Volume 15 Issue 4
Sliding Implied Volatility

After a better than expected ECB announcement Thursday options implied volatility made a noticeable decline last week although some uncertainty remains over the Sunday Greek elections and earnings reports from several large capitalization technology stocks are due this week. For now, the flight to safety evidenced at the start of last week seems to be diminishing.

We begin with a brief market review including an interesting look at VIX options activity Friday followed by an update of seasonal crude oil and the diverging oil and gas stocks in the sector along with comments and suggestions for PowerShares DB US Dollar Bullish ETF (UUP), Exxon Mobil Corporation (XOM), Anadarko Petroleum Corporation (APC), SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and Halliburton Company (HAL).

Market Review

S&P 500 Index (SPX) 2051.82 last week began Tuesday with SPX closing slightly above the neckline of a potential small Head & Shoulders Top illustrated in Digest Issue 3 “Risk Reduction Underway” with the VIX futures slightly negative at -1.06%. Thursday the picture changed as SPX advanced 31.03, right back to upward the upward sloping trendline, USTL from the October 15 low now resistance as the VIX futures remained negative at -2.45%. Friday it turned lower at the USTL resistance but still above lower neckline as the VIX futures premium turned positive at 10.52%. Depending on how the markets react to events in Greece and this week’s earnings reports it could go either way.

CBOE Volatility Index® (VIX) 16.66 as expected the big decline came with the ECB news Thursday and it now looks like it could decline back below 15 assuming Greece and earnings cooperate.

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 85% to February and 15% to March for a 10.45 premium shown above. Our alternative volume-weighted average between February and March, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 10.52%. For the week VIX declined 4.29 as the futures premium advanced from -2.73% to 10.52%. January futures expired last Wednesday while February futures will expire on February 18 with the last trading day February 17.

Premiums for a normal term structure are 10% to 20%, while premiums above 15% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Alternatively, premiums less than 10% suggest caution and negative premiums indicate an oversold condition. While the premium started the week negative, it ended positive 10.52% back into normal territory associated with uptrends.

VIX Options

With a current 30-day Historical Volatility of 155.67 and 148.62 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.

The implied volatility index was 84.96 and when compared to the range historical volatility of 148.62 the February and March options appear inexpensive.

The chart below shows unusual VIX put buying activity Friday on expectations implied volatility will continue declining and SPX will continue trending higher.

Over the last three months, there have been four spikes higher with Friday’s the highest. The February 14 and 15 puts accounted for a large part of the volume with the 14s trading 241,680 contracts with a closing open interest of 86,180, implied volatility 74.89 and the 15s trading 59,277 contracts with a closing open interest of 109,834, implied volatility 78.34. Compared to the range historical volatility of 148.62 they appear inexpensive, however if SPX resuming trending higher the implied volatility is likely to decline into the 60s and presumably that’s what Friday’s put buyers are expecting.

US Dollar Index (DX) 94.76 having exceeded all the previous highs with the exception of the downtrend that began in February 2002 from 120.40, the trend is your friend especially with currencies that have a tendency to trend for long periods. The rapid advances for the last two days after the ECB announcement are especially noticeable and appearing overbought, due for a correction back toward 93 before resuming the uptrend beginning August 15 at 81.38. The uptrend is likely to continue until the euro, now 112, reaches par with the US dollar in the opinion of as some economist. It would need to close below 90 to challenge the uptrend.

PowerShares DB US Dollar Bullish ETF (UUP) 25.21 since the dollar appears overbought and due for a correction now is a good time to close the March 24/25 call spread suggested in Digest Issue 49 “Seasonal Review” however, there is always risk the expected correction does not come right away. When considering a replacement we suggest using a spread since the implied volatility at 11.27 is at the 52 week high.

United States Oil ETF (USO) 17.00 off another 1.33 for the week it appears to have just broken below another small symmetrical triangle continuation pattern. In Elliott Wave terminology it still appears to be in a 3rd momentum down wave however oil & gas equities are showing signs turning higher and January is usually the seasonal low. For open short positions, use a close back above the January 15 high of 18.61 as the SU (stop/unwind).

Crude Oil and Oil Equities Disagree

WTI crude oil appears to have found some support at 45. The first indication of a trend change should come with a decline in open interest reported weekly by the CFTC in their Commitment of Traders report and indeed the COT dated January 20 shows open interest declined 190,135 contracts to 2,497,521. One more week of declining open interest would likely confirm the downtrend is ending at least temporarily.

In the meanwhile, the stocks of the oil and gas companies seem to have decided on January 14 that the downtrend was over as they reversed higher making well-defined Head & Shoulder Bottoms or in some cases double bottoms. We selected a few with good options volume for a closer look.

