Volume 14 Issue 33
Flight to Safety

Two weeks ago the concern was a bond market slide most noticeable at the long end of the curve set off by the +4% 2Q GDP report released July 30. Now worry about the deteriorating situation in Ukraine set off a “flight to safety” most noticeable once again at the long end of the Treasury bond curve.

After our regular market review, we update the chart for ProShares Ultra 20+ Year Treasury (TBT), our current long-term interest rate indicator.

Next, we have a new covered call trade idea for Under Armour, Inc. (UA) from our friends at The Blue Collar Investor.

S&P 500 Index (SPX) 1955.06 the turnaround advance that began Friday August 8, on what may have been short covering before the weekend, continued throughout the week until last Friday when Ukrainian concerns caused a reversal creating a large outside range day implying an interruption to last week’s uptrend, if only temporarily depending upon further geopolitical developments. The best fundamental and technical analysis will be meaningless if the situation deteriorates further.

iShares Russell 2000 (IWM) 113.39 moved mostly inline relative to SPX while also creating a large outside range day Friday raising the question if a short position should be established anticipating it will eventually close below the neckline of the potential double top and then accelerate to the downside.

Powershares QQQ (QQQ) 97.40 has been relatively stronger than both SPX and IWM making a higher high and higher low Friday. However, now at an important level near 97.50, any decline from here could raise the possibility of a developing double top like IWM mentioned above.

CBOE Volatility Index® (VIX) 13.15, was up .73 Friday, but down 2.72 for the week, after trading as low as 11.89 Friday, before abruptly turning higher on troublesome geopolitical news.

The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan’s day-weighted average between the first and second months.

The day weighting applies 4% to August and 92% to September for 5.96% shown above. Our alternative volume-weighted average between August and September, regularly found in the Options Data Analysis section on our homepage, is lower at 3.12%. Premiums for a normal term structure are 10% to 20%, while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Premiums less than 10% suggest caution and negative premiums are unsustainable suggesting an oversold condition. All last week, the premiums were positive but less than 10%.

VIX Options

With a current 30-day Historical Volatility of 152.81 and 111.51 using Parkinson’s range method, the table below shows the Implied Volatility (IV) of the at-the-money VIX calls and puts using the futures prices based upon Friday’s closing option mid prices along with their respective month’s futures prices, since the options are priced from the tradable futures.

Compared to the range historical volatility of 111.51 August and September options are undervalued. Friday’s volume at 870,767 was considerably higher than the week before at 526,550 contracts, consistent with an outside trading range day.

CBOE S&P 500 Skew Index (SKEW) 135.43 measures the purchase of out-of-the-money S&P 500 Index puts that require a very large downside move to profit from long put positions. An increase of this index indicates greater expectations for an extreme down move. The CBOE explains further, a Skew value of 100 means the perceived distribution of S&P 500 log-returns is normal so the probability of outlier returns is negligible. As Skew rises above 100, the left tail of the distribution acquires more weight increasing the probability of outlier returns.

In Digest Issue 29 “Sector Conflict” when SKEW was 141.19 we noted. “In the past, higher SKEW prices have been associated with short-term market tops and it appears the out-of-the-money put buyers got it right and are now less enthusiastic to retain their put positions as the market declines.” However, last week, SKEW advanced every day except Tuesday and now appears headed back toward 142.

ProShares Ultra 20+ Year Treasury (TBT) 55.60 the updated chart below shows the recent decline into oversold territory on “flight to safety” questioning the notion that declining long-term interest rates are primarily due to expectations for a slowing economy.

The downward sloping trendline in sold black that begins on December 31, 2013 requires a close above 60 to change the challenge the downtrend. Then a second confirmation requires a close above 64 as indicated.

This leveraged ETF, very sensitive to long bond price changes, helps demonstrate the extent of “flight to safety” into long-term Treasury Bonds.

Since geopolitical risk could overwhelm most long directional trades, perhaps it is time to add some hedges or at least consider positions such as credit spreads that are more forgiving and less reliant on getting the direction and timing right. Writing covered calls on stocks that remain in well-defined uptrends is a strategy that fits nicely since they provide some downside protection.

Covered Call Suggestion

For the past few months, we have presented some basic principles needed to master generating monthly cash flow by selling covered call options and have been presenting a series of “ideas for consideration” to further demonstrate how this strategy can improve portfolio results.

This week we highlight Under Armour Inc (UA) 68.84 using closing data on Friday August 15, 2014.

Under Armour, in the “Apparel” industry currently ranked in the top 20th percentile of all industries has a beta (historical volatility) of 1.64. In addition to great fundamentals, the price chart since early June has been a thing of beauty.

The short-term moving average (20d exponential moving average) crossing above the longer-term moving average (100-d exponential moving average) in early June, followed by a positive earnings report on July 24, reflects positive price momentum.

With the stock trading @ $68.84, the options chain shows the following bid prices and strikes:

— $67.50 (in-the-money): $2.90
— $70(out-of-the-money): $1.65

Checking the potential returns for both these strikes by feeding the information gleaned from the options chain into the “multiple tab” of the Ellman Calculator (Free copy available on the Blue Collar Web Site- free resources link on top black bar) shows:

We have potential 1-month returns of 2.4% in both cases that annualize to 29%. The $67.50 strike gives us 1.9% protection of that 2.5% initial profit (purple field) and the $70 strike gives us 1.7% upside potential (pink field) for a possible 1-month return of 4.1% (2.4% + 1.7%).

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. Once entered, positions need managing to maximize returns. For example, we always buy back the option if premium value decreases to 20% from the original sale in the first half of the contract term and 10% or less in the latter part of the term.

For example, here is an exit strategy presuming a bearish scenario.

— UA drops in price to $65 in the 2nd week of the contract but remains near its 20-day exponential moving average
— $70 call drops to $0.25 approximating our 20% guideline
— Buy back the $70 call and wait a few days to see if stock price recovers
— Say it returns to $67 and the $70 strike option is $1.10
— Sell the same strike option in the same month for a net credit of $1.10 – $0.25 = $0.85 or $85 per contract. If you sold 4 contracts that’s an additional $340 cash in your account (less commissions)
— This gives a net options credit of $250 per contract ($165 + $85) or 3.6% for the 1-month obligation still with the possibility of another 1.7% if share price moves to the $70 strike by expiration for a potential total 1-month return of 5.3%
— Of course, the final results will be dictated by stock price @ expiration
— If by mid-contract the stock price is stagnant, roll down to the $67.50 call to generate additional cash and downside protection
— The Blue Collar Investor methodology also has exit strategies for situations when share price rises dramatically and we explain other opportunities to generate even higher returns

For help mastering the skill of exit strategy execution and much more information on becoming an elite covered call writer, click on the Blue Collar Investor link.

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Summary

US Treasury bonds, particularly at the long end of the curve, along with US Dollar strength are understandably reflecting “flight to safety” as the geopolitical tensions increase while there was continuing evidence of rotation into a select number of large capitalization stocks included in the Powershares QQQ ETF. Until the geopolitical worries de-escalate we suggest considering hedging and credit spread less dependent on getting the direction right.