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Today


IVolatility Trading Digest™


Volume 8, Issue 42
Bear Killer

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).

October is over; the bulls can celebrate once again since the bear has been killed once again. October has marked the bottom of all eleven post World War II bear markets and there is little reason to doubt this one will prove to be any different. While any meaningful recovery may still take some time chances are we have made the bottom.

“The worse a situation becomes the less it takes to turn it around and the bigger the upside.”
– George Soros

From an options perspective the bottoming of the equity market provides an unusual opportunity since the options implied volatilities that have risen to abnormally high levels will start declining as the market turns higher. This usually provides many opportunities to sell options on good quality stocks having high options volatilities that are now declining.

Because there are still a number of concerns including the US elections, the upcoming G-20 meeting, economic stimulus proposals, a homeowner’s bailout plan, and earnings estimate reductions, we think the best approach is to use good quality stocks paying good dividends.

After the market review section we offer some suggestions to consider. Most were taken from the Top 200 stocks by volume/open interest found on our front page. Ideally, we prefer the ones that have already reported third quarter earnings and can maintain their current dividends.

Market Review

S&P 500 Index (SPX) 968.75. For the week the SPX gained 91.98 points after making a small double bottom from the low of 845.27 on Tuesday the 28th. Last week we doubted the October 10, 2008 low at 839.80 would hold but it appears to have held. For now we will use 1100 as the upside measuring objective from this new small double bottom.

CBOE Volatility Index ( VIX) 59.89. On a close-to-close basis the VIX was 19.24 lower for the week. For the entire week we saw lower daily highs and lower daily lows including Monday’s high of 81.65. Since this defines a downtrend the VIX action is encouraging for the SPX.

US Dollar Index (DX) 85.63. The US Dollar declined just .81 for the week after a surprising mid week of decline of almost 5 points from a high of 87.88 to 83.10 before recovering on Friday. Chances are it will now remain in this 83-88 range until after the US elections.

TED Spread 2.65. TED was almost unchanged last week declining just .02. Even though LIBOR declined almost a full percentage point for the week the decline was matched by lower Treasury Bill yields. 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.

NYSE McClellan Summation Index. Our market breadth indicator made an inflection point and turned higher last week confirming the change in direction of the broader market. Now reading -1.441.69 it gained 54.60 points for the week providing more encouragement for the bulls.

Strategy

Now that October is over and there is a reasonable chance we have seen the low for this bear market we can once again suggest selling option combinations such as covered calls, cash covered puts, and perhaps even straddles and strangles to take advantage of declining options volatility. Do the fundamental research, looking for good quality stocks that can maintain their dividends and are least likely to have their earnings estimates reduced.

IVOLopps™

Suggestions

There are many options opportunities now available. Here are just a few of the many ideas we found. They are all dividend paying stocks. In the first group are covered calls for those who prefer to buy the stock and then sell options in order to benefit from the dividends while enhancing the yield by selling premium. In addition, since some investors may be precluded from selling cash covered puts by account restrictions using covered calls is a way to sell attractive options premium. In the second group are the cash covered put sale suggestions.

The “O Price” in column 7 are the options prices as of Friday. Remember Monday’s prices will be slightly less due to time decay. Column 8 “IV” is the Implied Volatility in percentage for the specific option while “F-IV” in column 9 is a Forecasted Implied Volatility. Column 10 “Decline” represents the potential estimated total percent point decline in implied volatility, but not necessarily before the specific suggested option expires. The suggestions have been ranked in order of their greatest potential decline in Implied Volatility.

Covered Calls

Cash Cover Put Sales



Short Crude Oil Update

United States Oil (USO) 55.59. This ETF reflects the spot price of West Texas Intermediate (WTI) light, sweet crude oil. Last week USO increased 2.59 while the Implied Volatility Index Mean declined 4.73 to 78 from 82.73. The mid price of our existing long November 60, short November 55 bear put spread declined to 2.85 from 3.30 the previous week. Our current position cost is a credit or net gain of 6.10 or $610 since the initial combination suggestion four weeks ago. Crude oil prices turned up with the weaker dollar at mid week. Since the dollar rebounded again on Friday we do not see any reason to unwind this spread just yet. We do suggest lowering the SU (stop/unwind) to a close above 60, from the previous level of 62.

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:

I noticed you are using the Nov month for Cash Covered Put Sales...perhaps this is a good topic to discuss, but wonder if with just 15 trading days left to Nov expiration, would this be a justfied time period in which to put on these trades?...perhaps the Gamma is too high when nearer to the expiration?

I would love to hear a discussion of when to put on a trade when getting closer to the expiration month and whether how far along in the month would it be adviseable to do so.

tks!

Rob

Posted by Rob Gordon on November 03, 2008 at 02:33 PM EST

Hi. This is my first issue of your Digest. Thank you. I like it. I don't comprehend it all, because I am a rookie still in school (grin).

I have two Put trades that are currently suffering loss from recent bullish movement. If you would willing to comment I'd be grateful.

(1) AT&T APR27P TPA entered 10/23 at $5.05. One contract. My sell date is 12/16

(2) GE MAR20P QAAPT entered 10/23 at $3.85 One contract. My sell date is 12/16

Cheers,
William Comer
Loveland, CO

Posted by William Comer on November 03, 2008 at 03:30 PM EST

Rob,

Thanks for you comment and question with respect to using November for put trades. You are correct gamma is high and rising as we near expiration. Gamma is the measure for the rate of change in delta, the amount of price change. As the stock turns higher off the bottom the delta will increase at a faster rate. Since we are long delta by virtue of our short put this is favorable. More importantly Theta, the rate of change in the value of the option with respect to time is now rapidly declining also favorable. The rate of change with respect to the decline in time value accelerates rapidly in the last three weeks before expiration, so for sellers the current month is most favorable. You will now see the value of the out- of-the-money November options decline rapidly.

