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Today


IVolatility Trading Digest™


Volume 9, Issue 48
Carry Trade Frenzy

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

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Carry Trade Frenzy

Unexpected US employment data on Friday created a frenzy to unwind risk trades based on the fear of rising interest rates and a stronger dollar. Since the carry trade is short dollars no time was wasted buying dollars and closing short positions. For this Digest Issue we have one portfolio adjustment and then two more volatility trade suggestions. We begin with the Market review.

Market Review

S&P 500 Index (SPX) 1105.98. After Friday’s employment report SPX traded up 18.34 in the first 20 minutes, to make a new rally high at 1119.13, but then it was all down from there as the unwinding began. By the end of the day, it had managed to hold a gain of 6.06 points. For the week, the gain was 18.71 points or 1.7%. On both Thursday and Friday, it made outside range days, suggesting the most recent minor uptrend from 1083.74 is likely to be reversed. Although the upward momentum has slowed we are maintaining our minimum upside objective at 1233.29 shown in our Head & Shoulders Bottom chart in Digest issue 36. In order to take them higher from this level, equities need more positive news, but positive news results in carry trade selling, so it may be well into the first quarter before the minimum objective is reached.

E-mini S&P 500 Future (ESZ9) 1108. The December E-mini future contract is back above 1100 again closing 18.50 points higher on the week. Volume is still on the low side, but once again open interest increased by another 9,526 contracts through last Thursday. The increasing open interest suggests the bulls continue to be in control of this market.

S&P 500 Index Implied Volatility (IVXM). Our Implied Volatility Index Mean decreased 2.61 to 18.96 while the VIX declined by 3.60 to 21.25.

For the VIX futures, December closed 22.60, a 1.35-point premium over the cash at 21.15. January was 26.15 for a 4.90 premium. Using Larry McMillan’s day-weighted average between the first and second months, we calculated the premium to be 3.125 points compared to a .28 premium the prior week. When the futures are selling at a premium, they are giving a sell signal and presumably the strength of the sell signal and the market risk increases as the premium increases. Using this short- term measure the strength of the sell signal increased at the end of last week.

The adjusted implied volatility of the at-the-money VIX December call declined from 90.48 to 72.59 and the put declined from 94.15 to 78.83. For January, the call declined from 123.66 to 66.11 and the put declined from 69.51 to 69.04, while the current Historical Volatility is 122.11.

US Dollar Index (DX) 75.91. DX cash closed the week up .91 and it all came on Friday with the rush to unwind carry trades and buy back short dollars. In this highly leveraged environment, the slightest indication that interest rates could rise with an improving economy creates a frenzy to close long risk positions like equities and gold and repay the dollar loans. Surprisingly DX is once again back into the range between 75 and 76 ½ that we suggested in Digest issue 42.

iShares Barclays 20+ Year Treasury Bond (TLT) 93.34. For the week, TLT declined 3.06 points or 3.3% with the equivalent yield rising to 4.41%. With the first evidence that the employment situation may be improving long- term bonds were the first to be sold in anticipation of higher future interest rates. TLT is now likely to retest 93.34 made on November 12, 2009 at 4.48% or another 7 basis points higher.

NYSE McClellan Summation Index 443.97. The important market breadth indicator improved by 50.19 points as NYSE advancing issues led declining issues every day except one. If it continues this is an important development for the continuation of the market uptrend. As we suggested in Digest issue 46 this has been a sign of distribution and risk reduction as money was reallocated from small companies to those that offer greater liquidity in the event they need to be quickly liquidated. For now will continue flying the caution flag, with the expectation it will soon be taken down if the breadth continues to improve. caution flag  

Baltic Capesize Index (BCI) 6655. Our preferred Baltic dry-bulk shipping rate index for the larger ships was better by 302 points or 4.75% after declining 16% the previous week. The increase for Capital Link Tanker Index was almost equivalent at 110.12 points or 4.65% with at least one shipbroker saying owner’s confidence is improving.

Strategy

In last week’s Digest issue 47 we presented a table showing that for 7 of the previous 8 Mondays the S&P 500 Index was higher while the US Dollar Index was lower. Last week the relationship continued making it 8 of the prior 9 weeks that the S&P 500 Index closed higher and the US Dollar Index closed lower on Monday. We think it is unlikely to continue this week since the current momentum in the long-dated Treasury market is down meaning higher interest rates are supporting the dollar and the S&P 500 Index created two outside range days both Thursday and Friday. We will be very surprised if this short-term downward momentum is reversed Monday and thus creating the conditions for a higher S&P 500 Index and lower dollar once again.

