What's On Our Minds...

Barron’s –

Steven Sears writes about risk reversals in this weekend’s Striking Price column.  A risk reversal may encompass a variety of strategies, but the method discussed in his column involves selling an out of the money put and using the proceeds to purchase calls.  The result is the obligation to buy an underlying security at a lower price and the right to buy at a higher price.  With low volatility in the market a few suggestions are made to implement this strategy on market related exchange traded funds such as the SPDR S&P 500 ETF Trust (SPY – 136.93), iShares Russell 2000 (IWM – 82.64), and iShares MSCI Emerging Market ETF (EEM – 44.19).

Options Action –

The guys started out talking about strength in the overall stock market, but noting some caution based on oil and gold climbing to higher levels.  They cited geopolitical risk as the catalyst behind higher oil and risk of inflation as the reason behind higher gold prices.  Both of these factors could weigh on the stock market if they were to come to fruition.

The first trading recommendation is on Caterpillar (CAT – 116.00) and is looking out to April expiration.  CAT tends to trade in line with the price of oil and if the commodity backs off in price so may shares of CAT.  Looking out to April buying a CAT Apr 110 Put for 2.40 and selling a CAT Apr 105 Put for 1.40 is recommended.  This put spread would result in a profit of $4.00 if CAT is at 105 or lower.  Above 110 at April expiration the spread is a loser of $1.00 which is also the cost of initiating the spread.

The other recommendation is to buy a call option on Exxon Mobil (XOM – 87.34 ) as the stock is fairly inexpensive and due to the low volatility in the overall market options are cheap as well.  Like the CAT trade this trade focuses on April expiration and is a purchase of the XOM Apr 90 Call at 0.80.  Below 90.00 at April expiration this trade is out the 0.80 premium paid and as long as the stock is over 90.80 at expiration a profit will be the result.

One final note – if you haven’t heard Warren Buffet has released his annual letter to investors.  A full read can be found at http://www.berkshirehathaway.com/

Yesterday I met a very nice fellow in the waiting room of a doctor’s office.  We immediately hit it off sharing the pleasure that it was our wives having outpatient surgery and not us.

Our conversation turned to Facebook and its much anticipated IPO.  The big question we both had of course was how much the stock will cost?  With nothing but time in the waiting room I started my simple research to justify a price. 

Facebook has 845 million users and it earned $1billion last year up from $606 million in 2010.  So I guess that makes it a growth company.  So how much will the stock cost?  A lot.  Google’s IPO was $85 and rose to $100 on the first day of trading.  So how much is Google stock now?  A lot.

So when can my bullish buddy trade options?  He’ll have to wait a few days.  Once the stock starts trading there is an SEC approval process that takes about a week.  Upon approval, option markets will be ready to offer unique opportunities to capitalize on your personal outlook for the future of Facebook stock..

While the VIX^® Index has been below 24 so far in 2012, and the VIX closed at 16.80 yesterday (Feb. 23), the trends in trading volumes in VIX-related products indicate that there could be more recent interest in using VIX-related products for purposes of risk management for investor portfolios. 

The average daily volume for the VIX call options, VIX futures, and some of the VIX-based exchanged-traded products (ETPs) is more than 55% higher this month than it was in the previous four months (see table below)

This month the VelocityShares Daily 2X VIX Short-Term ETN (TVIX) had an average daily volume of around 21,887,000, but in the past week Credit Suisse announced that it had temporarily suspended creations of shares of the TVIX ETN.

TABB GROUP REPORT ON VIX TRADING

The Tabb Group recently issued a 20-page paper “VIX Trading: The Structure of Uncertainty” (available for purchase).   Tabb summaries of the paper on the CBOE Volatility Index^® (VIX) noted that --

“ …VIX trading quite literally exploded over the past few years. The notional value traded of VIX products grew at an ear-piercing 5-year compound annual growth rate of 131% from 2006. …  the S&P 500 volatility market reached an estimated 202 million average daily notional Vega (gross): SPX Options (75 million); VIX futures (48 million); VIX Options (39 million); VIX ETPs (30 million); and SPX Variance Swaps (10 million).  … ”

http://bit.ly/Tabb-VIX-2012-1      http://bit.ly/Tabb-VIX-2012-2

WHAT ARE EXPECTATIONS FOR FUTURE LEVELS OF VOLATILITY?

