"Santa Claus rally ... but for whom ?"

Right back before Thanksgiving the market had a decent dose of implied volatility and thetas were looking pretty good. Also refer back to the blog entry, "Crushing me to death ...", December 20th 2009.

However as we approached Thanksgiving, which was a four day holiday this year, the market makers began to crush down the IV, so as to artificially or prematurely adjust the theta out of the market to a point where prior to the Thanksgiving long weekend, the thetas values reflected the post holiday values. What this effectively means is that you cannot sell premium prior top the holiday break on say the Friday and expect to get the benefit of free theta without any market risk over the weekend because the markets are shut. This is because the market makers have adjusted the IV and theta values by the close of business on the Friday to reflect the values on market open on Monday.

The same situation has happened again over Christmas and again as we go into the New Year. If you click on the RUT graph on the right to increase it's size, you will see that at the holiday period progressed the IV levels for the RUT continued to fall. Some of this decline was due to the progressive rising prices for the RUT but again, some of the decline was artificially manipulated by the market makers not wanting to give away free Theta over the holiday break while the market was closed..

Cheers

"Scrutiny from below ...."

"..... why is it that when my children are happy and love me, I know everything, and when they are angry and upset with me, I know nothing ? ".

Guido Brunetti,

Commissario of Police, Venice.

Death at La Fenice, 1992.

Cheers.

Crushing me to death ...

Back on 18th October 2009, I discussed why there is no Theta advantage going into a weekend or extended holiday break - this was primarily because the Market Makers adjust the implied volatility to cut the theta back so that it reflects to approximate market price when the market reopens after the break.

Market Makers cannot directly change market prices but they can alter the level of the implied volatility they plug into their option pricing models to reflect how the market would change over the space of the holiday break. By doing this they compensate themselves upfront for the theta decay that should take place over the holiday break.

Yesterday, 19th December, was expiration Friday, and we are now well under way to place our portfolio trades for January 2010, and as good traders we need to look at balancing our portfolio Vegas. So the question is should we be neutral or a little skewed to the upside or downside?

Reviewing the implied volatility and statistical volatility charts for my favourite stocks shows that both IV and SV are essentially flatlining and are in the lower 20% of their yearly IV range. This would suggest that Calendars are the way to go. However if we look at the IV to SV ratio, then almost all of these same stocks are quite over valued suggesting that selling premium via Iron Condors and Butterflies may be a better alternate strategy.

So how to choose between these strategies - what do we know about IV that will help us make the right decision?

In order to keep it simple, we know from the discussion above that Market Makers are dragging down IV to reflect the theta decay and any drop in IV will crush the life out of a Calendar and help the profitability of a Butterfly. So if we choose a Butterfly and IV in fact rises instead of dropping due to some unforeseen news event, how would this effect our trade.

Well although the Butterfly would be damaged from rising IV in the short term, the Calendar would have increased profitability from IV, the fact remains, that as we move towards expiration Friday in January 2010, the IV will continue to drop out of the trades, so the Calendar which is already at low IV may drop further and be materially damaged. However, the Butterflies fortunes should reverse as IV comes out of the trade the closer we get to expiration. Thus, the profitability of the Butterfly will improve.

Another point to keep in mind is that there is no volatility in a trade on expiration Friday, everything about the trade is know. So, I am banking on the Butterfly over the Calendar as we move through this Christmas and New Year period to have superior profitability.

Cheers

Getting to Yes ....

John Lennon first met Yoko Ono in 1966 at an avant garde art gallery in London called Indica. There was an exhibition with a ladder that led to a painting, which was hung on the ceiling. It looked like a white canvas with a chain with a spyglass hanging on the end of it.

Lennon climbed the ladder, looked through the spyglass, and in tiny little letters it said, YES.

This was such a positive message that Lennon described his reaction as one of "relief".

