Tuesday, August 31, 2010


In continuing with the technical analysis theme laid down yesterday I wanted to make a few observations regarding the state of the S&P 500 Index. It strains the obvious to point out the significance of the 1040 level over the past year. Disregarding the short lived breach in July, it has held steady as a key line in the sand denying bearish advances time and time again. As the market action has become more and more erratic in recent days, it's been interesting to watch the interplay between the bulls and bears surrounding this pivotal level (click image to enlarge).

Source: [MachTrader]

Notice the sharp rallies quickly following each bearish attempt to breach this support level.
Were we to view these skirmishes using the SPY coupled with volume, you'd also notice a sizable amount of volume rising up during these engagements. Suffice it to say, the bulls are proving quite resilient and quick on the trigger in defending their turf. However, with each additional attempt at cracking this level, the resolve of the bulls is likely fading.

When and if the bears finally succeed (I'm in the "when" camp for what it's worth), this demarcation line will stand as yet one more victim, albeit the largest to date, to the current deterioration of the market.

For related posts, readers can check out:
On the Brink
Lines in the Sand
State of the Market

Monday, August 30, 2010

It's All Relative

In sizing up the equities landscape, one tool that has proven indispensable is a relative comparison chart. While one can usually determine the strength or weakness of various slices of the market simply by assessing sector and industry ETF's, it can prove rather cumbersome to sift through each chart individually. Relative comparison charts not only provide a quicker, more simplistic alternative, they often offer up the data in a manner which allows more meaningful conclusions to be drawn.

In the past I have used the simple charts offered within Yahoo! Finance's website. However, since catching wind of the impressive free tools offered at ETFreplay.com (hat tip Bill Luby), I've spent the bulk of my relative comparison efforts there. If we wanted to determine which major US sectors have been leading the downturn over recent weeks we could select the sectors in question and view how their performance has stacked up. The following chart displays the relative performance of the technology, energy, financial, consumer discretionary, and materials sectors over the past month (click image to enlarge).

Source: [ETFreplay.com]

Within this time frame, Financials have been the notable underperformer. If you subscribe to the notion that weakness begets weakness, you'd probably be well served by avoiding bullish trades in this sector and perhaps looking instead for bearish plays.

For related posts, readers can check out:
A Primer on Relative Performance
Comparing Apples to What?
Chinks in Small Cap Armor

Wednesday, August 25, 2010

Fading Away

The recent sell off in the equities market has ushered in yet another uptick in fear. During the past few weeks, the CBOE Volatility Index (VIX) has surged over 30%. While the increase in pessimism and insurance premiums may have investors cursing the market, you can bet volatility traders are looking at this as a visit from good ole' Mr. Opportunity once again coming to knock on their door. These traders are likely taking a contrarian viewpoint by seeking opportunities to fade the volatility extremes that have recently cropped up.

So, how might those who have been bit by the contriarian bug go about gaming some mean reversion in volatility? Well, take your pick. Nowadays we've got a smorgasbord of volatility products to play with. You could dabble with bearish plays on the VIX or VXX; or perhaps try out the newer inverse volatility product- the XXV. Of course, since the VIX is simply a reflection of implied volatility on S&P 500 options, you could try your hand using options on the SPX or SPY which afford bearish volatility exposure such as short put spreads or put ratio spreads.

Traders electing to take the S&P option route also need to consider their outlook on the underlying Index as it is possible to enter short volatility plays that provide either bullish, bearish, or neutral exposure. One of the strategies I've mentioned in the past which profits from a decline in implied volatility as well as neutral to mildly bearish movement in the underlying is the put ratio spread.

Suppose you purchase the Sept. 100 put for $1.15 while simultaneously selling three Sept. 97 puts for $.70 apiece. The net credit comes out to $.95. Consider the risk graph below modeling the effect a drop in implied volatility has on the PnL of the position (click image to enlarge).

Tuesday, August 24, 2010

Rolls... Fresh Out the Oven

Owning profitable positions always presents a dilemma of sorts. When things are going your way, do you double down and press the issue or ease off the gas a bit and exercise caution? In the past I've continually touched on the fortes of adjusting a position to reduce risk and potentially lock in gains. This provides a palatable alternative to those desiring to proceed with caution yet not wanting to completely close their position. Utilizing the bear playbook highlighted in yesterday's post, let's highlight one such example.

