Volume 14 Issue 42
Tradable Bounce

After the long awaited and much anticipated correction, we have some thoughts about the bounces seen Friday in the in the major indexes that have some pundits declaring the recent decline is over so it’s time to remove hedges and get long again.

Our friends at The Blue Collar Investor offer some thoughts about position management alternatives to use for market declines.

Then, since the recent decline in interest rates has renewed the search for yield again, we compare using iShares iBoxx $ High Yield Corporate Bond (HYG) to SPDR S&P 500 ETF (SPY) as an alternative option strategy. Finally, we introduce a new Activist category offering suggestions for Herbalife Ltd. (HLF) and Nuance Communications, Inc. (NUAN).

S&P 500 Index (SPX) 1886.76, for the week the decline was 19.37 points or
-1.02% including the 24-point advance made Friday. The first overhead resistance is the August low at 1904.78 followed by the upward sloping trendline resistance from the November 16, 2012 low that defines the intermediate term trend, now at 1964.96. With the help of bullish comments and the lack of any new geopolitical surprises, the current bounce is likely to advance up into this 60.18-point range before turning down once again to retest the October 15 low at 1821.61. Some of the bounce seen Friday could also be attributed to the monthly options expirations after the index declined earlier in the week.

iShares Russell 2000 (IWM) 107.48 although it made a higher high and higher low Friday it was unable to close higher after doing better than the S&P 500 Index for three days last week on unusually high volume. The first overhead resistance is now the August 1 low at 109.86 and unless it can continue higher, it will raise doubts about any further bounce for not only IWM but the other major indexes as well.

Powershares QQQ (QQQ) 93.00 after closing below well-defined support at 92.50 on Wednesday and Thursday it rebounded Friday closing 1.21 higher. Resistance is just one point higher at 94 and like IWM if it is unable to continue higher it will put the entire bounce scenario in jeopardy.

CBOE Volatility Index® (VIX) 21.99 up .75 for week but down from an intraday high of 31.03 on Wednesday, it gapped lower on the open Friday following positive European market activity. In the past this type of gap lower activity indicated a change in market direction if even for just a short time. The VIX futures premium was below 10% every day except Friday when it rebounded to -7.13% and will need to turn positive to confirm the bounce.

Trading Volatile Market Declines

With the stock market declining over 5% in the past month and volatility up 85% as a result of geo-political and global concerns exacerbated by the fears of an Ebola epidemic we find ourselves in a position that may lead to “panic” in our investment decisions. The stock market seemed to stabilize a bit on Friday but we are not out of the woods yet based on just that one day. Whether you are an experienced investor who has “been there, done that” or a newbie who is experiencing this discomfort for the first time, patience and non-emotional responses are the most prudent. In this article, we highlight strategies to manage existing option-selling positions in these extreme circumstances and strategies to initiate new positions for those who want to “stay in the game.” Much of the information comes from Blue Collar books and DVD Programs as well as previous published articles.

Managing existing positions

1- Always buy back an option when it approaches the 20%/10% guidelines (declines in value to 20% or 10% of initial sale value depending on when in the contract cycle the decline takes place). This frees up capital to sell another option or to close our long stock position.

2- When market tone is negative (as it currently is) and technicals are also negative, sell the stock. Many investors will also use a percentage price decline to determine when to sell a stock, usually 8% to 10% of the purchase price. Once sold, a decision is needed as to whether to “stay in the game” and enter a new position. See below for some strategies to consider. Many investors are more comfortable staying in cash until a firm bottom is in place.

3- Rolling Down iswhen we buy back a previously sold option (buy-to-close our short position) and simultaneously sell another option at a lower strike price in the same contract month (open a new short position).

We lean towards implementing a rolling down strategy when the market tone and technicals are mixed to negative. We are also more inclined to use this strategy later in the contract period (late in week 2 and week 3, rather than week 1 of a 1-month contract).

Entering new positions-staying in the game

For those who have a higher risk tolerance and want to remain in the market, it is prudent to implement strategies that are appropriate for current market conditions, especially extreme ones like now. Selling out-of-the-money strikes may work out but it makes little sense to take an aggressive stance until the market tone improves and stabilizes. Here are a few strategies that will allow us to generate an initial profit and provide us with some profit protection.

1- Sell only in-the-money strikes

If we buy 100 shares of XYZ for $32 and sell a $30 call for $3.50, we have sold an in-the-money call option because the strike price of the call option ($30) is lower than current price of XYZ ($32). The sale of this call option obligates us to sell 100 shares of XYZ for $30/share (or $3,000 in total) if the option is exercised. Should XYZ increase in price from $32 to $40, we make no additional income due to our obligation to sell our shares @ $30. The option premium we receive from the sale of this option has $2 of intrinsic value ($32 – $30). The remainder of the option premium is solely time value, which represents our true initial profit (ROO). Thus, if we received $3.50 in total option premium from the sale of the $30 call option, the $3.50 premium we receive consists of $2 of intrinsic value and $1.50 ($3.50-$2) of time value. Because our true profit is represented by time value only, for this example we generated an option profit of $1.50/share or $150 per contract, which represents a 5% ROO (the $2 intrinsic value “buys down” our cost basis to $30) per share). The protection of that 5% initial profit is the intrinsic value divided by the current market value or $2/$32 = 6.25%.

2- Buy protective puts-the collar strategy

As safe a strategy as covered call writing is, there is still some risk purchasing the stock, not in selling the option. For this reason, some investors who sell covered calls also buy protective puts to alleviate some of the risk. A protective put is an option purchased for an underlying stock already owned. It defends against a decrease in the share price of the underlying security creating a collar, the simultaneous purchase of a protective put option and the sale of a covered call option. In a true collar strategy, the puts and calls are both out-of-the-money and have the same expiration dates and an equal number of contracts. Thus, we sell an out-of-the-money call and add additional downside protection for the underlying equity by purchasing a protective put option. This strategy protects against catastrophic share value decline but also decreases our initial potential option profit.

