Apparently growing impatient waiting for the “third arrow”, the Bank of Japan decided to go it alone and buy 80 trillion yen worth of Japanese bonds each year by printing money.
It took the markets by surprise and the yen declined immediately so the reciprocal US Dollar Index advanced sharply although the yen represents just 13.6% of the index. However, since exchange rates move primarily in response to news that alters expectations about the future economic environment, now supported to a great extent by asset prices, large currency moves are likely to have unintended consequences.
Strategy Report
Responding to last week’s developments, keep in mind altered expectations about the future economic environment, Japanese equities are likely to continue higher as the yen declines. Using the currency hedged ETF, could offer an opportunity.
Next, since crude oil is considered a commodity price hedge and expectations are for lower commodity prices perhaps it is not too late to consider a lower crude oil price position, especially from the perspective of the long-term US Dollar Index chart above.
Lower Yen
WisdomTree Japan Hedged Equity ETF (DXJ) 53.82 while a lower yen is beneficial for Japanese exporters the rising dollar pressures commodity prices especially crude oil offsetting the higher yen cost. By hedging the currency, any further equity advance may be possible without concern about the declining currency. Using the advance made in early 2013 with the introduction of the “Abenomics” program as a guide, equities advanced a week before the first pull back and then finally peaked after about six weeks.
The current Historical Volatility is 28.20 and 12.77 using the Parkinson’s range method, with an Implied Volatility Index Mean of 21.70 up from 20.15 the week before. The 52-week high was 29.72 on February 3, 2014 while the low was 12.05 on August 28, 2014. The implied volatility/historical volatility ratio using the range method is 1.70 meaning the options prices are expensive relative to the movement of the ETF so a hedged position is preferable. The put-call ratio at just .25 is very bullish. Friday’s option volume was 143,827 contracts traded compared to the 5-day average volume of 36,920. Consider this December combination long call spread with a short put.
First the long call spread.
Using the ask price for the buy and middle for the sell, the debit is .63 although there is no volatility edge it does hedge both changes in implied volatility and time decay.
Then add a short put.
The short put adds some volatility edge and positive time decay, theta using the bid price of 1.06, making a net position credit .43. The additional positive theta will help offset any loss of time decay theta from the long call during early December when market volatility normally starts declining. The assignment risk on a close below 52 at the December expiration is a long ETF position at 51.57 just above support going back to June at 50 and the SU (stop/unwind).
Stronger Dollar – Lower Crude Oil
United States Oil ETF (USO) 30.63. The presumption here is crude oil now 80.54 basis December futures will decline below 80 on further US Dollar Index strength so the equivalent USO price will decline below 30. 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. There is a slight backwardation advantage currently .12 between December and January that should add some price support.
The current Historical Volatility is 22.73 and 21.83 using the Parkinson’s range method, with an Implied Volatility Index Mean of 27.71 down from 29.46 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 1.27 meaning the options prices are priced about normal relative to the movement of the ETF. The put-call ratio at 1.13 is bearish reflecting considerable hedging.Friday?s option volume was 52,116 contracts traded compared to the 5-day average volume of 43,130.
Consider this January long put spread with 75 days to expiration.
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 .49, a favorable 25% 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.
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
Although equities were almost back to their previous highs by Thursday last week they received an upside boost on the Bank of Japan bond buying jolt creating gap openings for the major indexes Friday. Since exchange rate changes alter market expectations it now appears the US Dollar Index will continue rising so commodity prices, especially crude oil and emerging market equities will continue to decline while the major US equity indexes will likely continue higher.