Suppose after the SPY broke below the 50 MA earlier this month you decided to up the ante on the bear side by actively seeking out low risk high reward trade setups. The retracement that occurred from 8/16 to 8/18 presented just such an opportunity. Let's say we purchased two Oct. 110 puts for $4.91 ($9.82 total) to exploit the anticipated sell-off. Given the recent bearish extravaganza, the put options have increased in value to $6.65 yielding a tidy $1.74 profit ($3.48 total). Consider the current status of our position illustrated below (click image to enlarge):

[Source: MachTrader]

Rather than staying the course or increasing our bets, suppose we take this morning's bloodbath as an opportunity to lighten up a bit by rolling our long puts into put spreads. We could sell two Oct 105 puts for $4.02 ($8.04 total) effectively morphing our position into a long put spread. Consider the updated position taking note of the overall change in risk and reward:

Though we've cutoff our unlimited profit potential, we still have the ability to double our current profits. We've also succeeded in dropping our risk capital from $982 to $178. Those actively playing with puts would be well served by familiarizing themselves with the advantages or rolling to spreads.

On a side note, the current surge we're experiencing in volatility maybe close to setting itself up for yet another fade.

For related posts, readers can check out:
Rollin with My Puts
Hedging with Calendars
Adjustment Thinking and the Salvation Syndrome

Monday, August 23, 2010

What's the Game Plan?

Over time traders are exposed to varying trading styles and strategies. While one could attempt to utilize every technique, most settle into a consistent routine with a few favorites. Though there are a variety of factors that ultimately influence which trading style trader's adopt, identifying one's niche boils down to personal preference, risk tolerance, and what I would call the success factor. I suspect most traders, like me, gravitate towards those strategies which consistently deliver. In other words, we use the strategies that have proved the most fruitful in the past. If it's a trading technique that fails to deliver after multiple attempts, I'm not afraid to toss it in the thanks but no thanks bucket and move on. While I'm always on the look-out for new ideas, I'm not on a quest to clutter my toolbox with unworthy, fruitless strategies.

I'm continually tinkering with better ways of organizing my play book. One preferred approach is to break it down into trade setups and strategies of choice. The graphic below displays my current method of choice for arranging my bear toolbox. I've not only identified the trading patterns of choice, but also the strategies used to exploit these trading opportunities.

The end goal and ultimate litmus test for any market participant is consistent profitability. Reason will tell you consistent results necessitate a more systematic, structured approach. If you're lacking structure, consider today's post just one idea of how to begin the process.

Tuesday, August 17, 2010

Expiration and the Resolution of our VIX adVentures.

This morning's opening prints ushered in the settlement value for August VIX options. While the VIX opened at $24.30, settlement came in a bit higher at $24.82 (click image to enlarge).
[Source: MachTrader]

In last week's Tale of the VIX and Mr. Upper B., we outlined the antagonistic past between these two foes, noting their inability to reside in the same place at the same time for extended lengths of time. The Fear Index once again followed the fairly predictable path of least resistance by retreating to its turf in the "meat" of the bollinger bands. While a continued sell-off in equities may cause yet another run-in with the upper bollinger band over the coming weeks, the ebb in fear experienced over the past few days was sufficient to deliver a winner for the suggested bear call spread.

By settling in the 23 to 24 area, our 27.50 - 30 bear call spread expired comfortably out-of-the-money. Those unwilling to brave all the settlement drama could have simply closed the spread yesterday at $.05, thereby locking in the majority of the gain.

For related posts, readers can check out:
Fading Complacency
VIX Expiration and Term Structure
VIX Options Laid to Rest as the Cash Springs to Life

Monday, August 16, 2010

Rough Seas Ahead?

In July's trio of posts, The Nifty Fifty, The Effectiveness of the 50 MA, and It Was the Best of Times, It Was the Worst of Times, I explored using the 50 day moving average to generate intermediate term long/short signals on the SPY. Though it experienced the occasional whip-fest , it proved quite beneficial over the long run. Due to the trending nature of 2010, the 50 MA has done a commendable job in positioning its followers on the right side of the trend thus far.

