« June 2012 »

IVolatility Trading Digest™

Volume 12, Issue 24
Watching the Bounce

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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The never-ending search for clues about market direction continues despite the turmoil in Europe that will ultimately determine the outcome. In the short-term the stage is set for the bounce that began last Wednesday to continue after the Euro zone finance ministers agreed on Saturday, to lend Spain up to €100 billion, from an undetermined source, to recapitalize its banks.

We will wait and watch cautiously to see how high this news carries the euro, the S&P 500 Index, and other risk assets along with a few select indicators. After a brief strategy comment, we have a new long suggestion for the bounce and then update a previous crude oil suggestion followed by a high-implied volatility trade idea.



StrategyS&P 500 Index (SPX) 1325.66. The flag pattern highlighted in last week's Digest Issue 23 was completely destroyed last Wednesday when SPX gained 29.63 to close at 1315.13, considerably above the crucial pattern low of 1291.98, made on May 18.  

Now with expectations that it will continue higher on the weekend news from Europe watch 1334.93 from May 29 where it could encounter some "sell the bounce" pressure.

NYSE McClellan Summation Index -450.53. Further validity supporting the bounce comes from an improving NYSE Composite breadth ratio, gaining 56.77 points last week, for the first improvement in the last four weeks.

S&P 500 Index Implied Volatility (IVXM). Since last week, the Implied Volatility Index Mean decreased 24.80 to 18.75, while the CBOE Volatility Index® (VIX) decreased 26.66 to 21.23.     

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 28% to June and 72% to July resulting in the average premium of 2.00 or 9.44% shown above. Our alternative volume weighting between June and July results in a 7.36% premium. Last week the day-weighted premium was 6.82% and the volume weighted was 6.09%.  

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 did appear to be a good way to measure professional hedging sentiment. Along with the slightly lower VIX, we consider the current futures premium reading to be neutral to slightly positive.  

Using a cyclical rotation indicator as another measure to help evaluate the strength of the bounce, we compare the Consumer Discretionary Select Sector SPDR (XLY) 43.41, divided by the Consumer Staples Select Sector SPDR (XLP) 34.09 creating the ratio index from last December shown below.



The downward sloping trendline labeled DSTL in blue above from the May 2 peak at 1.34 shows the Consumer Discretionary SPDR, XLY has already reversed the downtrend and appears headed higher once again adding support for "risk on" cyclical trading ideas.

Consumer Discretionary Select Sector SPDR (XLY) 43.41.

While there are many ways to increase risk exposure, this one keeps us focused on the ratio in the event the current bounce momentum falters.

The current Historical Volatility is 19.17 and 14.73 using the Parkinson's range method, with an Implied Volatility Index Mean of 20.48 down from 26.45 last week. The IV/HV ratio is 1.07 and 1.39 using the range method to calculate the HV. The put-call ratio at a whopping 17 reflects considerable hedging activity with Friday's volume of 6,717 contracts traded compared to the 5-day average volume of 14,550 contracts. The bid/ask spreads appear wide so use limit orders and consider legging into the position. Here is one long call short put directional idea.



There is some implied volatility edge in the short put. Use a close back below the downward sloping trendline shown above or alternatively the most recent pivot at 42 as the SU (stop/unwind).  




If the bounce continues and money flow returns to the cyclicals then we should close our crude oil put spread from Digest Issue 20 when USO was 36.26. Here are the trades need to close the position.

United States Oil (USO) 31.80.



The totals shown above are for 2 options at each strike price, the July 33s were 2.17 each, while the July 35s were 3.63 each. After the adjustment made in Digest Issue 20, the current position has a credit of .21


High Implied Volatility

Arena Pharmaceuticals, Inc. (ARNA) 6.62. On May 11, the stock was up 2.70 on news that a panel of experts for the FDA recommended the obesity drug Lorcaserin for approval. The FDA has assigned a PDUFA date of June 27, 2012.

While we are waiting to see if the bounce back accompanied by some rotation back into the cyclicals will continue here is one that is likely to move independently from the market.

Here is the option data.

The current Historical Volatility is 190.32 and 96.39 using the Parkinson's range method, with an Implied Volatility Index Mean of 150.05 up from 141.13 last week, but down from 341.01 last month before the panel of experts recommendation. The IV/HV ratio is .79 and 1.56 using the range method to calculate the HV. The put-call ratio is bullish at .46 and has been under .30 for the last month. Friday's options volume was 30,724 contracts traded compared to the 5-day average volume of 20,410 contracts.

Since the implied volatility is likely to continue rising going into the announcement date scheduled for June 27, here is long strangle to consider.



If the implied volatility continues to rise as expected both the call and put should rise in value regardless of any price change. Although the FDA announcement date is subject to delay, we plan to close this trade on June 26 unless there is a new date announced.

All of the suggestions above use the closing middle price between the bid and ask on Friday. 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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The weekend news from Spain will most certainly extend the bounce that began in the middle of last week. However, it could just be another opportunity to sell, so watch for further market breadth strength and cyclical rotation indicators among others for further signs of sustainability.


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In next week's issue, we will update all of our market indicators and report on the bounce.


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. Another way to find them is the Table of Contents link in the blog section of our website.

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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".