In focus: Has volatility returned?


BOULDER, Colo. (MarketWatch) — Our mission is to provide the most practical information for option traders and your questions and feedback allow us to provide relevant information that’s useful. During each issue, we will highlight subscriber questions that most likely represent the masses. Feedback is strongly encouraged. Send your e-mails to david@crosswindscapital.com.

Commentary

It’s too early to say that volatility has returned to the broad market, but it was certainly interesting to see the big swings today, on the first trading day of the new year. See the “Trader’s Insight” section as to why volatility is a welcome thing for option traders. By the way, “volatility” doesn’t necessarily mean “downward,” even though that’s the way it’s often used in the media. Volatility just means rapid price swings — and today we certainly had those.

First, the market bolted out of the box and gapped open higher, based on strong overseas markets yesterday while the U.S. was closed. That rally extended itself to the point where the Dow Jones Industrial Average
DJX,

was up 117 at one point. But by mid-day, the bulls had gotten tired and sellers decided to test the waters. Some large sell programs hit just about the same time that the FOMC minutes from last month’s meeting were released. Frankly, I don’t think the minutes were negative, but the selling was strong, and the Dow plunged 176 points in little more than two hours. By that time, the bulls had found their “buy” buttons, and the Dow rallied back 70 points to finish the day.

The most important technical indicator — the price chart of the Standard & Poor’s 500 Index
SPX,
+0.03%
— remains bullish. Once again, today it fell far enough to touch the trend line that has supported this whole move since June. And once again, it found support there. As long as $SPX stays within that bullish channel, a full-fledged sell signal will not be in effect.

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The other indicators are less bullish however. For example, the equity-only put-call ratios gave sell signals a couple of weeks ago, and those sell signals remain in force. The standard ratio (chart below) seems to show some wavering pattern, while the weighted chart does not. But, in reality, that “wavering” is an artificial force — dividend arbitrage. Last Friday, there was massive call option trading in Bristol-Myers
BMY,
-1.57%,
JP Morgan
JPM,
-0.14%,
and Petrobras Brasil
PBR,
-0.65%,
all which went ex-dividend today. A little more than a week ago, there had been similar action in Altria
MO,
-0.30%.
We would continue to consider both these charts negative as long as they keep rising.(or, if this dividend arbitrage is going to continue to be a factor in the standard chart) as long as the standard ratio doesn’t make new lows.

Market breadth (advances minus declines) has pretty much just been following the market lately: strong on bullish days, and weak on bearish days. As such, it’s not giving us much of a clue one way or the other. The most recent “signal” from breadth came late last week, when overbought conditions led to sell signals.

Finally, the volatility indexes
VIX,
-2.25%
have worked their way higher for three days now. $VIX has closed above 12 for the first time in nearly a month. Three days of rising $VIX is often a bearish signal, so we are grading this indicator as “cautiously bearish” now. But for volatility to really break out on the upside, it needs to close above the December highs, at 12.70.

In summary, the technical picture continues to weaken, but price action continues to be (barely) bullish. The selling that surfaced Wednesday afternoon seemed fairly scary as it spread across the board. As we’ve said before, there isn’t enough room in the exit for this market; if everyone decides to sell at once, they will crush prices in their rush to exit. That almost happened Wednesday. But until it does, the bulls keep the upper hand on this market, even it doesn’t look as strong as it used to.

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For the record, $SPX is up 5.96 points since the Santa Claus rally started — hardly an astounding gain, but with one day left to go in the Santa Claus rally period, it looks like it will finish bullish again this year.

Recommendation: Goodyear Tire (GT)

This stodgy old industrial stock has broken out to the upside, trading at multi-year highs on strong stock and option volume. Unfortunately, Goodyear Tire’s
GT,
+2.02%
probably gotten a bit ahead of itself, but we’d like to buy calls on a pullback.

IF GT trades at 22 or lower, THEN Buy 5 GT Feb 20 calls at the market at that time.

GT: 22.80 — Feb 20 call: 3.30 offered

If bought, stop yourself out on any close below 20-1/2.

Recommendation: CDC Corp. (CHINA)

Chinese stocks have been all the rage lately, as the group has been the stellar performer of the last few weeks. Some of these stocks and their options have become the object of rampant speculation (China Life Insurance – LFC – for example). We are going to select a less spectacular stock, CDC Corp.
CHINA,
+0.26%,
for it is bullish but not overdone yet. Stock and option volume patterns have been strong here as well.

Buy 6 CHINA Feb 7.5 calls at a price of 2.35 or less.

CHINA: 9.64 — Feb 7.5 call: 2.35 offered

Stop yourself out if CHINA closes below 8.70.

Trader’s Insight: Why volatility is a good thing

As option speculators, volatility is good for several reasons. Remember that higher volatility means higher option prices — for both puts and calls. So any positions we already have in place would benefit from an overall increase in volatility — i.e., an increase in option prices.

Any new positions we might buy would cost more, of course, but with increased volatility there would be increased chances for larger returns. Would risk increase? Yes, it would to a certain extent, but option buyers have limited risk, so the increase in profit potential should more than offset the increased risk that comes with paying a higher initial price for a more expensive option.

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More expensive options help in other areas as well — for example, if the underlying stock should fall and hit our mental stop. The more implied volatility that is built into the option when that happens, the more we will be able to recoup from the sale of the option.

And finally, a volatile market is just more fun. It’s a lot more interesting to watch prices move sharply than to sit through a dull, slowly trending market like we’ve seen in recent weeks.

Follow-Up Action

All stops are mental closing stops unless otherwise noted.

CTL Jan 40 calls (CTLAH): the stop remains at 42-1/2.

SCHW Jan 17.5 calls (SHQAW): raise the stop to 18.70.

SEPR Jan 60 calls (ERUAL): we rolled up into these calls last week. The stop remains at 59.

FMD Jan 50 calls (150 shares per options) (FWYAJ): the stop remains at 52.

MOVI stock: the stock was stopped out on Dec. 28.

SPY Feb 143 puts (SFBNM): aggressive accounts continue to own a partial position in these put. IF SPY should close below 140 then triple the size of your position. Meanwhile, the stop for the puts that are currently owned remains at 143.25, basis SPY.

PH Jan 80 puts (PHMP): we took a partial profit on 40% of our position last week. Lower the trailing stop to 79-1/2.

FDX Feb 110 puts (FDXNB): we bought these options last week. The stop remains at 122.

BG Feb 70 call (BGBN): we bought these calls last week. The stop remains at 70.

All stops are mental closing stops unless otherwise noted.

Q&A

Send questions to: david@crosswindscapital.com

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