Volume 14 Issue 38
High IV/HV Ratio Review

Seeking high-implied volatility ideas in a low implied volatility environment seems like a natural way to find trades with some edge. However, excessively high-implied volatility sends a warning signal that a large move in the underlying could trap those attempting to sell high-implied volatility. This week we report on a recently closed high IV/HV ratio trade idea for GT Advanced Technologies Inc. (GTAT).

After a few brief market observations, we have another new covered call trade idea for F5 Networks, Inc. (FFIV) from our friends at The Blue Collar Investor. Then, we return to volatility with the GTAT scoreboard along with a new Yelp, Inc. (YELP) idea and finally a comment about the Dresser-Rand Group Inc. (DRC) takeover announcement.

S&P 500 Index (SPX) 2010.40 last week we thought the decline could be halted at 1975 where there seemed to be good support and indeed there was since it made a reversal last Monday after reaching a low of 1978.48. By the end of the week, it was back in new high territory, but then made a key reversal Friday on high volume meaning a lower low is expected Monday.

iShares Russell 2000 (IWM) 113.97 making a noticeable decline Friday it continues underperforming the big capitalization indexes reflecting deteriorating market breadth remaining well below the July 1 high of 120.97 needed to breakout out above the current range thereby establishing a new uptrend. In the meanwhile, a potential double top continues as the operative technical pattern, activated on a close down near 108.

Powershares QQQ (QQQ) 99.98 since breaking out above the July 24 high at 97.51 and now moving in a narrow range just under 100, it remains the relative strength leader. However, deteriorating market breadth raises doubt the large capitalization stocks can continue higher.

CBOE Volatility Index® (VIX) 12.11 down 1.20 for the week while the VIX futures premium closed solidly in the green at 19.03% after starting the week at 5.19% in the yellow zone. However, both the low VIX put call ratio at .11 and the CBOE S&P 500 Skew Index (SKEW) 146.08 were flashing warning signals confirming the Friday key reversal.

Covered Call Idea

F5 Networks, Inc. (FFIV) 124.84 is in the “Internet” category currently ranked in the top 40th percentile of all industries with a beta (historical volatility) of 1.25.

Recently we presented a series of “ideas for consideration” to demonstrate how covered call writing can improve portfolio results.

This stock was a favorite of many covered call writers several years ago and is now making a significant comeback as it earned its way back on the Blue Collar Watch List of eligible stocks for covered call writing. In addition to great fundamentals, its price chart has been quite strong over the past four months.

Note in late December, 2013 there was a bullish moving average crossover when the 20-day exponential moving average broke through and above the 100-day exponential moving average. Since then, the price increased from 85 to 124 per share, up 50%.

With the stock at 124.84, the options chain shows the following strikes with bid prices:

— 120 (in-the-money): 6.40
— 125 (near-the-money): 3.50
— 130 (out-of-the-money): 1.61

Checking the possible returns for these strikes by feeding the data into the “multiple tab” of the Ellman Calculator (Free copy available on the Blue Collar Web Site- free resources link on top black bar) we have:

The 120 and 130 strikes have possible 1-month returns of 1.3%, annualized to 15.6%. The 125 strike generates an initial return of 2.8%, annualized to 33.6%. The 120 strike provides 3.9% protection of the 1.3% initial profit (top line) and the 130 strike gives 4.1% upside potential (bottom line) for a possible 1-month return of 5.4% (1.3% + 4.1%).

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 for maximum returns. For example, we always buy back the option if the premium value decreases to 20% of the original sale in the first half of the contract and 10% or less in the latter part of the contract term.

Previous articles included position management ideas under bearish conditions when share prices plummeted. This time we look at a management strategy for generating even higher returns.

Assume we sold the 125 strike and then the stock price skyrocketed to 135 shares, a 10 increase after the first week. Now are obliged to sell the stock at 125 so it appears we have maximized the position at 2.9%, for a very nice return. However, two very important features may create an opportunity to generate an even higher return. First, we are still early in the contract period with significant time value remaining. Second, as the 125 strike moves deep in-the-money (share price rises), the time value component of the premium approaches zero trading at or near parity (all intrinsic value). When this occurs, we buy back the short call (buy-to-close) and sell the stock. This results in a 10-point option debit (plus a few pennies of time value) but also a sale stock credit of 10 because our shares are now worth 135, not the original option obligation to sell at 125. Net, net it costs very little to close the entire position freeing up a significant amount of cash to begin a second income stream in the same month by initiating a completely new covered call position. For this exit strategy to work best, the share appreciation needs to take place in the first half of the contract term as the time value of the premium approaches zero.

The BCI methodology also has exit strategies for situations when share price declines dramatically and opportunities to mitigate losses or turn losses into gains as discussed in previous articles and will do so again in future IVolatility Trading Digests.

To learn about mastering the skill of exit strategy execution and much more information on becoming an elite covered call writer, go to the Blue Collar Investor.

