Comments? Strategy One advantage of using options is their ability to establish directional positions while defining and limiting risk. While the abnormal stress in the markets may indicate opportunity we do not know with certainly conditions will improve any time soon. Therefore, if we want to take positions based upon the abnormal market conditions we should create small positions with limited and defined risk. In an abnormal market with high levels of negative sentiment it is probably too late to short the market so we suggest small positions with limited and defined risk on the long side. IVOLopps⢠Equity Market For the equity market long consider one of our favorites. iShares Russell 2000 Index (IWM) 70.63. This ETF tracks the price and yield performance of the Russell 2000 index. The fund invests in approximately 2000 of the smallest capitalization-weighted companies in the Russell 3000 index. It invests at least 90% of assets in the securities of the underlying index and uses a representative sampling strategy in order to track the Russell 2000 index, which measures the performance of the small-capitalization sector of the US equity broad market. For long positions the IWM currently has the advantage of better relative strength. From the July 15, 2008 market low the IWM is up 9.5% while the S&P 500 Index ETF (SPY) is up just .7%. Part the relative strength advantage may be explained by fewer international companies with currency translation issues and fewer financials in the IWM compared to the larger companies represented by the SPY. In addition, with extremely high options volume and open interest the IWM offers very good liquidity. With a current Historical Volatility of 33 take a look at this idea. Trade Plan DR: Directional trade for the equity market based upon relative strength compared to SPY. SU: Unwind the position on a close below the last pivot at 67.16 on September 18, 2008. A close below this level indicates a likely retest the 65 level made in mid July. Sell IWM Oct 65 put DIWVM .90 IV 44.05 Delta .2000 At 44.05 the Implied Volatility of this is put is favorable compared to the Historical Volatility of the underlying ETF at 33. A reasonable IV forecast is for a decline back into the 25-30 range. However, if the IWM declines again to 67 we should expect to see our put selling around 1.50 where we would need to buy it back and close the short put position. If we are right on the market timing then we should also consider adding a bull call spread as the second part of this long trade. Buy Dec 73 call IQQLU 3.40 IV 28.82 Delta .4653 Sell Dec 75 call IQQLW 2.565 IV 28.11 Delta -.3898 Debit .835 Position net delta .0755 The combination of both trades results in a credit of .065 with a net delta of .2755. This is an example of long market position with good potential upside. While the downside for the bull call spread is defined by the debit of .835 there is a small margin requirement for the short October 65 put but the SU (stop/unwind) needs to be carefully watched to preclude a greater loss in the event the IWM does not continue higher in the next two weeks. Financial Sector If a government rescue package is agreed over the week-end these suggestions may change when the markets open on Monday. If so, use the position net deltas to adjust for the new option position prices. With this in mind we start with one of the more controversial financials. Wachovia Corporation (WB) 10.00. It has been reported that Charlotte, NC based WB has been talking with Wells Fargo & Co., Banco Santander SA., and Citigroup Inc. If the government rescue package is agreed soon there may be less pressure on this bank to do something right away. On Friday the stock declined on speculation that the rescue package will be delayed and WB may be forced into an asset sale and ending up like WaMu last Thursday with no stock value. With that in mind here is a credit call ratio back spread that would benefit from an upside move. With a current Historical Volatility of 235 consider this limited risk idea. Sell WB Oct 10 call WBJB 3.30 IV 245 Delta -.6196 Buy 2 WB Oct 15 calls WBJC 2.45 (2 X 1.225 each = 2.45) Delta .7116 (2 X .3558) Credit .85 Position net delta .0920. If the stock does not turn higher soon there will be a loss of time premium on the second long call but if the position expires with both legs out-of-the money the credit will be maintained. More problematical will be the short Oct 10 call if the stock quickly rises since it will be in the money and the stock will have to be bought in before expiration in order to be flat when the stock is called away. JPMorgan Chase & Co (JPM) 48.24. From the market reaction to their new $10 billion stock offering it looks like JPM is going to be one of the winners from the financial sector turmoil. They did a good job of risk management with their Bear Stearns assets purchase and now appear to have done the same or better with the acquisition of the WaMu assets. The management of this bank seems to have remembered the 1907 financial panic and is following the same astute strategy. With a current Historical Volatility of 107 and now declining consider this put sale. Sell JPM Oct 40 put JPMVH 1.05 IV 85.80 Delta .1756 This is an opportunity to sell nice premium in a well managed company. In the event it declines below 40 at the October expiration be prepared to take in the stock by assignment and then sell calls. Interactive Brokers Group, Inc. (IBKR) 24.19. Greenwich, Connecticut based IB serves both institutional and individual customers offering automated global electronic market making and brokerage services. It engages in order routing, executing and trade processing for equities, futures, and foreign exchange instruments on 70 electronic exchanges and trading venues worldwide. It provides bid and offer quotations on approximately 420,000 securities and futures listed on multiple electronic exchanges. They also offer an order management, trade execution, and portfolio management platform to access multiple asset classes, such as stocks, options, futures, foreign exchange, and bonds. They have just raised their guidance and are now forecasting third-quarter earnings to be .55 - .65 when the announce on October 23rd, well above the market estimates of .47, and have said they will buy back 8 million, or 20 percent of their outstanding stock. Yahoo finance shows their trailing twelve month price to earning ratio at 11.51 with a forward price to earnings ratio of 10.52 and with an attractive price to earnings growth ratio of .57. The total debt to equity ratio is 1.81 with an appealing return on equity of 21%. While the current Historical Volatility is 84 and now declining and with an Implied Volatility Index Mean of 72.04 and declining we expect to see the implied volatility back into the 55-60 range soon. Consider this combination trade to benefit from the value and growth prospects of this online brokerage company. Sell IBKR Nov 20 put QBOWD .925 IV 72.65 Delta .2048 In the event the stock closes below 20 on the October expiration be prepared to take the stock by assignment and then sell calls. In that event the basis in the stock would then be 19.075 about equal to the last pivot and before they announced higher earrings guidance and the stock buy back. Next, consider this bull call spread. Buy IBKR Dec 25 call QBOLE 2.80 IV 65.75 Delta .5329 Sell IBKR Dec 30 call QBOLF 1.05 IV 59.27 Delta -.2814 Debit 1.75 Position net delta .2515 While this spread does not have an implied volatility edge there is long gamma since the Dec 25 has a gamma of .0518 while the Dec 30 gamma is .0488 meaning the delta of the long call will increase faster than the delta of the short call when the stock price increases. Combining the two trades produces an attractively priced combination with a net debit of .825, a net delta of .4563 with good upside potential and with an acceptable and manageable risk.
People probably thought it was too late to short the market after last week's dump. I too make no predictions but see no reason why the market (Dow) could not shed another 1000 points over the next few weeks. We are just getting warmed up I think.