Exxon Mobil Corporation (XOM) 90.89 with 4Q earnings scheduled for February 2 before the opening the consensus estimate is 1.31 per share. On the January 14 reversal, it began forming a well-defined potential Head & Shoulder Bottom that requires a close above last Thursday’s high of 92.97 to set the pattern off.

The current Historical Volatility is 25.13 and 22.17 using the Parkinson’s range method, with an Implied Volatility Index Mean of 21.27 down from 24.59 the week before. The 52-week high was 31.03 on December 12 just before it reversed higher, while the low was 11.81 on August 21, 2014. Upon confirmation of the upturn, the implied volatility should decline back toward 15. The implied volatility /historical volatility ratio using the range method is .96 so option prices are relatively inexpensive compared to the recent movement of the stock, but remember the implied volatility is likely to continue declining. Friday’s option volume was 86,375 contracts traded compared to the 5-day average volume of 65,580.

Here is one idea as an example.

Comparing the implied volatilities there is a good edge in the February 6 put, but it comes with the 4Q earning report risk due February 2. Using the ask price for the buy and middle for the sell, the call spread debit is 1.46 about 29% of the distance between the strike prices. Adding the short put at the bid prices reduces the net debit to .86. Use a close back below 88.51 as the SU (stop/unwind).

Anadarko Petroleum Corporation (APC) 81.44 with the second best options volume for individual companies in the group and with higher volatility the 4Q earnings report is also scheduled for February 2, but after the close.

The current Historical Volatility is 47.33 and 37.13 using the Parkinson’s range method, with an Implied Volatility Index Mean of 36.90 down from 44.55 the week before. The 52-week high was 55.76 on December 16 just after it reversed higher, while the low was 19.68 on May 23, 2014. As the upturn continues, the implied volatility should decline back toward 30. The implied volatility /historical volatility ratio using the range method is .99 so option prices are relatively inexpensive compared to the recent movement of the stock, but remember the implied volatility is likely to continue declining toward 30. Friday’s option volume was 15,799 contracts traded compared to the 5-day average volume of 13,130.

Consider a trade structure similar to XOM above.

SPDR S&P Oil & Gas Exploration & Production ETF (XOP) 45.52 here’s an alternative in the sector without company specific earnings reporting risk that appears to be making a double bottom.

The current Historical Volatility is 50.41 and 45.23 using the Parkinson’s range method, with an Implied Volatility Index Mean of 43.42 down from 52.67 the week before. The 52-week high was 62.65 on December 15 just after it reversed higher, while the low was 19.12 on June 20, 2014. As the upturn continues, the implied volatility should decline back toward 30. The implied volatility /historical volatility ratio using the range method is .96 so option prices are relatively inexpensive compared to the recent movement of the stock, but remember the implied volatility is likely to continue declining. Friday’s option volume was 22,052 contracts traded compared to the 5-day average volume of 33,730.

Using the ask price for the buy and middle for the sell, the call spread debit is 1.65 about 33% of the distance between the strike prices. Adding the short put at the bid prices reduces the net debit to .43. Use a close back below the January 14 reversal low at 41.63 as the SU (stop/unwind).

Halliburton Company (HAL) 40.99 is in the oil service sector and turned higher January 16 just before reporting 4Q earnings.

The current Historical Volatility is 30.65 and 32.21 using the Parkinson’s range method, with an Implied Volatility Index Mean of 30.54 down from 39.03 the week before. The 52-week high was 51.23 on December 16 as it reversed higher, while the low was 18.81 on August 25, 2014. As the upturn continues, the implied volatility should decline back toward 25. The implied volatility /historical volatility ratio using the range method is .95 so option prices are relatively inexpensive compared to the recent movement of the stock, but remember the implied volatility is likely to continue declining. Friday’s option volume was 62,570 contracts traded compared to the 5-day average volume of 41,570.

Using the ask price for the buy and middle for the sell, the call spread debit is .92 about 26% of the distance between the strike prices. Adding the short put at the bid prices reduces the net debit to .12. Use a close back below the January 15 low at 37.27 as the SU (stop/unwind).

The suggestions above use the closing ask price for the buy and mid price for the sell since price improvement is possible when there is decent volume. Monday’s prices will be somewhat different due to the time decay over the weekend and any underlying price change.

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Summary

Sentiment improved last week after the ECB announcement as evidenced by declining implied volatility, especially for companies in the oil & gas sector that had been a drag on the S&P 500 Index appear to be in the process of turning higher. This week the concerns will be how the Greek elections will affect the markets along with the earnings reports of several large technology companies with foreign exchange exposure. Currently just under the upward sloping trendline, the S&P 500 Index could go either way, but likely to be supported by companies in the oil & gas sector that appear to be turning higher.