« January 2009 »

IVolatility Trading Digest™

Volume 9, Issue 1
New Beginning

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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New Beginning is the fourth album by singer and songwriter Tracy Chapman, released in 1995. It is also an appropriate title to begin this first Digest Issue for 2009. For the world’s economies and their equity markets will we see a new beginning in 2009 or will it be more of the same?

Thus far, a typical Santa Claus rally has extended into the New Year on typically low volume. Next week will give us a better reading as traders and investors return to work from the holidays and volumes return to normal levels.

In this Digest we will look at the S&P 500 Index Implied Volatility chart, close our low volatility trade suggestion from the last Digest, look at the Best Calendar Spread suggestion and then update the Takeover File. First, we begin with our market review.

Market Review

S&P 500 Index (SPX) 931.80. Over the two-week holiday period the SPX increased a net 43.92 points or 4.95%. Volume has been very light so we remain cautious that very much can be concluded from this rise as it continues to appear as a counter -trend rally, from the key reversal low on November 21, 2008.

S&P 500 Index IVX 34.41. The Implied Volatility Index Mean (IVXM) continued declining over the holiday period as expected. After several weeks of declining implied volatility, we now think it is about time for an increase as IVXM approaches the 30 level. A visual forecast range of 20-30 appears reasonable and we think in this still uncertain environment 30 is the more likely objective. For the major equity indexes, this suggests we are near a volatility low. A chart showing the IVXM follows.

US Dollar Index (DX) 81.84. The net change in the DX is just .54 over the last two weeks but this is just part of the story, as it appears to be making a rising wedge pattern with bearish implications. As usual, we suggest maintaining focus on the DX or the Euro as an alternative.

TED Spread 1.33. Bloomberg’s TED spread declined another 18 basis points on continuing lower Eurodollar deposit rates further indicating that conditions are improving in the important interbank market. We now consider TED to be back into a normal range and we expect to see a more normal bank lending environment resume in the near future.

NYSE McClellan Summation Index. Over the two- week period, our market breadth indicator continued higher adding 422.69 and moving the index up to -87.20 as the breadth continued improving with more issues trading higher thus confirming the continuation of the current rally.


We continue to see more potential Head & Shoulder bottom patterns in many charts but still reserve judgment that the final bottom has been made. While we may have several weeks of improvement we remain cautious until the technical condition as defined by the Elliott wave pattern, suggesting the current rise is a counter- trend 4th wave, has been resolved. This pattern is consistent with the traditional bar chart right triangle consolidation that began in the middle of October. The downside-measuring objective of the right triangle consolidation pattern for the S&P 500 Index is 690 and this would create a final Elliott 5th wave bottom as well. There are probably be a good number of opportunities but until the final bottom has been confirmed we suggest that individual positions be hedged by short ETFs, selling calls or by using collars or perhaps even a bull call spread on the VIX as a hedge.

Volatility Trade Update and Close

iShares Russell 2000 Index (IWM) 50.22.

In IVolatility Trading Digest™ Volume 8, Issue 49, Santa Claus Rally, dated December 22, 2008; we suggested the sale of a Jan 48 straddle based upon the assumption that implied volatility should decline during the two- week holiday period. The position was short the Jan 48 call and short the Jan 48 put for a credit of 5.15 or $515 based upon a one lot.

While IWM rose in price by 1.52 from 48.70, the implied volatility of the Jan 48 call declined from 49.49 to 43.79 and the implied volatility of the Jan 48 put declined from 50.19 to 47.26. While the declines in implied volatility were less than expected, we now suggest closing the position and booking the gain.

The middle prices for the straddle on Friday totaled 4.405. Assuming it had been closed Friday the gain was 1.105 in two weeks. Not as much as we had expected but still a 21% gain in two weeks.

