing prices were 1.81 as the implied volatility declined to 20.15 for a loss of .40. The overall result before commission costs was loss of .09, certainly not worth the effort. The issue was the greater than expected decline in implied volatility for the long straddle part of the strategy.   

Lululemon Athletica Inc. (LULU) 72.04 posted better than expected 4Q results of .51 per share, up 34.2% from the prior period, compared to the consensus estimate of .49 per share, but less than the whisper estimate of .53 per share.

At the end of the week, the stock was up 3.84 on increased gross profit and an increase on comparable store sales.

Once again using the March 23 weeklies we booked the short 72.5 straddle on last Monday’s close for a credit of 4.92 with implied volatility at 83.13. Against this, we used a long April 72.5 straddle that was 7.85 on Monday’s close with implied volatility of 45.59.

On Friday, the March 23-72.5 calls were 3.45 with an implied volatility of 35.64 and the 72.5 put expired worthless. For this side of the strategy there was a 1.47 gain.

For the long April 72.5 straddle the Monday purchase was 7.85 with an implied volatility of 45.59. On Friday, it was 6.38 with an implied volatility of 35.78 for a loss of 1.47. This time the result was a breakeven trade before commission costs as decline in the implied volatility of the long straddle was again more than expected.

KB Home (KBH) 10.29 reported Q1 earnings of -.59 on Friday while the consensus estimate was for a loss of .23 per share. In addition, they reported orders declined in three of their four regions. While some analysts are saying it was company specific we are not so sure and we will be closely watching the XHB to see if it can remain above its upward sloping trendline at 20. On a close below, we will be looking to close out our KBH position.  

By the end of the week, the stock had declined 2.47.

On Monday's close, we booked the sale of the April 11 put for .58 with an implied volatility of 71.59 and on Friday, it closed at 1.09 with implied volatility of 56.27.

Our estimate that it would hold above the upward sloping trendline was wrong and now we need to consider some alternatives. Our original plan was to take the stock by assignment, in the event of a close below 11 on the April expiration. We also have some other alternatives to consider, such as closing the position and realize the .51 loss or roll out the put by buying back the 11 and selling the April 10 put for a .49 credit. While the roll out alternative is still on the table, we will wait until we see a pivot in the stock price and then select the correct put for the sale. Until then we still have the choice of receiving the stock by assignment and then sell calls according to the original plan.

McMoRan Exploration Company (MMR) 12.64 closed the week .76 lower and the option implied volatilities we slightly lower.

We booked our long May 14/16 call spread with the short April 12 put on Monday for a .26 credit and on Friday it was a .51 debit for a mark-to-market loss of .25.

The company has not released the anticipated test results from Davy Jones so our planned event is still in the works. Our risk here is one of time but we have a short put to offset the loss of time value in the long May call spread, but our plans could change on a close below 12 on the April expiration. Stay tuned.

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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While there are some reasons to believe the correction in equities is over, we are not convinced until we see some weakness in crude oil prices that will help to support the transports. In the meanwhile, we continue to suggest more hedging strategies.


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