With the recent weakness in equities, we've seen another potential sell signal based on the 50 MA. The reason I say "potential" is because it really depends upon your filter. In outlining the initial strategy I mentioned we want to see a break of 1+% of the 50 MA before declaring it an official break. The idea is to avoid whipsaw by flipping your position too frequently based on noise. Given that the most recent 1% probes below the 50 MA have occurred during the opening of the market on sizable down gaps that have been immediately bought up, I'm biding my time before I call this a genuine sell signal.

[Source: MachTrader]

If another April to July type downdraft is in the cards, those heeding the most recent break of the 50 are going to be well-rewarded. On the other hand, if the SPY quickly reclaims the 50 MA and we turn into sideways chop city, this particular signal may not turn out as lucrative as some of the others in the past.

Friday, August 13, 2010

The Tale of the VIX and Mr. Upper B.

After a six week absence, the VIX has once again decided to pay a visit to its dear old friend Mr. Upper Bollinger. On the tails of a rapid two day 4% plunge in the S&P 500 Index and the constriction of Bollinger Band width, the encounter shouldn't be that surprising to those monitoring the touch and go relationship between these two pals.

Come to think of it, perhaps I've got part of this metaphor all backwards, as these two completely inanimate variables which I'm so heartily trying to anthropomorphize aren't so much friends as they are enemies. It seems they are hardly ever comfortable residing in the same location at the same time. Matter of fact, with the recent exception of May, virtually all of their confrontations turn into short lived skirmishes ending with the VIX returning, often speedily, to its home between Mr. Upper and Lower B. Consider the following chart highlighting the last ten run-ins of these two foes (click to enlarge).

[Source: MachTrader]

With yesterday's exhaustion gap on the S&P 500 and subsequent pop in the VIX, might it be time to bet on a bit of mean reversion? Given the VIX's historical tendencies, it seems we have probability on our side. With August expiration for VIX options comin' round the corner, front month options lend themselves to some interesting short term plays. How about selling an Aug 27.50-30 bear call spread for $.50? Risking $2.00 for a $.50 payout over three trading days isn't too shabby in my book. Provided the VIX settles below $27.50 next Wednesday morning, both calls should expire worthless resulting in the realization of max profit. But, who am I kidding. I never ride to expiration so I'd likely bail upon capturing the majority of the gains.

Those convinced the VIX's little run in with Mr. Upper B is likely to linger would obviously want to pass up the play. On the other hand, if you think the market sell-off is due for a pause or perhaps a bit of a rally back, this may be a strategy worth considering.

For related posts, readers can check out:
VIX Options
Settlin' Them VIX Options
A Volatility Inflection Point
Lessons Learned From a VIX Put Matrix

Thursday, August 12, 2010

Viewer Mail - Long Call/Short Put Combo

Hey Tyler,

I'm long term bullish on TM and think most of their issues are over and they make a great product. What are your thoughts on selling some short term puts (Aug or Sept. 70) to help buy a LEAPS call like the Jan 2011 or 2012 75 or 80 strikes? I then could continue to sell puts each month against the call to generate cash flow?

Thanks, V-

Keep in mind buying a long term call option and selling puts are both bullish strategies. It's not as if the short puts are hedging your exposure on the call or anything. So, I would simply look at your idea as two different bullish strategies. By buying a long term call you're acquiring positive delta. By selling short term puts you're simply acquiring more positive delta. So it's inaccurate to say you're selling the puts "against" the long call. As to whether it's a good idea, it really comes down to how bullish you are.

If TM behaves as expected, then selling puts and buying the call will produce more profits. However, if TM drops in value you'll get hit on both the short puts and the call. Furthermore, the short puts open you up to unlimited risk. It's certainly a legit way to place a bullish bet, but just know there isn't necessarily any distinct advantage to combining a LEAPS call with short puts.

