THE OPTION STRATEGIST HOTLINE™ © McMillan Analysis Corporation P. O. Box 1323, Morristown, NJ 07962–1323 800-724-1817 Email: info@optionstrategist.com Thursday, August 30th, 2012 Note: if you are viewing a text version of this report, click on the following link to see the charts: http://www.optionstrategist.com/weekly-charts The stock market has been in a dull, drifting mode all week. The media thinks it is because everyone is waiting with bated breath for Bernanke’s speech today at the IMF Summit in Jackson Hole, Wyoming. I really think it’s more because it’s a pre-holiday week, and things have been pretty slow anyway, so many of the active traders are either on vacation or at least on a modified work schedule this week. In any case, there has been some effect on the technical indicators. The Standard & Poors 500 Index ($SPX) itself has traded in a narrow range, which was pushed a bit on the downside Figure 1 yesterday. It is still easily within the bullish trend channel that began last August, and as long as that statement continues to be true, the bulls have the upper hand – no matter what the other indicators are reading. The lower band of that channel is in the 1370-1380 area. Meanwhile, there is support near 1400 (the low of both last week and this week, so far) and at 1390 (the late July highs). Figure 3 Figure 2 August 31, 2012 There is risk of loss in all trading Page 1 Equity-only put-call ratios are beginning to waver. Both ratios have curled upwards in the last two days. However, the computer program that we used to analyze these charts is continuing to see them as “buy” (there is only about a 30% chance that the “curl” will become an actual sell signal). The weighted ratio is very low on its chart, and as such is down at the levels from which previous sell signals have occurred. However, there is nothing “magic” about any level. It is strictly the trend of the chart that is important. And that trend is down (bullish for stocks) and will remain so, no matter how long it takes for it to roll over to a sell. Market breadth oscillators turned bearish a week ago. They have remained on sell signals ever since. These are short-term indicators when they act alone (as they are now). They are a result of the overbought conditions that had built up when $SPX was making new post-2008 highs nearly two weeks ago. Those overbought conditions have been alleviated, but there could be further deterioration before a breadth buy signal springs up. The breadth oscillators have not moved into oversold territory, which would be the harbinger to such buy signals. Volatility indices ($VIX and $VXO) have moved higher over the past two weeks. On some days, they have even been up when $SPX has been up. That is not only unusual, but it is detrimental to the $VIX/SPY hedges that we have in place. Even so, $VIX remains at a modest level, just above 17. As you may recall, the 17 level has been relatively important for $VIX for some time now. When it is below 17, stocks have risen without too much trouble. Between 17 and 21, stocks can still rise, but there are corrections. That is the state we’ve re-entered now. A $VIX above 21 would be outright bearish for stocks. Figure 4 The construct of the $VIX futures have changed a bit, but it still remains heavily affected by the “protection trade” (which we discussed in the feature article in last week’s The Option Strategist Newsletter). That is, futures premiums are high, and the term structure slopes steeply upward. The futures premiums aren’t as high as they were, though. On Monday of this week, $VIX was up 1.17, but the Sept futures were only up 25 cents. So a great deal of premium came out of the futures. SPY was completely unchanged that day. So the construct changed, but the hedges made no money (in fact they lost a little). The same picture holds true if one looks at the entire last week’s action: $VIX was up 1.87, the Sept futures were only up 40 cents, and SPY was down a mere 12 cents. I expect some of this abnormal rise in $VIX without a concomitant movement in either the Sept $VIX futures or SPY will end once traders are back at their desks next week. Speaking of September, it usually starts out well, but ends up being a bad month for the market. That may be another reason why $VIX is increasing: traders are buying September $SPX options in anticipation of some volatility before September expiration. None of the $VIX futures utilize the September options – only $VIX does. That’s why $VIX can move higher without the futures following suit (implying that traders are not buying October and later month $SPX options with any aggressiveness). In summary, there are some cautionary signs appearing: the breadth oscillator sell signals, August 31, 2012 There is risk of loss in all trading Page 2 the potential sell signals in the equity-only put-call ratios, and the rising $VIX. We will monitor these potential bearish problems closely, but the bottom line is this: as long as $SPX remains above 1370, it is still within the bullish channel, and we will remain bullish. Note: if you are viewing a text version of this report, click on the following link to see the charts: http://www.optionstrategist.com/weekly-charts First Day Of The Month Trading System Despite the fact that September is often a negative month overall, the first day of September has a profitable track record for a day trade. Since 1990, the net result of owning $SPX for the day is a gain of +69 $SPX points. That’s not as strong as Feb, April, May and July. But September ranks 5th, so it’s a decent play. We are using Position S657, which was the position number for the last “first day of the month” trade; we will aggregate them all into this one position number, so that it is easy to track our success in this system (so far, we have traded it twice this year – both successfully). Position S657: First Day of the Month Trading System At the close of trading today, Friday, August 