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Today


IVolatility Trading Digest™


Volume 8, Issue 45
Bear Revival

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

To add comments or to ask questions please click here (or use the blog "COMMENTS" link at the very bottom of the blog page).

Our announcement of the demise of the bear in IVolatility Trading Digest™ Volume 8, Issue 42, Bear Killer, dated November 3, 2008, now seems to have been a bit premature, reminding us of another Mark Twain quote.

“The reports of my death are greatly exaggerated.” - Samuel L. Clemens (1835 – 1910), better known by the pen name Mark Twain. Extensively quoted he was an American author and humorist most noted for his novels Adventures of Huckleberry Finn, and The Adventures of Tom Sawyer.

Now that the equity market has continued lower and with credit risk premium again increasing we are returning to the bear side once again with three more bear put spread ideas. Then we have a bull call spread suggestion for gold. First, a brief market review.

Market Review

S&P 500 Index (SPX) 800.03. Once again, the SPX was lower for the week with a decline of 73.26 points or 8.4%. Last Friday it attempted a reversal day, but not before making a new bear market low at 741.02. We are not seeing much buying enthusiasm so it looks as if the downtrend in the SPX is continuing.

S&P 500 Index IVX 68.80. The Implied Volatility Index Mean (IVXM) added another 5.80 for the week ending at 68.80 confirming the downtrend in the SPX. If the current downtrend continues, which seems likely, we would expect to see the IVXM return to the previous October 27th high of 76.67

US Dollar Index (DX) 88.19. The dollar strength continues and it is now making a potential double top. With credit risk spreads increasing once again the DX looks to continue moving higher. Notably over the past two months, the Japanese Yen has risen faster than the DX causing considerable concern for the Japanese exporters.

TED Spread 2.15. After being below the 2.0 mark earlier in the week Bloomberg’s TED spread rose .05 last week from 2.10 prior week. This rise reflects additional concern in the credit markets and is not helpful for the financial stocks. We think the TED needs to decline to the 1.40 - 1.45 range before we begin to see more positive sentiment for the banking sector.

NYSE McClellan Summation Index. Our market breadth indicator accelerated to the downside once again with a weekly decline of 324.24, now at -1499.01 and once again challenging the -1500 mark. While not encouraging for the bulls it is consistent with a lower market in the near term.

Strategy

With the new low in the S&P 500 Index last week, our previous trading range expectation was destroyed. The US Dollar Index and the Japanese Yen continue showing strength from the deleveraging of long commodity and emerging market positions. Sentiment was not help by the G-20 meeting and the credit risk spread is rising once again. We suggest more shorts in the financials and a new long suggestion for the gold market has suddenly become a possibility.

IVOLopps™

Here are a few additional short suggestions to consider. With extremely high-implied volatilities, many of these stocks are severely oversold and have the potential for short covering rallies at any time. When they rally there is the likely risk of declining implied volatility, as some of the spreads are not entirely protected against large changes in implied volatility. In the event the market opens higher on Monday due to President-elect Barack Obama’s Saturday economic plan announcements we suggest waiting until the strength begins to reverse.

Bank of America Corporation (BAC) 11.47. Bank of America Corporation is a financial holding company providing banking and nonbanking financial services and products worldwide. It also recently acquired Countrywide, the troubled mortgage banking company.

With a Historical Volatility of 117, consider this bear put spread.

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. The debit Monday should be about 2.37 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .24 for each point change in the stock price.

Set the SU (stop/unwind) at 15. On a short covering rally the implied volatility will likely decline. With a 10% absolute decline in implied volatility the risk at 15 would be about $100 or 42%. The gain is limited to the difference between strike prices less the debit of $237 or $263 for a one-lot position. By setting the stop at 15 we can limit the loss to $100 (presuming we have correctly estimated the decline in implied volatility) while having a potential a maximum gain of $263 if the stock continues lower.

General Electric Co. (GE) 14.03. GE operates as a technology, media, and financial services company worldwide with four segments: GE Capital, Energy Infrastructure, Technology Infrastructure, and NBC Universal. With a debt to equity ratio of 4.9 it has been recently trading more like the financials.

With a current Historical Volatility of 84 consider this bear put spread.

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. The debit Monday should be about 1.73 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .33 for each point change in the stock price.

Set the SU (stop/unwind) at 17 ½. On a short covering rally the implied volatility will likely decline. With a 20% absolute decline in implied volatility the risk at 17 ½ would be about $124 or 71%. The gain is limited to the difference between strike prices less the debit of $173 or $327 for a one-lot position. By setting the stop at 17 ½ we can limit the loss to $124 (presuming we have correctly estimated the decline in implied volatility) while having a potential a maximum gain of $327 if the stock continues lower.

Toyota Motor Corp. (TM) 63.68. Toyota Motor Corporation is a leading automotive manufacturer and marketer worldwide. While Toyota faces the same declining sales issues as all the other auto manufacturers, they have the added foreign exchange risk since the Japanese Yen is now rising faster than the US dollar.

With a Historical Volatility of 103 here is another bear put spread idea.

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Since the time decay is almost entirely offset for this spread, the debit Monday for the spread should be about the same price if the stock price remains unchanged, Use the position net delta shown above to adjust for any stock price change or about .09 for each point change in the stock price.

Set the SU (stop/unwind) at 70. On a short covering rally the implied volatility will likely decline. With a 16% absolute decline in implied volatility the risk at 70 would be about $75 or 33%. The gain is limited to the difference between strike prices less the debit of $230 or $270 for a one-lot position. By setting the stop at 70 we can limit the loss to $75 (presuming we have correctly estimated the decline in implied volatility) while having a potential a maximum gain of $270 if the stock continues lower.