Jack

Posted by Jacktrader (68.109.71.202) on November 03, 2008 at 03:59 PM EST

William,

Thanks for sending us your comment. There are a number of considerations to make with respect to your choice of stocks to buy puts on. First they are good quality companies with a lot of institutional following and they also pay good dividends. The stock prices will be supported by the dividends. As the stocks go lower the dividends go higher and at some point they are so attractive for their dividend they stop declining. Therefore, in general dividend-paying stocks are not the best choice for long put positions. Secondly as we discussed in the Digest when the stocks stop declining and turn higher the Implied Volatility of the options decline. This is what we are now seeing generally in the market. Options that have longer to expire have a higher Vega, or they are more sensitive to the changes in volatility. For example, your AT&T April 27 put will decline in value by 7 cents for each 1% decline in its implied volatility. As a comparison the November 27 put will decline by less than half or 3 cents for each 1% decline in volatility. You may have chosen options with a long time to expiration in order to avoid time decay, but you have traded this advantage for the disadvantage of exposure to the decline in volatility. In order to avoid this problem you could consider using a bear put spread where you are long a put and short a put so the Vega and Time decay concerns are greatly offset by one another. First however, we suggest you look for some growth stocks that don’t pay dividends.

Jack

Posted by Jacktrader (68.109.71.202) on November 03, 2008 at 04:37 PM EST

Thank you for the covered call suggestions. That is my basic way of trading. I hope you will provide them whenever possible.
Jerry Popp

Posted by Jerry Popp on November 03, 2008 at 05:07 PM EST

Jerry,

Thanks for sending us your comment. We often include selective covered calls in the Digest, but usually just one or two. This is a good time for this strategy so we will likely be doing a lot more in the next few issues.

Jack

Posted by Jacktrader (68.109.71.202) on November 03, 2008 at 05:08 PM EST

I agree with Jerry. I'm very interested in covered call strategies, because they eliminate the need for "sell discipline" when holding stocks in rising markets.

And as a low volume trader, they offer a way for me to start small and grow through compounding.

I'm also very interested in volatility forecasting for covered call positions. For example, in this issue, you've included volatility forecasts. I'd like to have a greater understanding of how the forecast numbers are derived.

Thanks,
Thisson

Posted by Thisson on November 04, 2008 at 10:38 AM EST

Hi,

I am trying to understand Options Volume and Open interest. I also want to know how I can use these data to set my trading strategy.

thanks a lot
amod

Posted by amod on November 05, 2008 at 01:49 AM EST

Hello Jack

Why would an investor pay to reserve buying the rights for a stock when they could buy the stock in the open market?

Thank You
Ron

Posted by RonCivil on November 05, 2008 at 08:30 AM EST

Ron,

Thanks for the question on the advantages of using options. There are a lot books and written material available on the advantages and risks of options. A good place to start is the Options Industry Council. They offer educational material and a series of seminars on the use of options. This would be a good place to start. Their web site is http://www.optionseducation.org/

Jack

Posted by Jacktrader (68.109.71.202) on November 05, 2008 at 12:11 PM EST

Amod,

Thanks for the inquiry on Volume and Open Interest. They are both important considerations for the options analyst and strategist. There are a number of good books available on the subject and it is included in the standard options reference books by McMillan and others. You can also find information at the Options Industry Council
http://www.optionseducation.org/ and on our web site by entering Volume and Open Interest into the search box.

Jack

Posted by Jacktrader (68.109.71.202) on November 05, 2008 at 12:35 PM EST

Thisson,

Thanks for your excellent comment on the selling discipline and the inquiry about volatility forecasting. In the volatility business it is obvious that the most important volatility is the future volatility. The basic concept is regression to the mean and it can be done visually by using long-term volatility charts. Just as in technical analysis it is best to start with a longer-term time frame to see where the volatility numbers have been in the past. Then narrow it down to a one-year chart and use this as the basic framework.
You are also interested in the difference between the Implied Volatility and the Historical Volatility. If the Implied Volatility is consistently higher than the Historical Volatility then there is a statistical advantage that we refer to a Positive Volatility Spread providing an edge to the seller of the options.

Look to see where the volatility measures are and where they are likely to go during the period of my position. Look for regular patterns around events such as earnings reports, governmental approvals, and take over developments. Does volatility spike and quickly return to normal levels or is it trending? Has it traded in a relevant range for a period of time and has now found a new relevant range? For example after recently reaching all time new highs in the VIX we are likely to stay in a higher range for awhile and this should translate into higher ranges for most of the equities as well.

IVolatility.com offers the best Volatility charts in the business. At our Advanced Historical Data page you will find current volatility charts on all the traded equities, ETFs and Futures going back to 1994 or from the date options started trading. You will find the long- term charts and then have the ability to narrow the time frame down in increments of years all the way to one month. This is a reasonably priced Internet delivered service that we maintain so you do not have to be downloading and updating an entire database. Just enter the symbol for the stock you want and the chart is delivered. We encourage you to try our Advanced Historical Data service for the best Volatility charts in the business.

Jack

Posted by Jacktrader (68.109.71.202) on November 05, 2008 at 01:21 PM EST


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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".