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Today


IVolatility Trading Digest™


Volume 9, Issue 49
Crude Oil Breakdown

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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Crude Oil Breakdown

The stronger US Dollar has contributed to the seasonal decline in crude oil prices that now appears to be gaining downward momentum. In this issue, we offer an options strategy suggestion for the continued decline in crude oil prices. First, we have our market review and one portfolio adjustment.

Market Review

S&P 500 Index (SPX) 1106.41. For the week, SPX gained another .43 with more signs of declining momentum. The previous week’s two outside range days gave a good short- term forecast as the minor uptrend from 1083.74 was mostly reversed with the decline to 1101.34 on Wednesday before rebounding higher once again to close with a small gain.

Although the upward momentum has slowed considerably we are still maintaining our minimum upside objective at 1233.29 shown in our Head & Shoulders Bottom chart in Digest issue 36. In the near term, it needs to reconcile with a stronger dollar.

E-mini S&P 500 Future (ESZ9) 1108. As a confirming indicator of declining volatility the December E-mini future contract closed the week unchanged. Volume increased back into the normal range as open interest started building for the December expiration on Thursday. The increase in open interest was 329K through Thursday to just over 3 million contracts on rollover serge and very near the September open interest total when it expired.

S&P 500 Index Implied Volatility (IVXM). Our Implied Volatility Index Mean increased 2.63 to 21.59 while the VIX increased .39 to 21.59. The Historical Volatility declined from 19.16 to 16.60 and may soon approach the 52-week low at 14.31 made on September 30, 2009.

For the VIX Futures, December closed at 22.10, a .51-point premium over the cash at 21.59. January closed at 26.00, for a 4.41 premium. Using Larry McMillan’s day-weighted average between the first and second months, we calculated the premium to be 3.83 points compared to a premium of 3.125 for 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 again at the end of last week.

The adjusted implied volatility of the at-the-money VIX December call declined from 73.59 to 58.33 and the put declined from 78.83 to 62.46. The January call increased from 66.11 to 66.58, the put increased from 69.04 to 69.76, as the Historical Volatility declined from is 122.11 to 109.95.

US Dollar Index (DX) 76.57. After a substantial increase two weeks ago, DX cash added another .66 last week and is now at the top of the 75- 76 ½ range that we suggested in Digest issue 42. Watch the high of 76.82 made on November 3, 2009 as continuing increases above this level will most likely create serious problems for equities, crude oil and gold.

iShares Barclays 20+ Year Treasury Bond (TLT) 92.09. TLT declined an additional 1.25 points in addition to the prior week’s decline of 3.06 with the equivalent yield rising to 4.49 up another 8 basis points and now higher than the 4.48% made on November 12, 2009. Here is part of a Bloomberg summary, “Treasuries declined, with the yield gap between Treasury 2-year notes and 30-year bonds reaching the widest since at least 1980 amid lower-than-forecast demand for the $74 billion in notes and bonds auctioned in the week.”

NYSE McClellan Summation Index 496.76. The NYSE breadth indicator improved by an additional 52.79 points and is now showing a slight positive uptrend. If it continues improving, it will be providing needed support for the continuation of the market uptrend. For now, it looks stalled so will continue flying the caution flag, with the expectation it will soon be taken down on further breadth improvement. caution flag  

Baltic Capesize Index (BCI) 5193. Our preferred Baltic dry-bulk shipping rate index for the larger ships declined by a substantial 1,462 points or 22%. While a portion of the decline may be attributed to the holidays this change in trend should not be ignored. The decline in the Capital Link Tanker Index was more modest at 73.51 points to 2180.42 and it was reported many cargoes were fixed without causing much movement in the rates. Due to the weakness in the dry-bulk rates, we will begin flying the caution flag here once again. caution flag

Strategy

The up equities, down dollar on Mondays that we discussed in Digest issue 47 ended last Monday, as we were expecting, and for first time in 6 weeks the US Dollar index closed higher as equities were lower. Now some are speculating that equities may decouple from a rising dollar. The most important indicators for this week will be the continuation of the US Dollar Index since it is at the top end of its recent trading range. Some hedging strategies are in order, but we are not expecting very much movement as the trading year is about over. Some individual issues with implied volatilities high enough to sell could be a way to earn some time premium over the year-end.

As for seasonals, it is late for gold as the seasonal high is usually seen in late December and it may have already been reached. For crude oil, the seasonal high appears to have been reached in October and it is now breaking down. A stronger dollar should add downside momentum for both.

