Volume 15 Issue 16
5 Volatility King Ideas

Just as it seemed the S&P 500 Index was about to exceed the important March 23 high of 2114.86 defining a potential right shoulder of a Head & Shoulder Top pattern when out of the blue Chinese regulators sent a blast of cold air chilling European markets already anxious due to the latest episode of the never-ending Greek drama. The result was a sharply lower opening in the US and when combined with the regular April options expiration there was hardly any indication of reversing before closing with a 1.13% decline while the earnings reports released so far were mostly negligible lacking many encouraging upside surprises.

After brief market comments, this week the focus is on those Volatility Kings™ scheduled to report earnings accompanied by a few trading strategy alternatives. Then our friends at The Blue Collar Investor offer some advice about improving trading results by working the bid/ask spread.

S&P 500 Index (SPX) 2081.18 down 20.88 or 1% for the week closed below the operative upwards sloping trendline shown last week in Digest Issue 15 “Earnings, US Dollar Index, DJ Transports [Charts]. The longer-term upward sloping trendline from November 2012 is now 1952.42. However, on any further decline it would first need to decline below the widely followed 200-day moving average at 2020.04 where it is likely to find considerable support.

CBOE Volatility Index® (VIX) 13.89 up 1.31 for the week on a gap up open Friday confirming the view the market’s sudden down move was following Europe lower.

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.

April futures expired last Wednesday making May the front month with the last trading day May 19. The day weighting applied 88% to May and 12% to June as of Friday for a 13.91% premium shown above. Our alternative volume-weighted average between May and June, regularly found in the Options Data Analysis section on our homepage, is slightly higher at 15.43 %. Premiums for normal term structures are 10% to 20%. Premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging often occurring around market highs suggesting overbought conditions associated with pullbacks. Alternatively, premiums less than 10% suggest caution and negative premiums indicate oversold conditions. Last week the premiums ranged from 6.05% Tuesday to 23.78% Thursday, closing at 15.47% Friday. Interestingly the close above 20% Thursday suggested trouble Friday but came too to take action.

iShares Transportation Average (IYT) 154.80, down 2.31 or 1.47 % for the week this ETF tracks the important Dow Jones Transportation Average Index measuring the performance of transportation sector US equities that again closed below the lower range boundary of 155. For details why this is important, see the chart in Digest Issue 15 “Earnings, US Dollar Index, DJ Transports [Charts].”

Last week we highlighted a Crestmont Research note as of 3-31-15 stating the current S&P 500 Index price-to-earnings ratio was 20.2 while the normalized Shiller ratio was 26.6 adding the “current status as near significantly overvalued.”

Price to earnings ratio apprehension especially from large multinationals with significant foreign exchange risk combined with macro events from China and Greece suggests caution until the S&P 500 Index closes back above the important March 23 high of 2114.86 defining a potential right shoulder of a Head & Shoulder Top pattern. For an all clear signal, it needs to close above the potential Head of the pattern at the February 25 high of 2119.59. In the meanwhile, the current operative upward sloping trendline at 2088.56 could still provide some support since the S&P 500 Index often exceeds technical objectives and then returns and the sudden Friday decline suggests this is a good possibility absent more negative news from Europe over the weekend. In the event it should now continue lower, look for support at the 200-day moving average now at 2020.04.

The initial negative market reaction to the message from the China Securities Regulatory Commission allowing mutual funds to make their shares available for short selling and banning methods brokers used to extend credit to OTC speculators through umbrella trusts will likely be limited since cooling the overheated OTC market should be a net positive.

However, renewed attention to the ongoing Greek saga could push European equities below the operative upward sloping trendline from January 7 as measured by the SPDR Euro Stoxx 50 ETF (FEZ) 38.85, where it found support Friday.

Noteworthy WTI Crude Oil (CL) 57.32 basis June declined just .79 and the Energy Select Sector SPDR ETF (XLE) 81.91was the only positive sector for the week gaining 2.21% further supporting the view that crude oil may have bottomed.

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Earnings Volatility Kings Ideas

For those interested in volatility trades around earnings reports the table below has five ideas for companies scheduled to report this week.