A February 22 news story at www.wsj.com noted:

“… current VIX levels also show that traders expect stocks to dart around far more in the future than they have over the last month. The realized volatility of the S&P 500 over the last 30 days stands at about 8%, its lowest level since May, according to data from Livevol. That means traders are paying more for portfolio protection despite the placid markets. …”

The chart below shows a large spread of 9.3 points on February 23rd between the VIX Index spot value (16.80) and VIX June ’12 Futures price (26.10)

The webpage www.cboe.com/VIX provides a table delayed quotes with updates on the VIX and VIX futures values.  Here is the table at mid-day on Feb. 24 --

UMASS STUDY ON VIX FUTURES AND OPTIONS AND DIVERSIFICATION

The paper "VIX Futures and Options--A Case Study of Portfolio Diversification During the 2008 Financial Crisis" was published in 2009 by an author from the University of Massachusetts.The paper found that, for a traditional portfolio of stocks, bonds and alternatives during the five-month time period from August through December 2008, if an investor made a 10% allocation to CBOE VIX futures--

- Total returns were improved by 15.7 percentage points (improvement to -4.0% from -19.7%)

- Standard deviation was reduced by about one-third (to 16.3% from 25.3%)

Please visit the VIX microwebsite www.cboe.com/VIX for the UMass study on use of both VIX futures and options.

The S&P 500 Index ($SPX) pulled back only a little, but that was enough to alleviate some of the overbought conditions and to establish support at 1340.

Equity-only put-call ratios have begun to move sideways recently, but they remain on buy signals.   Market breadth was fairly negative from Feb 10th through Feb 15th.  That was enough to alleviate the serious overbought condition that had existed in the breadth oscillators.  Since then, breadth has improved again, and at this time, breadth is on a buy signal.

Volatility indices ($VIX and $VXO) have been quite interesting. $VIX may no longer be in a confirmed downtrend.  But the stock market can continue to advance while $VIX moves sideway.

In summary, the low-volatility conditions are building.  This isn't necessarily the harbinger of a sell signal, but it is a sign that volatility will increase.  As long as $SPX holds above 1340, the technical picture

is bullish.

Note: if you are viewing a text version of this report, click on the following link to see the charts:

http://www.optionstrategist.com/weekly-charts

Larry McMillan

optionstrategist.com

Volatility as an asset class
 
Marvell Technology (MRVL) is recently up 35c to $16.40 in the premarket after reporting Q4 EPS 21c, consensus 18c. Overall option implied volatility of 40 is a below its 26-week average of 44.

Salesforce.com (CRM) is recently up $15.02 to $146.80 in the premarket after reporting Q4 EPS 43c, consensus 40c. March call option implied volatility is at 58, April is at 48; compared to its 26-week average of 51.
 
J.C. Penney (JCP) is recently up 27c to $42.20 in the premarket after reporting Q4 EPS (41c), consensus 68c. Overall option implied volatility of 42 is below its 26-week average of 46.
 
 
CBOE Volatility Index-VIX closed at 16.79, 10-day moving average is 18.93, 50-day moving average is 20.61. www.cboe.com/VIX
 

Stocks with significant put volume increases;

BAC 2/24/2012 8 9K contracts
 
NEM 3/17/2012 60 8K
 
AAPL 2/24/2012 500 8K
 
WAG 3/17/2012 33 5K

BAC 3/17/2012 8 5K
 
SWY 4/21/2012 23 5K

U.S. equities mixed to higher as oil trends above $108.  European stocks up a fraction, Asian stocks closed slightly lower.

(Editors note:  Dan sent this to us Monday afternoon, Presidents Day)

The American past time used to be baseball. But the last couple years that has changed. The new American past time has become get long AAPL any way you can and wait for the profits to accumulate. Over the last 2 years, AAPL has gone from around 190 to 500, you figure the yields, staggering! Since June 20, AAPL has risen from 315 to the current level of 502, 60% in 8 months! Let me say that one more time, 60% in 8 months!

So why shouldn’t it continue and why is it becoming dangerous? I’m glad you asked. Over the last 2 weeks, AAPL has shown a changed personality that you should be aware of. This personality is much different than the fun loving, get on my back, and I’ll take you up, up, to always higher stock prices. From a psychological perspective, this personality change started about 2 weeks ago around February 3. AAPL was trading at 460, and the March at-the-money implied volatility was around 19. What does that mean in English, Spanish, and Portuguese? It means everything was OK, and no real fear of the downside was popping up. But was it?  The speed to the upside was really picking up. From November 25 to February 3, AAPL went from 363 to 459, 26% in a little over 2 months. Everybody wanted in! On February 10th, AAPL hit 493 and March at-the-money implied volatility in the calls spiked to 27.

