« November 2012 »

IVolatility Trading Digest™

Volume 12, Issue 46
Oversold Bounce

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Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Options Education


By most measuring techniques the S&P 500 Index (SPX) is oversold and due for a bounce. The challenge will be to decide if the expected bounce forms the bottom for this down leg or is there still more downside to come.

We offer some thoughts along with a tally of our closed November positions, then a new add-on idea using previously assigned stock followed by a conditional hedge suggestion.





S&P 500 Index (SPX) 1359.88. The downward momentum accelerated, both in terms of the number of declining issues compared to advancing issues, as well as increasing volume that peaked with Friday's key reversal, much like the previous Friday, but with slightly higher volume. Both key reversal Fridays looked like short covering counter trend moves. In Digest Issue 44, we highlighted the close below the important 1400 support level set off the Head & Shoulders Top with the minimum downside-measuring objective at 1327.

Friday's key reversal objective is for a higher high than the Friday high and it could continue for a few more days before turning down once again. There is unlikely to be real buying support before reaching the 1327 minimum objective. The early April decline that lasted until early June was 10.7%, while the current decline is 9%. Presuming it eventually equals the spring decline it would reach 1317 thereby fulfilling the Head & Shoulders Top minimum objective.

A large contributor to the SPX key reversal was the very noticeable key reversal in Apple, Inc. (AAPL) 527.68, after testing 500 with a low of 505.75 on 45.2 million shares, the highest since March 14 at 50.7 million shares, as it was advancing. Since the decline from 705.07 was almost a straight line down it would very unusual to see a V shaped bottom pattern. More likely, it will continue higher for a few days or even a bit longer and then retest 500 once again. AAPL makes a good indicator for the overall market, and we would be looking for another short entry when the rally from the key reversal looks complete.

S&P 500 Index Implied Volatility (IVXM). At the end of last week, the Implied Volatility Index Mean declined from 16.97 to 15.36, while the CBOE Volatility Index® (VIX) declined from 18.61 to 16.41.

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


Since the last trading day for the November futures is Tuesday, the day weighting applied 8% to November and 92% to December resulting in an average premium of 1.64 or 9.98% shown above. Our alternative volume weighting between November and December is 6.62%. Despite the declining SPX, this indicator is not showing as much premium to cash as seen in previous declining periods. Initially we thought it was due to less hedging with VIX futures, but now we are beginning to think it could be related to the increasing volume in the short VIX futures ETN and ETF that need to short the VIX futures and their selling is reducing the premiums.

Fridays VIX futures volume was 177,816 compared to the week before at 128,566 contracts as the open interest increased from 375,058 to 384,448.

From a somewhat longer-term historical perspective, Jeffrey Hirsch at the Stock Traders Almanac, speaking at the Traders Expo in Las Vegas, said he is concerned since November is usually a good month and if it continues lower without recovering before month end, the usual seasonal year-end rally is likely to be weak. As for next year, he points out periods when there is a divided congress usually results in sub-par market performance and he thinks it may not improve before 2017.

Other than special situations, we suggest reducing overall market exposure using any short-term rally from the current oversold condition as an opportunity to increase hedges or open new shorts until SPX closes below 1327. We have one conditional short idea below.


For November, we closed some positions early based upon the trade plans, so by expiration there were only three open trades remaining. For the final tally we closed seven resulting in a 269 loss, the largest was a 164 loss with largest gain of 136, all based upon one lot position sizes.

The expiration of our Amarin Corporation plc (AMRN) 10.84, short November 13 call with a short 10 put, suggested in Digest Issue 42 is included in the results tally above. Originally assigned from a short October 12 put, the long stock was cover for the short November 13 call. Since both sides expired, the stock basis is now 9.90.

Ranked number four on Friday for high IV/HV (implied volatility/historical volatility) ratio due to continuing uncertainty about the final status of its FDA approved Vascepa, a treatment for high levels of triglycerides and without a specific date for a further announcement, the IV should remain elevated. Keep in mind high IV suggests the potential for a large stock move in either direction.

Here are the updated option details.

The current Historical Volatility is 59.59 and 60.52 using the Parkinson's range method, with an Implied Volatility Index Mean of 126.94, up from 117.99 last week. The IV/HV ratio is 2.13 and 2.10 using the range method to calculate the HV. Friday's put-call ratio was bullish at .50, with volume at 68,587 contracts traded compared to the 5-day average volume of 32,060. See the volume chart below.

Look at the volatility chart showing the relationship between the implied and historical volatility as well as the volume.


Daily 1 Year Volatility Chart


The continuing wide spread between the IV in orange and HV in blue represents the potential for the stock to move, however without a specific date this relationship could continue for some time and since we are long stock from the October assignment we can continue to sell both sides while waiting for the next FDA announcement.

Consider this replacement strangle.




Although the implied volatility declined slightly Friday, it is still high and the November options will soon rapidly lose time value. In the event the stock closes below 10 at the December expiration, our position will then be long 200 shares of stock with a basis of 8.19 per share. If the stock remains in the range between 10 and 12 then the second strangle will expire worthless, reducing our basis in the first 100 shares of stock to 7.37.

Conditional Hedge

iShares Russell 2000 Index (IWM) 77.48.  

With a slightly higher implied volatility than the SPX here is a hedge suggestion conditioned upon they key reversal rally extending and based upon IWM closing back above 79. We usually don’t offer conditional suggestions, but the rally could be completed quickly and we want to be prepared in the event it trades higher and rolls over this week. The premiums will need adjusting, but here is a suggestion using Friday closing prices.


iShares Russell 2000 Index


Use a close back above 82 as the SU (stop/unwind). Ideally, the debit premium should be about 30% of the strike price width.

Both the suggestions above use 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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Equities are currently oversold and Friday's key reversals suggest they will see higher highs Monday and there is a good chance a short-term counter trend rally could be underway.


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In next week's issue, we will return to review our market indicators and update the progress of our open hedge 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. Another way to find them is the Table of Contents link in the blog section of our website.

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".