Model Portfolio Adjustment

Since industrial activity begins slowing at year-end and since our preferred dry-bulk shipping index is now once again rapidly declining, we will close our remaining open position in this sector, the one we suggested in Digest issue 45.

DryShips, Inc. (DRYS) 6.09.

Here are the trades closing each of the five spreads.

DRYS

The mid price on Friday was a credit (Cr) of .08 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be .075 as shown above in the “E Price” column. The prices and Greeks shown above are based upon a single option so the total values will be five times as much for the five call spreads. Use the deltas for each leg to adjust for any change in the stock price or use the net spread delta for spread orders.

IVOLopps™

Crude Oil Breakdown

Crude oil, basis January reached a high of 82.58 on October 21, 2009 and then traded sideways around 80 until November 19, 2009 when it closed at 78.05 and began trending lower. Seasonally crude oil reaches a high in October and it now appears to be the case this year since momentum increased once it crossed below 75 on December 7, 2009 and closed at 73.93, below the upward sloping trendline from the February low.

For futures a bear market is characterized by prices moving lower on increasing open interest. On November 17, 2009 the NYMEX crude oil total open interest was about 2.49 million contracts and on December 8, 2009 it had increased to about 2.55 million contracts, or up 57, 895 contracts. When prices settle lower than the previous close on increasing open interest, the shorts are in control and are pressing their winning positions. The short positions are being increased in the “Producer, Merchant, Processor” and “Managed Money” categories perhaps the most knowledgeable market participants.

Based upon this we suggest a bearish position using the crude oil ETF.

United States Oil (USO) 35.48.

The last time we suggested a short position for USO was in Digest issue 39 on October 5, 2009 when it was 35.87 and somewhat premature as it turned out. Since we used a January put ratio backspread for a credit it can simply expire if USO does not get a low as we initially expected.

Before getting to the specifics of the recommendation, here is some additional information from their prospectus dated June 29, 2009 detailing why it makes an interesting short candidate.

United States Oil Fund, LP, a Delaware limited partnership, is a commodity pool. “The investment objective of USOF is to have the changes in percentage terms of the units’ net asset value reflect the changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, as measured by the changes in the price of the futures contract on light, sweet crude oil as traded on the New York Mercantile Exchange that is the near month contract to expire, except when the near month contract is within two weeks of expiration, in which case it will be measured by the futures contract that is the next month contract to expire, less USOF’s expenses.” (Bold emphsis added)

Further it states, ... “in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.”

Here are Friday’s NYMEX futures prices in contango.

Crude Oil Cash 69.87
January 69.87 (Expires December 21, 2009)
February at 71.95 is a 2.08 or 3% premium.
March at 73.54, is a 3.67 or 5.3% premium.
April at 74.63 is a 4.76 or 6.8% premium.

As long a crude oil futures remain in contango every time they renew their position they pay a premium to the cash value and then the premium declines back to the cash value at expiration. In addition, the expenses of the commodity pool, including brokerage and accounting and administrative fees are subtracted.

In a declining crude oil market when the futures are in contango there appears to be an advantage to the short seller.

By using a bearish put spread, we can establish a short position with a defined and limited risk, which can be further reduced by using a predetermined stop loss level in the event of an upside reverse as well as allowing sufficient time to minimizing time decay loss.

With a current Historical Volatility of 28.62 and with an Implied Volatility Mean Index of 38.52 the put call ratio is bearish at 1.1. Further risk management can be accomplished by considering the position size relative to the total portfolio and the margin requirements. For our model portfolio, we calculate purchasing 3 of the following put spreads should produce about the right combination of risk to reward.

USO

The mid price for this spread on Friday was a debit (Dr) of 1.87 as shown in the “Price” column above. Adjusting for time decay the estimated price on Monday should be about 1.86 as shown above in the “E Price” column. The prices and Greeks shown above are based upon a single option so the values will be three times as much for the three 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.

Since we have a multiple criteria spread we will use more than one SU (stop/unwind). If USO reverses and closes above 37 or if the open interest declines indicating short covering it would be the signal close or to begin unwinding the position.

Summary

The US Dollar Index, crude oil and gold are all now being influenced by seasonal factors. As the dollar moves higher, the negative correlation with crude oil appears to have attracted short selling in crude futures. Using USO put spreads offers several advantages including the contango cost disadvantage and the implied volatility edge in the position shown in the table above.



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In next week’s issue
, we continue focusing on the US Dollar Index along with crude oil and gold. In addition, we will be asking for reader feedback to help improve the Digest for next year.

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".