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Today


IVolatility Trading Digest™


Volume 8, Issue 49
Santa Claus Rally

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).

The Stock Trader’s Almanac reports that traders and investors can expect to see Santa Claus during the last five days of the year and he usually stays into the New Year creating what has become to be known as the “small cap January effect.” This year it looks as if Santa Claus arrived early as equities have been rising, in what appears to be a counter -trend rally, from their key reversal lows on November 21, 2008. In the Strategy section below, we explore the current rally in more detail.

We begin this last Digest issue of the year with a brief market review followed by updates for both the crude oil trend and the year-end gold rally. Then we offer a volatility trade suggestion and a hedged value investment idea in the oil sector.

Market Review

S&P 500 Index (SPX) 887.88. Equities continued their climb last week for another 8.15 point or .93% gain. As we mentioned in the prior two issues with all the negative news it is remarkable that equities have been able to rise. One part of the answer is the improvement in the credit market as defined by the TED spread shown below.

S&P 500 Index IVX 40.40. The Implied Volatility Index Mean (IVXM) declined another 6.92 after the prior week’s decline of 6.87. As we enter the less active holiday period, we can except to see further declines in both the Implied Volatility and the Historical (or Realized) Volatility measures. As the volatility declines we may be able to “sell some volatility” and we offer an idea below for this opportunity.

US Dollar Index (DX) 81.30. Last week DX crashed from 83.64 to a low of 77.69 last Thursday before recovering somewhat on Friday to close the week with a net decline of 2.34 or -2.8%. If volatility in the equity market has been declining, the same cannot be said for the currency market where it has risen dramatically. Year-end usually brings a firmer dollar as books are closed and currency is repatriated. If this year is going to be typical then volatility should decline for the next two weeks.

TED Spread 1.51. Bloomberg’s TED spread is the star of the week declining another 40 basis points on continuing lower Eurodollar deposit rates further indicating that conditions are improving in the important interbank market. Meanwhile the demand for 3-month Treasury bills has driven the yield down to 0% as excess cash balances continue to seek safety in Treasury securities. Previously we wrote the TED spread needs to decline to the 1.40-1.45 level to indicate normal money market conditions. At 1.51 TED is just about there and we expect to see the 1.40 -1.45 level very soon. The chart below shows the recent dramatic improvement for the star of the week.

Open 1.52, High 1.52, Low 1.50, Close 1.51

NYSE McClellan Summation Index. Make it four triple digit gains in row for our market breadth indicator last week adding another 256.09 and moving the index up to -509.89 confirming the continuation of the current equity rally.

Strategy

The S&P 500 Index has risen from the November 21, 2008 key reversal low at 741.02, but we think the gain is losing momentum and will not likely carry much further into the New Year. We were encouraged by the appearance of potential Head & Shoulder bottoms in several charts but now reserve judgment that the final bottom has been made. While the Bush administration agreed to advance the US Auto manufacturers $17.4 billion, less than many had originally expected, it only postpones the tough decisions into next year for the new administration to handle. Of equal concern is the technical condition as defined by the Elliott wave pattern suggesting the current rise is a counter- trend 4th wave and consistent with the traditional bar chart right triangle consolidation pattern that began in the middle of October. The downside-measuring objective of the right triangle consolidation pattern for the S&P 500 Index is 690 and this would create a final Elliott 5th wave bottom. While we have been somewhat more constructive, we now remain cautious until this technical condition is finally resolved.

Short Crude Oil Update

United States Oil (USO) 33.06. This ETF reflects the spot price of West Texas Intermediate (WTI) light, sweet crude oil. For the week, USO declined another 5.04 points on volume twice the average.

In lieu of reviewing the current open positions, we will use this space to justify adding another bear put spread. We will update the current USO position status again in the near future.

Last week our caution ahead of the OPEC meeting in Oran, Algeria on Wednesday December 17, 2008 proved unnecessary and in fact, there is so much of the stuff around there is no apparent place to store it as traders dumped the spot and near term crude oil contracts.

A noteworthy but somewhat irrelevant development for the near term was the continuation of the OPEC meeting in London last Friday. British Prime Minister Gordon Brown made this observation,

“Wild fluctuations in the market prices [of crude oil] harm nations all round the world. They damage consumers and produces alike.”

OPEC Secretary-General Abdullah El-Badri, added,

“We all know that extreme oil prices whether too high or too low are as bad for producers as they are for consumers.”

While everybody seems to agree that extremes are undesirable, nobody seems to know what to do about it. In the meanwhile, following the old Wall Street adage, “the trend is your friend,” we suggest adding another bear put spread.

The current Historical Volatility is 76 and the Implied Volatility Index Mean (IVXM) is 83.99 and rising.

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 3.09 if the stock price remains unchanged. Use the position net delta shown above to adjust for any ETF price change or about .16 for each point change in the ETF price.

