Volatility Trading Digest – Strategy Ideas
Strategy
The implications of QE3 and a declining dollar are higher commodity prices, gold, and crude oil along with other risk assets including equities. Since several sectors are overbought and subject to correcting, we suggest adding to positions Monday since it is typically the weakest day of the week while keeping in mind this is options and futures expiration week. Review your portfolio for positions expiring in September since long call spreads may need closing.
Now that the major equity indexes have broken out to the upside, underinvested mutual and hedge funds will need to chase performance going into year-end since they risk losing assets under management if their yearend performance lags the S&P 500 Index. We expect there could be a broad based momentum rush as managers look for sectors that have not yet advanced in hopes of catching up with the benchmark index by yearend.
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Momentum Trend Continuation
If we are right about a momentum rush into the lagging sectors then the broader based indexes should perform better than the S&P 500 Index (SPX).
iShares Russell 2000 Index (IWM)
Since breaking out above 82.50 on September 6, IWM has been handily outperforming the SPX.
On the presumption it continues outperforming, here is an idea to consider.
The volatility edge and time decay is in the short October put. Use a close back below the breakout at 82.50 as the SU (stop/unwind).
Earnings Report Idea
Although most of the companies have reported 2Q earnings there are still some interesting ones yet to report including two in the homebuilding sector. Here is one reporting Friday that may show some weakness on Monday and provide an opportunity.
KB Home (KBH)
Scheduled to report earnings on Friday September 21 before the opening the consensus estimate is for a loss of .18. Anything better should be positive for the stock, but it may already be in the price since it has risen from 12 in the last 3 days.
Here is the options data.
The current Historical Volatility is 41.68 and 39.28 using the Parkinson’s range method, with an Implied Volatility Index Mean of 53.77, up from 48.78 last week. The IV/HV ratio is 1.29 and 1.37 using the range method to calculate the HV. Friday’s put-call ratio at .55 was unusually bullish for a company just before reporting, while the volume was 12,807 contracts traded compared to the 5-day average volume of 8,880. Consider this put sale idea.
The put has a good implied volatility edge, but if it does not pull back on Monday, we do not suggest completing it since the premium would be very low. Otherwise, if done and it closes below 13 on Friday then take the stock by assignment and sell a call against the stock since the implied volatility is still likely to be attractive in the 50 range.
Both suggestions above use the closing middle price between the Friday bid and ask. Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.
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Summary
After breaking out to new highs after QE3 and the dollar decline, the stage has been set for equities to continue higher, probably until year-end, especially since underinvested funds will now be scrambling to catch up with their benchmark index, which should expand the market breadth. While crude oil is still subject to a seasonal decline, the current level is likely due to Middle East risk premiums.