Although this incident took place well over fourty years ago, I find myself thinking about the message of relief behind the art quite often. Every day when we turn on the news channel, it seems that the overwhelming number of news items are about, how many people are killed in terrorist attacks, car accidents, shootings and other destructive acts.

It seems that if there are not enough of these types of stories from the murkier side of human nature, the media looks to the economy, the level of  unemployment, encroaching deflation, spiralling interest rates and how it will directly affect us all. Not only do they tell us about their worst fears, they continually remind us over and over every night, so the cycle of worry and anxiety feeds incessantly on itself.

Sensationalism often takes the place of balance reporting, and words such as alleged, reported, possible and so forth creep into the story line all too often when it is very obvious that the media is on weak ground and fishing around for something "meatier" than a more upbeat humane story or scientific discovery.

It seems to me that the combined impact of the global financial crisis on our personal lives, whether it be through the loss of a job, depleted savings, lower superannuation or the secondary impact on friends and relatives, the last thing we need is an over abundance of negatively slanted news in our lives.

Now I want to be very clear about what I mean here. I am not advocating that the media ignore the tragedies happening in the world, but more, a balance approach to news presentation. Instead of five out of six stories being negative, how about fifty fifty or better. In these difficult times we need to hear more about the positive side of life, society and the economy. Lets look to the future with a positive approach and not one of anxiety and despair. Facing reality in times of change is a challenge for all of us and we really do need the glass to be half full.

The bad times are over, if you really want them to be. .....

Cheers

Trading in the time of shadows

Ever wondered about what sort of trader you are?. What your temperament for taking losses is?. When you were going to move from trading as a possibility to trading as a reality and way of life?.

I have pondered long and hard over many years and wondered about these questions, and the best reflection of my trading journey is much the same as my reflection on travelling through life's many shadowy and labyrinthine corridors.

Cheers

Even in obscurity we can help

The story goes that many years ago there was a priest who lived in the Australian high country. Every morning at 6.30am he would say Mass but nobody came. The days stretched into weeks and the weeks into years. And still, nobody came.

He consoled himself to this disappointment by believing that he was doing something beneficial by praying for all those in need and less fortunate, not only in his own parish, but throughout the world. He prayed for them every morning.

As time went by, he found that in his prayers, he had begun to pray that someone would come to Mass. It was not that his focus has strayed from praying for the less fortunate, but that he longed for someone to join him in his prayers.

Then one day as he was saying Mass, he heard the door to the church open behind him. Then he heard strong purposfull steps making their way down through the church until finally he felt a hand on his shoulder. As he turned, he heard a voice say:.

"Father, can I borrow your mower ?".

Luckily the priest had kept the mower in good shape and was able to help.

Is there a moral to this story, who knows, but it is fair to say that even in obscurity we can offer help when least expected.


Cheers

IBM & Thanksgiving IV Crush

IBM seems to have been really effected by pre holiday weekend IV Crush. The theory is, that as the long four day holiday for Thanksgiving approaches, the Market Makers are pushing down implied volatility quite severely so that they are not giving away free Theta over the long break.

As you can see from this chart of IBM the implied volatility line has dropped by around 6% even though the price has dropped slightly over the same period. Normally, one would expect that if price drops that implied volatility should rise, but not on this occasion it would seem.

Looking at the risk chart of IBM on the left, this represents an IBM Double Calendar as at Wednesday COB 25th November 2009. Notice that the white P&L line is way below the zero line and this trade is making a loss. It was not always like this. Over a week ago the trade was very healthy and making a profit, but as the weekend holiday approached the implied volatility began to drop dramatically.

Now look at the risk chart below - I have rolled the trade date forward to estimate the position as at the Monday after the four day break and also increased the implied volatility up by 5%. This estimate is based on the price chart above which shows a drop of 6%..

Notice that after adjustments the white P&L line is now significantly back above the zero line., Now assuming implied volatility is mean reverting, the volatility should begin an upward journey back to it's mean position over the next week or so. Or maybe not, there are no promises.

