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

Introduction

Our purpose is to offer some ideas that will help you make 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 Market Volatility

Market implied volatilities appear to be turning higher.

The change is most noticeable in the VIX and reflects the relative poor performance of the market on Friday. It may be too soon to declare the start of an upward trend in volatility but remember we are near the lows and we should be aware that the change could start at any time.

If we are concerned about the potential of an increase in volatility, we should be looking for opportunities to be long options in order to benefit from the rise. We are also aware that increases are associated with declining prices. This may very well mean risk exposure for other long portfolio holdings.

Can we use an increase in volatility as a portfolio hedge? Keep in mind that it’s better to buy fire insurance before the fire starts.

IVOLopps™

Long Straddles

A long straddle consists of a long call and a long put with the same strike price and expiration date. While they benefit from changes in volatility, they lose value each day through time decay. Therefore, selection of the time frame is an important concern. In addition, we want to select the options that have the most sensitivity to changes in volatility or Vega which are the at-the-money (ATM) options.

So with these thoughts in mind let’s go see if we can find some bargain priced portfolio insurance.

Look in the left column under My Services for Spread Scanner, and see below:

Fig. 1 Spread Scanner position selections (Long Straddle)

At the first box, scroll down to Long Straddle. One the same line at the far right you will see "Service Guide" with the PDF icon. If you have not yet printed this, you should do so as it provides comprehensive instructions for using the Spread Scanner. In "Position Selection" Both leg indicators will be highlighted as buying a call and a put. Now at the "Expiration" box scroll down and enter Jun07. Remember we don’t want to have time decay concerns and this will cover the risk of another spring sell off similar to last year. For "Moneyness" select ATM, as we want the best response to increases in volatility. In the "Position Criteria" section, debit will already be selected.

Next, we will scroll over to the right and complete the Stock Selection section. See below:

Fig. 2 Underlying filtering - Stock Selection area

For "Group Selection" scroll down and find --- All ETFs. Of course, you could make other selections but or objective is to find a broad based index so we don’t compound complexity with specific stock events. In "Relative volatility" scroll down and enter: "Any". Next, in the "IV in 52 Week Range" scroll down and enter: "Cheap". Now in "Filter by" enter 100 for Options Volume and 5,000 for Open Interest. We want to eliminate those that are too thin and not practical to trade. Use the preset default values for the remainder of the selections. Next, select the Save & Search button.

Your result should be as follows:

Fig. 3 Long Straddle Search results

See the 12 candidates above.

Now we need to make just a few more decisions. In the 13th column you will see "Position Price ($)", the price for one Straddle. For the higher priced indexes, the Straddles will cost more. For example, 1 Jun EEM, number 3, will cost $14.00, while 1 Jun EWJ, number 6, is only $1.275. Here we have two considerations, the first is position sizing and the other is correlation with the market.

Neither the EEM, the Emerging Markets ETF, nor EWJ, the Japan ETF, provide us with our desired correlation with the US Market. Further refining the selection look at column 8 "Relative Volatility (IVX/HV)". The lower this ratio the better as it indicates greater probability of the option’s implied volatility to follow the changes in the historical volatility of the index. Less than 1 would be best, and give us the most edge, and in fact, there is an index with the value of less than 1 at .89, EWC the Canada ETF.

However, it is not suitable for the US market, but would be a good selection if you were holding many Canadian stocks. QQQQ, number 11, with relative volatility at 1.23 would be a good consideration as it has gigantic volume and open interest. They would cost $3.67 for each Straddle and have an 88% correlation with the S&P. Another that may give is the same result at a lower cost would be XLK, the Technology SPDR at only $1.725 per Straddle. Here the correlation is 85%. See correlations below (The correlations are at the bottom of page in the Stock Sentiment Analysis in the Stock Sentiment section):

Fig. 4 QQQQ Correlation again major market indices

Fig. 5 XLK Correlation again major market indices

Using the XLK will give us the opportunity to increase the number of Straddles without materially increasing our total commitment. For a total of $872.50, we can purchase a 5 lot, which may come in handy for future adjustments and allow us to scale out of the position if required.

Trade Plan

The plan is to buy 5 Jun 24 Straddles XLK.

Buy 5 Jun 07 24 Calls XLKFX .75-.85 MIV 15.88
Buy 5 Jun 07 24 Puts XLKRX .85-1.00 MIV 13.62

Based upon closing prices Friday 2-09-07 the Straddle would have been 1.725 each. The position delta per Straddle is -0.0823 for a total of -.4115

DR: This is a volatility trade with a slight negative bias. The primary objective is to benefit from an increase in market volatility over the next several weeks. If the volatility does not increase or in fact declines from current levels then the position size will need to be reduced. It may take some time for volatility to increase. Some patience may be required. The options expire in 124 days but we will not want to hold them for more than 90 days. If we do not get the desired result in this period, we will adjust the position. This can be used as hedge trade for other longs.

SU: If IV declines again to below 14 on a closing basis for QQV, the volatility index for the Nasdaq 100 then scale out of the Straddles, one per day for each day the index closes below 14. ALTERNATIVELY, if the desired increase in IV does not materialize in 60 days then start to scale out at the rate of one Straddle per week until the position is closed.

IVolatility Trading Digest™ Disclaimer
All prices and data are based upon closing prices as of February 9, 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.