The more popular approach is to sell short term calls against the LEAPS, thereby acquiring negative delta and thus a partial hedge against your long call. This would simply be a calendar spread and works best in neutral to mildly bullish environments. Keep in mind long term calls are very sensitive to changes in volatility making it ideal to purchase them when vol is cheap. For what it's worth, TM implied vol does seem to be on the lower end of it's historical range. Here's a quick risk graph comparison of the two strategies (click image to enlarge).

[Source: MachTrader]

I'll point out two key differences and leave it to you to draw other conclusions. First, the position delta on the long call/short put combo is much higher (96 vs. 30), making it a more aggressive, directional bet. Second, while the calendar spread risk is $600, the long call /short put combo is unlimited.

For related posts, readers can check out:
The Oracle Calendar
The Oracle Calendar Part Deux
Naked Puts vs. Put Spreads

Wednesday, August 11, 2010

Hey Blockbuster, Eat My Dust...

... Love, Netflix.

Normally I don't get caught up in all the fundamental mumbo jumbo as it usually only takes me three minutes of looking at a balance sheet before I start to doze off. Charts, volatility, and market sentiment are more in my wheelhouse. But, I'd be lying if I said I haven't developed a great deal of curiosity with NFLX and it's veritable take-over of the movie rental industry. All it takes is one look at their stock chart to determine they've got some major mojo going on.

In a long line of goodies for the bulls, NFLX has delivered yet again:
Netflix Inc.has announced a deal, reportedly worth $1 billion, to bulk up its increasingly popular Internet streaming service with Hollywood blockbusters such as "Star Trek," "The Curious Case of Benjamin Button" and "The Godfather."

"What's exciting here is it really reaffirms that the Internet is a serious delivery channel," said analyst Colin Dixon, a senior partner for the research firm the Diffusion Group. Netflix has really been the catalyzing force on the market and it has illustrated very graphically that consumers are very comfortable consuming quality content directly from the Internet and in some respects, it's their preferred medium."

Published reports on Tuesday said the deal between Netflix, the Los Gatos firm that has built its business mailing rented DVDs to its subscribers, and Epix, a pay-TV service that is a joint venture between MGM, Lionsgate and Viacom Inc.'s Paramount, is worth $1 billion in licensing fees over the next five years.
One would have thought with the poor reaction to their quarterly earnings announcement on July 22nd, it may have been time for NFLX to pay the piper for their 400% gain over the past two years. Well, not so much. The good times continue to roll.

As is typically the case post earnings, implied vol may have put in a cyclical bottom last week making options a tempting buy. Due to yesterday's news and no doubt an uptick in demand for options we have seen vol pick up a bit.

[Source: Livevol Pro]
For related posts, readers can check out:
The Cycle of Implied Volatility

Tuesday, August 10, 2010

Stock Replacement Strike Selection

In Steven Sear's recent column How to Avoid Seller's Remorse, he expounds on some alluring advantages to the stock replacement strategy. One key takeaway is the drastic reduction in risk that occurs when one switches from stock to options. Yet another is the fact that options are relatively inexpensive right now given the VIX's steady decline toward the 21 level. I received a question regarding how one might go about selecting strike prices when implementing the stock replacement.

While there may be a few different tactics for deciding the optimal strike price, perhaps the easiest and most direct is to approach strike selection from a delta perspective. Since delta can be used to determine equivalent stock and option positions, it is particularly helpful when assessing which strike price provides the ideal outcome. Suppose you purchased 100 shares of AMZN at $122. Given its recent rise to $128, you're sitting comfortably on a $600 unrealized gain. In addition, your position's delta is +100. Suppose you wanted to replace your long stock position by purchasing a January 2011 call option. Consider the following two choices - a 100 strike call and a 140 strike call:

[Source: MachTrader]

While the deep ITM call costs more ($3200), you gain a higher delta (+84) making the position a closer equivalent to the shares of stock. Furthermore, the majority of what you paid is intrinsic value and will remain in the option so long as AMZN doesn't drop.
Though the OTM call is much cheaper ($730), you acquire a lower delta (+39). The ITM call was the theoretical equivalent of owning 84 shares of stock, the OTM call is the equivalent of owning 39 shares of stock. Since the call strike is 140, 100% of what you paid is extrinsic value and will incrementally erode away if AMZN doesn't rise past $140 by expiration.

