Volume 14 Issue 45 US Dollar & Crude Oil

Although the major large capitalization equity indexes broke out and closed above their previous highs the smaller capitalization stocks appear range bound below their previous highs. However, despite the major index new highs the real story last week was about the continuing strength of the US Dollar and declining crude oil prices.

After updating our market indicators, we offer some additional thoughts about crude oil along with an idea for Linn Energy, LLC (LINE) as well as another United States Oil ETF (USO) hedge suggestion.

S&P 500 Index (SPX) 2031.92 advancing 13.87 points or .69% for the week, the big day was last Wednesday as it closed above the September 19 high to make another new closing high. Following the rules for defining a properly drawn trendline, we recalculated the upward sloping trendline from the November 16, 2012 low although it now just has two points after the October 15 pull back. The new slope is .69 points a day, making the new trendline support 192.37 points lower down at 1839.55. While there is currently no overhead resistance, look for a retest of the breakout to establish new long positions in large capitalization stocks.

iShares Russell 2000 (IWM) 116.71. While the relative underperformance continues, chances for activation of the previously identified potential double top or alternative Head & Shoulders Top are declining. For now, it looks more like a trading range between 105 and resistance at 117. A close above the July1 high of 120.97 should generate a lot of enthusiasm for equities going into year-end.

Powershares QQQ (QQQ) 101.60 after gapping open up into new high territory it should attempt to retest the breakout back toward 100.56 and close the gap providing another opportunity to establish new long positions.

CBOE Volatility Index® (VIX) 13.12 down another .91 for the week and 17.91 lower from the spike up high to 31.03 on October 15.

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 35% to November and 65% to December for a 16.09% 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 lower at 15.48%. 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 remained in the cautious zone until Thursday at 10.87% followed by Friday at 15.48%.

VIX Options

With a current 30-day Historical Volatility of 154.01 and 126.08 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 132.71 both the November and December options are inexpensive and considerably less than last week. For example, the November call implied volatility was 101.02 vs. 81.88 and the December was 84.25 vs. 70.48.

CBOE S&P 500 Skew Index (SKEW) 127.08 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.

Although there may have been a data problem on October 15 at the correction bottom when it dropped down to 111.31, nevertheless it established a new range with the September 19 high of 146.08. At Friday’s close of 127.08, it’s now just below the center of the range in the neutral zone.

Market Breadth

Until recently, deteriorating market breadth has been a sign of an anxious equity market seeking liquidity and risk reduction, but the condition markedly improved in the last two weeks.

Updating the summation index of the McClellan oscillator, McClellan Financial Publications reports the summation index was 1881.67, up 892.98 for the week and 2,006.28 for the last two weeks increasing bullish optimism that underperformance of small capitalization stocks may be ending soon.

US Dollar Index (DX) 87.64 the upside acceleration continues after the Bank of Tokyo stimulus announcement boosted it above 86.75. Digest Issue 44 “Japanese Jolt” included a long-term chart suggesting it may go considerably higher. If so, downward pressure on commodities, especially gold and crude oil is likely to continue. For now, the next target for the advancing dollar index to watch for is the June 7, 2010 high at 88.71.

Using PowerShares DB US Dollar Bullish ETF (UUP) 23.27 for the dollar index here is a chart showing the recent relationship to crude oil represented by United States Oil ETF (USO) 29.76.

USO, the green ling above, peaked on June 20 at 39.44. Friday it closed at 29.76, a decline of 24.5%.
While negative correlation does not necessarily mean causation, this relationship of declining crude oil prices with an advancing dollar is well accepted.

Stronger Dollar – Lower Crude Oil

United States Oil ETF (USO) 29.76. As suggested in Digest Issue 44 “Japanese Jolt” last week as crude oil declined below 80 and USO declined below 30. Friday WTI Crude Oil (CL) basis December closed at 78.65 down 1.89 for the week, on news Saudi Arabia reduced crude oil prices to US buyers.

Although there is some confusion, the FT provided a good summary.

“In the US, the price of Saudi imports was set at a premium of $1.60 a barrel to the Argus Sour Crude Index for December, down 45 cents from November. Saudi Aramco, the state-owned oil company, said it would sell its benchmark Arab light to customers in Asia at a discount of 10 cents a barrel to the Dubai/Oman contract in December, up from a discount of $1.05 in November.”

While some analysts claim the reduction was in response to increased production by US shale oil produces, others said the move was in line with market fundamentals due to slowing economies in Europe and Asia and not about market share in the US. It seems likely some of both are involved but we can also include the stronger US dollar as a reason for declining prices as shown in the chart above.

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. Presuming the pattern will be the same again this year and there are no further surprises from Saudi Arabia before the OPEC meeting on November 27 crude prices could stabilize. If so, there may be an opportunity to sell options with elevated implied volatility after the recent decline.

Linn Energy, LLC (LINE) 24.20 an independent oil and gas production company focused on distributing cash flow to unit holders. At the current annual distribution rate of 2.90, the yield is 12.10% presuming it’s sustainable.

The current Historical Volatility is 55.13 and 63.05 using the Parkinson’s range method, with an Implied Volatility Index Mean of 47.72 up from 46.86 the week before. The 52-week high was 66.28 on the market decline October 15, 2014 while the low was 15.78 on June 6, 2014. The implied volatility/historical volatility ratio using the range method is .76 meaning the options prices seem inexpensive but there is considerable disparity between the strike prices. The put-call ratio at .30 is very bullish. Friday’s option volume at only 4,983 contracts traded compared to the 5-day average volume of 8,020 means the trading is thin so use patience placing orders.

Consider this put sale idea,

At the middle price, the IV is 62.37 and November options will expire in two weeks, before the OPEC meeting on November 27. Use a close back below 22 as the SU (stop) or be prepared to take the stock by assignment in the event it closes below 22 at the November expiration. If so, the stock basis would be 21.65 using the middle price, increasing the yield to 13% while assuming the risk of a price decline into the January seasonal low.

Hedging Crude Oil

United States Oil ETF (USO) 29.76. To hedge any further crude oil price decline here is an updated version of the put spread suggested last week in Digest Issue 44 “Japanese Jolt.”

The current Historical Volatility is 24.09 and 22.73 using the Parkinson’s range method, with an Implied Volatility Index Mean of 28.43 up from 27.71 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 1.25 meaning the options prices are priced about normal relative to the movement of the ETF. The put-call ratio at 1.15 is bearish reflecting hedging activity. Friday’s option volume was 79,830 contracts traded compared to the 5-day average volume of 96,450, so there is good liquidity as reflected in the narrow bid/ask spreads shown below.

Consider this January long put spread with 68 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 .41, a favorable 21% 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. With negative delta of .1453, it partially hedges the positive .1996 delta of the LINE short put idea above.

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

While the large capitalization indexes broke out to the upside the small caps continue lagging, but appear to be doing somewhat better based upon recent improving breadth. For now, the focus in on the US Dollar and crude oil prices after news that Saudi Arabia slightly lowered prices for US crude buyers last week. Since there is no overhead resistance, the S&P 500 Index is likely to continue higher but expect a retest of the breakout sometime in the next two weeks or so.