Using Friday’s middle prices the straddle was priced at 4.045 and since it is short time premium it should be 3.69 on Monday assuming no change in the price of IWM. Use the current position net delta of -54.10 to adjust for any change in the price. For example if IWM is .50 higher, expect the straddle to be priced at 3.96. If it is .50 lower, expect it to be 3.42. Since the straddle has become more delta negative further increases in the price decreases the value of the straddle.

Since we are near our current forecasted implied volatility based upon the S&P 500 Index (see above) we suggest closing this position.

Best Calendar Spread

As a regular feature on our home page, we offer a Calendar Spread suggestion found at the bottom of the “Options Data Analysis” and the “Rankers & Scanners” sections. The scan result is a call calendar spread suggestion based upon a differential between the implied volatility of the near term call compared to the implied volatility of the deferred call.

Last Friday the selection was a stock that we previously suggested for a bear put spread in IVolatility Trading Digest™ Volume 8, Issue 41, Brothers Grimm, dated October 27, 2008.

Sears Holdings Corporation (SHLD) 41.49. SHLD is a broad-line retailer with operations in the United States and Canada. The company has three businesses: Kmart, Sears Domestic, and Sears Canada.

When we last visited SHLD in late October it was 47.67 with an Implied Volatility Index Mean of 108.53. At the time, we suggested the long Dec 50 put and short the Dec 40 put for a credit of 5.05. Since the stock closed at 39.14 on the December options expiration, the estimated value of the spread was 9.63 for a gain of 4.58 or 90.7% in 53 days.

The new suggested calendar spread is long the Jun 40 call and short the Mar 40 call for a 1.90 debit using the indicated ask price for the purchase and the bid price for the sale. The implied volatility differentials are 55.27 for the Jun 40 call and 69.06 for the Mar 40 call. When we looked at the options, we noticed large volatility skews between the call prices and the put prices as well as the large volatility differentials between the expiration periods. The current Implied Volatility Index Mean is 90.42 but the implied volatility for the Jan 40 put is 96.24 and increases to 149.60 for the Jun 40 put. With this large implied volatility disparity we would not want to have a call calendar spread while put option buyers are paying substantial premiums for downside protection. We think these put buyers know more than we do about this business and we would not want a long delta position. If we are going to open another position in SHLD, we need a different strategy that has negative delta or is at least delta neutral.

The next earnings report is due February 26, 2009 and since the holiday retail shopping numbers have been reported very weak it may partially explain the higher put volatility for the Mar 40 at 138.43 but not for Jun 40 at 149.60. These put values lead to the conclusion that something else is going on as the put buyers are hedging long stock positions and are willing to pay hefty premiums for the protection.

As an alternative to the call Calendar Spread consider this covered put sale.

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 14.82 if the stock price remains unchanged. Use the delta shown above to adjust for any stock price change or about .29 for each point change in the stock price.

The plan is to hold the position until the February earnings report or about 52 days.

The Implied Volatility Index Mean has declined from 211.53 on November 19, 2008 and our forecast is for it to continue lower reaching the 75 level.

SU (stop/unwind): If the Implied Volatility Index Mean trend reverses and starts increasing going into the earnings the position will be closed when it increases by 20% absolute from 90.42 to 110.42. Alternatively, if the implied volatility of the Jun 40 put increases to more than 170 from the current 149.60 then close the position. Further, the position should be closed if the stock closes above 50.

Takeover File Update

In IVolatility Trading Digest™ Volume 8, Issue 47, Bad News, dated December 8, 2008 we suggested selling a Jan 70 put on Rohm & Haas (ROH) 64.76 based upon the proposed $78 per share takeover bid by Dow Chemical Co. (Dow) 15.41.

Since then the Kuwait Petroleum Company has indicated that it will back out their proposed Joint Venture with Dow to for a new company called K-Dow. Since Dow had been planning to use the joint venture proceeds to finance the ROH acquisition it created doubt about the ability of Dow to continue with the ROH acquisition causing the shares of ROH to drop more than 15 points to under 50. Now back at 64.76 some analysts think the deal will still be completed but at new negotiated price. If so, the new price remains the subject of the current speculation.

