« November 2009 »

IVolatility Trading Digest™

Volume 9, Issue 46
Divergence Theorem

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Divergence Theorem

In vector calculus, the divergence theorem, also known as Gauss' theorem is a result relating to the flow of a vector field stating that the volume total of all sinks and sources, the volume integral of the divergence, is equal to the net flow across the volume's boundary. A somewhat easier to understand concept, but of no less importance is a divergence in the financial markets referring to when the price of an asset and an indicator move in opposite directions. In this Issue, we highlight the continuing divergence between the S&P 500 Index, the iShares Russell 2000 Index and the Advance Decline line. Then we have two model portfolio adjustments and finish with another hedging idea. We start with a review of the markets.

Market Review

S&P 500 Index (SPX) 1091.38. For the last two Mondays, the equity market has made substantial up moves following the Asian markets higher. We wonder if this Monday will be the third. By the end of last week, SPX was 2.10 points lower and back under 1100 once again, but it was options expiration week so are somewhat cautious about making short-term forecasts until we see how it trades without the options expiration influence. While a Double Top is now less likely, be aware of a potential developing new Head & Shoulders Top with two left side shoulders. For now however, we are maintaining our upside objective at 1233.29 shown in our Head & Shoulders Bottom chart in Digest issue 36, although we are increasingly concerned about the breadth divergence explained below in greater detail.

E-mini S&P 500 Future (ESZ9) 1090.00. The December E-mini future contract declined 1.50 points or .14% for the week as open interest continued to expand by 36,215 contracts through last Thursday. Although volume was light, increasing open interest continues to provide confidence for a bullish interpretation.

S&P 500 Index Implied Volatility (IVXM). Our Implied Volatility Index Mean declined another 1.51 to 19.15 while the VIX was lower by 1.17 to 22.19 having been as low as 19.77 during the day on Friday.

The VIX futures were mixed with December slightly lower at 24.20 for a 9.1% premium. However, January at 27.00 increased from a premium of 17.5% to a 21.7% premium. According to Larry McMillan, the author of “Options as a Strategic Investment,” when the futures are at a premium, they indicate a sell signal. Presumably, the strength of the sell signal along with the market risk increases as the premium increases. Larry says he uses a day-weighted average between the first and second months for his premium calculation.

The implied volatility of the VIX options were lower with the call Implied Volatility Index Mean at 76.00 a decline of 22.95. The put Implied Volatility Index mean was 78.38 or 19.17 lower. Since the VIX is calculated from the futures price not the cash when adjusted the Dec 24 call implied volatility is 74.49 while the put is 70.65. This compares to a current Historical Volatility of 103.88.

US Dollar Index (DX) 75.66. DX cash was .33 higher for the week after declining as low as 74.91 on Monday of last week with the 15.82 advance in the SPX. With a reversal higher by the end of the week it appears to be holding in the trading range between 75 and 76 ½ that we suggested in Digest issue 42. There is a reasonable chance for DX stability until after year-end

iShares Barclays 20+ Year Treasury Bond (TLT) 95.12. As DX declined, long- term interest rates made a noticeable but out of character decline. At the end of the week, the yield had declined from 4.35% to 4.29% with a 1.20-point or 1.3% TLT increase.

NYSE McClellan Summation Index 414.94. Our market breadth index managed to gain only 18.14 points for the week after a big up day last Monday. As the major indexes moved to new highs fewer individual issues are following, suggesting distribution. We have more on this subject in the Strategy section below. For now, we continue flying the caution flag. caution flag  

Baltic Capesize Index (BCI) 7542. Our preferred Baltic dry-bulk shipping rate index for the larger ships was under pressure at the end of the week, but still managed to climb 359 more points or another 5%. Meanwhile the Capital Link Tanker Index increased 64.82 points or 3.1% for the week, although it also sold off from earlier highs. After substantial increases in both dry- bulk and tanker shipping rates, we would expect some retracement.


Continue to focus on the US Dollar Index and its ability to remain in the range between 75 and 76 ½. A breakout out above 76 ½ will be a further problem for both equities and commodities.

With US Dollar stability, the major indexes have lost their primary momentum driver. Now support will have to come from portfolio performance demand. As the major indexes continue higher the broader indexes, such as the iShares Russell 2000 Index (IWM) 58.59 are diverging making lower lows and lower highs.

Since the November options have expired, we will see signs early next week if the much rumored portfolio performance demand can support the major indexes into the year- end.

The Divergence Concern

Here is a divergence example using a chart comparing the SPY with the broader based IWM.


