Volatility Trading Digest - Strategy & Hedging Suggestion
Volatility Trading Digest - Strategy & Hedging Suggestion
Strategy
Interrupted only a few times like the brief flash of optimism on a short-lived improvement in market breadth, we have been documenting the divergence between this important indicator and the NYSE Composite Index since Digest Issue 9 on February 27. The second important divergence occurred on April 2 as the SPX made a high of 1422.38, but was unconfirmed by the DJ Transportation Index, using IYT that only reached 93.66 after making a high of 96.13 on March 16. In combination, these two divergences were good early warning signs that were the basis for several hedging suggestions in subsequent Digest Issues. "Sell in May and go away" is clearly the current mood of the markets and until we begin to see a sustained improvement in market breadth, we continue to suggest hedging and/or short positions.
Hedging Suggestion
While the primary driving force for the market decline since early April has been the fundamental deterioration in Europe and the declining euro along with the associated decline in global growth expectations equities are probably better to use for hedging than the euro since it could stabilize on central bank support long before equities reach the bottom. Accordingly, here is another hedge suggestion to add to the crude oil suggestion made in Digest Issue 14 and adjusted in Digest Issue 20 last week.
Along with market breadth, the euro and the US dollar index, we also suggest watching 10-year Treasury note interest rates as any further decline from the current level of 1.70% will continue indicating global economic weakness and even the fear of currency devaluations in the euro zone.
SPDR S&P 500 Index (SPY)
Since we made the case for a SPX decline to 1200 in the section above we will use this objective as the basis for our hedge position. However, because the decline is now obvious to most everyone in the market the stage could be set for short counter-trend rally so we suggest using a put spread instead of the put ratio backspread with the extra long put that could incur time decay in the event a rally occurs.
The current Historical Volatility is 13.57 and 11.33 using the Parkinson's range method, with an Implied Volatility Index Mean of 22.22, up from 17.83 last week. The IV/HV ratio is 1.64 and 1.96 using the range method to calculate the HV. Friday's put-call ratio was bearish at 1.95, in the upper portion of 1.5 - 2.5 range since January where occasional spikes above 2.5 are quick and infrequent. Friday's volume was 4,896,765 contracts traded compared to the 5-day average volume of 3,537,270 contracts.
Here is a put spread to consider for this plan.
With a decent volatility edge and slightly long vega of .0315 with enough time to expiration to allow for a possible counter trend rally this spread has a good risk reward ratio of almost 3 since the risk is 1.30 and the maximum gain is 3.70.
Use a close back above 135 as the SU (stop/unwind).
The suggestion above is based upon last Friday's closing prices using the mid price between the bid and ask. On Monday, the option prices will be somewhat different due to the time decay over the weekend and any price change.
Summary
With last week's decline, the equity market could be oversold and due for short-term bounce, but depending upon actions taken to stabilize Europe, the evidence suggests there is more downside yet to come.
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