What’s the big deal? Option volatility usually decreases on the upside as prices go up and fear of the downside isn’t usually there. And remember, this is AAPL, this is America! But last week, the personality disorder got much worse. As AAPL climbed a bit higher to 500, the March at-the-money option volatility climbed higher to 32 in the calls. That is an increase in 2 weeks from 19 implied volatility to 32, an increase of 68% with the stock rising. Why are the option volatilities going up and what does it mean?  First of all why are the option volatilities going up?   SPEED!! Look at a pivotal day, Wednesday Feb 15, AAPL traded intra-day to 526 and closed at 497. That’s a decrease of 5% from the daily high to the close. The stocks rate of speed up and down intraday is really picking up in both directions. Sellers are coming in a bit!  The last time I really saw this kind of speed to the upside was the internet debacle many years ago when stocks were screaming to the upside, do you remember what happened after they went up very fast?

What does increasing option volatility mean to the retail trader? It means the green light on the stock may possibly be turning to yellow and you should exercise a bit of caution. Does this volatility news mean I can’t stay bullish on my beloved AAPL?  No, it just means HOW you get long may need to change. This leads me to the strategy for today if I want to be long AAPL but be cautious!

Strategy idea: With this disturbingly changed personality in AAPL the last 2 weeks, I would approach any bullish trade very cautiously and make sure the risk/reward looks acceptable to me. In other words, if AAPL nosedives, I’m very comfortable with my total downside risk. I would initiate the below strategy after 1-2 down days.

Strategy example:  Stock at 502.50  Buy 1 March 500 call and sell 1 March 505 call for a debit of around $2.40 ( $240). This strategy called a bullish vertical debit spread, allows you to play a high priced stock for a very reasonable cost. We are actually selling an option with more time premium than we are paying for with our long. This is good considering option volatilities (called implied volatility) have skyrocketed the last few weeks. The risk/ reward is about 1 :1 meaning we can make $250 profit potential with maximum risk of $250. If the stock is 505 or higher at expiration ( 2 ½ dollars higher than the current 502 level), I can make 100%. This again is a cheap way with limited downside risk ( $250) to play a very expensive and volatile stock.

Be careful and have a great week! 

Dan Sheridan      dan@sheridanmentoring.com

The scales could have tipped either way last week, but Thursday's encouraging news on the jobs front (against a backdrop of a potential resolution to the European crisis) sparked a buying effort that cemented last week's gains.

Volatility as an asset class
 
Kohl's (KSS) is recently down $1.78 to $50.41 in the premarket following the company seeing FY12 EPS $4.75, consensus $4.29.  Overall option implied volatility of 29 is below its 26-week average of 31.
 
Limited (LTD) is recently down $1.43 to $44.05 in the premarket following the company seeing 2012 EPS $2.60-$2.80, consensus $2.91. Overall option implied volatility of 30 is below its 26-week average of 37.

Target (TGT) is recently down 57c to $52.40 in the premarket following the announcement of Q4 revenue $21.29B, consensus $21.21B. Overall option implied volatility of 22 is below its 26-week average of 27.

CBOE Volatility Index-VIX closed at 18.19, 10-day moving average is 19.06, 50-day moving average is 20.80.
 


 
Stocks with significant put volume increases;
 

BAC 2/24/2012 8 5K contracts

SWY 4/21/2012 23 5K

NBR 3/17/2012 19 4K

AAPL 2/24/2012 500 4K

NFLX 2/24/2012 110 3K

HPQ 3/17/2012 27 3K

JAH 3/17/2012 40 3K

JAG 3/17/2012 5 3K

DELL 3/17/2012 17 3K

U.S. equities mixed to higher as China's stocks rallied for fifth day.  Retailers took center stage before opening.  TGT & DRI upped guidance, KSS lowered.  Sears disappointed big time but is selling some stoires and spinning off others, might be worth watching this morning.  VVUS got FDA approval for a diet drug and is up $11 pre-opening.

Be clear about your goal but be flexible about the process of achieving it.  (Brian Tracy)

It can be challenging to change our way of thinking.  Naturally, we form opinions about people, events and expectations and move forward based on our own logical answers.

But, what if we are wrong?  Is that defeating?  Are we too set in our ways to make changes, stuck in the mud and unable to do what is necessary?  What if the road is blocked on the way to your destination – do you sit there and stare at it or move?

How about Eli Manning reading a defense.  If he sees something ‘odd’ he may call an audible.  To help our bodies become more flexible we may go to the gym for some classes or just even stretch.

The ability to change and do something different when the obstacles are too much to overcome is not a sign of defeat, rather a sign of strength, having the power and willingness to make the adjustments to get ahead.

Stay committed to your decisions, but stay flexible in your approach. (Tom Robbins)

Trading requires flexibility and nimbleness.  Have a bad trade result?  Happens too often, doesn’t it?  How do you handle it?

How about an unfortunate circumstance where you thought you had checked your risk but some ‘outlier’ hits your P/L hard.  How do you make the adjustments to make this work for you?   I have been in many painful situations, as have you.

