« October 2012 »

IVolatility Trading Digest™

Volume 12, Issue 39
Nemesis of the Longs

Nemesis of the Longs - IVolatility Trading Digest

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Nemesis of the LongsAs if to say there is a limited permissible travel speed, corrections are the "Nemesis of the Longs". Nemesis, related to the Greek word némein, meaning "to give what is due", as depicted on the Greek coin, was the goddess of divine indignation and retribution, who punished excessive pride, arrogance, or good fortune, and the absence of moderation.

In this issue, we examine the current correction from our unique market review perspective and then offer some thoughts for the fourth quarter, followed by a trend continuation suggestion for PulteGroup (PHM), the homebuilder.


Review Notes Clip ArtS&P 500 Index (SPX) 1440.67. The third quarter ended in a quiet correction, as we suggested it might in Digest Issue 38, last week. Now that September options and futures are gone and 3Q earnings reports will soon be arriving after the September employment report, we wonder if they will be enough to take our attention away from the daily gyrations of euro that seems to be driving the equity markets lately.

E-mini S&P 500 Future (ESZ2) 1434.25. During the first week after the September expiration, open interest resumed advancing moderately after the large decline due to the expiration. As a reminder we follow changes in the volume and open interest since a healthy trend needs open interest to continue expanding and any decline in open interest, especially on large volume in excess of about 3 million contracts could indicate a change in the major trend as existing longs liquidate to existing shorts who begin covering.

S&P 500 Index Implied Volatility (IVXM). At the end of last week, the Implied Volatility Index Mean increased from 11.31 to 12.89, while the CBOE Volatility Index® (VIX) increased from 13.98 15.73.

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.


VIX Closing Cash


The day weighting applied 60% to October and 40% to November resulting in the average premium of 1.31or 8.35% shown above. Our alternative volume weighting between October and November calculates to be a very similar 8.63% premium. Last week the day-weighted premium was 16.75%, while the volume weighted was 19.89%. The decline suggests there was a lot less interest in hedging at the current level. Friday's volume was 103,032 contracts and the open interest was 384,291 contracts.

Since the CBOE updates the VIX futures term structure during the day an estimate of the current premium or discount is always available. In addition, the data is available on our Advanced Futures Options pages, using VX as the Instrument symbol and CF for the exchange. Compare the options Implied Volatility to the Historical Volatility by setting HV chart to 21 days.

VIX Options

With a current 30-day Historical Volatility of 100.31 and 78.33 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 Friday's closing option mid prices along with their respective month's futures prices, since the options are priced from the tradable futures.


Implied Volatility (IV) of the at-the-money VIX calls and puts


Using the IV Index Mean of 76.12 the IV/HV ratio is .76, using the range method for Historical Volatility the ratio is .97 while the VIX put-call ratio at .27, down from .42 last week, is now quite bullish for VIX, but bearish for the SPX since they move in opposite directions. Friday's options volume was 529,386 contacts compared to the 5-day average of 461,080 contracts. The lower premium in the futures seems offset by more volume in the options.

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) 125.87. Designed to measure the purchase of out-of-the-money S&P 500 Index puts that would require a very large downside move to profit from long put positions, an increase of this index indicates a higher expectation of an extreme down move. After a quick spike up to 130.67 on Friday September 21, most likely related to options and futures expiration, it declined back into the upper part of the new 114-130 range. Remaining in the upper part of this range indicates OTM puts are still very much in demand.

CurrencyShares Euro Trust (FXE) 127.69. Recently it seems all "risk on" assets, including equities, have been following the euro. When the euro is up "risk on" assets are also up and vice versa. Lately it seems all the focus of attention has been on Europe in general and Spain in particular, as nothing else seems to matter, not the US economy, the "fiscal cliff", the upcoming elections, or even disappointing earnings pre-announcements. All one needs to do was watch the euro for a sense of market direction. Of course, it is not that simple as the charts below from the Correlation function in our Advanced Historical Data section illustrates the 30-day correlation between the S&P 500 Index and FXE, which is now only 40.25, having been as high as 72 in late July.