31st, Buy 5 SPY Sept (7th) calls one strike in-the-money. Sell the calls at the close of trading on Tuesday, September 3rd. We are using weekly options to provide a bit more leverage (but also to limit the dollar risk in case we are wrong). Even though September has been profitable in the past, there is no guarantee that this September will produce similar results. Naked Put Writing Volatility is still low, which makes it difficult to find put writes. For September expiration, the only ones are the traditionally risky ones such as SHLD and FSLR, or with potentially volatile earnings (BBBY). The fact that September is often a down month for the market makes writes in later months potentially dangerous, so once again we are not making a naked put recommendation this week. Daily Sentiment Extremes A sell signal has been registered in Heating Oil, as it was above 90% for six days (ending on August 23rd) and has now fallen below 85%. We would like to see confirmation from the chart in the form of a breakdown below 310 on the October contract. There is an ETF for Heating Oil (UHN is the symbol), but it does not have options. So we would have to use futures options in this trade. Unfortunately, they are extremely expensive, so a bear spread is going to be necessary, lest we risk too much in this trade. Position S669: Conditional Put Buy in Heating Oil Futures options IF Oct Heating Oil futures close below 310, THEN Buy 2 Oct HO at-the-money puts August 31, 2012 There is risk of loss in all trading Page 3 and Sell 2 Oct HO puts 10 points out of the money Options expire 9/25/2012 A one point move = $420 /HOV2: 313.33 Example: If Oct HO futures drop through 310, and close at 307.20, then you would buy 2 Oct HO 307 puts and sell 2 Oct HO 297 puts. Currently, the equivalent 10-point spread settled at about 3.80 (or $1,595 per spread). If bought, stop yourself out on a close above 315, basis the Oct HO futures. In addition, Soybeans and Soybean Meal are both above 90% bulls on the DSI survey at this time. No other futures are below 10% or above 90%. Put-Call Ratio Charts There were new buy signals in AXP_w, LOW, NKE, PCLN, and the following futures: Japanese Yen, Coffee_w, Sugar_w, 10-Year Notes_w, and T-Bonds_w. There are oversold conditions in DE, MRVL, and XLU. There are new sell signals in ATK_w, GG, GM, IBM_w, JOY, SINA, SLB_w, STKX_w, XOM_w, YHOO_w, EWZ_w, GLD, SLV, $SPX, $SOX, XLK, and XRT_w. There are overbought conditions in AAPL, AMZN, EBAY, GE, GOOG_w, LMT_w, LULU, RIMM, SBUX, WAG, EFA_w, and XME, Position PC1222: IBM Put Buy Buy 2 IBM Oct 195 puts At a price of 6.50 or less. IBM: 193.37 Oct 195 put: 6.40 Stop yourself out on a close above 198. Position PC1223: SLB Put Buy Buy 4 Oct 72.5 puts At a price of 3.60 or less. SLB: 71.60 Oct 72.5 put: 3.60 Stop yourself out on a close above 74. Volatility Skews: The only earnings-related skew for next week is Ulta Salon (ULTA), but there are no weekly options, and the volume and open interest are illiquid. In futures options, there are steep forward skews (i.e., where out-of-the-money calls are more expensive than at-the-money calls) in Euro FX, Gold, and Silver. Either Gold or Silver works as a call ratio spread. We are going to recommend Gold because the options are more liquid and the overall volatility levels are lower than those of Silver. August 31, 2012 There is risk of loss in all trading Page 4 Position F401: Gold Call Ratio Spread Buy 2 Oct GC 1655 calls and Sell 2 Oct GC 1675 calls and Sell 2 Oct GC 1695 calls For a credit of 3.00 per 1x1x1 spread. Options expire 9/25/2012 One point move = $100 /GCv2: 1654.80 Oct 1655 call: 25.70 Oct 1675 call: 17.30 Oct 1695 call: 11.50 Allow $9,000 in margin per naked call sold. The upside breakeven is 1718. Close down the entire position if Oct Gold futures trade at 1718 or higher at any time. Volatility Derivatives We have plenty of positions geared to take advantage of the potential futures decay or a flattening of the term structure, so are not recommending anything additional this week. The two positions recommended in the last newsletter (I464 and I465) are still viable if you haven’t already established them. Follow-Up Action: All stops are mental closing stops unless otherwise noted. Position E953: the CRM dual calendar did not have a profit on the day after it was established, so we rolled the August 24th options out to August 31st options. Now roll those Aug 31st options out to Sept 7th options. Positions I462, I464, I465, and S667: are all variations of the $VIX/SPY put hedge or a $VIX calendar spread hedged with puts. Remove if the premium on the Sept $VIX futures contract diminishes to 50 cents or less. Position S660: this is the Total put-call ratio buy signal. Sell the Sept 133 calls now. The target hasn’t been reached, but with put-call ratios apparently ready to generate sell signals, it seems prudent to take a partial profit now. Position PC1214: the TLT Sept 125 puts were stopped out on August 27th. Position PC1217: raise the stop for the Feeder Cattle Sept 143 calls to 142. Position PC1220: raise the stop for the MCD Oct 90 calls (which were bought on August 27th) to 87.70 Position PC1221: the MON Oct 85 puts were bought on August 24th. The stop remains 88. Position W1: the SPY weekly calendar spread. We are long Sept options and short Aug 31st options. If it is necessary to roll the entire position, buy Sept options and Sell Sept 7th August 31, 2012 There is risk of loss in all trading Page 5 options, using strikes +/-2.5 points from the SPY closing price on Friday. Otherwise, roll the Aug 31st options to Sept 7th options, per the following table: SPY > 145: re-center as noted above. SPY 144-145: sell 144 calls and 139 puts SPY 140-144: sell 143 calls and 139 puts SPY 137-140: sell 142 calls and 138 puts SPY 136-137: sell 142 calls and 137 puts SPY < 136: re-center as noted above August 31, 2012 There is risk of loss in all trading Page 6