Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.

Last week the Digest highlighted four areas of special concern first introduced in Digest Issue 23 “Sell in June before the Swoon [Chart]” with charts, this week we add more detail updating the progress of the advancing “Four Horsemen of the Apocalypse.”

Then, for those looking for something other than hedging perceived market downside with SPY put spreads, the primary focus of this issue, Friday’s Advanced Ranker results shows two small biotech stocks with extremely high implied volatility/historical volatility (IV/HV) ratios although the options volume is less than ideal there may be one volatility trade opportunity for Exelixis Inc. (EXEL).

Market Review

S&P 500 Index (SPX) closed the week down 8.50 or -.4% after advancing as high as 2129.49 last Monday before reversing to decline the remainder of the week forming a possible right shoulder of a Head & Shoulder Top with a neckline just under 2080 and a downside measuring objective about 2007. Adding to this unwelcoming technical outlook is the ongoing Rising Wedge first identified two weeks ago and then again last week. Now approaching the apex, with a downside measuring objective near 1842, the Rising Wedge combined with a potential Head & Shoulder Top produces a risky technical outlook for the bulls.

CBOE Volatility Index® (VIX) up only .06 for the week and just before an uncertain outcome for the ongoing Greek Tragedy perhaps suggesting market participants are growing weary of this drama, although the VIX futures are more insightful.

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.

062915VIX1

The day weighting applied 68% to July and 12% to August as of Friday for a 5.90 % premium shown above. Our alternative volume-weighted average between July and August regularly found in the Options Data Analysis section on our homepage was slightly higher at 6.12%.

Premiums for normal term structures 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 premiums started near 20% but ended the week in the cautious zone. 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.

Four Horsemen of the Apocalypse Update

Just for clarification, the context for apocalypse is the lesser meaning for an event of great importance rather than the biblical reference to the imminent destruction of the world. From this perspective, it only implies the start of an overdue market correction.

Market Breadth

The McClellan Oscillator Summation Index reported by McClellan Financial Publications improved slightly last Monday andTuesday, but at the week end the final result was a further 25.68 decline thereby increasing the importance of this negative divergence.

iShares Transportation Average (IYT) down 3.49 or 2.31% for the week this ETF tracks the important Dow Jones Transportation Average Index measuring the performance of transportation sector US equities and considered a leading economic indicator. According to the widely followed Dow Theory, the transports and the Dow Jones Industrial Average should move in the same direction while divergences signal a possible trend change from a Dow Theory perspective.

After rising up to meet the active downward sloping trendline last Tuesday any chance of a further advance was rebuffed Wednesday after a 3.19 point decline reflecting the 2.9% drop of Union Pacific (UNP) that finally closed the week at 96.77 or 4.34% lower.

FedEx (FDX), the other sector bellwether, fared a bit better declining only 3.49 points or 2.31% for the week. While the strong dollar was recently cited as a reason for FedEx decline, it’s harder to make the same argument for the Union Pacific Railroad.

After downward momentum increased, it needs to close back above 152 to challenge the current downward sloping trendline.

US Dollar Index (DX) up 1.40 for the week or 1.49%, with most all of the advance occurring last Tuesday thereby increases the probability that an Elliott Wave five-wave pattern shown in the chart last week may be complete. Based upon seasonal patterns the dollar may continue higher as suggested by Tom McClellan, adding additional headwinds for equities. Since the news over the weekend from Greece to vote on a proposal of reforms that the Greek government rejected as imposing cuts too harsh could result in capital controls along with a global flight to quality favoring the dollar over the euro.

ProShares UltraShort 20+ Year Treasury (TBT) our preferred interest rate indicator was up 3.18 points or 6.52% for the week after reversing last Monday to resume trending higher as long-term interest rates advanced from 3.06% to 3.25%. For the last several months long Treasury bonds have sold off going into the nonfarm payroll reports and since the next one is dueThursday it looks like the pattern will repeat although the current trend is higher adding pressure to equities especially interest rate sensitive sectors and companies. However, expectations for higher rates could diminish by concerns for the situation in Greece resulting in a global quality flight back into Treasuries.

