I ran a few Monte Carlos to see if it mattered if you sold the near month versus the far and to get a feel for how often you would have to adjust given where you choose to play. These are for the Russell 2000 index, RUT.

So here, this close in, it doesn’t matter if we trade the near month, October or November. We’d have to adjust all the time, though it would close past one of the strikes between 60% and 65% of the time.

What happens if we move farther out?

This is much more manageable. One has to adjust about 25 – 30% of the time, though the market closes past one of the strikes less than 20% of the time.

Next question is, what happens if you don’t adjust? Take your lumps when the market closes past your short strike but sit with it and make the return when the market turns back around. Is that a good strategy or poor one?

Stay tuned.

Safe Dividend Capture

Call holders don’t get the dividend, so my idea was to buy the ETF and sell in the money calls. If I sold September calls, they would have, most likely, been called away since there was very little time value left in them.

So I sold October 103 calls for close to $5. There was $0.70 of time value left in them making them too expensive to call away for a $0.52 dividend.

What I thought would happen is that the calls would drop in value by $0.52 * delta or about 40 cents, reflecting the drop in price of SPY. That would be my return from the trade, minus transaction costs and slippage.

This morning, as expected, SPY was trading lower, but the calls were unchanged!

Solution To The Mystery

I looked at the implied volatility of the calls at yesterday’s SPY price, and it was 14, the same as the historical volatility of SPY. Today, at the new SPY value, the implied volatility of the calls is 21, in line with all the other options.

So the option was already discounting the dividend yesterday.

Even if that argument doesn’t convince, he does mention an interesting trade, which is to buy September 30 or 32.50 VIX (Chicago Board Options Exchange volatility index) puts and hedge with at the money SPY (ETF that tracks the S&P 500, whose implied volatility is measured by VIX) puts. What happens is, if the VIX drops as the market rises, the VIX puts make money, but the SPY puts lose value. If the market drops, the SPY puts increase in value, but the VIX puts lose value.

Now the question is, how much of each to buy?

Vega

What we have to look at is, for a move of, say, ten points down in the S&P 500 (which is equal to one point in the SPY) which would make our SPY puts more valuable, how much would VIX drop, which would make the VIX puts less valuable?

How much would the value of the SPY puts increase for a 1 point drop in SPY? Since their delta is near -0.5, they would increase in value by half a dollar.

That is one piece we need.

We need to figure out how much the VIX puts drop in value when SPY drops. To do that we use the SPY vega. Vega of SPY is 0.12 so the change in the implied volatility of SPY would be given by the change in the SPY option value divided by the option’s vega, or 0.5 / 0.12 or 4% for a 1 point drop in SPY. But this is 4% of the implied volatility. Since the implied volatility is 27, this gives a change of the implied volatility of 4% of 27 which is about 1. So the implied volatility would go from 27 to 28.

This change is the underlying that moves the VIX puts. So since the VIX 30 puts have a delta of -0.7, that would change the value of the VIX puts by (-0.7) * (1) = -0.7

So it is these two changes in value that we want to hedge. It looks like we would need about 7 SPY puts for every 5 VIX puts (7 SPY * 0.5 + 5 VIX * (-0.7) = 0).

Where Does The Profit Come From?

One way to figure that out is to look at the vega of the SPY puts and compare it to the delta of the VIX puts. That way, we are looking at the change in the value of the SPY puts when their implied volatility changes (that is what vega measures), and comparing that to the change in the VIX puts when its underlying (the implied volatility of the SPX index) changes.

The vega is the change in the value of the option for a small change in the implied volatility. For the 99 or the 98 SPY put, vega is $0.12 and the delta of the September 30 VIX put is -$0.71. For the September 32.50 VIX put the delta is -$0.89. So we would have to buy six times as many SPY puts as VIX puts. That would make us immune to movements in the implied volatility.

If we bought 7 SPY for every 5 VIX, we would profit from the change in implied volatility calculated above. The VIX puts are six times as sensitive to changes in implied volatility of the SPX as the SPY puts are. If the S&P implied volatility drops, the vega measures the change for the SPY while it is delta that changes the value of the VIX puts.

Here’s an updated Market Delta chart for the day’s trade. Note how volume at bid has consistently exceeded volume at the offer for the ES contract (bottom histogram); how we’ve remained below the volume-weighted average price (VWAP) all morning (red line); and how we have accepted value lower by trading increasing volume at lower prices (side histogram). The reason I have my chart set up this way is that it provides me with a quick, visual sense for the structure of the day’s trade.

Where I see traders making mistakes in trading this market is by focusing on what has been happening in the last few ticks of movement, rather than the emerging day structure. That has kept many traders out of the market–or on the wrong side of it–even as we’ve taken out the S3 level. A thorough market perspective also needs to look beyond the day timeframe; that shows how we have moved below last week’s lows and, so far, have accepted value beneath that level. Given that dynamic, bounces that stay below last week’s range become candidates for selling.
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With the S&P 500 Index e-mini futures market (ES) unable to hold above the 915 level stressed last week, we’re now seeing selling toward last week’s lows, continuing the market’s trend shift. We also continue to see intermarket themes dominate: the strong U.S. dollar versus the euro and weak commodities accompanying stock selling. Meanwhile, the Market Delta chart shows that we’re building volume overnight in the 908-909 level, with the volume-weighted average price higher at 911.50. Inability to rally above those levels will target last week’s lows below 900.
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Here’s how we look (bottom chart) in the S&P 500 e-mini (ES) contract going into the 7:30 AM CT jobless claim numbers. Note the resistance between 912 and 914, as we continue in a short-term downtrend mode. If the 7:30 AM number cannot move us above that resistance level, I’ll be looking for a test of Wednesday’s lows below 900. Note that we’ll have a few opportunities to move this morning, with Treasury Secretary Geithner talking at 8:30 AM CT and Leading Economic Indicators and Philadelphia Fed reports at 9 AM CT.

