« December 2008 »

IVolatility Trading Digest™

Volume 8, Issue 47
Bad News

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Last Friday’s equity market trading reminded us of this old Wall Street saying,

“The market bottom is defined when it stops going down on bad news.”

Recall last October the equity markets were still going down on what should have been considered good news with respect to the actions that were being taken by the Treasury and Federal Reserve to rescue the credit markets and the financial sector.

The employment report released last Friday with job losses of 533,000 in the month of November 2008 was bad news for the economy.

Here is what The New York Times said,

“The nation’s employers cut 533,000 jobs in November, the Bureau of Labor Statistics reported Friday.”

“Not since December 1974, toward the end of a severe recession, have so many jobs disappeared in a single month – and the current recession, far from ending, appears to be just gathering steam.”

While there could be many explanations why the equity markets ended the day higher and not lower on the bad news, including short covering on the widely expected bad employment report. We also wonder if there is another possible answer like the one raised by Richard Russell last October when he said:

"Bear declines end in only one way – in exhaustion."

Has most of the selling been done and could we be near the exhaustion point? Friday’s market action raises this possibility.

After our brief market review, we present additional information on the Stock Trend Analysis and Best Calendar Spread selections found in the Data Analysis and Rankers & Scanners sections of our home page. Then in the Takeover File, we have one new suggestion and an update.

Market Review

S&P 500 Index (SPX) 876.07. Although closing 20.17 lower on the week the noteworthy turnaround on Friday from a 26.81 intraday decline to end the day 30.85 higher could mark the beginning of changing market sentiment. A resolution to the continuing the auto industry drama should also play a role in changing the sentiment.

S&P 500 Index IVX 54.19. The Implied Volatility Index Mean (IVXM) gained 1.79 for the week. The well-defined divergence between the lower low in the SPX on November 21, 2008 not being confirmed by a higher high in the IVX Mean did not hold up when we extended the same analysis to the SPDRs (SPY) as it did make a new late November high.

US Dollar Index (DX) 87.12. Once again the dollar index turned higher with a gain of .59 while the ETF for the Japanese Yen (FXY) rose 3.08 to 107.40 further supporting the deleveraging thesis that has been in place since the middle of August.

TED Spread 2.18. Bloomberg’s TED spread remained stuck at 2.18, which is not very helpful for the financial stocks. We think the TED needs to decline to the 1.40 - 1.45 range although we are beginning to see some of the stocks in the group turn higher.

NYSE McClellan Summation Index. Our market breadth indicator scored its second weekly gain increasing 272.60 and taking the reading up to -1089.56. If we did not have a positive divergence in the Implied Volatility Index Mean (IVXM) for the SPY we clearly do have one in the NYSE Summation Index for it did not again decline below the 1500 mark on the last lower NYSE down leg.


With the risk of being whipsawed, we are encouraged once again by the markets response to the bad employment report last Friday. While we will likely continue seeing volatile trading, we may be nearing the exhaustion point for new selling. With all of the support programs being offered by the Treasury and the Federal Reserve and with the thought that more will be introduced by the new US administration, the risk for short sellers could be rising to unacceptable levels. It may be too soon for enthusiastic buying but it is probably too late for enthusiastic selling. For now, look for special situations and stocks that pay good dividends.


Stock Trend Analysis

As a regular feature in the Options Data Analysis and Rankers & Scanners sections on our home page we show the results from the Stock Sentiment Ranker based upon the short-term market trend, which considers, the Historical Volatility term structure, call/put ratio, exponential moving average, 14 day RSI (relative strength index), and the 21 day Chaikin Money Flow. Once again, here is last Friday’s selection from the home page.

Sherwin-Williams Co. (SHW) 58.73. Cleveland, Ohio based SHW is in the paints and coatings business in North and South America, the United Kingdom, Europe, China, and India. Lower commodity prices are helping to support sentiment in an otherwise difficult marketing environment. With a 1.40 dividend at a 2.50% rate and with a reasonable debt to equity ratio of .59 they have exceeded earnings estimates for the last four quarters. The next earnings report is due January 29, 2008 with an estimate of .88. The Implied Volatility Index Mean is 57.53 in a Type II pattern where both measures are abnormally high while the longer-term forecast is 40. The options are thinly traded so expect to see wide spreads between the bid and ask prices. With a current Historical Volatility of 65 and declining along with the implied volatility, consider using limit orders and having some patience with this opportunity.

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 2.90 if the stock price remains unchanged. Use the net delta shown above to adjust for any stock price change or about .33 for each point change in the stock price.

