Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
Please read IVolatility Trading Digest™ Disclaimer

Introduction

In this first issue of IVolatility Trading Digest™ we want to introduce a methodology of trade selection and analysis. Our purpose is to offer some ideas that will help you made money using IVolatility. We will also use some other tools that are easily available with an Internet connection. Not a lot of complicated math formulas but good trade management. In addition to Volatility we use fundamental and technical analysis tools to increase the probability of success and reduce risk. We prepare a written trade plan defining why the trade is being made, what we call the "DR" (determining rationale) and the Stop/unwind, called the "SU".

IVOLopps™

In this section which we call IVOLopps™ (IVolatility Opportunities) we will focus on recommendations that should be made now, or Action Now! For many event driven opportunities volatility will be abnormal for very short periods of time so action is recommended without delay. Our assumption is the trade will be made the next day.

IVOLalerts™

Our next section we call IVOLalerts™ (IVolatility Alerts). These recommendations require some additional time before being made. Often we will be waiting for confirming fundamental or technical developments before making these trades.

Current Volatility Condition

Before we get to specific recommendations let’s set the volatility stage by a review of the current condition of the equity markets.

With a quick scan of the above you can see that we are near the lower end of the one and five year ranges and that the current trend is lower, suggesting that option premiums are fairly low. Analysts debate the causes of low volatility and cite global economic stability and declining inflation, financial innovation and the ability to transfer risk, improved central bank management and transparency, along with more premium sellers in the market seeking income, as some of the causes. Look at the Stock Sentiment Analysis below:

Fig. 1 VIX Sentiment Analysis

In addition, take a look the 5 year chart of the VIX with some moving averages. See below:

Fig. 2 VIX 5 years price

This current condition favors strategies that are biased toward long volatility or those that are near delta neutral.

With this background set let’s see what opportunities are available.

Cash Covered Short Puts

One of the better long strategies is to sell puts. If you sell something with a negative value the result is a net positive. The risk is the put will be in the money at expiration and you will be assigned the stock. If you sell expensive puts on stock that you would like to own you have the opportunity to buy it at a discount. The key to this strategy is to be certain that you would be comfortable with the stock. Check the fundamentals and the technical condition. In the event you are put the stock you will then have an opportunity to sell out-of-the- money calls against your long stock. Often when this happens the market implied volatility of the calls you are then selling are higher than the puts you originally sold. Let’s see what we can find using IVolatiltiy tools.

Using 'The Strategist' Scanners (see left margin under "My Services") select the second tab labeled Naked Put Scanner. Select New Profile and then complete the Scan Criteria by answering the questions. For the expiration period enter Min: 30 with Max: 60. Options with less than 30 days to expiration usually have very little time premium and are not worth selling. On the other hand, options with more than 60 days to expiration have not yet started their most rapid time decay. Therefore, Min: 30 and Max: 60 is just right. The next question asks for returns to expiration or annualized. Leave it set at to expiration. Then for dividend yield range enter 0 Min and 20 Max. For option price range use .50 Min and 5 Max. For underlying stock price range enter 5 Min and 50 Max. You could enter a higher Max but remember you should be prepared to buy the stock if and when it’s put to you. For most of us the recommended range Max is 50. Next leave the 'stock to exercise price relationship' boxes blank. For the percentage difference for purchasing the stock if put enter 10 Min and 100 Max. If we get put the stock we want to have at least a 10% difference. For if the put expires worthless (%) use 10 Min and 500 Max. For the IV Index 30d to Historical Volatility 30d ratio enter 10 Min and 500 Max. For the last 3 boxes you have some additional selections. The number of results should be set at least 50 to 100. At the bottom set the Filter to the markets you prefer. Start with All USA. Next enter a profile name in the very first box before selecting Add & Search.

Fig. 3 'The Strategist' Naked Put Scanner profile

Naked Put Scan Results

When we ran this scan we found 42 companies with a total of 50 different put sale candidates. Our next task was to go through them and look for ones that have acceptable fundamental and technical conditions. Remember you should be fully prepared to buy the stock. Several candidates offer good opportunities, one that seems to stand out is Whole Foods Market (WFMI) $44.67 One reason is that the 30 day Historical Volatility is 24.37 and the Market Implied Volatility of the March 40 puts are 42.19. While priced at .71-.75 the puts don’t seem that expensive, but in Volatility terms they have an edge. If we sold the put for .72 and it was exercised we would then have a basis in the stock of $39.28. Since this stock began selling off in November of last year the low has been $42.13. See the chart below (from the Sentiment Analysis screen).

Fig. WFMI 6 months price chart - Sentiment Analysis service

Last year Whole Foods was a darling of Wall Street trading above $60 per share. Then management warned that they would not be able to maintain the rapid rate of growth and the stock was dumped. Many believe that is still a premier retail company and fancy grocery store serving the luxury market and still growing revenue at 20%. It appears to be a well managed company with little risk of going out of business. Many of us wanted to own it last year when it was accelerating to the upside. Now is our chance to buy it at a discount. Before selling the put however we want to further increase our odds of success by waiting for the stock to start rising again. Though the Sentiment Analysis suggests that the stock is still in downward trend, the RSI indicator shows that the stock been oversold for some time and it is possible that the trend is about to revert:

Fig. 5 WFMI Sentiment Analysis - RSI indicator

So let’s consider WFMI for our IVOLopps™ list for Monday morning.

Trade Plan

The trade plan is to sell one or more WFMI Mar 40 Puts FMQOH .71-.75 MIV 42.19.

DR: A quality company that has been oversold. Selling puts gives us an opportunity to acquire the stock at a lower price or earn the put premium. The stock has been oversold but is now turning upward. We are fully prepared to take the stock if it’s put to us. We would then sell calls against the long stock.

SU: Close below $40 would cause concern, if we were long stock even though we would have sold calls against the long stock. In this event we would purchase a put and convert our position into a collar.

IVolatility Trading Digest™ Disclaimer
All prices and data are based upon closing prices as of February 2, 2007. Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the recommendation, as the prices are likely to change on the next trading day. Make sure to due your fundamental and technical analysis work along with a realistic evaluation of position size before making a commitment.