In summary - if you want the call option to behave in a similar fashion to your stock position, buy an ITM higher delta option. If your focus is rather on reducing the amount of risk capital in the trade and you don't mind traversing the cheaper, lower probability route, consider OTM options. I suspect most traders reside somewhere in between.

For related posts, readers can check out:
The Replacements - As Good as the Original?
Stock Replacement Redux

Monday, August 9, 2010

Flys... of the Butter Variety

Let's take a brief stroll down memory lane to last Thursday. With the jobs report coming across the wires on Friday morning, the day prior would have been an opportune time to take some money, and perhaps more importantly, risk off the table. Particularly on positions that had behaved well and accumulated notable profits. The OIH bullish risk rocket outlined in last week's Bulls Bid-up Black Gold post may have been one such position, so let's walk-through a strategic adjustment.

The initial trade involved purchasing 100 shares of OIH at $107.35 and two September 115 calls for $1.95 apiece. The underlying rationale for the play was to exploit further upside movement in the oil services space based on the breakout of an ascending triangle two months in the making. The original risk graph is displayed below:

[Source: MachTrader]

While the OIH didn't rise high enough to reach our initial target of $110.35, it had accumulated enough profits to merit an adjustment. As previously explained in Evolution of a Bullish Risk Rocket, common adjustments for the risk rocket include rolling to a call spread, butterfly, or condor. Given the fact that I believe the odds of OIH breaching $120 by September expiration are slim, I opted to roll into the 115-120-125 butterfly versus a simple 115-120 call spread. Since the butterfly involves selling twice as many 120 calls it brings in a higher net credit thereby locking in more gains versus the simpler 115-120 call spread.

To fully grasp the drastic risk differential between the initial risk rocket with the post adjustment butterfly, consider things from a delta perspective. Due to the aggressive nature of the risk rocket, its position delta was relatively high at +160. Morphing to the butterfly reduced the delta to a mere +10. Even if OIH were to have the bottom drop out of it, the rate at which the position gives back profits has changed from being akin to an open fire hydrant to more of a leaky faucet.

For related posts, readers can check out:
Adjustment Thinking and the Salvation Syndrome
Risk Rocket
Rolling on the Fly

Thursday, August 5, 2010

Odds of Assignment

It's been awhile since I tackled some viewer questions, so here ya go:

I've been trading a calendar spread on VMW by selling short term calls against my Jan 2010 60 strike LEAPS call option. Currently I'm short the Aug 75 call option which has moved notably ITM due to the strong performance of VMW this month. Though the short option had about $400 time value a few weeks ago, it now only has $78. I've done this strategy for awhile and it has worked out nicely, but I haven't been faced with this dilemma. I don't want to close the position, nor do I want to be called out. Am I at risk of being called out? How?

Hey David,

Anytime I want to assess my odds of early assignment (you never really know for sure if it's going to happen), I consider three things: Is the short option ITM? Is it trading close to parity? Is the stock close to its ex-dividend date?

The first question is a no-brainer as no one in their right mind would exercise an OTM option. With VMW residing around $81.10, the Aug 75 call is certainly residing ITM. When we say an option is trading close to parity, that simply means it's trading close to its intrinsic value and possesses little to no extrinsic (time) value. As of this morning I'm seeing it trade for about $6.80. $6.10 of that is intrinsic value, the other $.70 is extrinsic. Based on the $70 remaining, I'd say your odds of assignment are still quite low.

Remember that option owners lose the extrinsic value when they exercise. So if someone owned the 75 call and exercised it, they would effectively be giving up the $70. Consequently, they are better off simply selling the call to close the position. Occasionally if the ex-dividend date is approaching and they want rights to it, investors may opt to exercise the call and buy stock. Thus, you may also want to consider whether an ex-dividend date is looming on the horizon.

Wednesday, August 4, 2010

Rhyme and Reason

Turns out my MasterCard pre-earnings analysis turned out to be spot on ... or not. Despite its historical bias towards rewarding volatility buyers and utter lack of volatility bid-up into earnings, MA still chalked up a win for volatility sellers. This go around the absence of any pre-earnings excitement turned out to be justified as the earnings reaction was a veritable snooze fest. With a mere 1.9% gap down, the reaction turned out to be the second smallest move over the past two years. I've updated the earnings table originally displayed in the For Everything Else There's MA post (click image to enlarge).

