Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Although the major indexes, along some sectors look overbought, using technical analysis tools, until something occurs to diminish enthusiasm reasons to sell anticipating overbought corrections conflict with trading rule number nine: “Trade what you see not what you think.” Since current interest rates already reflect Wednesday?s widely anticipated hike from the FOMC, the market could remain overbought through the end of the year, unless surprised by an unknown macro event. After a brief market review along with an updated VIX futures premium chart, we offer some implied volatility ideas to consider for the upcoming FedEx Corporation (FDX) earnings report.
S&P 500 Index (SPX) rocketed up 67.58 points or +3.08% for week, after retesting the previous the previous high made August 15 at 2193.81 and then breaking out above the retracement high on Wednesday gaining 29.12 points flashing the green light. While appearing overbought, other indicators like the DJ Transportation Index confirmed the uptrend according to the Dow Theory. Add improving breadth to the mix and the result is a bull market called the Trump Rally.
VIXCBOE Volatility Index (VIX) dropped 2.33 points or -16.50% for the week. Our comparable implied volatility index mean, IVXM declined 1.92 points or -16.95 %.
VIX Futures Premium
The premium measures the amount the futures currently trade above or below the cash VIX, (contango or backwardation) until front month future converges with the VIX at expiration. Depending on the time to expiration, premiums for normal term structures during uptrends are 10% to 20% and decline when the VIX advances faster than the nearest future as the market declines and/or the futures decline as the front month expiration approaches. Premiums less than 10% suggest caution and negative premiums indicate oversold conditions when the VIX is higher than the futures and are usually associated with reversals.
Friday the premium returned to the upper bullish green zone ending at 23.95%. However, another indicator that compares the VIX to the short term VIX, the VXST flashed a brief warning Thursday closing at 12.92 when the VIX was 12.64, then Friday it closed at 11.10 back below the VIX at 11.75.
Just to add some juice to the Trump Rally mix the 30-day SPX volatility charts shows declining implied volatility associated with uptrends.
While focusing on the major indexes the confirmation of the uptrend by the DJ Transportation Index closing back above the November 2014 high warrants some additional attention especially since a good part of the advance can be attributed to both delivery services supporting online shopping, United Parcel Service, Inc. (UPS) and FedEx Corporation (FDX). However, FDX leads the charge since it reports 2Q earnings on December 20.
Strategy Idea
In the “Rankers and Scanner” section of our home page we feature a complimentary ranker sample at the “Top 5 stocks by implied volatility change” link. The click goes to an Advanced Ranker Sample of the top and bottom five stocks and ETFs in four categories. For ideas, we often look at the top five based on the Implied Volatility Index Mean vs. the 30-day Historical Volatility (IV Index Mean vs 30D HV) and Friday FDX was at the top of the list at 2.15.
The supporting details:
FedEx Corporation (FDX) gained 3.80 points or 1.97% for the week as a well-defined uptrend that began from the low of 170.16 on November 1, continued higher heading into 2Q earnings on December 20, with the consensus earnings estimate of 2.91 on revenues of 14.81 billion.
The current Historical Volatility is 13.73 and 14.92 using the Parkinson’s range method, with an Implied Volatility Index Mean of 29.54 up from 27.71 the week before. The 52-week high reached 35.77 on December 14, 2015 while the low was 14.49 on August 12.
Referring to the volatility chart, 1Q earnings released on September 20, implied volatility, at the second arrow, reached about 26 and then quickly declined to 16 after reporting. The previous quarter released on June 21 it reached 28 and then declined all the way to 15 after reporting. Now almost 30 it could continue somewhat higher for the next seven trading days.
Charts source: IVolatility .com/Advanced Historical Data
Adjusting the implied volatility/historical volatility ratio to the range method reduces it slightly to 1.98 from 2.15 calculated using the annual rate of change for historical volatility, but still high so option prices are relatively expensive compared to the recent movement of the stock. Friday?s option volume was 12,319 contracts traded compared to the 5-day average volume of 15,410 with reasonable bid/ask spreads for a high priced stock. Since implied volatility is high and likely to be even higher on December 20 and then decline after reporting, option strategies with more long options than short will be disadvantaged, so positions with net short options or net short Vega are preferable.
While a calendar spread, short near term options while long deferred options with the same strike price could work, it will lose if the stock makes a large move in either direction since it is net short gamma, or the rate of change Delta.
Short straddles or strangles are two alternatives, but a short straddle risks losing on one side if the stock makes a large move in either direction. A short strangle reduces the risk by selection strikes away from at-the-money. Since the stock gapped up 7% or 11.21 after last quarter?s report, anticipating another large move seems prudent and the option prices are already implying another large move.
Since the stock price could be almost 203 if the current narrow range uptrend continues by the report date, here are some thoughts using Friday?s prices only for initial planning.
Sell the January 20 210 call for 2.30 with an implied volatility of 25.54 and sell the January 180 put for 1.99 with an implied volatility of 30.02, allowing for a similar price move as last quarter. Another alternative with less risk is to sell the 220 call for .69 and the 170 put for .88. Others with defined risk include selling out-of-the money call spreads with out-of-the-money put spreads or Iron Condors.
The objective is to structure the position with net short Vega, or the rate of change of an options value with respect to the 1% change in the volatility, while allowing for a large price move since the implied volatility could decline 15% or more based upon the last two reports.
Summary
Last week?s breakouts by the major indexes confirmed by DJ Transportation Index along with positive supporting risk measures relabeled a positive market, about to retest prior highs, to the Trump Rally. While overbought by most traditional technical measures and subject to corrective pullbacks the odds are good it will remain near the high through year-end and perhaps until the Presidential inauguration.