I find it worth tracking interest rates and the dollar in response to these releases and events and correlating those moves to stocks to pick up on emerging and continuing intermarket themes. In general, if the numbers cannot move us out of a value range that was established up to that point, I assume that the trend that has been in place will remain intact. Once again, I’ll be tracking all of this intraday via Twitter (follow the tweets here).

8:15 AM CT – Update: We traded higher on the jobless claim numbers, but have stayed firmly within the overnight range. Note in the middle Market Delta chart that we’re now trading above the day’s volume-weighted average price (VWAP; red line), as the dollar has weakened versus the euro and 10-year rates have bumped higher. I’ll be watching to see how we trade around VWAP to handicap the odds of taking out Wednesday’s lows in early morning trade vs stay within the overnight range trade.

10:24 AM CT – I’ve added a fresh Market Delta chart (top) to show how we’ve been accepting value above the VWAP (red line) and around the 914/915 ES resistance. This raises the odds that, rather than trap bulls, we’ll flush out bears by taking the market above that resistance. I’m watching TICK and intermarket themes (weak dollar, strong 10-year rates) to see if that scenario unfolds.
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Not sure I’ve ever seen a single trade get this much press. But Don Fishback finds this reference to The Most Important Options Transaction Ever.

Can’t take it anymore. I’ve seen this too many times to not comment. Yesterday, a reporter for the Washington Post’s “The Ticker” wrote:

“At least one trader today placed a nearly $1 million bet that the VIX will rise above 45 by July, buying several thousand option calls.”

No, No, NO!

Just because somebody bought a million dollars worth of options does NOT mean that that person thinks volatility is going to 45. People buy options for 2 reasons: speculation and hedging. There is simply no way to know from the information presented in the article that this VIX call buyer was a hedger or a speculator. If the person was a hedger, then by definition they think the most likely event is that volatility is not going to go to 45, but they want to be protected in case it does. They bought volatility insurance!

It refers of course to the 20,000 lot of VIX 45-55 call spreads that went up last week.

Basically, following options order flow for directional clues is more art than science. When I was on the floor way back when, you kind of sort of kind of could get a feel for which players you wanted to follow and which ones you wanted to fade. But even that’s far from a path to riches.

And like Don says, who ever knows exactly what the player is doing overall. Even if you did, it’s still not a lock you want to follow them directionally or not. And let’s put this particular trade in perspective. Again, it was a low delta, way OTM call spread in the VIX. Remember it’s a VIX future, which this far out we figure will track about 40-50% of the VIX move. And even with the recent rally, the VIX still has a 31 full. Yes, you don’t need the VIX to actually go to 45 and above to win big on the trade. But as Don notes, 38 sure would work. We’re nowhere near that yet, and truthfully to get there you’d need to see the VIX in the 40’s as July would move to a discount.

Here’s a look at my Market Delta screen shortly after release of the PPI and housing numbers (bottom chart), both of which were better than expected. We have held above Monday’s lows in the overnight trade, with commodity weakness and dollar strength reversing. Note the volume at offer exceeding volume at bid (bottom histogram) so far; I’m now watching to see if we can move back into the June trading range vs. establish value lower, into May’s range. A bounce following a high momentum decline is not unusual; returns thereafter tend to be dicey. A move below the level from which we rallied with the 7:30 AM CT numbers would suggest difficulty moving higher on good news; that would hit my radar.

9:03 AM CT – Here’s an update of ES trading (top chart); note how we’re building value between 921 and 924 in a range trade so far this morning. I’m watching closely to see if moves toward the edges of this range attract volume (institutional participation). Should volume slow significantly, we could set up some extended range trade.
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One of the topics I’d like to cover in the summer seminar in Chicago is recognizing range vs. breakout trading conditions. The Market Delta chart above (click for detail) shows how we broke below the volume bulge mentioned in the intraday tweet (921-924) and found increased volume/participation as we broke the overnight lows and then broke below Monday’s low. It is the acceptance of price at lower levels that creates a shift in the market’s estimate of value. That acceptance, demonstrated by increased volume-at-price, is our best indication that the institutional traders/investors that move markets are participating in–indeed, leading–the weakness.

If we can get conference room space during market hours, perhaps we’ll be able to track some of these ideas in real time. More on the seminar to come…
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Here we see the S&P 500 e-mini (ES) futures prior to the 7:30 AM CT release of consumer inflation numbers (bottom chart). What you can see is that we broke below the early June range (purple horizontal line); note how that range support turned into upside resistance early yesterday as we moved further into May’s trading range. This transition from a range trade to a short-term downtrend was anticipated by the non-confirmations among the indicators I track and has also been reflected in recent indicator readings, which I put out via Twitter (follow here) prior to each market open: more new 20-day lows than highs; Supply exceeding Demand; less than 50% of stocks trading above their 20-day moving averages, etc.

We should stay below the early June range to sustain the downtrend. I’ll be tracking intraday sentiment and intermarket themes (strong dollar, weak commodities) via the tweets to see if we can sustain the downside.

8:23 AM CT – In the top Market Delta chart, we see that we’re building value at the low end of yesterday’s trading range, as in-line inflation numbers at 7:30 AM CT could not sustain a move to the upper end of the overnight range. With acceptance of lower value, we keep the short-term downtrend intact, with short-term resistance at 908/909.
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