Portfolio Adjustment

Last Tuesday we were shaken out of our long US Dollar ETF (UUP) Mar 23/24 call spread, three days too soon. In addition, we closed one of our Russell 2000 put spreads. Now with the improving market breadth we are becoming more constructive on the market so we will also close the remaining put spread.

iShares Russell 2000 Index (IWM) 60.42. While the IWM is up 2.84 points, or 4.9% for the week the S&P 500 Index was up just 1.7% thus confirming the improvement in market breadth indicated by the McClellan Summation Index above. Just as important, IWM traded above the prior minor high of 60.68 made on November 16, 2009 so it appears to have reversed the previous downtrend.

Considering the developments above and the potential for an early start of the “January Effect,” when small capitalization stocks outperform the broader market in the month of January, with a few exceptions, it is time to close the remaining open put spread.

Here is the trade to close.

IWM

The mid price on Friday was a credit (Cr) of .39 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .37 unchanged as shown above in the “E Price” column. Use the deltas for each leg to adjust for any change in the stock price or use the net spread delta for spread orders.

Gold’s Wild Ride

Gold’s Wild Ride

Like Mr. Toad, gold made a wild ride on Friday.

Gold December (GCZ9) 1168.80. At mid- afternoon Friday it was as low as 1147 or off by 70.40 before recovering to close down 48.60.

As Treasury bonds declined and with the US Dollar Index higher gold made a steady decline and then recovered some of the loss later in the day.

This could be a one-day correction, but we think it will probably continue for a few more days based upon the downward momentum in the long Treasury bond market. If so, and then if it appears to be reversing before the end of the week we will send a gold trade suggestion by Twitter using the gold miner IAMGOLD Corp. (IAG) 18.24.

Number 2

For ideas, we often look at the top 5 stocks based on IV Index Mean vs 30D HV. Click on the link and go to the Advanced Ranker Sample of the top and bottom 5 stock in four categories.
Top 5 stocks by implied volatility change

 Here is number 2 from Friday’s listing found in the “Rankers and Scanner” section of our home page.

 Medivation, Inc. (MDVN) 33.31. Medivation, Inc. is a biopharmaceutical company focused on the rapid development of novel small molecule drugs to treat serious diseases for which there are limited treatment options.

With a current Historical Volatility of 32.15, the Implied Volatility Mean Index is 54.83 for an IV/HV ratio of 1.71, but the at-the-money Implied Volatilities rise from 46 in December to 133 in June of 2010 most likely related to expected product test data release dates.

While our record to date in the biotech sector has not been very good this one has unique implied volatility characteristics suggesting the most likely date for a large stock move is in June. By selecting a strategy in March where the at-the-money implied volatility is around, 97 we have an IV/HV ratio of 3, and a considerable edge.

Once again, we select an Iron Condor, selling both an out-of-the-money call spread and an out-of-the-money put spread.

First the call spread.

MDVN

Next the put spread.

MDVN

The mid prices for the spreads on Friday are shown as Credits in the “Price” columns above. Adjusting for time decay the estimated prices on Monday should be about as shown above in the “E Price” columns. Use the deltas for each leg to adjust for any stock price change or use the net spread delta for spread orders. The combined deltas are 10.25 (21.29-11.94) and the combined theta is 1.36 (1.44-.08).

The position has one downside breakeven point at 24.33 at expiration. Use a close near the March expiration of 24.33 as the SU (stop/unwind). On the upside, the profit line is flat at around $69 above 40 and the maximum gain of $567 is in the range between 35 and 40 as shown in the graph of the position at expiration below.

MDVN

More Agriculture

Here is an idea from last week’s Digest issue 47 that should be less sensitive to the dollar and the market direction. For the time being, we favor this type of trade so we suggest it once again.

Origin Agritech Limited (SEED) 11.60. Beijing based SEED received approval for of the world’s first genetically modified phytase corn seed. With a current Implied Volatility Index Mean of 114.14 and most likely declining, here is another put sale.

SEED

The mid price for this put sale on Friday was a credit (Cr) of .525 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .44 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.

Summary

In our opinion, it will likely take longer that the market assumed on Friday for the improving labor conditions to have as much influence as was being priced into Fridays trading. We think some portion of the moves will be retraced in the next few days and continue to suggest the US Dollar Index and its ability to stay in 75-76 ½ range is one of the best indicators.



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In next week’s issue
, we will continue evaluating the improving equity market breadth and see how the markets reevaluate Friday’s reaction to the employment report.

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".