Our original suggestion in early December was for the sale of the Jan 70 put at 5.60 when it had an implied volatility of 63.89. This put is now selling at 8.60 with an implied volatility of 102.95 for a mark-to-market loss of 3.00.

We think the Kuwaitis are too smart to walk away from the joint venture since they know the necessity of diversifying their economy for the long term and since Dow has the management experience they are the best joint venture partner available. We doubt the Kuwaitis will lose this opportunity but will use it to improve the terms of their joint venture deal with Dow.

With a current Historical Volatility of 70, consider selling another ROH put that is now 14.76 out-of- the- money.

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 1.85 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .17 for each point change in the stock price.

In addition, since we think the deal will be completed after negotiating new terms we suggest a bull call spread on Dow as follows:

With a current Historical Volatility of 96, look at this spread idea.

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the debit Monday should be about .64 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .14 for each point change in the stock price.

To protect the downside we suggest using a close below 14 as the SU (stop/unwind).

This position has a limited and defined risk of the debit while the reward is limited to the difference between the strike prices less the initial debit or 1.86 for a risk to reward ratio of 2.9. Further while the maximum risk is .64 it can be further reduced by following SU (stop/unwind) at 14 suggested above.

The combination of adding to the ROH put and initiating a new Dow call bull spread keeps us in this position with a minimal increase in risk exposure.

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. If you would like to receive the Digest by e-mail let us know at Support@IVolatility.com.


SHLD: Why are the June 40 puts (around $15) so much higher than the synthetic puts ($6). Was there a strike adjustment or is that because the stock is so hard to borrow and conversion is bid up? In which case you would not be able to short stock and do your trade.

Posted by Adam on January 05, 2009 at 11:57 AM EST


Thanks for your comment. You may have the answer for the extreme volatility skew. If the stock is not available for shorting, and it may not be available, then we would need to find an alternative, perhaps a bear put spread.


Posted by Jacktrader ( on January 06, 2009 at 10:21 AM EST

with regard to the Sears spread above.
I've been long calls & puts this past year, mostly DIA, and have done alright. I'm interested in spreads but don't quite understand how they might pan out both as winners or losers. Would you point to some more in depth learning?

Posted by Fritz on January 06, 2009 at 11:53 AM EST


Thanks for your comment and question about spreads. In general, spreads are much more forgiving. Buying a call or put requires being right on the direction and being right on timing. In addition, even if you do the direction right and have good timing but the stock begins to trade in a narrow range you could still lose money as the implied volatility declines. In addition to being right about the direction and the timing, there is a requirement to be right in the forecast for the future implied volatility of the options. Therefore, buying calls and puts outright provides several ways to lose money. The alternative is to use a spread that is both long and short options so that the changes in volatility and time decay are offsetting. With a spread, there is a better chance of not losing money on changing volatility or time value decay, while retaining to directional objective. Now with some creative construction a spread can be designed to retain its volatility and time decay protection while building some edge into the position. This is done by buying an option that has a lower implied volatility than the option sold. Spreads constructed with edge have an advantage from the outset and improve the probability of success.

With spread, your risk is defined by the debit or credit when the position is established and in exchange, the maximum value of the spread is defined by the difference between the strike prices.

Further using a spread requires a lower capital commitment, since were buying just the difference in the strike prices. For example, buying calls or puts on expensive stocks or ETFs requires a large capital commitment and can discourage considering the underlying even though it may be the best suited for a particular opportunity. There is also a margin requirement advantage when using a spread compared to options strategies that require margin like short puts, for example.

Controlling the risks creates an opportunity for larger position compared to buying or selling call or puts outright.

In summary, spreads have a more forgiving risk profile, provide the opportunity to gain some edge and require less capital.
Most of the standard option reference books provide details on spreads and some do a better job than others explaining the advantages and limitations.


Posted by Jacktrader ( on January 06, 2009 at 08:19 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".