Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
The sudden U.S. Dollar Index decline Wednesday initially supported crude oil and the S&P 500 Index as markets seemed to react to the increasing possibility the Federal Reserve may dial back expectations for another rate hike anytime soon. However, the weaker than expected employment report on Friday created a rush to replace high price-to-earnings ratio stocks with less glamorous but more defensive telecom and utility issues.
After a brief market review, we offer some “mostly neutral” ideas for Time Warner Inc. (TWX), Mylan N.V. (MYL) and First Solar, Inc. (FSLR) in a more adverse market atmosphere with higher implied volatility that may be transitioning from a correction into a more serious cyclical bear market.
Market Review
S&P 500 Index (SPX) ?ended down 60.19 points or -3.10% for the week. After the negative interest rate announcement by the Bank of Japan a week ago last Friday SPX made an unusual upside breakout from a small developing bearish rising wedge. However, large declines last Tuesday and Thursday renewed and redefined this bearish continuation pattern with a downside-measuring objective at 1830 about 50 points lower.
CBOE Volatility Index? (VIX) ?advanced 3.18 for the week. Based on real-time prices of options on the S&P 500? Index, VIX reflects investors’ consensus view of future (30-day) expected stock market volatility.
The table below shows the VIX cash compared to the next two futures contracts as well as our calculation of Larry McMillan?s day-weighted average between the first and second months.
With 7 trading days until the February monthly expiration, the day weighting applied 35% to February and 65% to March for a .58% premium shown above. Our alternative volume-weighted average between February and March regularly found in the Options Data Analysis section on our homepage was slightly higher at 1.02%.
While day-to-day VIX changes offer little forecasting insight following the VIX futures premium helps since it measures expectations of tactical professional traders and money managers using VIX futures and options for hedging long portfolio risk.
Premiums for normal term structures during uptrends are 10% to 20% while premiums above 20% are unsustainable suggesting a lack of enthusiasm for VIX hedging often occurring around market highs suggesting overbought conditions associated with pullbacks. Alternatively, premiums less than 10% suggest caution and negative premiums indicate oversold conditions. Last week the volume-weighted premium started the week at 7.15% then declined to end Friday at 1.02% near the lower end of the caution zone.
US Dollar Index Update
For the second week, there was little doubt the most important market indicator was the dollar index.
US Dollar Index (DX) ?down 2.58 or -2.59% for the week after closing below the newly established trendline from the December 15 low that lasted just one week. Wednesday?s 1.58 point drop was the second dramatic decline since the December 2 high at 100.51. The first occurredDecember 3 when it suddenly declined 2.37 points ahead of the December 16 interest rate hike announcement from the Federal Reserve. Considering the enormous amount of foreign currency exchange involved, these rapid declines occurring before releases of important data are astonishing. While the latest plunge provided little support for crude oil after inventories increased again, gold seems to be the immediate beneficiary reinforcing the cu rrent dollar commodity/price linkage. Support from last September around 96 and then the pivot low made October 15 at 93.81 are reasonable targets should the decline continue as strong dollar sentiment fades.
Strategy Review
As the VIX hovers in 20 range and high price-to-earnings ratio former leaders begin losing their luster, higher implied volatility creates opportunities to sell option premium as mentioned last week. The challenge is to minimize risk as much as possible by using neutral or near neutral strategies while keeping in mind implied volatility will continue rising if equities remain under selling pressure. While companies that have yet to report 4Q earnings and appear more attractive from an implied volatility perspective they also have more directional risk seen last week when some former internet/social media favorites seemed to collapse as money rotates into less risky positions.
Using our IVolatility Advanced Ranker set to the top 200 by options volume helped find some candidates that all have options implied volatility in excess of 40 with Implied Volatility/Historical Volatility Ratios less than 2 using the range method to calculate historical volatility.
Here are three ideas to consider all currently trading in well-defined ranges. The first two will be reporting 4Q earnings this week, but have not experienced recent selling pressure.
Time Warner Inc. (TWX) ? will report earnings Wednesday before the opening with a consensus estimate of 1.00 per share on 7.53 billion revenue and a trailing twelve month price-to-earnings ratio of 16. The Implied Volatility Index Mean is 42.63 with a Historical Volatility of 32.02 for an IV/PHV Ratio of 1.33 suggesting moderate expectations for a large stock move.
First a call credit spread.
Using the ask price for the buy and mid for the sell the call credit would be .26 and delta .0668 negative. Adding a put credit spread increases the total credit and makes the position almost delta (?) neutral but increases the assignment risk should the stock decline significantly after reporting.
Using the ask price for the buy and mid for the sell the put credit would be .82 and delta .1325 positive. The total for both sides would be a credit of 1.08 and slightly .0657 delta positive.
Mylan N.V. (MYL) ?reports earnings Wednesday after the close with a consensus estimate of 1.25 per share on 2.70 billion revenue and a trailing twelve month price-to-earnings ratio of 29. The Implied Volatility Index Mean is 47.65 with a Historical Volatility of 38.13 for an IV/PHV ratio of 1.25.
First a call credit spread.
Using the ask price for the buy and mid for the sell the call credit would be .37 and delta .1099 negative. Again adding a put credit spread increases the total credit and makes the position almost delta neutral but increases the assignment risk should the stock decline significantly after reporting.
Using the ask price for the buy and mid for the sell the put credit would be .28 and delta .0791 delta positive. The total for both sides would be a credit of .65 and slightly .0308 delta negative.
Here is one more reporting earnings later, with higher implied volatility.
First Solar, Inc. (FSLR) scheduled to report February 23 after the close with a consensus estimate of .80 per share on 966 million revenue with a trailing twelve month price-to-earnings ratio of just 11. The Implied Volatility Index Mean is 61.15 with a Historical Volatility of 43.76 for an IV/PHV Ratio of 1.40.
Using the ask price for the buy and mid for the sell the call credit would be .64 and delta .0736 negative. Adding a put credit spread increases the total credit and makes the position almost delta neutral but increases the assignment risk considerably since the options have more time to expiration in a negative market environment and the earnings have a tendency to fluctuate more than other companies from quarter to quarter due to the variability of project completions.
Using the ask price for the buy and mid for the sell the put credit would be .54 and delta .0642 positive. The total for both sides would be a credit of 1.18 and slightly .0094 delta negative.
The suggestions above are based on the ask price for the buy and middle price for the sell presuming some price improvement is possible. Monday?s option prices will be somewhat different due to the time decay over the weekend and any price change.
Summary
Markets appear unstable reacting to increasing probability the Federal Reserve may dial back expectations for another rate hike anytime soon. The rotation out of high price to earnings multiple growth stock favorites into more stable defensive positions appears to be following the late cycle playbook. Based upon the weakening U.S. Dollar index the markets apparently no longer believe the Federal Reserve will increase interest rates again anytime soon thereby supporting dollar reporting multinational companies, emerging markets and commodity prices.