Volume 14 Issue 44
Japanese Jolt

Apparently growing impatient waiting for the “third arrow”, the Bank of Japan decided to go it alone and buy 80 trillion yen worth of Japanese bonds each year by printing money. It took the markets by surprise and the yen declined immediately so the reciprocal US Dollar Index advanced sharply although the yen represents just 13.6% of the index. However, since exchange rates move primarily in response to news that alters expectations about the future economic environment, now supported to a great extent by asset prices, large currency moves are likely to have unintended consequences.

First a few brief market comments along with selected indicator updates followed by two US Dollar Index charts and two trade suggestions, the first WisdomTree Japan Hedged Equity ETF (DXJ) and then United States Oil ETF (USO).

S&P 500 Index (SPX) 2018.05 last week the task was to overcome overhead resistance created by the upward sloping trendline from the November 16, 2012 low of 1343.35, accomplished on Tuesday, with the close at 1985.05 followed by a gap open up Friday. For the week, the advance was 53.47 points or 2.7%. The next challenge will be to close above the September 19 high of 2019.26. While this now seems very likely, any hesitation will evoke potential double top speculative comments. Then watch for an upside breakout.

iShares Russell 2000 (IWM) 116.56 although it also gapped up on the open Friday it is still below the September 3 high at 117.80 and the July 1 high of 120.97. Even though a stronger dollar should be relatively favorable to smaller capitalization stocks, several well-known value mutual fund managers consider small capitalization stocks expensive as noted last week in Digest Issue 43 “Overhead Resistance.”

Powershares QQQ (QQQ) 101.40 by Thursday it was back up near the September 19 high at 100.56 and then gapped up on the open Friday into new high territory thus remaining the relative strength leader. Now look for a retest back toward 100.56 to close the gap.

CBOE Volatility Index® (VIX) 14.03, down 2.08 for the week and 17.00 below the spike up high to 31.03 on October 15, at the market pull back bottom.

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 60% to November and 40% to December for a 13.14% premium shown above. Our alternative volume-weighted average between November and December, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 13.21%. 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. Last week, the premiums increased every day and by Thursday, they were 11.56% closing the week at 13.21% back in green territory.

US Dollar Index (DX) 86.92 after reaching 86.75 on October 3 it retreated back to retest 85 accompanied by comments from some analysts that the high had been made for this cycle. However, Friday’s .77 advance on the Bank of Tokyo announcement to close above 86.75 changes the picture. The next target for the advancing dollar index is the June 7, 2010 high at 88.7. See the chart below.

Since the euro represents 57.6% of the index and economists in Europe say the euro will likely continue falling from the current 1.25 to 1.20 or even 1.15 by year-end and since the euro represents the largest weight in the dollar index the advance is likely to continue.

Looking at the US Dollar Index using the FRED chart from the St. Louis Federal Reserve as of 10-17-14 below for a longer-term perspective, we see it has hardly begun to rise up from the bottom.

In the past, a rising US Dollar Index has not been friendly to commodity prices especially gold and crude oil as well as emerging market equities.

Responding to last week’s developments, keep in mind altered expectations about the future economic environment, Japanese equities are likely to continue higher as the yen declines. Using the currency hedged ETF, could offer an opportunity.

Next, since crude oil is considered a commodity price hedge and expectations are for lower commodity prices perhaps it is not too late to consider a lower crude oil price position, especially from the perspective of the long-term US Dollar Index chart above.

Lower Yen

WisdomTree Japan Hedged Equity ETF (DXJ) 53.82 while a lower yen is beneficial for Japanese exporters the rising dollar pressures commodity prices especially crude oil offsetting the higher yen cost. By hedging the currency, any further equity advance may be possible without concern about the declining currency. Using the advance made in early 2013 with the introduction of the “Abenomics” program as a guide, equities advanced a week before the first pull back and then finally peaked after about six weeks.

The current Historical Volatility is 28.20 and 12.77 using the Parkinson’s range method, with an Implied Volatility Index Mean of 21.70 up from 20.15 the week before. The 52-week high was 29.72 on February 3, 2014 while the low was 12.05 on August 28, 2014. The implied volatility/historical volatility ratio using the range method is 1.70 meaning the options prices are expensive relative to the movement of the ETF so a hedged position is preferable. The put-call ratio at just .25 is very bullish. Friday’s option volume was 143,827 contracts traded compared to the 5-day average volume of 36,920. Consider this December combination long call spread with a short put.

First the long call spread.

Using the ask price for the buy and middle for the sell, the debit is .63 although there is no volatility edge it does hedge both changes in implied volatility and time decay.

Then add a short put.

The short put adds some volatility edge and positive time decay, theta using the bid price of 1.06, making a net position credit .43. The additional positive theta will help offset any loss of time decay theta from the long call during early December when market volatility normally starts declining. The assignment risk on a close below 52 at the December expiration is a long ETF position at 51.57 just above support going back to June at 50 and the SU (stop/unwind).

Stronger Dollar – Lower Crude Oil

United States Oil ETF (USO) 30.63. The presumption here is crude oil now 80.54 basis December futures will decline below 80 on further US Dollar Index strength so the equivalent USO price will decline below 30. Seasonally for the last 5 years, USO was weakest in October then recovered somewhat in November and December before reaching the seasonal bottom in January. There is a slight backwardation advantage currently .12 between December and January that should add some price support.

The current Historical Volatility is 22.73 and 21.83 using the Parkinson’s range method, with an Implied Volatility Index Mean of 27.71 down from 29.46 the week before. The 52-week high was 35.31 on the market decline October 15, 2014 while the low was 13.19 on June 11, 2014. The normal range is between 15 and 20. The implied volatility/historical volatility ratio using the range method is 1.27 meaning the options prices are priced about normal relative to the movement of the ETF. The put-call ratio at 1.13 is bearish reflecting considerable hedging. Friday’s option volume was 52,116 contracts traded compared to the 5-day average volume of 43,130.

Consider this January long put spread with 75 days to expiration.

Based upon the seasonal pattern for the last 5 years the low should occur in January. Using the ask price for the buy and middle for the sell, the debit is .49, a favorable 25% of the width of the spread with a slight volatility edge it hedges both changes in implied volatility and time decay. Use a close back above the last pivot made on October 29 at 31.45 as the SU (stop/unwind) since a close back above this level suggests the seasonal strength is offsetting the stronger dollar.

The suggestions above use 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 equities were almost back to their previous highs by Thursday last week they received an upside boost on the Bank of Japan bond buying jolt creating gap openings for the major indexes Friday. Since exchange rate changes alter market expectations it now appears the US Dollar Index will continue rising so commodity prices, especially crude oil and emerging market equities will continue to decline while the major US equity indexes will likely continue higher.

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.