Market Watch Options Trader

8/14/2019 Market Watch Options Trader

1/6

MarketWatch Options Trader

March 10, 2010, 7:40 p.m. EST

In focus: Extremely overbought

Plus: Stock option volatility has been crushed, SPY and MPEL

By Lawrence G. McMillan

If you thought the market was overbought last week (as we did), wait until you sell it now.

Since the Standard & Poor's 500 Index (INDEX:SPX) was down 14 points on Feb. 23, the market has been risi ng

steadil y: SPX has been up every day s ince then, s ave one, includi ng the la st eight in a row, and advances have led

declines every day s ince one, incl uding the last eight in a row. Meanwhil e SPX is bumping up agai nst resi stance at

the 1150 area at the January highs (it would be especiall y devious and cruel -- typical market behavi or -- for the

market to stage a fa ls e upside breakout over 1150).

At this point, one can (barely) stil l say the SPX is within the confines of the la rge trading range between 1060 and

1150. If that statement continues to hold true, there i s a lot more room to the downside within that trading range,

than to the upside.

Equity-only put-call ratios continue to remain bull is h, as they are decl ini ng steadi ly. As long as they continue to

decline, that is a buy si gnal for stocks. Neither ra tio is a t an extreme level, so this i s one of the few indica tors that is

not overbought ri ght now.

Wednesday, March 10, 2010

7:40 PM

Unfiled Notes Page 1
mailto:[email protected]:[email protected]


2/6

Conversely, market breadth is the most overbought indi cator of the ones that we foll ow closely. Breadth indicators

have reached levels rarely seen. The last time they were this high was las t August -- right before a 40-point

correction in SPX dropped them down to oversold levels , from which another ral ly was l aunched. It would not beunusual for something simi la r to unfold now. When these breadth i ndica tors are so overbought, sharp, but short-

li ved, corrections ca n take place at any time. However, they do not necessa ri ly lead to severe declines (although

they might -- it depends on how the other i ndica tors react when breadth worsens).

The volatil ity indexes (INDEX:VIX) (INDEX:VXO) are s til l technically in downtrends. However, their recent behavior

is a devia tion from other market factors. $VIX ha s now ris en three days in a row. The fi rst two days were jus t

fractional gains -- pennies, real ly. But today, as SPX staged its usual l as t-half-hour rally, VIX actual ly started rising

sharply, and closed at the highs of the day (see chart below). There are plenty of other ins tances in the past where

a three-day VIX rise after the market had been risi ng for quite some time, was actuall y a strong sell si gnal. This i s a

warning sign flashing brightly.



3/6

The VIX futures had been trading with large premiums to VIX, although that premium has shrunk over the l as t

three days (as VIX has ri sen). Meanwhil e, the term structure continues to s lope sharpl y upward. The premium and

the upward-sloping term structure are positive, but too much of a good thing (i.e., too s harp of an upward sl ope) is

yet another overbought condition.

In summary, this market i s due for a correction, and the l onger the bull s manage to stave it off, the worse it will be.

You know that when the market fina ll y breaks, there wil l be a rush of sell ers al l trying to squeeze out the "exit" at

the same time - at least for a day or two. This i s not to say that there wil l be a maj or decl ine, or that the bottom of

the tradi ng wil l be tested agai n, for the i ndica tors are stil l on intermediate-term buy s ignal s. But it is unnatural formarkets to move constantly in one direction or the other without correcting.

Recommendation: SPDR S&P 500 ETF (SPY) puts

Even though we were stopped out of last week's put purchase, we want to insti tute another one:

Buy 6 SPY April 115 puts (OPRA:SPY100417P00115000) at a price of 2.65 or less.

SPY: 114.97 -- April 115 put: 2.65 offered

Stop yourself out if SPY close above 115.20 for two consecutive days.

Recommendation: Melco Crown Entertainment (MPEL)

Melco Crown Entertai nment (NASDAQ:MPEL) broke out over 4 .50, completing a basing area. Stock volume

patterns are very s trong, and call option volume is heavy. We are buying the common stock rather than the

options, since the only in-the-money strike is 2.50, and the options at that strike don't have very tight markets.

Buy 1000 MPEL at 4.60 or less.

MPEL: 4.54

Stop yourself out on a close below 4

.



4/6

Trader's Insight: Stock option volatility has been crushed

We al l know that volatil ity has decli ned substantially over the past year. For example, VIX recently traded below

18 -- about where i t was two years ago. That is down from 93 i n October, 2008, and from the 40's a year a go. But

those figures don't reall y state the "damage" that's been done to volatil ity.

