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.
Strategy Ideas
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 onNovember 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) 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’soption 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.
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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.
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.