Using percent change this chart shows IWM rose above SPY in the middle of July and remained higher until the end of October when it crossed back below SPY. After the recent sell offs SPY was able to recover and move to new highs, but IWM did not and then declined back below its upward sloping trendline (not shown).

The Advance Decline line is the basis of a classic market breadth indicator and the one used for the McClellan Summation Index (see the section above with the link for more details). Usually the Advance Decline line moves with the major indexes, but when there is a divergence, it often signals a coming change in trend. Adding a breadth oscillator give an earlier signal than just using the Advance Decline line. There are many examples of success using this indicator including August of 1987 before the October decline later in that year. Norman G. Fosback in “Stock Market Logic” offers other examples of success using the advance decline indicator leading market declines in the 1940’s, 1970’s and more. In the major 1987 decline, the divergence was apparent for several months before the market finally rolled over. Of course, the divergence can also be resolved by more stocks again participating in the advance and this is probably a necessary requirement for the current market advance to continue.

The divergence remains a concern so we will reduce the number of long model portfolio positions and increase our hedging strategies until the divergence issue is resolved. Since a good number of our put positions expired in November, we will replace them with hedges.


Short Put Adjustments

Selling puts involves assuming risk the underlying stock may decline below the strike price of the sold put creating a dilemma between buying back the short put at a loss or being assigned stock. We advocate addressing these choices as a part of the risk management process when the decision is first make to sell the put. By limiting short put sales to stocks that we consider as long candidates and by limiting the size of the trade to something that is manageable in the event the stock is assigned we accept the risk from the outset. Once assigned, we have exchanged one earning asset, a short put, for another, long stock. The next step is to begin selling calls against the long stock. An alternative strategy based upon the assumption that the fundamentals remain favorable and the positions size remains manageable is to sell not only a call against the long stock but also another put.

Since ETFs settle for cash this precludes the opportunity to be assigned the underlying and reduces the attractiveness of selling puts on cash settled ETFs.

At the November expiration, we had two short put portfolio positions that were in- the -money at expiration. This is noteworthy since it the first time this year we have been assigned stock from short puts and it says something about the changing breadth character of the market.

The next step is selling a call. Ideally, this should have been done at the close last Friday, further reducing Monday price risk. Since we did not include them in our Update Tweets, we will make these adjustments Monday.

Clean Energy Fuels Corp. (CLNE) 12.00. From Digest issue 44, CLNE designs, builds, finances, and operates fueling stations and supplies compressed and liquefied natural gas. We buy into the concept that natural gas will have a role as an important transition fuel and CLNE will be a part of this process. Since we sold a November 12 ½ we are now long 100 shares. With a current Historical Volatility of 57.85, here is the suggestion.


The mid price for this put sale on Friday was a credit (Cr) of 1.45 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be 1.43, but since these options are thinly traded, an additional .05 has been allowed for slippage so the estimated price is 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 call is sold. Use the delta as shown above to adjust for any change in the stock price.

ValueClick Inc. (VCLK) 10.00. From Digest issue 42, when VCLK the online advertising agency was 12.85. While the current Historical Volatility is 71.34, we expect it will decline into the 50 range once it adjusts for the gap lower after the October 27th earnings report. Since the options are thinly traded, we do not want to use a strategy requiring multiple trades. This time we are going to use the dual strategy of selling a call against our long stock and selling another put. Here is the suggestion that results in covered straddle.


The mid price for these sales on Friday was a credit (Cr) of 2.375 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be 2.335, but since the options are thinly traded, an additional .105 has been allowed for slippage so the estimated price is as shown above in the “E Price” column 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 call and the put are sold. Use the delta as shown above to adjust for any change in the stock price.

Hedging Once Again

iShares Russell 2000 Index (IWM) 58.59. Since IWM is now declining faster than the SPY it is preferred as a downside hedge.

The current Historical Volatility is 25.75 and the Implied Volatility Index Mean is 27.43. The put call ratio at 2 appears to be trending higher. Put call ratios above .7 at the sold blue line below are considered bearish while readings at .3 or below are bullish. From our Advanced Historical Volatility service here is a chart showing the rising trend of the ratio in what appears to be increased hedging activity as the ratio is much higher than .7.


Consider this long put spread idea.

Buy 2 Put Spreads


The mid price for this spread on Friday was a debit (Dr) of .645 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 put 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.

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

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In next week’s issue, we should know if there is going to be a year-end performance run with an improvement in the market breadth or not.

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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