As a review, the typical pattern is for implied volatility to rise for about 3-4 weeks before the next report date and then decline for 4-6 weeks after reporting. Since most of the expected increase has already occurred for those in the table below, it’s too late for long volatility strategies so consider mostly neutral short volatility strategies such as short straddles or strangles, or calendar spreads, short near term higher implied volatility strikes and long the same deferred strikes.

Another alternative with negative delta is short call spreads especially when the stock has risen in anticipation and is up against resistance. Listed in order from the highest IV/HV ratio, using the range HV method or PHV, here are 5 ideas to consider.

For example, using FB with good options volume, second in the table, scheduled to report Wednesday with an implied volatility index mean IVXM of 37.23 and based upon previous results could decline to 22 in a month to 6 weeks after reporting, the implied volatility for the April 24 at-the-money call is 61.80 while the put is 61.40.

Based upon Friday’s prices selling the straddle, that is sell the April 24 80 call and the April 24 80 put results in a 5.50 credit with a delta of -.1242 or slightly short. However, there is a margin requirement to consider.

For a calendar spread, selling the April 24 80 call, implied volatility of 61.80 for 3.15, while buying the May 15 80 call, implied volatility of 38.50 for 3.83 results in a .68 debit with an almost neutral delta of -.0042.

Then for a short call vertical spread selling the April 24 82 call, implied volatility 60.23 and buying the April 24 85 call, implied volatility 57.31 for a 1.10 credit results in delta of -.1715, slightly negative, however it gives up some implied volatility edge.

The calendar spread with the largest implied volatility differential seems the most favorable, but it also has short gamma so any large price move, say more than 2 standard deviations will likely result in a loss. Generally, when the IV/PHV ratio is greater than 2 the probably of a large move in the underlying is greatly increased. Based upon this EBAY or QCOM are safer calendar spread ideas, however with less potential gain.

Improving Option Prices

Covered call writers generate cash flow by selling call options on a stock or exchange-traded fund. The goal is to generate the highest possible returns with low-risk trades that fit the requirement for capital preservation. The three required skills for achieving these goals are stock (or ETF) selection, option selection and position management (exit strategies). This article considers one more, negotiating a better price between the indicated the bid and ask option price.

Market makers generate income from the bid-ask spreads…the greater the spread the more money they can make. From their perspective, they want to buy as low as possible and sell as high as possible. To protect retail investors from unusually large spreads, the SEC established the Show or Fill Rule also known as the Limit Order Display Rule or technically the Exchange Act Rule 11 Ac1-4. This regulation requires market makers to show or publish any order that improves the current bid or ask prices unless filled. Any order between the bid and ask will improve the market.

When the spread is small, say 2.50 – 2.60, there is not that much to work with. But what if the spread was 2.50 – 3.00? A market order to sell would likely be filled at the bid price of 2.50 representing a possible opportunity lost. Instead, to leverage the Show or Fill Rule: Find the mark or mid-point of the bid-ask spread and drop down slightly in favor of the market maker. In this example, the mark is 2.75 so price the limit order to sell the call at 2.70, not 2.50 better by .20. Now the market maker is faced with a dilemma…execute the trade for 2.70 or publish the new spread at 2.50 – 2.70. The .50 spread now becomes a .20 spread. It is now in the hands of the market maker. In many cases, it will be executed at 2.70 and the published spread will remain at .50 improving the position by 20 per contract. Covered call writers are in the business of selling options and these 20 “bonuses” will add up over an investment lifetime.

An example as of the market close 4-17-15

• Spread: 2.00 – 2.35
• Mark: 2.175
• Place limit order to sell covered call at 2.15

One more thing: on trade execution forms with an All or None (AON) box, do not check this box since market makers are no longer obligated by the show or Fill Rule.

Enjoy the extra cash!

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Summary

While earnings reports will get cranked up this week cold macro winds from Europe could shift the focus to risk aversion once again. While Friday’s sell-off took the markets by surprise, there are well-defined support areas that could limit the decline assuming the Greek can gets kicked down the road a bit further. In the meanwhile, damage from regulatory changes in China is likely to be limited and viewed positively after an initial shock decline. For the S&P 500 Index the concern is about price-to-earnings ratios especially for large multinationals with significant foreign exchange risk.