« November 2009 »

IVolatility Trading Digest™

Volume 9, Issue 43
Unwinding Carry Trades

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Unwinding Carry Trades

Foreign Exchange trading is currently in control of the markets, not only the currency markets but the fixed income and equity markets as well. We offer some thoughts and suggestions about using options for dollar hedging and then a few trade suggestions. First, we review our market indicators.

Market Review

S&P 500 Index (SPX) 1036.16. After declining 43.41 points or 4% for the week, SPX is now once again below the active upward sloping trendline from the July correction low at 872.81. While maintaining our minimum upside measuring objective at 1233.29, from the large Head & Shoulders bottom explained in Digest issue 36, there is now a genuine concern that the resistance at 1100 will turn into a near term market top.

E-mini S&P 500 Future (ESZ9) 1033. The weekly decline for the December E-mini future contract was 44.00 points or 4.1%. Although open interest declined by 20,237 contracts last Thursday, for the week ending it increased by 72,846 contracts. A substantial decline in open interest on Friday with the contract declining 28.50 points would be confirmation that the bears are gaining the upper hand. We will have Friday’s open interest numbers Monday morning.

S&P 500 Index Implied Volatility (IVXM). Our Implied Volatility Index Mean moved 6.05 higher to 26.05 while the VIX was up 8.42 at 30.69 and now substantially above the VIX 20-day moving average.

Surprisingly the VIX futures declined. The November future at 27.85 is lower than the cash by 9.25%, while December at 27.70 is lower by 9.74% and January at 29.95 is an 8.93% discount to cash.

The implied volatility of the VIX call options also declined with the November 22 ½ calls lower by a substantial 14.38 at 106.21, the November 25 calls were 11.16 higher at 123.15 while the December 25 calls were 14.54 lower at 91.18. Interestingly the at-the-money November puts were 159.77 while the out-of-the-money November 32 ½ put was 176.70 and the further out-of-the money 35 put as 192.94. There is noticeable short term skew with the puts considerable higher than the calls. See the skew graph below.

US Dollar Index (DX) 76.30. The oversold bounce we suggested last week in Digest issue 42 began promptly last Monday and for the week, the rebound was .83 points or 1.1%. Since both the US Dollar and the Japanese Yen are being sold and converted into long risk positions, called the “carry trade” any time these currencies turn higher it immediately creates selling pressure for equities and commodities including crude oil as these carry trades are quickly unwound. Based upon last week’s analysis DX could enter a trading range between 75 and 77. We offer some additional thoughts and a currency trading suggestion below.

iShares Barclays 20+ Year Treasury Bond (TLT) 95.78. If the dollar was higher then we can expect higher long Treasury bonds and that was the result as TLT increased .83 points or .9%.

NYSE McClellan Summation Index 593.44.  Our market breadth index declined 439.46 points or 43% one of the largest point declines since February and March of this year. The developing divergence between this index and the NYSE composite that we noted two weeks ago, provided an early warning.

Baltic Capesize Index (BCI) 5047. Our dry-bulk shipping rate added another 205 points or 4.2% while our benchmark VLCC crude oil tanker rate, MEG – Korea added another $453 per day to $29,362, while still a long way from rates in excess of $100,000 per day in early 2008, it is much better than rates as low as just $3,594 per day in August.


In the event the US Dollar Index continues to rise, consider using options strategies with PowerShares DB US Dollar Index Bullish (UUP) 22.70.

To see how well UUP tracks the near term DX future contract we used our new IVGraph for the comparison. See below.


The UUP shown in black above closely tracks the futures contact shown in blue while offering greater liquidity. See the volume and open interest notes in the chart.

There were several factors leading to the equity market correction that began last week. As we noted in last week’s US Dollar Index section the dollar was oversold at 75 and the euro was overbought at 150. The SPX was meeting resistance at 1100 and we noted the NYSE breadth divergence two weeks ago. In addition, gold and crude oil began to show some signs of resistance, but the key driver most likely came from the currency markets, as risk positions were unwound to repay US dollar and Yen loans. Most of the carry trades are made in the interbank market while the exchange volume probably represents just a small fraction of the total.


If the US Dollar follows the course described in our analysis in Digest issue 42 then a further rise may be limited, however we should be prepared in the event it continues higher. Here is a suggestion using

PowerShares DB US Dollar Index Bullish (UUP) 22.70.

With a current Historical Volatility of 8.42, consider 2 of these long vertical long call spreads as a hedge against a further rise in the dollar index with a defined risk limited to the debit.

Buy 2 long call spreads.


The mid price for this spread on Friday was a debit (Dr) of .15 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be about the same as the time decay is offset by the spread and is shown above in the “E Price” column. The prices and Greeks shown above are based upon a single option so the values will be doubled for the two long call spreads. Use the deltas for each leg to adjust for any change in price of the underlying ETF or use the net spread delta for spread orders.

Volatility Skew

Now turning to the VIX Volatility skew, we offer a conditional trade suggestion. The past 5 spikes in implied volatility have all been brief and in most cases lasting only one or two days before heading lower once again. Here is an idea conditioned upon the VIX closing above 28 on Monday.

First, here is a graph showing the call and put skew.

Volatility Skew

In the VIX section above, we noted the skew between the calls and puts. The graph shows the implied volatility of the calls in a range between 55 and 130 (green) while for the puts the range is from just above 100 over 225 (blue). This disparity could result from the underling VIX not being tradable and the futures contracts are being used to hedge put sales, which is the most likely the reason the premiums for the VIX futures are now at a discount.

CBOE Volatility Index (VIX) 30.69.

With a current Historical Volatility of 104.65 and a bearish put call ratio of .8, consider this conditional contrarian long call spread as a hedge.


The mid price for this spread on Friday was a debit (Dr) of .48 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be about .50 as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in price of the underlying or use the net spread delta for spread orders.

The Bull Market Continues

There is a reasonable chance that the current correction will be short lived and the bull market will soon resume its uptrend. Based upon this possibility here is a put sale suggestion for consideration.

Fuqi International, Inc. (FUQI) 20.49. Shenzhen, China based FUQI is a designer of high quality precious metal jewelry in China, developing, promoting, and selling a broad range of products in the large and rapidly expanding Chinese luxury goods market.

Yahoo Finance shows the trailing price to earnings ratio at 12 with the forward ratio of 9 and the price to earnings growth ratio of just .44. With a current Historical Volatility of 88 and the put call ratio somewhat bearish at .7 consider this put sale.


The mid price for this put sale on Friday was a credit (Cr) of .725 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .63 as shown above in the “E Price” column. The other “Greeks” are also based upon Friday numbers, before the position is established, and will reverse when the put is sold. Use the delta as shown above to adjust for any change in the stock price.

In the event the US Dollar continues higher and the equity markets continue lower use a close below 17 ½ as the SU (stop/unwind). The alternative is to consider taking the stock by assignment in the event it closes below 17 ½ on the November expiration. This will depend upon market sentiment and available margin balances, among others, at that time.

Visit us on twitter for more ideas from our scanners and portfolio updates, including positions closed or unwound during the week. 

IVolatility.com IVolatility.com Bookstore. In addition to the vast number of articles on our web site, take a browse through our bookstore for more reference information and material.

In next week’s issue, we will again look at earning opportunities assuming there are signs that the uptrend is resuming. If the correction continues, we will focus on more hedging opportunities.

Previous Issues and Reader Response Request

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.



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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".