3- Sell out-of-the money cash-secured puts

With this strategy, we are selling the right, but not the obligation, for the buyer of the put to sell a stock to us at a specified price, by a specified date. In return for undertaking this obligation, we also receive a premium. For example, a stock is trading at $32 per share and we sell a $30 out-of-the-money put for $1.50, receiving a return of $150 per contract. The returns in these scenarios are generally similar to the returns of generated from selling covered calls, and if the put is exercised, we are required to buy the stock for $30, meaning we purchase the shares at a cost basis of $28.50 ($30 less the $1.50 premium). Some investors consider this “buying at a discount” from the original $32 share price. We can then write a covered call on the assigned shares.

4- Use inverse ETFs

Inverse ETFs use derivatives to bet against the direction of financial markets. Known as short or bear ETFs they will make money if markets decline. They will lose money, however, if markets move back up. Covered call writers who have a bearish market outlook may find these funds useful for hedging.

Many sophisticated covered call writers can benefit from the use of inverse ETFs in the short run when the market is bearish.

Inverse ETFs with options to consider

— PSQ: short QQQ
— DOG: short Dow 30
— SH: short S&P 500
— RWM: short Russell 2000

In Conclusion

Currently equity markets are reflecting concerns about both positive domestic economic news and negative geo-political and global economic influences. This will pass because it always does. The greatest error we can make is to act emotionally without employing the critical investment parameters that will make us all succeed in the long run-fundamental, technical and common sense principles. In challenging times, there may not be great choices to make but there will ALWAYS be the best choices to make under the circumstances. Finding these and implementing the most sensible strategies are some of the prime mission statements of Blue Collar Investors all over the world. The purpose of this article was to summarize and highlight these guidelines.

To learn more about 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.

Seeking Yield

Wednesday’s surprising decline in yield on the benchmark 10-Year Treasury Note to an intraday low of just 1.87% on increased concerns about a global economic slowdown seems to have dispelled anxiety that interest rates will be raising anytime soon. If so, perhaps high yield corporate bonds are worth considering again.

iShares iBoxx $ High Yield Corporate Bond (HYG) 91.77 at the current rate of about .40 per month the return is 5.20% while SPDR S&P 500 ETF (SPY) 188.47 yield is 2.00% paid quarterly while the current correlation is about 75%. From the lows on August 7 to the lows made Wednesday October 15, the decline for HYG was 3.73% compared to 4.53% for SPY.

Comparative options data,

While less volatile HYG is highly correlated with SPY, yet the option prices are slightly higher although less liquid, adding some edge to a cover call strategy on the presumption that interest rates will not be rising anytime soon.

Activist File

Since activist pressure for corporate change is increasingly producing positive results time has come to create a new category to facilitate following developments.

Herbalife Ltd. (HLF) 45.43

The battle between activist hedge fund manager Bill Ackman at Pershing Square and HLF management has been going on for a long time and the recent increase in options implied volatility suggests expectations for new developments are increasing. Perhaps it could be an announcement from the Federal Trade Commission about its current investigation into the business model and accounting practices or even the foundations of the Multi level marketing model itself.

While the next earnings report is due November 3, the company has been making expensive high-level appointments in hopes of influencing the outcome of the FTC investigation. Since the January high at 82.35 the stock prices has declined 55% all the while Ackman claims the earnings continue to be overstated and the company could eventually be worthless.

Here is the increasing volatility we noticed.

Since there is no specific date for the FTC report and this could become a battle of attrition we suggest allowing considerable time.

For example, consider this put spread.

Using the ask price for the buy and middle for the sell, the debit is 3.52 about 35% the width of the spread that has a slight volatility edge. Based upon the range historical volatility of 53.13 the IV/HV ratio of the short Jan 30 put is 2.21. Of course, if the FTC rules against the company the stock price will decline more than suggested by the implied volatility. Use a close back above resistance at 50 as SU (stop/unwind).

Nuance Communications, Inc. (NUAN) 14.60 offers voice and language services and is thought to be behind Siri the personal assistant built into Apple iPhones. In addition, there is Nina, the voice ordering capability used by Domino’s Pizza.

Since Carl Icahn owns stakes in both companies, the expectations are for Apple to acquire NUAN.

Having bounced off support at 14 on Friday and ranking second in implied volatility change in our scan, consider this idea.

The current Historical Volatility is 26.36 and 29.66 using the Parkinson’s range method, with an Implied Volatility Index Mean of 39.80 down from 42.67 the week before. The 52-week high was 59.75 November 14, 2013 while the low was 24.92 on May 22, 2014. The implied volatility/historical volatility ratio using the range method is 1.34 so the options prices are about normal relative to movement of the stock. The put-call ratio at just .30 is very bullish. Friday’s option volume was 18,968 contracts traded compared to the 5-day average volume of 14, 370.

Consider a January synthetic long idea that should allow enough time.

Using the ask price for the buy and middle for the sell, the credit is .05 although there is no volatility edge it does hedge both changes in implied volatility and time decay. Use a close back below the recent support at 14 as the SU (stop/unwind).

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

After rapid declines last week the major indexes attempted to rebound on options expiration Friday as sentiment seemed to improve somewhat. While chances are good the rebound can continue a bit higher, there is considerable overhead resistance that will need to be overcome. However, the rebound is likely to be limited and the October 15 lows will likely need retesting before an all clear green light signal can given.

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.