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Today


IVolatility Trading Digest™


Volume 8, Issue 39
Wild Ride

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer at the very bottom of this page

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).

We think a wild ride is the best description we can give to the equity markets last week. Looking at the SPY, the ETF for S&P 500 Index we see a gap lower on the opening Monday followed by three days in a row with the closes on the low and then an attempt to make a key reversal on Friday. The iShares Russell 2000 Index (IWM) 52.45 did manage to make a key reversal but the volume was not really sufficient to validate it with any conviction. Regardless, equities are oversold and we will likely see them attempt to turn higher this week. We will offer a trade plan suggestion using the SPY for this opportunity. First we are going to make a suggestion for the ever rising US Dollar and then we will update our short strategy for crude oil. First the Market Review.

Market Review

S&P 500 Index (SPX) 899.22. For the week the SPX lost 220.01 points or 18% while trading in 10% ranges for three of the five days and three days it closed at or near the lows of the day. Finally on Friday there was an attempt to close higher and it almost managed a key reversal. The volume at 871 million shares would have certainly qualified it for a key reversal if it could have closed the day with a gain. However, at the close, it was down 10.70 dashing hopes of a key reversal. As mentioned above the iShares Russell 2000 (IWM) managed a key reversal but the volume was not good enough to be convincing.

CBOE Volatility Index (VIX) 69.95. After making a new intra-day high of 76.94 the VIX closed Friday at 69.95 without providing any help to the SPX in its struggle to make a turn around. The 10 day Historical Volatility of the SPX is 61.32 while the somewhat longer-term numbers are 48.05 for the 30-day Historical Volatility and 46.23 for the Historical Volatility based upon the 30-day range method. We would need the VIX to start declining in order to confirm that we have made a final low and as yet we do not have it.

US Dollar Index (DX) 83.00. The US Dollar continued higher as it added almost two points on Friday breaking out above 82. With 90-day Eurodollar deposits yielding 5.25% we can see where the money is going although there continues to be some risk in this market as measured by the TED spread below.

TED Spread 4.64. The TED spread is difference between the 90-day LIBOR (London Inter-bank Offer Rate) and the equivalent term Treasury Bills. In normal market conditions this spread is about 50 to 75 basis points or .50% to .75%. Since the US Government guarantees Treasury Bills and Eurodollar deposits have bank risk the TED spread give us a way to measure the current perceived risk in the Eurodollar market. Here is the updated Bloomberg chart of the TED Spread showing an all time high at 4.64.

Open 4.23, High 4.65, Low 4.05, Close 4.64

NYSE McClellan Summation Index. Last week our market breadth indicator accelerated to the downside, as we could have expected, declining 536.07 and now at –1319.34. On the bright side this reading may provide a glimmer of hope since bear markets end when the Summation Index is below –1200 and we have now met this downside objective.

Strategy

For now the US Dollar looks like one of the better long candidates. For those who need to be in the equity market, consumer staples are going down at a slow rate than the consumer discretionary stocks. With a few exceptions this is probably not the time to be shopping for bargains in most sectors including materials and energy as most have declined below their long- term uptrend lines going back to their 2002 lows. Many sectors are now in downtrends and should be managed accordingly.

IVOLopps™

In IVolatility Trading Digest™ Volume 8, Issue 32, Dollar Redemption, dated August 25, 2008 we suggested a bull call spread using PowerShares DB US Dollar Index Bullish (UUP) 24.99.

At that time the UUP was 23.93 and the long Dec 22 ½/ 25 bull spread was priced at 1.35. It is now showing a market value of 1.80 for a 33% gain in 7 weeks. That’s not too bad in this market environment.

Since we have no reason to think the dollar will decline in the near term we suggest another UUP bull call spread. With a Historical Volatility of 16.76 consider this idea.

While the options volume is not very large there are options trading near-the-money strike prices in all expiration months. Some patience may be required, but here is a trade with good edge and enough time to reach its objective. We suggest setting the SU (stop/unwind) at a close below 24.

Short Crude Oil Update

United States Oil (USO) 66.50. This ETF reflects the spot price of West Texas Intermediate (WTI) light, sweet crude oil.

Last week in IVolatility Trading Digest™ Volume 8, Issue 38, Oktoberfest, dated October 6, 2008 when USO was 75.25 we suggested a combination of a put ratio backspread and bearish call credit spread for a net credit of 1.275. Based upon Friday’s closing prices if the position were to be closed we would keep 1.625 of the 1.875 credit from the credit spread and the backspread would be worth 3.60 for a gain of 3.00. The combination total gain is 4.625 or $462.50 for one a one-lot position. The USO price decline was 8.75 and it was accompanied by a rise in implied volatility of 16.43 percentage points, both exceeded our expectations. Here is the graph using our soon to be released IVolatility.com Profit and Loss Calculator with the original options cost prices at the current market value.