CurrencyShares Euro Trust (FXE)


NYSE McClellan Summation Index 749.88. Not surprisingly, our NYSE Composite breadth indicator declined 70.68 points since we last reported in Digest Issue 37, with 138.66 points of the decline occurring last week, as the correction got underway. For now, the issue of divergence is not a major concern, as breadth and the composite index are moving together.

iShares Dow Jones Transportation Average Index (IYT) 87.09. If one were looking for the "Dogs of the Dow", a good place to begin would be in the transportation index since it is back near the bottom of the range it made last June. It is difficult to see how the major market indexes can continue very much higher if this group continues to wane. In order to improve, they would need to get some help from declining crude oil prices, to provide some cost pressure relief, since transportation demand has slowed in certain sectors.

SPDR Homebuilders (XHB) 24.83. As we noted in Digest Issue 37, this top ranked group was almost four points above our upward sloping trendline, overbought and vulnerable to a near term correction. As cautioned, a correction began last week and now the question is how much further it goes? Since the Federal Reserve is targeting housing construction employment with its open-ended mortgage buying plan, and with home prices now increasing once again, we think the answer is not very much lower. Accordingly, we have another trade suggestion in this sector below.

United States Oil (USO) 34.12. Absent any unforeseen surprises from the Middle East, we think chances are good that crude oil prices will continue the expected seasonal decline that began on September 18 when it closed below our upward sloping trendline. This should give some needed help for both the transports and the consumer discretionary sectors since less money will be needed for transportation fuels. In the absence of the often-cited Middle East risk premium, USO seems likely to decline to the 30 level or about 80 per barrel for WTI crude.



StrategyChances are the markets will soon start to focus attention on 3Q earnings reports and less on the problems in Europe. First, however the September employment report needs consideration. However, the run up to November elections have traditionally been favorable for equities.

Further, between now and year-end we think another important influence will be underinvested mutual and hedge funds chase performance since they risk the loss of assets under management if their year-end performance lags the S&P 500 Index. This could create a broad based momentum rush as managers look for sectors that have not yet advanced in hopes of catching up with the benchmark index by the end of the year. With some help from declining crude oil prices, we think the S&P 500 Index could reach 1500 by the end of the year. 

Trend Continuation

While there are several ways to gain exposure to the improving housing sector, including the SPDR Homebuilders (XHB) above, we prefer individual stocks with higher implied volatility since we use short options in many of our trade plans.

Here is a supplement to the suggestion made last week in Digest Issue 38.       

PulteGroup, Inc. (PHM) 15.50. Their homebuilding business includes the acquisition and development of land primarily for residential purposes offering various home designs, including single-family detached, townhouses, condominiums, and duplexes under the Pulte Homes, Del Webb, and Centex brand names.

Last week we incorrectly wrote that 3Q earnings was last Tuesday before the opening, with the consensus estimate is .20 per share. The correct reporting date is October 25 before the opening.

The current Historical Volatility is 41.27 and 41.68 using the Parkinson's range method, with an Implied Volatility Index Mean of 51.60 up from 45.94 last week. The IV/HV ratio is 1.25 and 1.24 using the range method to calculate the HV. Friday's put-call ratio was bearish at 1.00, while the volume was just 3,027 contracts traded compared to the 5-day average volume of 12,890.

Here is another call spread, this time with a put sale in addition to the October call spread from Digest Issue 34, and the put October 16 put sale last week in Digest Issue 38.


PulteGroup, Inc. (PHM)


With decent volatility edge in the short put and a good risk to reward ratio, use a close back below the upward sloping trendline at 13 as the SU (stop/unwind). On any further decline, watch 14 where there is considerable support. The options volume is low so it may be advantageous to leg into the position to avoid paying the ask price for the purchase and the bid prices for the sales.

The suggestion above uses the closing middle price between the Friday bid and ask. Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.


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Although attention shifts from the euro to the employment report this Friday we think the current correction has just about run its course, but could continue somewhat lower on a worse than expected report as reflected in the still active hedging activity especially in the VIX options. Nevertheless chances are the correction is about over and the uptrend is likely to continue into year-end with some help from our European friends.


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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".