Despite the US dollar strength, gold turned higher on Friday with Comex cash gold breaking out above 778.16. This move could be just short covering since it is currently oversold or it may be the start of something more. In this uncertain market environment it is hard to tell, but it may be worth considering and in the event it is more than short covering here is a defined and limited risk bull call spread trade suggestion.

SPDR Gold Shares (GLD) 78.85. The Trust holds gold and issues shares in exchange for deposits of gold.

With large trading volume and open interest the bid/ ask spreads in the options are reasonable. The current Historical Volatility is 45.

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Since the time decay is almost entirely offset for this spread, the debit Monday for the spread should be about the same price if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .12 for each point change in the stock price.

Set the SU (stop/unwind) at a close below 70. If the rally loses momentum the implied volatility will likely rise as the stock turns lower. With a 5% absolute rise in implied volatility the risk at 70 would be about $95 or 56%. The gain is limited to the difference between strike prices less the debit of $170 or $330 for a one-lot position. By setting the stop at 70 we can limit the loss to $95 (presuming we have correctly estimated the rise in implied volatility) while having a potential a maximum gain of $330 if the ETF continues higher and moves back up to the previous resistance at 90.

Takeover File Update

Yahoo! Inc. (YHOO) 9.39.

Our last Yahoo! suggestion was made in IVolatility Trading Digest™ Volume 8, Issue 43, Change is Coming, dated November 10, 2008 when it had closed at 12.20.

In the original plan we suggested setting a SU (stop/unwind) at a close below 10 for a maximum loss of about $66 on a one lot position.

Using the closing mid prices on Friday of 9.39 for the stock, the suggested bull call spread - long Jan 10/short Jan 14, was priced at 1.06. Since the initial debit was 1.92, the loss is .86 or $86 for a one lot position.

We now suggest closing the position in accordance with the original trade plan in Issue 43. Unless these is a material change in the relationship between Yahoo! and Microsoft we do not intend to offer any more suggestions for Yahoo! and we are closing the file with very mixed results of more losses than gains.

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.

Comments:

I have followed QCOR for some time and have made a reasonable profit on call options. What is you opinion of this stock and it's pontential? Thank's for your opinon. Don

Posted by Don Lytle on November 24, 2008 at 08:11 AM EST

Hello Jacktrader, I was wondering as a professional in the option trading sector, what do you look for in finding a stock that fits the mold of a good option candidate? How do you limit what option strategy to use? what factors do you look for to limit risk? I am a beginner in option trading and have spent the last 3 months reading and using practice trading acct at OIC, and feel options are a great addition to portfolios. Thank You Ron

Posted by Roncivil on November 24, 2008 at 09:15 AM EST

Don, Thanks for your question on Questcor Pharmaceuticals, Inc. (QCOR), a small pharmaceutical company that appears to be in an uptrend from late July. We are not qualified to express an opinion on this stock from a fundamental perspective. We are willing of offer some observations about their options. The option volume and open interest is small meaning the liquidity is low with fairly wide spreads between the bid and ask prices. With fairly high implied volatility selling calls is fairly attractive if you are comfortable owing the stock and if so then selling expensive puts as the first step would also be an alternative. However, with small options volume and open interest there are probably better alternatives with more liquidity. Jack

Posted by Jacktrader (68.109.71.202) on November 24, 2008 at 09:48 PM EST

Ron, Thanks for your question about selecting a good options candidate. Since you are not an options market maker and have no obligation to make a market in particular stocks you can be selective in your choices. Our focus is on volatility both implied and historical and we think this is one of the better approaches. We offer many articles on our web site and there are several good books on the subject. By subscribing to our Advanced Historical Data and Advanced Options you will have the tools you need in order to start using volatility as a selection strategy. Jack

Posted by Jacktrader (68.109.71.202) on November 24, 2008 at 10:04 PM EST

Hello, Regarding your GLD trade suggestion, I do not understand how my loss can only $95 when GLD goes down to 70. The loss for the bull call spread will be equal to the debit I paid for the spread. Can you tell me at price should I unwind the trade? I do not think 70 is the right price to unwind. If yes, Pleaswe explain.

Posted by Promod Lodhia on November 26, 2008 at 01:27 PM EST

Promod, Thanks for the question on the GLD trade loss estimate. You are right the maximum loss at expiration would be limited to the debit and in this case it is 1.70. Using the IVolatility.com Profit and Loss calculator we modeled the $95 loss assuming a price of 70 with a 5% increase in implied volatility by 14 days from last Friday, November 21, 2008. Since there would still be a lot of time value in the options in 14 days we would not expect to see the maximum loss until expiration. Since GLD broke out of the triangle reversal pattern to the upside and traded higher on Monday the debit would have been higher than the indicated 1.70. Since we know our maximum loss is the amount of the debit at expiration we can use SU (stop/unwind) levels to limit the loss even further. Looking at the chart now we see that any pull back into the reversal pattern would create doubt about the validity of the breakout. There are two gaps to watch and we would suggest using a close below 72.5 as the SU. Jack

Posted by Jacktrader (68.109.71.202) on November 26, 2008 at 03:09 PM EST

good day: I have only $2000.00,how can I multiple

Posted by jose yanes on December 04, 2008 at 10:08 AM EST

Jose, Good question about multiplying your capital. In the current market environment probably the best thing to do is keep it in cash for now. Many brokers require a somewhat larger balance to open an options account. In the meanwhile save your money and learn about the markets to determine if options are right for you. Jack

Posted by Jacktrader (68.109.71.202) on December 04, 2008 at 10:58 AM EST


Permalink Comments [8]



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".