However, the risk graph does demonstrate how material the implied volatility crush has effected the profitability of IBM over the past week.

Cheers

National Australia Bank in decline?

Over the past few weeks NAB has been rising with the market in general but is it time to rest? Lets have a look to see if NAB is ready to retrace.

In the above daily chart of NAB we can see the following observations that might indicate that NAB is about to drop.

1. Current price has rolled over and gapped down to $28.89.
2. Price has moved outside the upward regression channel materially the wave 4 Elliott Wave statistical bands have been materially exceeded indicating that a new wave 5 low is a very low probability and that it is more likely that we will get a double bottom around the previous wave 3 low of  $27.85.
   
3. The proprietary Profit Taking Index, (PTI), from Advanced GET is at 23 and is materially below the minimum target of 35, indicating a potential failed wave 4, and
4. The weekly chart shows exactly the same wave count and is seen as a stronger indicator of the wave position than the daily count.

If we force a more aggressive wave count onto the weekly chart we get the following chart.

In this chart we see that the more aggressive count has changed the wave 4 count to a rising wave 3 and that the current retracement is a wave 4 which is well within the wave 4 statistical guidelines with a PTI at 67, it is materially greater than the minimum of 35.

With each of these points in mind, it would seem that the stronger weekly chart indicates that NAB is trending lower but only for the moment and that we should expect a near term low around $27.85 and then for the stock to resume it's upward trend early in the new year - possibly due to the added value drawn from the potential financial rewards of the retailers "Santa Claus rally" - if there is one this year.

Time will tell.

Cheers

To Assign or Not to Assign - that is the worrying question !

How can you figure out if you are going to be assigned on your short options positions, particularly if their is a dividend due?

The main reason that this situation occurs is that a market maker would typically be on the other side of your short position. Thus this long call would then be hedged with short stock. Synthetically the short stock and the long call equate to a long put. So if the market maker needs to maintain this risk position, they can assign your short call which closes out their short stock and if they then buy a long put to reinstate their original risk position at a cost that is less than the dividend amount, they will make a profit by assigning you.

Assignment only effects short calls because these are where your obligation to buy rests. Thus in order to work out if you will be assigned on your short calls, (A), simply look at the equivalent Put price (B), and if it is less than the expected dividend, (C), then there is a high probability that you will be assigned.

In our DIA example, the dividend, (C) is$0.0942 cents whilst the Put value,(B),  is $3.20 so the cost far outweighs the benefit derived by assigning your short calls and claiming the dividend.

In addition your trade will need to be close to expiration as well - trades that have multiple months to run will usually have such high remaining extrinsic or time value that assignment will not make sense.

Cheers

Is Existentialism on the rise ?

Like “rationalism” and “empiricism,” is “existentialism” a term that belongs to intellectual history ?

If like me, you grew up in the 1960's and 1970's you were almost certainly exposed to Albert Camus and Jean Paul Satre at school, drank lots of coffee in small clubs with close friends, wore black and were constantly wondering why "... man was free but everywhere in chains ..".

I could not say that I was a staunch existentialist back then, but I did wonder about how much freedom we all had; in art, in literature, in the ways we sought relaxation and escape from a drab reality and most of all in our daily toil, whether at school or at a job.

It was a subject that hooked me in and made me wonder. After I read Camus's "Outsider" and "On the Road" by Jack Kerouac, I saw references to the conundrum of perceived freedom everywhere, particularly in music. Not so much jazz, but for me, more in the nuances of inference in the music of the Beatles and Van Morrison.

So here we are some 50 years after the bulk of existentialist works were written, and I am still reflecting on whether we have more or less freedom, am I better off now than back then, and is the world a better place?

Cheers

Schadenfreude

Schadenfreude is a German word.

Translated, it loosely means, "... the pleasure taken from someone else's misfortune ..."
So now I think I understand the rise and popularity in reality shows on TV.

