Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
After three weeks of trading in a narrow sideways consolidation with declining momentum, the S&P 500 Index broke out to the upside after the better than expected non-farm payroll report on Friday. Of the two alternatives considered last week, it seems the least likely prevailed. More details follow along with our regular update for the VIX futures premium followed by trade idea to consider for NVIDIA Corp. (NVDA)
S&P 500 Index (SPX) advanced 9.27 points or +.43% for the week for the week gaining +18.62 points Friday after the non-farm payroll report breaking out to a new closing high, although it has yet to retest the previous breakout above the June 8 high at 2120.55, as upward momentum resumes.
CBOE Volatility Index? (VIX) declined another .48 last week and now back near the low made last year on August 5, 2015 at 10.88. Interestingly 20 days later it reached an intraday high at 38.06.
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 August monthly expiration, the day weighting applied 35% to August and 65% to September for a 27.06% premium shown above. Our alternative volume-weighted average between August and September regularly found in the Options Data Analysis section on our homepage was slightly lower 23.02% while the open interest weighted premium was 22.38%
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.
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.
Based upon the principal of regression to the mean, as the VIX goes lower the VIX futures open interest increases, this week adding another 20,518 contracts or 3.97%. Options on the futures experienced an even more dramatic change as volume increased 60% with open interest increasing 13% for the week. The obvious issue here is one of timing, as values for both will decline as expiration approaches so only those with substantial long portfolios are willing to pay the cost of hedging with VIX futures and options.
Strategy Ideas
Once again, the S&P 500 Index confounded the bears relying on comparisons to previous price-to-earnings ratios or any number of other fundamental valuation measures as well as traditional technical analysis methods, as it broke out to a new closing high. Now in the dog days of summer, the hottest days of the year in the Northern Hemisphere, between July 3 and August 11, not typically a seasonally strong time of year for equity markets, perhaps the time has come to consider making hay while the sun is shining and don?t fight the tape. The bears say it defies gravity, so sell everything and they may be right, but until something significant changes sentiment, equities appear headed higher.
Accordingly here is an earnings idea based upon the premise upside momentum continues.
In the Rankers and Scanners section on our home page, we offer the ?Top 5 stocks by implied volatility change? as a 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. A little more investigation will usually provide clues as to the reason. From Friday, number 5 in the high IV/HV category follows.
NVIDIA Corp. (NVDA) up 1.10 points or +1.93% for the week and up 7.35 points or +14.45% for the month with a well defined upward sloping trendline from the May 12 earnings report date after it gapped up on the open. The second quarter earnings report is due Thursday August 11 and there is a reasonable chance it will gap up once more as it has for the last four quarters if the earnings estimates are again too low and thereby claiming the well-deserved title of “the great gapper.”
Although not included in this quarters Volatility Kings,?it does occasionally appear when attention is focused on the semiconductor sector.
Consider this call spread and or call spread – put combination alternative.
The current Historical Volatility is 28.95 and 22.14 using the Parkinson‘s range method, with an Implied Volatility Index Mean of 47.97 down from 48.89 the week before. The 52-week high was 66.61 on February 12, while the low was 26.49 on May 20. The implied volatility/historical volatility ratio using the range method is 2.17 so option prices are high relative to the recent movement of the stock. Friday?s option volume was 39,023 contracts with the 5-day average of 26,140 contracts with reasonable bid/ask spreads. First the September call spread.
Using the ask price for the buy and mid for the sell the call spread debit would be 1.51 about 30% of the distance between the strike prices with 42% of the long price risk hedged by the short call, but without implied volatility edge.
Adding a short put takes advantage of rising implied volatility that will most likely decline after the earnings report as shown in this one-year volatility chart with the last four quarters earnings report dates marked with arrows:
For the put sale, the IV/HV ratio is 2.91. Using the bid price, the combination cost is .01, but there is margin to consider for the short put along with the downside risk in the event the stock declines more than the implied volatility indicates. If so, the plan is to receive the stock by assignment and then sell calls against the assigned long stock while the implied volatility remains high.
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. The put sale uses the bid price. Monday?s option prices will be somewhat different due to the time decay over the weekend and any price change.
Summary
Despite high valuation using historical fundamentals, the S&P 500 Index broke out to the upside and appers headed higher although August is seasonally weak and a good reason to continue limiting risk by using trade plans with limited and well-defined risk.