Calendar Spread

As a regular feature in the Options Data Analysis and Rankers & Scanners sections on our home page, here are the details of Friday’s calendar spread selection.

Wells Fargo & Company (WFC) 29.94. San Francisco based WFC is one of the major money center banks that is in the process of acquiring the banking operations of Charlotte, North Carolina based Wachovia Corp. The Wachovia shareholders are scheduled to vote on the stock deal December 23, 2008. WFC’s dividend at 1.36 is now at an attractive 4.9% rate. While WFC is considered well managed both volatility measures, along with many other banks are quite high. While the Implied Volatility Index Mean is 95.64, down from 124 on November 21, 2008, the current Historical Volatility is 125.

Here are the details of the calendar spread.

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the debit Monday should be about the same as the time decay is offset in this spread. Use the position net delta shown above to adjust for any stock price change or about .08 for each point change in the stock price.

Takeover File

The following takeover candidate came from the number one place in our “Top 5 stocks based on IV Index Mean vs 30D HV” in the Rankers & Scanner section on our home page. With an Implied Volatility Index Mean at 60.11 and a Historical Volatility of 36.13 there is a good edge with IV/HV ratio of 1.66.

Rohm & Haas Co. (ROH) 71. Philadelphia based ROH provides various specialty materials used in the building and construction, electronics, packaging and paper, industrial, transportation, household, personal care, water, and food markets.

Last July Dow Chemical (DOW) 19.00 offered to buy ROH for $78 per share cash, a $28 dollar premium to the price at the time. The deal is expected to close in January yet it still trades at a 9.86% discount to the cash purchase price. The credit crunch may be the reason for the discount as there are concerns that the financing banks may be unable to deliver the cash claiming unstable market conditions. While acceptable if the deal is delayed, it could create a substantial loss if it is terminated altogether.

Consider this idea:

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 5.39 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .43 for each point change in the stock price. If the deal is terminated, there could be 20 point of downside risk that would turn a trade into a long-term investment with the assignment of the stock at the January expiration. In this event, the plan would be to sell calls against the long stock.

Constellation Energy Group, Inc. (CEG) 27.58. CEG supplies energy products and services to wholesale customers, and retail commercial, industrial, and governmental customers in North America with three operating segments: Merchant Energy, Regulated Electric, and Regulated Gas. This is the company that Berkshire Hathaway announced its MidAmerican Energy Company planned acquire for $26.50 per share after Standard & Poor’s threatened a downgrade that would have required CEG to post another $3.3 billion of collateral for its trading and hedging operations.

We first suggested CEG as a Buffet Put Sale in IVolatility Trading Digest™ Volume 8, Issue 36, The Week That Was, dated September 22, 2008, when CEG was 26.76. We suggested selling the October 20 or the October 22 ½ puts. Since CEG closed at 24.06 on the October options expiration both put sales expired and the premiums of 1.35 and 2.05 were booked as gains.

Now the French owned power company EDF is bidding almost as much for half of the company as Buffet’s MidAmerican bid for the whole thing.

MidAmerican responded by saying it will not raise its bid from the original 26.50 per share. This could be an interesting opportunity as the MidAmerican bid provides a floor price while waiting to see if the EDF bid will be accepted by CEG, and while waiting for the necessary approvals. This could take quite some time to be completed. In the meanwhile, CEG makes a good covered call candidate as it is paying a 1.91 dividend for a 6.8% yield. With a current Historical Volatility of 45, consider these ideas.

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 1.10 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .35 for each point change in the stock price.

Based on the prices above if the shares rise and are called at 30 on the January expiration the gain would be 3.52 or 13.3% in six weeks, or 115% annualized rate. If there are no further developments between now and January and the stock remains unchanged the call will expire and another call option could be sold for the April expiration. In that event there would be a dividend payment of .478 made in March further reducing the cost basis.

As an alternative, here is another put sale idea:

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 1.18 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .31 for each point change in the stock price.

Both of these suggestions have downside protection based upon MidAmerican’s 26.50 per share bid for the company.

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.


Jack, Very good stuff – enjoy reading it and learning the rationale of your picks; since I discovered your site only recently, I grab your posting as soon as it shows up online. Re ROH deal – I’ve noticed there is a considerable OI in the lower put strikes for December, seemingly suggesting that the market sees a high likelihood of the deal failing. How does that fit into our equation? I may be right or wrong, but am mostly interested in your opinion. If you discount the market’s view, I would like to know why. Also, I am wondering why you haven’t suggested ROHAO – JAN 75 Call @ $2.25 – downside would be the loss of premium; minimum upside of .75 = (78-75) – 2.25 for a 33% return. Not so with the put – considerable downside possible. Looking forward to your response.