We often look at volatil ity in terms of percentiles. ou know "percentil es" -- those things you bri efly had to deal

with in some statis tics c lass somewhere. Simply stated, if we ha ve a set of 100 numbers, i tems, or statistics , and

we al ign them in order, then the one i n the 50th percentil e is greater than 50 of them. The one in the 90th

percentile is greater than 90% of them.

Every day, we compute a composite impl ied volatil ity for each stock. We weight the impl ied volatil ity of each

indi vidual on that stock by its trading volume and distance in- or out-of-the-money. The at-the-money options get

the most weight. With this weighting system, we can arrive at one number each day as a composi te impliedvolatil ity for each stock.

After that i t's a simple matter to compute percentil es. Say we consider the la st 500 trading days --about two years'

worth. Then we can compare today's composi te implied volati li ty with the las t 500 trading days and easi ly

determine the percentile of today's reading.

When options are i n the 90th percentile or higher, we consi der them expensive. That i s an attractive time for

sell ing options, for example -- perhaps as covered cal l writes. When options a re in the 10th percentil e or l ower, we

can say they are cheap. Option buying strategies are more apropos at such times.

Back in the fal l of 2008, the average stock's options were i n the 97th percentil e of impli ed volatil ity, looking back

over the previous 600 tradi ng days. That was the higher average percentil e reading I have ever seen.

Now, however, the exact opposi te is true. The figure below shows that the average stock's options are in the third

(yes, third) percentile of composi te implied volatil ity over the past 600 tradi ng days. This is the lowest such readingI've ever seen.

The blue area on the left encompasses half the stocks and the red area to the right encompasses the other half.

You can see that 23% of a ll stocks are in the zero percentil e (that is, the dail y composi te impli ed volatil ity was

never lower over the past 600 tradi ng days). Hardly any stocks are in the 100th percentil e (there are always a

coupl e of FDA-related s tocks that are in that category). And there are virtual ly no stocks from the 50th to the 99th

percentiles.

What does this mean? It l ikely means that a volatil ity explosion lies in the (near) future, al though we don't know

how long that wil l take to materiali ze. Just as market tops can take quite a whil e to unfold, so ca n lows in volatil ity.



5/6

Follow-Up Action:

All stops are mental closing stops unless otherwise noted.

AIG May 29 straddl e (long put and cal l): AIG has finall y moved higher. Sell al l of the May 29 puts now, and set a

trail ing stop at 33. That i s s ell the cal ls if AIG closes below 33.

SPY Mar 113 puts: were s topped out when SPY c losed above 113.50.

UAUA April 18 ca ll s: raise the stop to 16.50.

SQNM Mar 8 cal ls : the stop remai ns at 7.

MIL April 95 call s: were sol d per ins tructions in last week's newsletter.

TD March 65 cal ls : we were unable to buy these a t our s tated l imit of 2.10, s ince the stock gapped up a nd jus t kept

going. Cancel the recommendation. If you di d buy them (ignoring our limit in the process ), I would take a partia l

profit on at l east two-thirds of your posi tion and set the trai li ng stop at 67.

VKX/SPY Hedged Put Strategy: Long 6 VIX Apri l 25 puts and Long 3 SPY April 114 puts: the Apri l futures continue to

have a large premium. However, the posi tion has become unbala nced with the drop in VIX, so rol l the VIX April 25

puts down to April 20 puts. This wi ll take a credit out of the position, and reduce exposure should VIX ral ly strong

during a market decl ine.

All stops are mental closing stops unless otherwise noted.

Q&A:

Q: I am having a hard time finding a quote for the VIX Futures. I have bee n to CBOE but I cannot seem to get a

quote on it. I even tried Future Source for a quote. Could you direct me to the right place to find the

information? -- E.M.

A: The futures exchange on which they trade is the "CBOE Futures Exchange" (CFE). Their web site is:http://cfe.cboe.com

The futures quotes (free, but delayed) are on the upper left of that page.

VIX/H0 is the March 2010 contract (H stands for March; 0 stands for 2010)

VIX/J0 is April

VIX/K0 is May

In futures parl ance, the month codes are F=January, G=February, H=March, J=Apri l, K=May, M=June, N=July,

Q=August, U=September, V=October, X=November, and Z=December.

Send questions to: [email protected].

Lawrence G. McMillan is president of McMillan Analysis, a registered investment and commodity trading advisor.

McMillan may hold positions in securities recommended in this report, both personally and in client accounts. He is

http://cfe.cboe.com/mailto:[email protected]://www.optionstrategist.com/mailto:[email protected]://cfe.cboe.com/


6/6

Market Watch Options Trader

Documents

Transcript of Market Watch Options Trader