As for using ETF options also consider iShares Trust – iShares 20+ Year Treasury Bond ETF (TLT) 115.23 put spreads with good options volume, reasonable bid/ask spreads and some volatility edge as well.

High IV/HV Ratios

In the Rankers and Scanners section of our home page, we offer the “Top 5 stocks by implied volatility change” as regular feature. Of the four categories included, the high IV/HV ratio is the first alert that something unusual is happening since options prices are being bid up to abnormal levels. From there a little more investigation will usually provide clues as to the reason.

Friday two small capitalization biotechs were at the top of the list.

First was XOMA Ltd. (XOMA) with an implied volatility of 219.28 and a historical volatility of 48.43 for an IV/HV ratio of 4.53, market capitalization 462 million.

In second was Exelixis Inc. (EXEL), implied volatility 178.19 and historical volatility of 51.51 for an IV/HV ratio of 3.46, market capitalization 739 million.

Both are in the red-hot biotech sector that some say is in bubble territory, but recent takeover activity has drawn attention to even small companies that may develop new treatments.

IV/HV ratios in excess of 2.50 usually means the potential for a price move is greater than implied by the option prices especially for low priced small capitalization stocks. In this case, the high implied volatility most likely suggests takeover speculation more than drug announcement news, the usual force underlying high implied volatility in the biotech and pharmacy sectors.

The combination of small capitalization and low stock price often translates into low option volume and wide bid/ask prices and these two are not exceptions, while both traded more than 20K option contracts Friday the bid/ask spreads were so wide they precluded using spreads, with one credit spread exception.

Exelixis expects to make two announcements, one sometime in July, and the other before August 11.

062915EXEL

 

Using the ask price for the buy and mid for the sell the credit would be .13 and needless to say a very speculative position but with less risk than one based upon getting both the direction and timing right.

Strategy Ideas

Until there is some improvement in market breadth and DJ Transportation Average divergences adding hedges until the Greek situation is resolved along with more clarification about rising interest rates continues to be the prudent plan.

Accordingly, updated SPY put spreads ideas follow.

SPDR S&P 500 ETF (SPY) before expenses generally corresponds to the price and yield performance of the S&P 500 Index.

The two suggestions made a few weeks ago would have been closed out according to the trade plan when SPY exceeded the SU (stop/unwind) high of 212.09 closing at 212.78 on June 18.

Here are two replacements,

The current Historical Volatility is 9.24 and 7.23 using the Parkinson’s range method, with an Implied Volatility Index Mean of 12.14 down from 12.40 the week before. The 52-week high was 23.25 on October 15, 2014 while the low was 8.10 on July 3, 2014. The implied volatility/historical volatility ratio using the range method is 1.68 so option prices are relatively high compared to the recent movement of the ETF. Friday’s option volume was 2,998,141 contracts traded compared to the 5-day average volume of 2,059,100 contracts.

July put spread,

062915SPY1

Using the ask price for the buy and mid for the sell the debit would be .61, about 20% of the distance between the strike prices, with a volatility edge and with slightly positive Vega of .0322 since implied volatility will likely rise when SPY turns lower positive vega adding some additional edge. Use a close back above the last pivot high at 212.78 as the SU (stop/unwind).

Here is an alternative with more time to expiration meaning less time decay.

062915SPY2

Using the ask price for the buy and mid for the sell the debit would be .76, about 25% of the distance between the strike prices, with a small volatility edge and with slightly positive Vega of .0239 since implied volatility will likely rise when SPY turns lower positive vega adding some additional edge. Use a close back above the last pivot high at 212.78 as the SU (stop/unwind).

Since the news from Greece over the weekend will likely cause a gap lower opening that could be the trigger for a further decline based upon the Head & Shoulder Top or Rising Wedge patterns described above, adjust the strike prices lower maintaining 3 to 4 point spread between them.

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 ETF price change.

Summary

From a technical perspective along with market breadth and DJ Transportation Average Index divergences the market outlook continues to deteriorate and when combined with the seemingly never ending uncertainty about Greece along with rising interest rate concerns the risk of an overall market decline remains high so consider hedging any remaining portfolio risk.