Volume 15 Issue 8
Equity Uptrends Resume

Until Friday’s news from Europe about an extension for Greece accompanied by short term funding, equities appeared stalled with the S&P 500 Index moving sideways in a narrow range just under 2100. On the news, equities pushed noticeably higher in both Europe and the US addding to the previous week’s advance.

After a brief market review, we have a volatility article from our friends at The Blue Collar Investor followed by ideas for Cisco Systems, Inc. (CSCO), FireEye, Inc. (FEYE), Southwest Airlines Co. (LUV), AbbVie Inc. (ABBV) and Celgene Corporation (CELG).

S&P 500 Index (SPX) 2110.30 for the short trading week equities were waiting for some indication of a solution for the Greek problem trading around 2100 until Friday when it broke out to the upside. Digest Issue 7 “Cyclical Optimism Returns” included a chart with the new operative upward sloping trendline from the October 15 low at 1821.61 to the February 2 low at 1980.90. Now expect a further advance perhaps to 2150 before it attempts to retest the breakout above 2100.

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 March and 15% to April for a 19.30% 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 20.43%. Premiums for a normal term structure range between 10% and 20%, while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging. Alternatively, premiums less than 10% suggest caution and negative premiums indicate an oversold condition. Last week the premiums were above 10% every day beginning Tuesday at 10.01% and ending Friday at 20.43%.

Since the uptrend resumed more longs than shorts are the order of the day however, individual stock selection is becoming problematic as many seem to be selling at high price-to-earnings multiples. While the oil and gas sector may have made a bottom with crude oil trading in a 50-55 range, it will probably take another few weeks to confirm the upturn. Interest sensitive sectors like utilities and REIT’s are likely to continue under selling pressure.

Crude Oil Update

Last week in Digest Issue 7 “Cyclical Optimism Returns” we included CFTC data on Non-Reportable trader positions. As a reminder, here is the article by Tom McClellan explaining this approach.

As of December 9, the Non Reportable position was net long 12,122 contracts or .53% of the open interest. On February 3, the CFTC reported the net position as -380 contracts or -.01% thus suggesting capitulation. For the report dated February 10, the net long position was again positive at 3,889 contracts or .14%, but the most recent report dated February 17 shows the net short position negative once again at -3,797 or -.15%. This analysis, seems to confirm the low was made on January 29 at 44.37 basis April futures or 16.30 for USO.

Using Volatility When Selling Short-Term Options

Understanding the concept of implied volatility is essential for successful covered call writing and put selling. Implied volatility gives us a window into the “market’s” perception of future price movement. It also allows us to calculate the probability of a stock price reaching a certain level. Like all other parameters, implied volatility, although quite important and useful, does have its limitations. First, let’s first compare the two most frequently mentioned types of volatility.

Historical vs. Implied Volatility

Historical volatility (HV) refers to the actual price fluctuation of the underlying security during a specific period, also called Statistical Volatility (SV) or Realized Volatility, all referring to the past price movements of the underlying asset.

Implied volatility (IV) is a computed value using an option-pricing model such as the Black-Scholes. Since the actual options prices are an input into the model Implied Volatility reflects expectations about the future volatility of the underlying. It can also help to gauge if options are cheap or expensive when compared to the movement of the underlying. In addition, each option contract has a unique level of Implied Volatility, which can change over time as the demand for each option rises or falls.

Understanding implied volatility allows us to make informed decisions when comparing premium to implied risk.

Standard deviation and implied volatility

The implied volatility generated from an option pricing model indicates the probability of a certain price movement in either direction on an annualized basis. Let’s say a stock is trading at 30 and has an implied volatility of 20% for the at-the-money strike. This means the expectation for the stock price, based on current option value is to move up or down 6 points during the next year. In other words, the anticipated trading range is between 24 and 36 based on a 1 standard deviation related to a lognormal distribution curve of potential prices. Stated differently, we would expect a trading range of 24 to 36, 68% of the time. Then, 2 standard deviations would be 12 in either direction or a range between 18 to 42 and expected to be in that range 95% of the time. 3 standard deviations would represent a range between 12 and 48, 99% of the time.

The volatility chart below illustrates the difference between implied and historical volatility for Skyworks Solutions Inc. (SWKS).

Earnings release dates shown at the red arrows are good examples of increasing implied volatility leading up to the event and shows how they frequently diverge from the actual stock volatility.

In Conclusion

For short-term option sellers, implied volatility is more important than historical volatility since it demonstrates market sentiment about future price movement although does not define direction. We can use it to determine price probability and therefore risk parameters that will allow us to decide if a trade is consistent with our personal risk-tolerance and monthly goals. A quick, user-friendly way to estimate implied volatility is to look at the expected returns for an option. For example, if a 1-month at-the-money strike generates more than 6%, we are dealing with a high-implied volatility trade and while appropriate for some, it may not be for others.