High IV/HV Ratio

When options implied volatility rises before an expected event, it signals expectations that the price of the underlying will likely change, perhaps significantly. While not a foolproof indicator, the record of large moves exceeds those times when the underlying price change is small. Knowing the event date is helpful when selecting the options expiration date and planning a strategy.

GT Advanced Technologies Inc. (GTAT) 11.16 declined after the Apple new product announcement.

In Digest Issue 36 “Two Upcoming Event Ideas,” we offered a long idea for both out-of-the-money call and put spreads. Last week in Digest Issue 37 “Interest Rate Jitters,” we further explained the rationale and reported the stock had declined from the initial entry price of 17.15 to 12.82 for the week while the option position marked-to-market at 1.07 was up from the initial .41 debit.

Since the momentum was down, we stayed with it until the close last Friday when the options expired as the stock closed at 11.16 down 35% from the initial entry while the options position was 1.92, up 368% from the initial .41 debit.

At the initial entry, the average implied volatility of the four legs was 125.03 while the range method historical volatility was 43.94 for a high IV/HV ratio of 2.85.

In this example, as with many others high IV/HV ratios before an event underestimates the subsequent move of the stock. If so, then we should define a high IV/HV ratio that underestimates the subsequent move of the stock from those when the stock remains within a normal estimated range. Although the task in complicated since the implied volatility level can be influenced by the overall market implied volatility as well as the implied volatility of the underlying stock. Further, with the volatility chart check to see if it exceeded prior highs. As a guideline, in the current environment we are going to use implied volatility above 50 with the IV/HV ratio greater than 2 using the range method for historical volatility.

IV/HV Ratio Idea

Yelp, Inc. (YELP) 75.89 the stock dropped 5.16 points last Monday without any specific news. Another decline seems unlikely since the decline may have been selling to raise money for the upcoming Alibaba IPO. Further, it remains above the upward sloping trendline from the April low and there appears to be good support at 70.

As a test of the high IV/HV ratio concept here is a volatility trade idea selected from Friday’s Top 5 in the low range category regularly found in the “Rankers and Scanner” section of our home page.

The current Historical Volatility is 34.40 and 34.02 using the Parkinson’s range method, with an Implied Volatility Index Mean of 40.96 down from 41.11 the week before. The 52-week high was 93.37 on April 11, 2014 as the growth at any price group was under selling pressure. The low was Friday at 40.96. The implied volatility/historical volatility ratio using the range method is 1.20 so the options prices are about normal relative to movement of the stock. The put-call ratio at 1.00 is cautious due to hedging long positions. Friday’s option volume was 10,784 contracts traded compared to the 5-day average volume of 11,310.

Although the implied volatility at 40.96 is sufficiently high for a volatility trade it’s at the low end of the 52 week range with an IV/HV ratio of 1.20 suggesting a low probability of a move beyond the normal estimation.

Consider this short Iron Condor long theta volatility idea.

First, the short call spread.

Next, the short put spread.

In terms of implied volatility the prices are about the same expect there is a slight loss of edge on the put side. Using the ask price for the buy and middle for the sell, the call credit is .38 while the put side credit is .68 for a combined 1.06 credit and a potential 21% return based upon a 500 margin requirement assuming the stock closes between 70 and 85 at the October 19 expiration in 29 days. In the event of an unexpected large move use a close below 70 as the downside SU (stop/unwind) and above 85 on the upside.

Takeover File

Dresser-Rand Group Inc. (DRC) 79.91 up 6.88 on news reports that German engineering firm Siemens was preparing a bid. In addition, Investor’s Business Daily reports Peter Loesche, the Chariman of Sulzer, the Swiss pump maker and ex-CEO of Siemens ex-CEO, said Siemens is talking with Dresser and that GE (GE) had been talking with Dresser.

However, the options data is not yet confirming another bid in the works since the implied volatility declined to 37.83 from 40.67 and the options volume was low for a takeover at 3,431 contracts compared to the to the 5-day average volume of 2,659.

Further, look at Friday’s the slightly out-of-the- money options activity.

If General Electric is about to make an alternative bid against Siemens it is not reflected in the options market, especially noticeable in the December options with both low volume and implied volatility for out-of-the money options. This is not the profile of a competitive takeover attempt.

The suggestion above uses the closing ask prices for the buys and middle prices for the sells presuming some price improvement from indicted prices is possible for liquid stocks. Monday’s option prices will be somewhat different due to the time decay over the weekend and any price change.

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Summary

Although the S&P 500 Index again closed in new high territory last week, it made a key reversal on heavy volume Friday implying a lower low Monday. In addition, lagging market breadth is raising questions about the sustainability of the Powershares QQQ relative out performance. Further, Fridays low VIX put call ratio and the CBOE S&P 500 Skew Index are both signaling caution at least for the next few days.

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.