Nope, maybe not.

Schadenfreude !

Why there is no weekend Theta advantage

Many traders think that if they sell a credit spread, Iron Condor, or Butterfly on a Friday, they will get the advantage of making free Theta over the weekend without any risk. Then by buying back the trade in the following week they have scooped up two days of free money due to Theta decay - They are wrong, and lets see why this rather logical reasoning is flawed.

It all stems from the fact that market makers are also very logical and are not in the business of giving away free Theta to the retail trader. In essence, the market makers begin to move their computer system clocks gradually forward from around the end of business on Thursday. This has the effect of pricing the Friday open by the close of business on Thursday, by midday on Thursday they are reflecting the close of markets on Friday and by close of business on Friday they are reflecting the opening of the markets on Monday morning.

Let's have a look at the numbers to prove the theory. Using and Iron Condor on the SPX as at Thursday July 2nd 2009, we have the following option chain prices:

(Click on the image to enlarge).

Lets now see how the pricing of the Iron Condor has changed by the open of the markets on the Monday morning, the 6th July 2009 :

 On Monday we see that the price has moved down by $5.70 (A), Using the short 1000 call leg as an example, we note that the Delta has moved from 7 down to 4.4 and that the option price has moved from $2.35 down to $2.05, a price change of $0.30.

So we see that the short option has dropped -$0.30 over the weekend, but what was the cause of this move - was it Theta related?

Step 1 - Calculating the average Delta : Thursday Delta @ 7 + Monday Delta @ 4.4 / 2 = 5.7.

Step 2 - Calculating the price effect of the Delta move : Price change -$5.70 * Average Delta move 5.7 / 100 = $0.32.

Thus almost 100% of the change in the option value over the weekend was due to price effect and Delta and not Theta.

Cheers

Memorizing the Greeks

Have you ever been in a trade and the market has begun to move quickly and you are not quite sure of what the combinations of impacts from Delta, Theta, Gamma or Vega will do to your trades profitability and eventual return ?

Well, here is an interesting note on memorising the Greeks by Jay Baily, a mentor at Sheridan Options Mentoring.

Click on the following link.

Memorizing the Greeks

Regards

Market Direction : Time to take a rest

Over the past week the S&P 500 & the DOW have been on a roller coaster ride. Both indexes began last week with very strong rises only to have a significant drop off going into the weekend. Whilst last night - 6th Oct, the market rose strongly for the second day in a row.

The danger with this market is the focus on "not so bad news" and how the market makers seem determined to push the market up despite the constant feel that the market needs a rest or pull back.

In the S&P chart above, the price has just finished a major wave 5 sequence and seems primed for a retracement. If we assume the wave count is correct, then the first target is for the next wave 3 at around the 827 - in fact the market could retrace into the zone between the previous wave 4 at 880 and the Fibonacci wave 3 target at 827 mark.

Once this target is hit, a new wave 4 would see the S&P retracing back up into the vicinity of 955 with the final and rather significant drop in the S&P down toward the potential wave 5 low in the vacinity of 670 mark.

Scary targets indeed if Fibonacci can be believed.

M& A activity on the move?

Kraft announce a takeover for Cadbury recently and as usual Krafts price dropped substantially - $28.10 on 4th Sept and $26.45 on the 8th Sept - around a 6% drop in price.

Meanwhile back at the ranch ...

I put on an ATM Sept PUT calendar in Heinz (HNZ) and you guessed it - given Cadbury's reluctance to be taken over, all the other alternative food conglomerates have shot up in price. Heinz in particular shot up from it's dozy sideways path at $37.80 on the 4th up to $39.92 on the 10th - a 5.5% rise driven by the Kraft takeover.


Interestingly, my calendar has made greater than 10% in less than 10 days and the question is where is HNZ going as far as price is concerned?