Because we are now beginning to see declining demand on a year over year basis in several sectors of the crude oil and products complex we think there is more downside potential in USO and we suggest the addition of a bear put spread to the position as follows.

Subtracting the initial credit from this indicated debit gives us a net cash investment for the entire position of .10 or $10 assuming one lot positions for all the legs. With this addition here is the new P&L profile. Notice the change in the upward slope of the line.

If USO continues lower to 60 as we expect our gain would then be $858 as shown above. A further price decline is likely to be accompanied by a further increase in implied volatility. For example, if IV rises from the current 71 to 75 the gain would be $896 (not shown). At $10 our costs have been very small and all of our risk has been defined and limited. So far this has been a good example of using a more complex strategy helped by the rapidly declining ETF price and the accompanying increase in implied volatility.

Oversold S&P 500 Index

On the assumption the S&P 500 Index is oversold and due for a counter-trend rally here is a short-term trading suggestion using the SPY.

SPDRs (SPY) 88.50. SPDR Trust is an exchange-traded fund that holds all of the S&P 500 Index stocks. It is comprised of undivided ownership interests called SPDRs. With a current 10-day Historical Volatility of 58.85 consider this bull call spread for a trade.

Trade Plan

DR: Short-term counter trend trade.

SU: Unwind the position if SPY makes a lower low and lower high on Monday.

The upside target for the SPY for this trade is 105. This position does not have edge; it is a short-term trade based on the premise that the SPY is oversold. The maximum value is 5 points. However, if it makes a lower trading range day unwind the position as all of the required indicators for a bottom are not yet apparent, in particular the VIX.

Hang on!

Previous Issues and 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. 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 for us to take a look at a specific stock or ETF just let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.

Comments:

Hello there,

Thanks for the wonderful education, I learned a great deal.

Here is my question for the USO strategy, is it possible to explain a bit in details why the increase in volatility will help the overall positions? It seems the bear call spread would be hurt by the increased volatility.

Thanks a lot

Posted by Mika on October 13, 2008 at 01:12 PM EDT

Mika,

Thanks for asking the question about changing volatility in the USO position. When we do a 1:1 spread such as a bull call spread or a bear put spread, when both options expire in the same month we are long one option and short one option. As a general rule, changes in volatility and time decay are offset since we are long one and short one. If however, we do a ratio spread, such as a put ratio backspread that we suggested for the USO trade in IVTD V8 Issue 38, Oktoberfest, dated October 6, 2008 we have more long options than short options. We are long two and short one. The additional long option, in this case a put, helps the position as the stock declines and volatility increases. Most of the time this is the case when we experience large decline in a short period of time. In this Issue we suggest adding one more bear put spread, but the volatility assist would come from the original bear put ratio backspread that we detailed in Issue 38 that still has the extra long put. Hopefully this explains how the increase in volatility would help.

Jack

Posted by Jacktrader (68.109.71.202) on October 13, 2008 at 08:14 PM EDT

I am confused. There is a best calendar spread on the home page each day. In this very high volatility environment, shouldn't you be recommending the sale of the spread instead??
With the inevitable mean-reversion that is sure to come sooner or later, time spreads are long volatility and will lose value - no?? Thanks - love your blog and hope you can offer more complex structures like the recent USO trade.
Bill

Posted by Bill on October 14, 2008 at 03:01 AM EDT

Bill,

Thanks for the comment on the Best Calendar Spread that appears as a regular feature in the Rankers & Scanners section of our front page. You are probably right with respect to the current volatility conditions in the market. These sample suggestions are returns from our Spread Scanner that is automatically set to search for long call calendar spreads by scanning for differentials between the near term Implied Volatility compared to the deferred month Implied Volatility. At this point they are untouched by human hands. They are simply ideas for further consideration. When using a scanner you are limited to the set parameters and unless you specify for the levels of relative Implied Volatility it will not differentiate between low or high overall Implied Volatility as it is scanning for the difference in Implied Volatility between two expiration months. Calendar Spreads are always problematic since in many cases the higher implied volatility is well justified by events underway making the near term options priced correctly. You are correct to take the suggestion as a starting point and then see if the idea has merit based upon additional facts and criteria. As you correctly point out it may make more sense in the current environment to be selling the Calendar Spread than buying it.

Thanks for the comment on USO, now that we have the use of our soon to be released IVolatility.com Profit & Loss Calculator we can better explain more complicated strategies.

Jack

Posted by Jacktrader (68.109.71.202) on October 14, 2008 at 01:48 PM EDT


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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".