Crude oil could be oversold and may turn higher at some point. In the meanwhile we suggest staying on the short side, but now also suggest lowering the SU (stop/unwind) once again to a close above 40.39, the most recent pivot made on December 15, 2008. In order for crude to form a price bottom USO will have to close above 40.39 and when it does we suggest unwinding all of the positions.

Long Gold Update

SPDR Gold Shares (GLD) 82.63. The Trust holds gold and issues shares in exchange for deposits of gold.

For the week the net GLD gain was 1.78, but it had the volatility of the currency markets. GLD formed an unusual right triangle reversal pattern from the October low at 66 and last week met the upside measuring objective from the reversal pattern when it reached at 85 on Wednesday December 10, 2008. It then promptly reversed and is now testing support at 81.72. Chances are the support will hold if the US dollar volatility declines as expected over the next two weeks.

In the meanwhile, keep the long bull call spread, long the Jan 85 call and short the Jan 102 call. We will update the position accounting status in the near future.

We are now suggesting a change the SU (stop/unwind) to a close below 80, up from the previous level of 72 ½.

IVOLopps™

Volatility Trade

Going into the holidays we expect to see volatility continue declining in a usual seasonal pattern and offer this straddle idea as an options volatility trade.

iShares Russell 2000 Index (IWM) 48.70.

Last week IWM gained 1.81 and the Implied Volatility Index Mean (IVXM) now at 50.20 is rapidly declining from the highs above 80. Our unscientific visual forecast is for a decline back to the 35 level, which could occur within the next few weeks. With a current Historical Volatility of 80 and about to follow the Implied Volatility lower, consider this straddle sale suggestion for the next two weeks.

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 5.15 if the ETF price remains unchanged. Use the position net delta shown above to adjust for any ETF price change or about .12 for each point change in the ETF price.

With a short straddle, the risk is increasing volatility and large price changes in the underlying. If we see the current trend in Implied Volatility reverse or if the ETF price declines below 45 or rise above 55 we will adjust or unwind the position. If the Implied Volatility were to decline to our forecast of 35 within 14 days, we could expect to see the combined value of the straddle decline to $273 from Monday’s estimated price of $515 for a gain of about $242.

Hedged Value

Although crude oil prices continue to decline, the share prices of the major integrated oil companies are not declining to the same extent as they are being supported by a combination of their dividends and the expectation that refining and marketing profits will expand to offset the decline in crude oil prices.

BP plc (BP) 45.13. London based BP operates in two segments, Exploration & Production, and Refining & Marketing worldwide. In the western US they are the retail gasoline price leader with their many ARCO self-service stations.

The current annual dividend is 3.36 for a yield of 7.45%, which is more than twice the average dividend rate of 3.3% for the last five-years. Since their payout ratio is just 35%, they should be able to maintain the dividend rate from earnings. The total debt is $28.3 billon and the debt to equity ratio appears comfortable at .268. The book value is $33.87, making the current market price just 1.33 times the book value.

The plan is to capture the dividend by purchasing stock while hedging the crude oil risk by selling a call and then using the call sale proceeds to buying a USO bear put spread. With a current Historical Volatility of 79.54 and declining and with an Implied Volatility Index Mean (IVXM) at 51.12 and declining consider this plan.

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 3.03 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .40 for each point change in the stock price.

With the estimated call proceeds, we suggest hedging the crude oil risk by purchasing a bear put spread using USO, the crude oil ETF as described in the section above.

The current Historical Volatility is 76 and the Implied Volatility Index Mean (IVXM) is 83.99 and rising.

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 3.09 if the stock price remains unchanged. Use the position net delta shown above to adjust for any ETF price change or about .16 for each point change in the ETF price.

Crude oil could be oversold and may turn higher at some point. In the meanwhile we suggest staying on the short side, but now suggest lowering the SU (stop/unwind) once again to a close above 40.39, the most recent pivot made on December 15, 2008. In order for crude to form a price bottom USO will have to close above 40.39 and when it does, we suggest unwinding this hedge put spread.

The combination position net delta is .4347 or the equivalent of about 43 shares of stock.

The next dividend of .84 will be paid about February 20, 2009.

In the event the stock price is 50 or above by the April options expiration we will have unwound the bear put spread as USO crosses above 40.39 recovering the then remaining portion of the spread cost. Our long stock will be called away from the short call at 50 and without considering the potential recapture of the put spread premium the return on investment would be about 12% in 115 days or about 38% annualized with a risk equivalent to about 43 shares of stock. This remaining risk can be further limited by setting a SU (stop/unwind) to sell the long stock in the event it closes below 40.

For those with a longer time horizon this suggestion represents value in a quality company with hedged risk.

Final 2008 Issue

As we mentioned above this is the last IVolatility Trading Digest for the year. We return on January 5, 2009 with many more exciting option ideas for the coming year. Happy holidays to all of our readers.

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".