“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…” Charles Dickens
Although the analogy may be a bit of a stretch, the divergence between the blue chip big capitalization stocks of the Dow Jones Industrial Average and the S&P 500 Index compared to the NASDAQ and small capitalization stocks represented by the iShares Russell 2000, along with “growth at any price stocks”, tells a story of significant rotation away from risk toward quality, dividends and liquidity.
While one day does not make a trend, Friday the iShares Russell 2000 turned higher after testing 107.50 Thursday indicating the possibility the divergence may be ending so we have a long IWM trade idea. Then we offer a new idea from our friends at The Blue Collar Investor followed by another for Caterpillar Inc. (CAT), Friday’s Best Trend selection.
S&P 500 Index (SPX) 1877.86 with the new intraday and closing high made Tuesday at 1897.45 thereby exceeding the April 4 high at 1897.28 the possibility of a Head & Shoulder Top has been negated thereby highlighting the continuing small capitalization divergence.
PowerShares QQQ™(QQQ) 86.18 the “NASDAQ-100 Index Tracking Stock®”, still exhibits a well defined potential Head & Shoulder Top activated on a close below a well defined neckline at 83 with a new potential right shoulder made Tuesday at 88.61.
iShares Russell 2000 (IWM) 109.57 this is where the divergence with the blue chips is most noticeable and of the greatest concern. While the location of the potential right shoulder of a possible Head & Shoulders Top was not previously evident, the decline down to test 107.50 Thursday seems to suggest the formation of a possible double bottom. Alternatively, it may now advance back up and attempt to define a right shoulder. Either way IWM may continue higher this week having been oversold. Last week in Digest Issue 19 “Rotation Appraisal”, we suggested a long June 107/102 put spread as a hedge against a further decline, but now may be the time for a call spread anticipating an oversold bounce. Accordingly consider this long call spread.
Countertrend Bounce Suggestion
iShares Russell 2000 (IWM) 107.57 reversing last week’s “just in case its needed” hedge, here is a conditional suggestion for a possilbe oversold bounce only implemented if Monday’s trading range has a higher low and higher high near the close.
The current Historical Volatility is 18.76 and 18.36 using the Parkinson’s range method, with an Implied Volatility Index Mean of 18.28 up from 17.94 the week before. The 52-week high was 23.88 on February 3, 2014 while the low was 13.62 on January 22, 2014. The implied volatility/historical volatility ratio using the range method is .99 so the option prices are reasonable relative to movement of the ETF and just below the 18.75 midpoint of the 52 week range. Friday’s volume was 828,574 contracts traded compared to the 5-day average volume of 955,550 contracts, representing good options liquidity.
Without implied volatility edge use a close back below 107.50 SU (stop/unwind) and delay implementation in the event it trades below 107.50 Monday.
Covered Call Writing Idea for Consideration
Over the past few months, we presented many of the basic principles needed to master generating monthly cash flow by selling covered call options. Now we will be presenting a series of “ideas for consideration” to demonstrate how this strategy can enhance our portfolios. This week’s idea highlights Sandisk Corp. (SNDK).
This company is in the “chips” industry, ranked in the 20th percentile of all industries and generates a 1% dividend yield. In addition to great fundamentals, its price chart is a thing of beauty.
Currently trading @ $89.90 (mid-day Friday May 16, 2014), the options chain shows the following:
Checking the possible returns for the $87.50, $90 and $92.50 strike prices along with the math using the Ellman Calculator (Free copy available on The Blue Collar website – free resources link on top):
We have potential 1-month returns of between 1.9% and 3.2% that annualize to between 23% and 38%. The $87.50 strike gives us 2.7% protection of that 2.1% initial profit and the $92.50 strike gives us 2.9% upside potential for a possible 1-month return of 4.8%. The $90, near-the-money strikes generates the highest initial return of 3.2%.
One of the keys to successful covered call writing is to only select stocks that you would otherwise want to own in your portfolio and then select an appropriate strike price that meets your monthly goal.
Then maximizing the returns requires some management. For example, we always buy back the option if the premium value decreases by 20% of the original sale amount in the first half of the contract term and 10% or less in the latter part of the contract. Just in case, let’s set up an exit strategy example for a bearish scenario.
— SNDK drops in price to $85 in the 1st week of the contract but remains near its 20-day EMA
— $90 call value drops to $0.60 meeting our 20% guideline
— Buy back the $90 call and wait a few days to see if share value recovers
— Let’s say it recovers to $89 and option value for the $90 strike is $2
— Re-sell the same option in the same month for a net credit of $2 – $0.60 = $1.40 or $140 per contract (in addition to the original $284 per contract shown above)
— If by mid-contract the share value is stagnant, roll down to $85 call to generate additional cash and downside protection
— If share value declines below $85, close the entire position and use the cash to enter a new covered call position to help mitigate losses
Mastering exit strategy skills and much more information on becoming an elite covered call writer is available at The Blue Collar Investor.
Best Trend Selection
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. On the presumption that the blue chip uptrend continues here is Friday’s selection.
Caterpillar Inc. (CAT) 106.03 now right on the well-defined upward sloping trendline from the January 24 low at 88.86 it appears likely to continue trending higher.
The current Historical Volatility is 12.70 and 14.52 using the Parkinson’s range method, with an Implied Volatility Index Mean of 15.28 up from 15.13 the week before. The 52-week high was 25.40 on October 8, 2013 while the low was 14.53 on November 26, 2013. The implied volatility/historical volatility ratio using the range method is 1.05 so the option prices are reasonable relative to movement of the stock and near the lower part of the 52 week range. Friday’s volume was 22,918 contracts traded compared to the 5-day average volume of 23,270 contracts.
With low option implied volatility relative to both the historical volatility and the 52-week range along with good bid/ask spreads a rare long only call seems justified. Use a close back below the upward sloping trendline at 104 as the S (stop).
The suggestions above use the closing middle prices between the Friday bid and ask, except where noted. Monday option prices will be somewhat different due to the time decay over the weekend and any price change.
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Summary
The blue chip bulls were encouraged last Tuesday as the S&P 500 Index closed at 1897.45 negating the potential Head & Shoulder Top that had been forming. In addition, based upon Friday’s trading there could be an oversold bounce coming in the relatively weaker iShares Russell 2000. If so, it would begin to narrow the divergence between the large and small capitalization stocks, which would be a favorable development for equities.
Actionable Options™
We now offer daily trading ideas from our RT Options Scanner before the close in the News section of our home page based upon active calls and puts with increasing implied volatility and volume.
Follow us on twitter for more ideas from our scanners and other developments.
In next week’s issue, we will update all of our market indicators and report on both the S&P 500 and Russell 2000 indexes.
Finding Previous Issues and Our 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. Another way to find them is the Table of Contents link in the blog section of our website.
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