Over the next few days there is an expectation of further good economic news but counterbalancing this for HNZ is that how much upward pressure can be maintained on it's share price when it is not part of the Kraft M&A deal - the HNZ increase in price I feel is over zealous traders buying the rumour and over the next days they will sell the fact and HNZ will retrace.

And so Tonto, what's happening back at the ranch - what does this mean for my Calendar trade?

Well right now the price hike in HNZ coursesy of the Kraft deal, has cause my calendar to be under stress but still up good money (11% in about 4 days)

If the market pulls back after the news of the Kraft action is digested and calmer markets prevail, I will make an even higher return. However if the economic news on the budget and the Kraft action continues to stimulate the market my profit will vapourise.

As this is a September trade and I usually plan to exit on the friday before expiration, I think I will take my 11% and sit back on the porch and drink lemonade over the weekend.

Cheers

Delta & IV balance - which is best?

The following RUT Iron Condor has been constructed based on Deltas of between 6-7 points. The aim is to run the trade for 36 days with no adjustments & target the 12% potential ROI.

This trade is constructed with short deltas of 7 for each side, thus the probability of success in the trade between now and expiry is around 86%. (100%- 2*7 deltas). In fact, You can calculate the probability of remaining between the upper and lower standard deviation marks off the risk chart (35.7% + 32.2% = 68% or 1 standard deviation). In addition this trade has a yield of 12% (potential profit of $660 / $5,340 margin = 12%). Not bad for a monthly return.

The trade has the 1 standard deviation bands marked on the risk chart and the issue here is that the trade has much more room to the downside at execution. We received $1.10 credit for this trade and we could increase the upside width or keep the full $1.10 on the basis that the market has appeared to be over bought for some time now and many traders are expecting a retracement to lower levels. In this case keeping the full $1.10 and leaving the trade with greater downside capacity would seem logical.

So what is more important when constructing the trade - Implied volatility as indicated by the standard deviation range or the probability of success as calculated by the 7 point delta range?

Cheers

OTM RTH Butterfly

Will RTH continue to strengthen or has the steam come out of the retail sector ?

If we consider that the wave 3 high is near to completion, we could aim to buy a cheap OTM Fly at $80 which equates to the 61.8% retracement point.

Right now the implied volatility against the Statistical volatility is very high indicating options on the RTH are very over valued and that we should be selling premium - hence the Butterfly.

The problem here is that if we place the Fly at the OTM $80 mark we get a cheap trade and as the price retraces into the mouth of the Butterfly we will gain in value. Additionally we will gain in values by Theta decaying over the life of the trade as we hve sold premium in the trade.

The issue I have with this strategy is that as RTH retraces and goes lower, IV will essentially rise and thus damage the ROI on our Fly trade. If the retracement is a slow movement rather than a rapid movement, then it may be possible that the gain from Theta will offset the declines caused by rising implied volatility.

It's getting better all the time ?

Its a classic line from the Fab Four :

"... I've got to admit it's getting better, it's getting better all the time .."

But is it - that is the question?

Recently the DOW has been down because of weak GDP numbers being worse than expected, however the data also indicates that inventories have been falling over the months due to lack of production productivity and are now at a point that in order to stay in business, companies will need to ramp up production to replace the delpleted stocks.

If the underlying consumer demand does not pick up to coincide with this increased productivity then it is my guess that once the inventory levels are back up above their minimums, companies will wind production back again. This will mean we could only be watching a medium term bull run at present and that it is due to fade if consumer sentiment and support wain in the mid term.

But,

"... I've got to admit it's getting better, it's getting better all the time ..."

Cheers

Selecting a target return ?

In finance theory there is a rule of thumb called the rule of 72. Under this rule if you divide the annual interest rate of your loan into 72 it approximates how long it will take to pay off the loan. Thus if the loan was at 6% p.a. it would take roughly 12 years to pay it off.

If we look at this rule as an investment then the interpretation would be you would double your money in 12 years.