Click on The Blue Collar Investor link to learn about mastering the skill of selling options and much more information about becoming an elite covered call writer.

Long Ideas

As the uptrend resumes long positions should have the advantage, but valuations of many individual stocks are beginning to look stretched. Here are a few ideas to ponder.

Cisco Systems, Inc. (CSCO) 29.55. In a February 12 CNBC interview CEO John Chambers said Europe is coming back and is ahead of the US. With substantial European exposure, this could be a way to participate in an improving Europe since the options trade with good volume and are relatively inexpensive.

The current Historical Volatility is 35.24 and 22.23 using the Parkinson’s range method, with an Implied Volatility Index Mean of 17.62 down from 18.31 the week before. The 52-week high was 30.27 on October 16, 2014 while the low was 12.53 on August 28, 2014. The implied volatility/historical volatility ratio using the range method is .80 so option prices are inexpensive compared to the recent movement of the stock. Friday’s option volume was 94,359 contracts traded compared to the 5-day average volume of 66,900.

Using the ask price the debit is .40. Use a close back below 28 as the SU (stop/unwind).

FireEye, Inc. (FEYE) 46.15 as hacking and network security has increasingly become a real concern to both large companies and governments the security company stocks have increased in value however, most do not trade with sufficient options volume and liquidity, except for FEYE.

The implied volatility/historical volatility ratio using the range method is 1.08 so option prices are reasonable compared to the recent movement of the stock. Friday’s option volume was 39,445 contracts traded compared to the 5-day average volume of 42,290.

While there is no implied volatility edge it does partially hedge time decay since March options are now the front regular month. Using the ask price for the buy and middle for the sell, the debit is 1.05, about 35% of the distance between the strike prices. Use a close back below 40 as the SU (stop/unwind).

Southwest Airlines Co. (LUV) 44.78 although the airline group has been trending higher since last October on expectations of improving earnings from lower fuel cost and higher passenger loads they reported better than expected earnings of .59 on January 22 as revenues advanced 4.5% year over year. With a well defined upward sloping trendline and a 2015 consensus earnings estimate at 13x it could continue higher as the busy summer travel season is about to begin.

The implied volatility/historical volatility ratio using the range method is 1.13 so option prices are reasonable compared to the recent movement of the stock. Friday’s option volume was 34,395 contracts traded compared to the 5-day average volume of 22,820.

While there is no implied volatility edge it does partially hedge time decay since March options are now the front regular month. Using the ask price for the buy and middle for the sell, the debit is 1.00, about 33% of the distance between the strike prices. Use a close back below support at 42.50 as the SU (stop/unwind).

Now for two that are unrelated to crude oil prices, but still have market risk.

AbbVie Inc. (ABBV) 61.30 after declining from 70 in December it appears to be turning higher accompanied by considerable controversy about its Viekira Pak Hepatitis-C competing with Gilead Sciences (GILD) along with its extensive new product pipeline. Based upon Yahoo data the current price-to-earnings ratio is 56 but the forward is only 12 times with a price to earnings growth ratio (PEG) of .90.

The implied volatility/historical volatility ratio using the range method is .88 so option prices are inexpensive compared to the recent movement of the stock. Friday’s option volume was 23,258 contracts traded compared to the 5-day average volume of 21,730.

While there is no implied volatility edge it does partially hedge time decay since March options are now the front regular month. Using the ask price for the buy and middle for the sell, the debit is .70 about 28% of the distance between the strike prices. Use a close back below 60 as the SU (stop/unwind).

Celgene Corporation (CELG) 123.43 now back above the upward sloping trendline from the October 15 low the story here is the European Commission approval for Revlimid along with the FDA announcement for its use in combination with dexamethasone for treating patients newly diagnosed with multiple myeloma.

The implied volatility/historical volatility ratio using the range method is .97 so option prices are inexpensive compared to the recent movement of the stock. Friday’s option volume was 47,143 contracts traded compared to the 5-day average volume of 43,000.

Once again, without implied volatility edge it does partially hedge time decay since March options are now the front regular month. Using the ask price for the buy and middle for the sell, the debit is 1.70 about 34% of the distance between the strike prices. Use a close back below support at 120 as the SU (stop/unwind).

The suggestion above uses closing ask prices for the buy and middle price for the sell presuming some price improvement from indicted prices is possible. Tuesday’s option prices will be somewhat different due to the time decay over the weekend and any stock price change.

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Summary

Compared to concern the week before about possible negative macro events from Europe, last week the news was positive so equities responded accordingly with another new higher close for the S&P 500 Index and European equities shared the enthusiasm. Presuming the January 29 crude oil low holds, the remaining concerns are Ukraine and the anticipated interest rate hike announcement from the Federal Reserve.