« February 2012 »

IVolatility Trading Digest™

Volume 12, Issue 7
Greek Despair

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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The image of Oedipus in despair reminds us the Greek sovereign debt issue is not yet resolved. After a month long advance the equity markets began wobbling as it realized many Greeks are questioning whether more austerity is the right solution for the debt crisis or whether a new pro-growth approach is needed. For now, Sunday’s vote in the Greek parliament on the latest austerity package should provide the answer with the results reflected in the markets as they open on Monday.  

This Digest has our market review along with strategy comments suggesting some hedging may be worth considering. Then we look at a new takeover file entry along with another earnings trade idea.


Market Review

Review Notes Clip ArtS&P 500 Index (SPX) 1342.64. With a small decline on Friday SPX is still 5% above our well-defined three-point upward sloping trendline from the October low and now up against resistance in the 1350 area from last February through July.  

E-mini S&P 500 Futures (ESH2) 1340.50. Volume continues to be on the light side with only Thursday's volume of 1.76 million contracts slightly in excess of our light volume marker of 1.7 million contracts. Friday's preliminary open interest continued to increase, but it is often adjusted dramatically by Monday's final report. If the final report shows a decline in open interest it would imply long liquidation.

S&P 500 Index Implied Volatility (IVXM). Since our last market review, in Digest Issue 5, the Implied Volatility Index Mean increased from 16.06 to 16.86, while the CBOE Volatility Index® (VIX) increased from 18.53 to 20.79.  

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 10% to the February and 90% to March resulting in the average premium of 2.58 or 12.41% shown above. An alternative volume weighting between February and March results in a lower 8.35% 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. Last week the premium was 14.85% compared to premium of 13.17% in Digest Issue 5, our last market review based upon January 27 closing prices. We consider the current premium levels to be in the normal range. In the past when the premium levels have been above 20%, corrections have usually followed. Alternatively, when the premiums are at a discount to the cash VIX, SPX upturns usually follow very soon.    

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 65.83 and 70.42 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 87.54, the IV/HV ratio is 1.33, using the range method for Historical Volatility the ratio is also 1.24 while the VIX put-call ratio is low at .45 suggesting there was considerable call activity on Friday, which is usually associated with hedging activity using VIX calls.   

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

CBOE S&P 500 Skew Index (SKEW) 129.59. When out-of-the money S&P 500 Index puts are purchased for downside protection, the SKEW is designed to increase. Friday's increase was the second time this year that it spiked above 128.  On January 18, it spiked to 130.78 and then declined back to the center of the range along with the minor correction that ended on January 30. This is the eighth time SKEW has exceeded 128 since it began trading on February 23, 2011.

CurrencyShares Euro Trust (FXE) 131.18. It was renewed uncertainty from Greece that turned the euro 1.10 lower on Friday closing on the upward sloping trendline from the January 13 low at 125.75 when sentiment began improving. If the Greek parliament rejects the proposed austerity package the euro will likely decline below our trendline creating a headwind for equities, commodities and gold as the euro weakness reflects dollar strength. 

NYSE McClellan Summation Index 1325.47. This indicator, used as a measure for the number of advancing issues compared to declining issues on the New York Stock Exchange, increased another 275.47 points since Digest Issue 5, although Friday's 17.83 decline reversed a string of increases that began on December 20. Unless there is a serious market correction of 5% or more we expect the Summation Index to continue advancing.

iShares Dow Jones Transportation Average Index (IYT) 93.76. In its confirming indicator role, the transports are signaling caution as Friday's close was below our upward sloping trendline from last October's low. From a Dow Theory perspective, it is a signal to consider some hedging strategies.

SPDR Homebuilders (XHB) 19.96. The upward momentum stalled on Friday with a close below 20, it now looks overbought and due for a correction. Now 7.3% above the upward sloping trendline it could pull back to 18.50 and still be in an uptrend based upon the trendline.  



StrategyAlthough we will not know the results of the Greek parliamentary vote until Sunday, we can review some other indicators in an attempt to assess the current situation. A negative Sunday vote will most likely result in a further euro decline along with a rising dollar, declining equities, commodities and gold.

Another indicator we occasionally check to determine their bullish or bearish bias is the weekly Investors' Intelligence survey of financial newsletter writers. Although backward looking, it is considered contrarian since at the extremes it has signaled changes in trend. As of February 8, the current reading was 52.1 % bullish and 28.7% bearish for a bull/bear spread of 23.4%. While the bullish percent is high, the bull/bear spread is not extreme like 35% seen before the market top last April.   

While the S&P 500 Index is 5% above the upward sloping trendline, the iShares Russell 2000 Index (IWM) 81.27, is 3.8% above its trendline, while the PowerShares QQQ (QQQ) 62.47 is 8.8% above its trendline, which means corrections of 3% to 5% would not reverse the current uptrends.

While our VIX futures premium shown above at 12.41% is not signaling an immediate correction, the CBOE SKEW Index at 129.59, also shown above is at levels that have been consistent with corrections in the past.


Hedge Idea

While positive results of the Greek parliamentary vote could make a hedge unnecessary, here is VIX idea to consider in the event of a negative vote. Alternatively consider it in the event a correction begins on a positive vote outcome. Here is a conditional suggestion if VIX appears to be continuing higher.

The current Historical Volatility is 65.83 and 70.42 using the Parkinson's range method, with an Implied Volatility Index Mean of 87.54, up from 70.24 last week. The IV/HV ratio is 1.33 and 1.24 using the range method to calculate the HV. Friday's put-call ratio was .45, bullish for the VIX, but bearish for SPX, with 637,076 contracts traded compared the 5-day average volume of 485,420 contracts.

If the VIX continues rising the spread between the near term option and the deferred should narrow.



Although there is no apparent volatility edge, the spread should narrow if the VIX continues higher as the long March contract should increase faster than the short April contact. 

Takeover File

Illumina, Inc. (ILMN) 53.89. In the past week, the company reported earnings and rejected the Roche offer of $44.50 per share saying they are unwilling to participate in discussions.

The decline in implied volatility shown in orange below suggests options traders think the stock is fully valued around the current level, or no new developments are expected very soon.




While we usually try to find deals that are likely to attract options activity it is instructive to look at some that are not very likely. However if the implied volatility starts rising it will be worth reconsidering.

Earnings Report Idea

MercadoLibre, Inc. (MELI) 92.78 operates online commerce and payments platforms in Latin America. Scheduled to report 4Q earnings on February 22 after the close, the consensus estimate is .51 per share.

Since the implied volatility is starting to rise in anticipation of the earnings report as shown by the rising orange line in the volatility chart below we suggest a long volatility strategy such as a straddle, strangle or call spread.  



The current Historical Volatility is 28.32 and 32.48 using the Parkinson's range method, with an Implied Volatility Index Mean of 47.71, up from 43.25 last week. The IV/HV ratio is 1.68 and 1.47 using the range method to calculate the HV. Friday's put-call ratio was at .40 bullish, with only 582 contracts traded compared the 5-day average volume of 1,280 contracts. The low volume means the bid/offer spreads will be wide requiring some patience to open the position and that subsequent adjustments are not practical. 

Consider this long strangle.



The plan is to sell the position the day before the earnings report.

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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Until the results of the Sunday Greek parliamentary vote is known, strategy planning is not likely to be very productive. There will still be many opportunities after the markets react to the results.   


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