On Jim Cramer’s Mad Money last Friday he stresses some important lessons learned over the years at his hedge fund and prior.  I enjoyed the show immensely, I highly recommend this one to you.  He learned to be flexible, admit when he was wrong but NOT defeated and to change the shape of his thoughts to be more accommodating to the occasional surprises.  This change seems to have served him well.

Be firm on principle but flexible on method. (Zig Ziglar)

As a trader I use some simple methods of technicals and charts to enter/exit my trades.  I have survived and thrived for years using the tools in my toolbox, but it’s far from the best.

You’ve heard me say many times that trading is not a game of perfect, and it is so true.  What allows me to continue on in the trade, grow and survive is my ability to change and admit when wrong.

Success requires discipline, flexibility but also humility.  A big ego is destructive to your mind and your bottom line.  Marry yourself to one way of thinking and you’ll eventually find yourself on the short end of the stick.

That which yields is not always weak. (Jacqueline Cary, from Kushiel’s Dart)

Bob Lang is the founder of Explosive Options
http://explosiveoptions.net

Volatility as an asset class
 
Brocade (BRCD) closed at $5.50 prior to guiding Q2 EPS 11c-12c, compared to consensus 13c. Overall option implied volatility of 55 is below its 26-week average of 58.
 
Dell (DELL) is recently down $1.21 to $17 in the premarket on the company expecting the first half of FY13 to be "challenging." Overall option implied volatility of 33 is below its 26-week average of 38.
 
NASDAQ 100 (QQQ) overall implied volatility at 19; 26-week average is 23.

Russell 2000 (IWM) overall implied volatility at 26; 26-week average is 27.
 
 
Active options at CBOE

LNG 3/17/2012 12 25K contracts
CSCO 4/21/2012 22 22K
CHTP 3/17/2012 4 16K
AAPL 2/24/2012 510 11K
SWN 3/17/2012 36 10K
JPM 3/17/2012 40 9K
INTC 7/21/2012 25 7K
MSFT 3/17/2012 30 7K 

U.S. equities are mixed to lower as investors are sceptical of Athens’ ability to enact reforms.  Dell miss didn't help.  Hewlett announces after the bell.

Volatility as an asset class
 
VIX methodology for Amazon (VXAZN) at 35.53, below 50-day moving average of 41.83.
 
VIX methodology for Google (VXGOG) at 26.31; below 50-day moving average of 28.25.
 
VIX methodology for Apple (VXAPL) at 33.70; above its 50-day moving average of 29.64
 
VIX methodology for IBM (VXIBM) at 19.86; below its 50-day moving average of 22.03.
 
VIX methodology for Goldman Sachs (VXGS) at 33.77; below its 50-day moving average of 40.93

Barron’s –

Steven Sears writes about a stock replacement strategy in the Striking Price column.  The gist of the strategy is that investors will sell high priced stocks, or stocks that have had a bullish run, and replace the shares with low priced call options.  The example he cites is Apple (AAPL – 502.12) which ran to 526.00 last week before backing off to as low as 490.00 before settling in for the long weekend around 500.00.  A stock mentioned as a candidate for this sort of trade is Disney (DIS – 41.75) which is up over 15% this year.

Options Action -

In the introduction it was noted that the financial stocks have taken a breather in the midst of the recent market rally.  This is a precursor for the first recommendation that is in Goldman Sachs (GS – 115.91) stock.  As the stock has advanced nicely in 2012, the suggestion is to initiate a butterfly using April call options.  Using the April options is suggested so that the trade may benefit from GS earnings due out in April before expiration.  The butterfly would be constructed buying the GS Apr 120 Call at 4.00, selling 2 GS Apr 130 Calls at 1.30 each and buying a GS Apr 140 Call at 0.40 for a net cost of 1.80.  To be profitable GS should fall between 121.80 and 138.20 at April expiration.  The best outcome would result with the stock at 130.00 at expiration with the resulting profit coming in at 8.20.  Finally, the worst case involves GS below 120.00 or above 140.00 at expiration.  In either of these situations the result is a loss of 1.80 on the trade.

The next recommendation is on Priceline.com (PCLN – 582.52), a company that has made me personally angry since killing off Shatner from their commercial series last month.  Although Shatner is no more, the recommendation is bullish in the form of a calendar call spread.  This trade sells the PCLN Mar 620 Call @ 13.80 and buying the PCLN Apr 620 Call at 20.50 for a net cost of 6.70.  The goal of this trade is for the stock to trade up to 620.00 around March expiration.  Also, PCLN reports earnings before March expiration and the March options are pricing in higher implied volatility than April options so there is a time decay benefit from this trade structure.