Volatility Trading Digest - Mr. Stark's Surprise
Volatility Trading Digest - Mr. Stark's Surprise
Pressure on the Eurozone was unexpectedly increased Friday when J¸rgen Stark announced his resignation from the ECB executive board exposing serious divisions between the members over recent bond purchases of Italian and Spanish debt. While we have been expecting volatility to remain high until the September 29 German Bundestag vote on the European Financial Stability Facility, this action will surely increase doubts about the outcome.
Strategy
While the euro had been declining for the last week, on Friday it broke down below support in the 1.40 area. Considering the current momentum, it looks like it could continue lower to the next support around 1.30. The declining euro will push the US dollar index higher and unless the recent correlations begin to change equities and commodities will be pressured lower as well. Below we have two trade ideas that should work for this situation.
With the added uncertainty from Europe, we suggest hedging existing long positions while limiting news ideas to special opportunities such as the four other ideas below.
Whacking the Euro
As for the euro, here is an addition to the suggestion we made in Digest Issue 25 using EUO. On a mark-to-market basis, the November 18/20 call spread has increased in value from .45 to .65. Here is the new breakout trade suggestion for the euro.
ProShares UltraShort Euro (EUO)
The ETF seeks to provide daily move corresponding to twice (200%) the inverse (opposite) of the daily change in the US dollar price of the euro. The fund invests in swap agreement, futures contracts, forward contracts, option contracts.
The current Historical Volatility is 25.12 while the Parkinson's range method, arguably more applicable for EUO is 14.21. The Implied Volatility Index Mean is 38.61, up from 30.78 last week, for an IV/HV ratio of 1.54, however comparing the Implied Volatility to the range Historical Volatility the ratio is 2.7. The put-call ratio is .05 or about 20 times more call volume than puts with a similar ratio between call and put open interest. Fridayís option volume was 33,487 contracts compared to the 5-day average of 21,380 and much higher than in June when we first suggested the EUO call spread.
Here is another call spread idea.
With a good volatility edge, the debit is a favorable 21.50% of the distance between the strike prices providing an attractive 4:1 risk to reward ratio. Use a close back below the last pivot just under 16.50 as the SU (stop/unwind). With similar gamma, or rate of change of delta, as the previously suggested long November 18/20 call spread there is less time value since we are expecting EUO to advance during the next month.
Hedging Equities
If the euro continues to decline and the current correlations remain unchanged then we should also hedge our equity exposure, however we want to make this suggestion conditional upon the S&P 500 Index (SPX) 1154.23, closing below Friday's low at 1148.37. The reason for making this suggestion conditional is based upon our expectation that the European leaders will most likely be working this weekend and there is no telling what they may say by Monday to support the euro.
Direxion Small Cap Bear 3X Shares (TZA)
This ETF seeks daily results, before fees and expenses, of 300% of the inverse (or opposite) of the price performance of the Russell 2000 Index.
The current Historical Volatility is 167.53, while the Parkinsonís range method 121.53. The Implied Volatility Index Mean is 134.64, up from 118.98, for an IV/HV ratio of .80, however comparing the Implied Volatility to the range Historical Volatility the ratio is 1.11. The put-call ratio is .22 or about 4.5 times more call volume than puts while the call open interest is more than 2 times the put open interest. Friday's option volume was 39,316 contracts compared to the 5-day average of 29,980.
Here is a long call spread as a hedge, but without much volatility edge.
The increasing price of the ETF corresponds with the expected decrease in the price of the Russell 2000 Index. In the event the market turns higher once again use a close back below 40, as the SU (stop/unwind).
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