Posted by SaltMines on December 07, 2008 at 09:04 PM EST

SaltMines, Thanks for your kind comment about the IVolatility Trading Digest. We agree with your view that the put open interest is an indicator of the level of concern that the deal may be in doubt. The first indication comes from the IV/HV ratio at 1.66 that we call a positive volatility spread and the reason we selected ROH. The implied volatilities for the out-of-the-money puts are very high indicating that the insurance premiums are very high. For example, the Jan 50 put at 2.70 has an implied volatility of 121.18 and there are 11,127 puts outstanding. Your long Jan 75 call idea at 2.25 is excellent and we agree it has less risk than the put sale suggestion. In order to reduce the risk of the put sale suggestion it should be augmented with a bear put spread, such as buying the Jan 60 put at 4.05 IV 95 and selling the Jan 55 put at 3.50 IV 109 for a .65 debit. This spread with good edge will reduce the risk of the put sale suggestion and could even be done more than one time further reducing the downside. We welcome your comment and contribution and hope you will continue writing to us. Jack

Posted by Jacktrader ( on December 08, 2008 at 12:38 AM EST

Thx for your previous comments - great conversation. More questions: 1. What is the definition and interpretation of the positive volatility spread the way you apply it and as quoted in "IV/HV ratio at 1.66 that we call a positive volatility spread and the reason we selected ROH". Is there a directionality in the parameter? High ratio - bearish, go long puts; low ratio, bullish, go long calls? If so, it seems to contradict your pick of a put. Unless a) it's a contrarian move - why? and/or b) we dismiss the bearish odds (why?) and want to capitalize on the rich premium value (high IV/HV = bearish bias + rich put premiums). Does low IV/HV automatically imply a bullish bias + rich call premiums? 2. TLT showed up a few times on Top 5 Stocks last week. Is there a tradable strategy you could think of here? Thx for taking the time to look at it.

Posted by SaltMines on December 08, 2008 at 11:01 AM EST

SaltMines, Thanks for the questions about the IV/HV ratio from the Advanced Ranker Top 5 stocks sample on our home page. This sample is a compilation of several sections from the Advanced Ranker and uses an index to express the relationship between the options implied volatility and the stock’s historical volatility (also called statistical volatility or realized volatility). The higher the ratio the wider the spread between the two measures with the implied volatility exceeding the historical volatility. We refer to this as a positive volatility spread as our perspective is from the viewpoint of an options seller. We are looking to sell expensive options with the expectation that the implied volatility will revert to it’s mean over time and the options value will decline accordingly. The high ratio in itself does not give all of the needed information; it is simply the starting point. Once identified we need to make some estimation as to why it is high and when will it likely revert to a normal range. Takeover activity is a good example as it usually causes implied volatility to rise above the historical volatility creating a positive volatility spread. For example, we may decide to fade the volatility by selling it using combinations of call or puts. Alternatively, we made decide to take the direction opportunity that was highlighted by the high IV/HV ratio by using a bull call spread that mostly neutralizes the volatility but retains some upside potential. The Advanced Ranker allows you to greatly expand the selection universe beyond just the Top 5 stock we offer in the sample. In Summary, the IV/HV ratio and the positive volatility spread are the starting points in a selection process. With respect to the TLT, the iShares Trust for the 20- Year Treasury Bond, the IV/HV ratio from Friday’s Top 5 was 1.39 indicating a positive volatility spread. When we go the Advanced Historical Data and look at the IVolaility.com Volatility Chart we see that the current implied volatility is now 37 and the historical volatility is 27 for a ratio of 1.37. We also note that the normal range for TLT is somewhere between 10-15 for both volatility measures. We could conclude this is an opportunity to sell options premium on the expectation that they will revert to the mean at sometime in the future. Next, if we go to the Options Volume and Open Interest feature and the Put Volume/Call Volume feature also found at Advanced Historical Data we quickly conclude that the high implied volatility of TLT is due to considerable put buying. Our conclusion is that long bondholders are using TLT as a hedging tool for their long bond positions, as one might expect in the current environment. We don’t think is a risk we would want to assume so fading the high implied volatility is probably not the right strategy in this particular case. We might well conclude that we would like to be one same side of this trade with the hedgers and look to creating a bear put spread combination in anticipation of the decline in TLT and corresponding interest rates sometime in the future. In summary, yes - there could well be a trade here. Jack

Posted by Jacktrader ( on December 08, 2008 at 02:12 PM EST

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