Now if we use the rule for our trading, a monthly return of 6% would indicate that it would take 12 months to double our equity. So what monthly target ROI should we aim for to double our money?

As a starting position lets work backwards from our targeted 6% :

• Target after tax and risk reward adjustment :6%
• Assuming 30% tax (0.06 / 0.7) : 8.57%
• Now adjust this pre-tax return by 50% Risk Reward ratio (8.57 / .5) :17.14%
  

On this basis we should try to stay in our trades until we achieve a targeted 17.14% ROI so that the post tax return gives us 6% and helps us double our equity within a single trading year.

Cheers

AUD continues it's rise - Next stop $0.8262 ?

The AUD continues to remain in the regression channel as it climbs to the recent high of $0.8262

Options on Indexes - A risky choice ?

In his book "The Volatility Edge" Jeff Augen makes the comment that trading options on an index because it is safe is flawed logic, because index options do not reflect the true state of implied volatility.

Right now trading XLE which is a broad based energy index has shown a rather smooth price chart that moves between a reasonable range but over the past two months double diagonal and
calendar trades seem to have been crushed as a result of IV even though the IV has continued to remain low and the XLE options are under priced - low IV type trades such as a double Diagonal or Calendar have been punished over the past month.

Refer to the price chart above and note that both IV & SV remain low.

Maybe Augen is right in that some index options simply hide their real volatility away and are deceptive when it comes to income trades such as time spreads?

AUD/USD - Still potential to fall?

The AUD has been indecisive over the past week bouncing between the previous high of AUD$0.8263 and the channel low of AUD$0.7880

The question is still where is it heading over the medium term?

Even with the sideways movement over the past week, it has not broken outside of the lower regression channel and we can see from the attached graph that there is downward pressure on the AUD showing up in a drop in the Oscillator, a declining ADX and the MACD well and truly rolling over fromn an over sold position.

Is the Wave 4 target still viable at this stage - well yes but the longer the AUD stays in the channel the weaker the evidence becomes that the AUD will breakout to retest the earlier lows of AUD$0.75.

However even this may be a bit od a stretch as in order to get down around AUD$0.75, the currency needs to break out of the channel and the key support at AUD$0.7840 and then it will encounter resistance around AUD$0.7640 which is the 50 day MA.

If the AUD beaks the lower regression channel and falls below the support of AUD$0.7840, then odd on that we will see the AUD fall to around AUD$0.75 and at this stage an opportunity to lock in a few contracts as the next retracement would look to retest the new high of AUD$0.8600

AUD-USD retracing to 0.75 ?

AUD-USD is off it's recent high of AUD$0.8263 (3rd June), and looks to be retracing back down to the next support level at AUD$0.7740. If this support is breeched then the next support level is around AUD$0.7500.

Pressure for the retracement increased earlier in the week when :

1. the Reserve Bank of Australia (RBA) left the cash rate on hold and strongly indicated that ecxonomy was sufficiently stimulated with the impacts of previous rate cuts now flowing through.
2. An historic balance of trade deficiet caused by the high value of the AUD
3. GDP was reported as a positive 0.4% growth - theoretically making Australia one of the only advanced economies in the world to not be in recession
4. In addition to the economic indicators, the technical indicators are also showing a weakness with the oscillator declining, MACD crossing over and the ADX weakening.

So is the AUD in decline and is the next level of support AUD$0.7740 ?

Where is the DOW heading?

Currently there is a lot of discussion by the talking heads about the DOW retesting the March lows around 6470 and the question on my mind is "what is the probability of this happening?"

In the chart above we can see that before the DOW can get anywhere near the March lows, it has to break down through the current support level around 8225 and then it has to overcome the support from the two moving averages - in the case above both the SMA are fibonacci SMA at 55 and 89.

Once past this point there is further support around 7435.

So what is likewly to drive the DOW through each of these levels in the short term?