Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Since there were few surprises in run up to Presidential Inauguration the cautious posture suggested last week remains unchanged. In the meanwhile, the current low implied volatility offers opportunities along with special situations and one of each follow brief market commentary. For low implied volatility, we have Enterprise Products Partners L.P. (EPD) and TransDigm Group Incorporated (TDG) as a special situation.
S&P 500 Index (SPX) slipped another 3.33 points or -.15% for week in a narrow trading range and still below the important December 13 intraday high at 2277.53. While there could be a developing rising wedge, until it breaks out or breaks down the focus remains on the previous high. Should it turn lower, there is good support in the area around 2185 where it traded between August 5 and September 8.
CBOE Volatility Index® (VIX) bounced briefly higher then declined again Friday to close up .31 points or +2.76% for the week. The comparable IVolatility implied volatility index mean, IVXM closed .25 lower Friday at 8.50, a 52- week low.
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.
With 17 trading days until the February expiration, the Day Weighted premium between February and March allocated 85% to February and 15% to March for a weighted average of 21.66%, right in the bullish zone.
Low Implied Volatility
Enterprise Products Partners L.P. (EPD) was up .47 points or +1.72% for the week with a well defined upward sloping trendline, USTL it appers headed back up to test the high at 30.11 made July 14, although 4Q earnings that will be reported in one week on January 30 could cause it to stumble. However, since the implied volatility is at a 52-week low and not advancing before the report the risk seems acceptable.
The current Historical Volatility is 18.54 and 17.61 using the Parkinson’s range method, with an Implied Volatility Index Mean of 18.26 down from 22.02 the week before. The 52-week high was 70.08 on January 20, 2016 while the low was 18.26 Friday one year later. First the volatility chart followed by the price chart.
The implied volatility/historical volatility ratio using the range method is 1.04 so option prices are inexpensive relative to the recent movement of the stock. Friday’s option volume was only 5,657 contracts with a 5-day average of 14,510 contracts and reasonable bid/ask spreads.
Consider this long call idea.
Using the ask price the debit would be .55. Use a close back below the USTL at 26 with some allowance for a brief decline after reporting earnings next week as the SU (stop/unwind).
The suggestion above is based on the ask price. Monday’s option prices will be somewhat different due to the time decay over the weekend and any price change.
Rising Implied Volatility
Now going in the other direction, this one comes from Friday’s news.
TransDigm Group Incorporated (TDG) plunged 25.34 points or -10.05% for the week with 24.86 points on Friday after a report from Citron Research claiming “roll-up” status for this heavily indebted airplane parts manufacturing company scheduled to report 1Q earnings on February 13. Citron gained credibility after taking a similar negative view of Valeant Pharmaceuticals last year.
The current Historical Volatility is 33.39 and 28.66 using the Parkinson’s range method, with an Implied Volatility Index Mean of 46.58 up from 33.86 the week before. The 52-week high was 52.99 on February 19, 2016 while the low was 16.27 on August 23, 2016. However, after the dramatic price decline Friday both volatility measures are likely headed much higher.
The implied volatility/historical volatility ratio using the range method is 1.63 so option prices are moderately expensive relative to the recent movement of the stock. Friday’s option volume was only 16,341 contracts with a 5-day average of 4,6,40 contracts, but with wide bid/ask spreads.
The volatility chart shows both volatility measures spiking higher.
Using the ask price for the buy and mid for the sell the put spread debit would be 2.40 about 24% of the distance between the strike prices with 75% of the long put risk hedged by the short put. In the event it opens considerably lower or higher, adjust the strike prices accordingly. Use a close back above Friday’s high of 250.85 as the SU (stop/unwind).
The spread suggestion above is 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.
Since the S&P 500 Index traded in a narrow uncommitted range last week as the VIX returned near its recent 52-week low before the Presidential Inauguration, this week should provide some clues about any potential profit taking activity by market timers and hedgers who may be anxious to sell the inauguration news.