« May 2012 »

IVolatility Trading Digest™

Volume 12, Issue 20
JPMorgan Hangover

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Once again, the obscure world of illiquid OTC interbank trading without clearing firms or margin requirements is back in the news. This time it was JPMorgan, a firm with the reputation for having the best risk controls in the banking industry. Assuming it was possible to close the positions immediately, the reported mark-to-market loss was $2 billion and since the positions are illiquid, the counterparties will make JPM pay up as they attempt to unwind them, so the final losses could be even more unless interest rates rise as we suspect this was the basis of their speculation.  

Chief Executive Officer Jamie Dimon, an outspoken critic of Dodd-Frank regulatory implementation prohibiting banks from taking such positions for their own account now looks like he was the self-appointed fox guarding the henhouse. 

While the size of the loss may not be material to JPMorgan, the hangover will surely be body blow to needed market confidence since Friday's S&P 500 Index (SPX) close at 1353.39 was below our previously identified trigger point at 1357.38 in Digest Issue 19, confirming the now active Head & Shoulders Top with its minimum downside-measuring objective at 1300.

In this Digest, we update two of our important indicators, followed by two previous suggestion updates as well as an update in the takeover file then a new quarterly earnings report idea.



StrategyThose using VIX futures to hedge downside risk seem less concerned about the current technical condition as the day-weighted VIX premium indicator closed Friday at 7.84%, down from 15.75% reported in Digest Issue 18. The day weighting applied 10% to the May futures contract and 90% to June. Our alternative volume weighting between May and June resulted in a 5.05% premium.

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. In the past premiums in excess of 20%, have usually preceded corrections, although not a precise timing tool it does appear to be a good way to measure professional hedging sentiment. We consider the current readings to be on the low side of neutral. 

NYSE McClellan Summation Index 95.66. In Digest Issue 18, we were ringing bell about the improvement of this important indicator that has since gone backward by 97.86 points, but down 147.80 points in just the last week. We maintain improving market breadth, is a necessary condition for the market to advance and now it seems to confirm the Head & Shoulders Top with more downside yet to come.

Contrary to our comments in Digest Issue 18, it is again time for more hedges and put spreads.




Here are two previous suggestion updates.

Williams Companies, Inc. (WMB) 32.54. In Digest Issue 4, we included a May long call spread with a short put in the reorganization file for this major natural gas pipeline company. Since then the stock has made steady upward progress, but the options expire at the end of the week so we will close this one and book the gain using Monday's closing prices. On Friday, the mark-to-market gain was 2.02 from an initial debit of .24.

United States Oil (USO) 36.26. Digest Issue 14 included a put ratio backspread based on the assumption that crude oil prices were going to continue declining and just recently they declined somewhat, but not as much or as soon as we anticipated. Accordingly, since the position as an extra long call that experiences time decay we suggest converting this position into a put spread with an equal number of long and short options. Initially it was long 2 July 35 puts and short 1 July 39 put.

Here are the adjustments converting it into a 2-lot put spread.



Since the July 33 puts were .675 each on Friday the total for both shown above are 1.35. The initial position was booked for a credit of .63, so with the debit of 2.10, the net position debit will be 1.47 but we have reduced the time decay and implied volatility risk making it a better position in the event crude continues drifting lower for the next two months. Use a close back above the gap at 38 as the SU (stop/unwind).

Takeover File Update

Avon Products Inc. (AVP) 20.19. As noted in Digest Issue 18, AVP rejected the offer to buy the company made by Coty, the French fragrance and global beauty company, at 23.25. Now apparently with Warren Buffet involved with financing the offer has been increased to 24.75. As a result, the options are starting to reflect some interest in the deal, although the price has declined and is below the new offer amount.  

Here is the options data.   

The current Historical Volatility is 68.27 and 48.79 using the Parkinson's range method, with an Implied Volatility Index Mean of 75.05, up from 62.09 last week. The IV/HV ratio is 1.10 and 1.53 using the range method to calculate the HV. Friday's put-call ratio was bullish .30 while the volume was 94,192 contracts traded compared to the 5-day average volume of 68,250 contracts.

The increased options volume along with higher implied volatility suggests increasing expectations that a deal is in the making.

Our first long 22/24 June call spread with a short May 21 put suggestion was booked with a .22 credit, but the short 21 put could be in-the-money at Friday's close. If so, we suggested accepting the stock by assignment and then plan to sell a call against the long stock.

In addition, we noticed a large amount of June put volume and since the put implied volatility was lower than the call implied volatility, concluded their decline was due to out-of-the money put selling at the 18 and 19 strikes. This seems about right since there is good support at 18. Accordingly, we suggest adding this put sale to the position.



Use a close back below 19 as the SU (stop/unwind).


Quarterly Earnings Report

J. C. Penney Company, Inc. (JCP) 34.33. J. C. Penney has been reorganizing with a new pricing strategy, fresh logo, strategic merchandise initiatives, reducing costs, and attempting to improve the shopping experience.

Scheduled to report 1Q earnings Tuesday before the opening the consensus estimate is for a loss of .09. Since management has previously advised that the turnaround will take at least two years, there is a good bit of doubt about the estimate, which means the options implied volatility has been rising. If we had been watching it sooner we may have suggested using a long straddle starting in early April with the plan to sell it before the announcement.

However, we did not spot is before it was brought to our attention by our RT Spread scanner as the Best Calendar Spread suggestion on Friday. We modified the standard suggestion by using May options with a higher implied volatility on for the short leg.

Here is the options data.

The current Historical Volatility is 33.13 and 30.75 using the Parkinson's range method, with an Implied Volatility Index Mean of 55.98 5up from 51.63 last week. The IV/HV ratio is 1.69 and 1.82 using the range method to calculate the HV. Friday's put-call ratio was bearish at 1.85, no doubt reflecting hedging while the volume was 13,323 contracts traded a good bit lower when compared to the 5-day average volume of 32,910 contracts.

Here are the volatility and options volume charts showing the noticeable increase in implied volatility since April.



Since we know the is considerable risk with calendar spreads when the underlying makes a big move we think in this case the near term options are priced high enough and expectations are low enough that there will not be a large move. If it does, this calendar will lose money so the best risk strategy is to limit the position size.



The implied volatility of the short call is more than twice the long call and should be sufficient unless the stock makes a large move. Scheduled to report on Tuesday before the opening this one will needs doing Monday. We will not have very long to wait for the results.


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.

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With Friday's S&P 500 Index close at 1353.39 and below our previously identified trigger point at 1357.38, the Head & Shoulders Top with its minimum downside-measuring objective at 1300 is now the active technical pattern. More unfavorable revelations from JPMorgan or Europe would surely hasten the expected decline.


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In next week's issue, we will update all of our market indicators.


Finding Previous Issues and Our Reader Response Request

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