After all these musings on MA earnings, traders (including myself) may be wondering if their is really any value added to all the data mining. After assessing past earnings announcements and the volatility landscape, is one's ability to forecast the earnings move really improved? Well, consider the alternative. Suppose instead of the aforementioned educated approach, you simply flip a coin before earnings. Heads you buy volatility, tails you sell.

I gotta say my logic and reasoning rules in favor of the educated approach. Despite the fact that each earnings is unique and seemingly unaffected by past announcements, it is possible to identify a stock's normal price and volatility behavior around this event. I would submit this knowledge of the norm would improve one's chances of traversing the often treacherous earnings season.

Adam Warner of Daily Options Report posed a similar question in his cleverly titled Captain Kirk Dance Party Time. In regards to the accuracy of option expectations pre-earnings he states:

"So no, option players get it right at times....and also get it wrong.....and also pretty much scratch. It's a full range of outcomes.

Why bother looking then?

Well, I do like to see if we get some sort of pattern. Are high profile names getting "overbid" for the most part? If so, it presents some opportunities to net short options ahead of reports."

I like the analysis. The key is lies in identifying some sort of pattern. If one finds a discernible edge, exploit it. If things seem completely random, go golfing.

For related posts, readers can check out:
GOOG, What Volatility Bid-Up?
AAPL Options, A Steal or Too Rich?
The Relativity of Volatility

Monday, August 2, 2010

Bulls Bid-up Black Gold

Though equities were bid-up across the board in Monday's surge, the oil patch experienced notable relative strength. While there are a variety of charts I could cite to adequately display oil's bullish price action, I've settled on the Oil Services HOLDRs (OIH). Since imploding amidst the BP debacle in April and May, the OIH has formed a textbook ascending triangle over the past two months. With the successive higher lows as well as tight basing action in recent weeks, bullish footprints had already begun to appear prior to Monday's pop.

[Source: MachTrader]

When entering directional option plays I'm continually on the lookout for strategic entries to increase the likelihood of success. Of the plethora of bullish price patterns in the technical analysis realm, breakouts are one of my bread and butter. In anticipation of further upside in OIH, suppose I entered a bullish risk rocket by purchasing 100 shares at $107.35 and two Sept. 115 calls for $1.95 apiece.

With an ATR of $3, my initial profit target would be around $110.35. Upon reaching the target I could dump the shares of stock and roll the 115 calls to either a vertical call spread or a call butterfly. If executed correctly the adjustment should take the original risk capital off the table.

For those interested in more information on breakouts you can check out this short breakout video I drummed up from the archives. I posted it in early '09 just after starting Tyler's Trading.

For other related posts, readers can check out:
Christmas Musings and a Trade Journal
Fire Up the Boosters
Evolution of a Bullish Risk Rocket

For Everything Else There's MA

MasterCard is set to report earnings before the bell Tuesday morning. As I've mentioned ad nauseum, my default earnings bias is to short volatility as vol sellers typically have the upper hand. As with any set of stats, you always have your outliers bucking the trend. Looking at the data for MasterCard's last seven announcements, one could certainly assert it's one such outlier. In fact, it seems to be on a mission to punish short volatility players. Consider the following table outlining the earnings performance of MasterCard (click image to enlarge).

The Gap columns track the performance of MA from the prior day's close to the earnings gap open. The Straddle Value and Change columns track the performance of a front month ATM straddle from the prior day's close to the earnings day close.

Though it's granted three winners to vol sellers over the last two years, the rewards have been a paltry sum in comparison to the losses incurred by the four losers. Surprisingly, even the smallest short straddle loss (2/5/2009) was larger than the biggest winner (5/1/2009). Trader's habitually selling the pre-earnings vol ramp up may want to take this data as a note of caution for MasterCard. While short strangles or condors may have fared better, shorting straddles has not been a lucrative endeavor.

For related posts, readers can check out:
GOOG, What Vol Bid-Up?
Earnings Season Primer
Earnings... the Wrench in the Theta Clock