This is more of “what the…” chart more than anything tradeable, but it’s interesting that as of the latest release covering positions through the June 9th close, the CFTC shows that large speculators are net long VIX futures to a degree not matched in the past few years.

Normally, large speculators are more of a contrary indicator than anything when their positions reach an extreme, but that hasn’t worked in the VIX.  This is a relatively new futures contract, and it can act pretty screwy when compared to the cash VIX index, but the last couple of times we saw large specs build big positions (relatively speaking) in the futures, we saw implied volatility jump over the next couple of months.

There was a temporary spike in their positions in early March of this year which was quickly reversed before volatility began to fall, but that’s still kinda sorta a false signal.  Anyway, like I said, I wouldn’t trade on this by any means, but it does make me raise one eyebrow just a bit.

Further to this morning’s pre-market post, Volatility in Context with VIX at Pose-Lehman Low, today’s 0.35% drop in the SPX means that it has now been four days since the S&P 500 index has moved more than 0.35%.

The range-bound trading is taking a heavy toll on historical volatility (HV), with today’s action pushing the 10 day HV in the SPX down from 21.54 to 18.10 – the lowest reading since September 3, 2008.

The graphic below attempts to put the current historical volatility levels into the context of the past 2 ½ years. Note that the current 10 day HV of 18.10 fits right in the middle of the range for this measure during 2007 (a year of very low volatility) and the pre-Lehman portion of 2008. In fact, given the recent historical record, I would be quite surprised to see 10 day HV fall any farther than the current level for at least another month or two.

Of course the VIX can continue to decline in the absence of falling volatility, but at some point historical volatility begins to provide some semblance of a floor below which the VIX is unlikely to remain.

On the other side of the coin, investors should also be aware that it has now been 26 sessions since the VIX was above the 35 level. If there is a catalyst (such retail sales numbers, housing data, industrial production statistics, Treasury auction results, the FOMC meeting in two weeks, etc.) that will change the volatility equation, then it is reasonable to look to 35 – not 40 or 50 – as the target for a VIX spike.

Finally, with volatility expectations shrinking almost on a daily basis, those who may be interested in speculative buying VIX out-of-the-money calls might find them a lot cheaper than anticipated – and perhaps a lot cheaper than they will be in another week or two.

[graphic: VIXandMore]

To get an idea of what size move the $22.40 will cover, I calculate the one day standard deviation of price moves for FSLR. That is, how much does FSLR move over the last 20 trading days by taking the one day historic volatility and multiplying by the price. So 68% of FSLR’s one day price changes should be within $4.21 of the daily price.

So the $22.40 covers that almost five times. So it will cover a 5 standard deviation move. Pretty good.

Now let’s look at previous earnings announcements. How much did FSLR move on those days? Here is a table of price moves on earnings days and the day after:

Looking at the last column, FSLR moves more than 5 standard deviations during most of the earnings announcements.

I think Green Mountain Coffee Roasters (GMCR) is a better bet tonight.

So Barron’s hired Audit Integrity to evaluate which companies might have to take a charge  this year. They have a methodology for calculating the probability of negative earnings surprises. It is a forensic accounting exercise, they look to see if there are signs of trouble on the company’s balance sheet.  In this case, they are looking at companies that use aggressive accounting.

In the article they mentioned several companies that recently took a goodwill impairment charge.  Let’s look to see if that was already discounted by the market or lead to a surprise and thus a large move in the stock.  That is what we need to use this information in our trading.

NYSE Euronext, NYX, would have had a profit if not for the charge that it took last week.  They announced earnings on February 9th.  If you look at the daily chart, there is no sign of a large price bar on the 9th or 10th. The price is fluctuating within the trading range of the week before.

The stocks which Leslie Norton discusses in the article which moved on earnings announcements where all financial stocks, Fifth Third Bancorp, Regions Financials,  and Hartford Financial.  It seems to me, without investigating any further, I did look at Regions Financial’s stock chart, that the movement has to do with the volatility of financial stocks not the goodwill impairment.

Transocean (RIG) is on the list too and I bought a straddle last week looking for an increase in volatility and a possible spike when earnings are announced tomorrow.  Right now, the call is in the money, we will see if there is a move due to earnings this week.

What do you think?

It depends.

If you listen to the folklore, 80 – 90% of options expire worthless. That indicates that it is more profitable to sell options.

On the other hand, like a lottery ticket, an option can pay off big. So you should buy.

What about the risks?

If you buy an option, you can lose the premium you pay so the risk is limited.

If you sell, your risk is unlimited if you sell a call and the stock goes to the moon.

Event Trades

Like the event trade discussed in the last two posts, it depends on what volatility will do and if you expect a spike in price. The event we looked at this week was the Treasury Secretary’s speech on the fiscal stimulus plan. The financial stocks are so volatile now that you can expect large spikes in price often. So we bought.

Another common event is quarterly earnings. As the earnings date approaches there is an increase in uncertainty about what the earnings will be. Implied volatility may increase because there is a chance for a big price move on earnings. That would be dangerous to sell. Earnings are of ten announced after the market closes or before it opens.

If you are short the option and the price of the stock moves overnight against you, the only thing that you can do is sell or buy stock in the after hours market which is illiquid with larger bid ask spreads, or wait until the market opens to get out of your position.

Volatility Trades

As a first pass, compare historical volatility to implied volatility. If implied volatility is much higher than historical volatility, that is a candidate for sale. If implied is much lower than historical, you might want to buy.

Next look at how volatility varies through time. Plot it. Is the historical volatility low now or high? What is the implied volatility of the options. Answering these questions will help you formulate good trades.

The Event

Today, the new Treasury Secretary, Tim Geithner, was scheduled to speak at 11 AM about the economy.  As an added bonus, the Chairman of the Federal Reserve, Ben Bernanke is speaking at 1 PM. Yesterday’s trading was flat waiting for his speech.  The market thought it was important enough to wait for

The idea is that a spike up or down in the price will increase the volatility of the options, increasing their value.  Also, if the price moves down, the volatility increases more.  The problem with this trade is that the implied volatility of financial stocks is already high, pricing in these kinds of large moves.

I bought a straddle and a strangle on JP Morgan Chase.  Here is how it works.

The Straddle

JP Morgan Chase closed yesterday at 27.28.  .

So I bought a put and a call both with a strike price of 27.  The call cost me $1.97 and the put cost me $1.76.

Total cost: $3.73

The idea is that the financial stocks will have the biggest reaction to Geithner’s speech.

The Strangle

To compare returns, I also bought a strangle, or combination, which was a 29 call and a 26 put.  The 29 call cost me $1.01 and the 26 put cost $1.31.

Total cost: $2.32

These are both nearly delta neutral trades which means that they shouldn’t change in value as the underlying stock moves.

So why would I do this trade?

Chase has moved down $2 as of 1:30 PM which is a 7% move.  Both puts are in the money and so are trading with a delta closer to 1.  The 27 call is now out of the money and so has a lower delta than the 27 put, so what should happen in that the 27 put should gain value faster than the 27 call loses value.

For the strangle, both options started out of the money about the same distance from the stock price.  Now the put is in the money and has a much higher delta than the call which is now more out of the money.  So again, the put should gain value faster than the call loses value.

We will see how it all ends.