This was originally sent to subscribers of TheStreet.com Options Alerts on July 18 at 9:01 a.m.TheStreet.com Options Alerts is TheStreet.com's newest product. Here's how this alert service works, as well as Steve's market oulook and some specific trades in Boston Scientific, Sovereign Bank and others.
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, I will be using a variety of analytic tools and screens to find options positions with attractive risk/reward profiles, including tracking usual option activity, changes in implied volatility, impending news and reaction to unexpected events. The recommended trades will include both long- and short-term positions, directional or opinion-based strategies that are based on risk/reward probabilities or take advantage of pricing anomalies.
The Options Alerts newsletter is a different type of service from others at TheStreet.com. Instead of publishing a weekly summary on Friday that highlights the week's events, Options Alerts will publish a Weekly Outlook on Monday to highlight upcoming opportunities and how I plan to play these investments.
Each week the outlook will provide an overview of general market trends, highlight noteworthy options activity, provide a Watch List and offer specific recommendations. In many cases we will be monitoring situations that affect options and will send out an alert with the recommendations, confirming execution and updating changes to the model portfolio.
Also, those readers who are new to options can check out an options glossary on the Web site, which is part an "EduCenter" that offers a great opportunity for investors of all levels and styles to add options to their portfolios.
Since the July 7 London bombings, stocks have enjoyed a powerful rally. The
index has gained some 3.2%. As the major indices approach and, in the case of the S&P 500, break through four-year highs, one must certainly acknowledge that the market action is bullish from both a technical and fundamental standpoint.
But for options strategists, the attention-grabbing byproduct of this strong leg-up is that the VIX sunk to a new 10-year closing low of 10.84 on July 13. The VIX measures the implied volatility of the S&P 500 index and is known among options traders and market observers as the "fear" index. It tends to rise in a declining market, but it should also reflect the movement and velocity in price changes of the underlying index regardless of direction. This means that, contrary to popular misconception, volatility can also increase in a rising, or bull, market.
This past week's action represented an increase in market volatility. So it is somewhat curious that even as the SPX's 10-day historical volatility has increased from 8.65 to 10.85 over the past month, the 10-day average of the VIX or implied volatility has actually declined to the point where the implied volatility of SPX options have next to zero premium above the index's actual price volatility.
This selloff, or premium crush, came as traders rushed to sell option premium in the wake of the London bombings, which spiked the VIX to 13.95. It tumbled some 25% from the brief "London spike" to below 11 within a two-day period.
This willingness to sell premium on any uptick in implied volatility is premature, unwarranted, and smacks of unhealthy complacency -- especially given that we are just now entering the heart of earnings season and external events such as occurred in London remain a constant threat. What should be made of the fact that options seem to be pricing in zero risk premium?
This complacency in the market represents an opportunity to add inexpensive index-based options that will benefit from an increase in both real and implied volatility to the model portfolio. The specifics of how I suggest building an inventory of options to create a broad market base of positive gamma for the model portfolio will be described in the recommendations section below.
Earnings Will Drive Trading This Week
Our focus this week will be on companies that are reporting earnings, as they will likely be generating the most price movement, option volume, and therefore the potential for both anticipatory and reactive trading opportunities. Here are some names that we'll be keeping an eye on.
is slated to report earnings Tuesday, July 19. The earnings results will be less important than the company's response and guidance regarding the mounting problems of its malfunctioning coronary stents. The ongoing patent lawsuits with
Johnson & Johnson
have been a draw, with two of three decisions within the past five weeks going in Boston Scientific's favor. Those wins have helped put a floor under the stock but have not been positive enough to provide a catalyst for gains. There is important support at the $27 level, but the downtrend remains firmly in place.
After Tuesday's earnings report, if the stock gets a lift from a positive report and trades near $29 per share, I'd look to sell an the August $27.50/$30 call spread for a credit of $1.30 or greater on the belief that recent news that Boston Scientific's stent continues to malfunction has recast a cloud over the stock and should limit any near-term gains. This is a moderately bearish strategy that will profit if BSX remains below $28.80 until the Aug. 19 options expiration date.
shares jumped some 9% to a new all-time closing high of $24.79 on Thursday as increased merger activity among regional banks continues to heat up many names in the sector. Takeover speculation, coupled with the fact that Sovereign is also slated to report earnings Tuesday, has prodded the implied volatility of Sovereign's options to a 52-week high of 26%. This is up from 17% one week ago and still represents a 4% point premium above the stock's 10-day historical volatility.
Currently, the stock looks a bit overbought and due for a pullback, as Friday saw the shares slip fractionally. If earnings fail to inspire and implied volatility (I.V.) levels retain the current premiums, I'll look to sell put options to establish a bullish position based on using an effective purchase price of $23.50 a share or lower. I will be using the August $25 puts as the contract of choice to be sold at $1.50 as the entry point. I expect this target purchase price to come this week. The belief here is the prospect of a takeover remains very real and I wouldn't mind owning, or being assigned the stock, at an effective price of $23.50 or lower.
is another company in which impending earnings and takeover speculation are giving its options the double pump. But in this case the price action is less impressive with the stock facing, and so far failing to close, a large gap between $28 and $30 per share. But with implied volatility having increased from 26% to 28% in just the last 10 days, and running at more than a 100% premium to the stock's 10-day historical volatility, Eastman Kodak appears to be a ripe candidate for us to earn some short-term income.
I'll be keeping an eye on what the return on investment of a near-term at-the-money covered-call will be ahead of the July 20 earnings release. If the August $30 call were to offer a return greater than 12% for the four-week period, I would look at doing a buy-write with the hopes of having the stock called away at the Aug. 19 expiration.
This Week's Strategic Recommendation
As mentioned above, I'll start building a small inventory of index options this week that will underpin the portfolio and act as a leveraged base for trading. The recommendation is to start by getting long, or buying, a September butterfly call spread in the
options with $124 as the midpoint. The initial position would be:
Buy 10 September $122 calls and
Sell 20 September $124 calls and
Buy 10 September $126 calls.
This trade will be put on for a net debit of 30 cents, or a total cost of $300 for the 5x10x5 butterfly. This cost represents the maximum risk or loss that would occur if the SPY is below $122 or above $126 come the September expiration.
(For a full explanation of the how and why of using butterfly spreads, I've written an article, "Butterfly Season in Optionland," which is located on the
Once this butterfly is established, I will look to buy five contracts of the August $123/$125 strangle as a means of benefiting from short-term price movement or an increase in implied volatility. This would consist of buying five August $123 puts and five August $125 calls.
For an explanation of how buying nearer-term straddles or strangles can be used to leverage existing spread inventories such as a butterfly, please look at "More on Butterflies: Techniques of Pros" in the EduCenter portion of the Options Alerts newsletter Web site.
The basic theory is that the biggest win on the butterfly comes with the Spyder at 124. Buying a strangle around that strike creates the opportunity to profit if the Spyders move away, either above or below, the butterfly's break-even points during the near term. My target is to buy the strangle for less than $2 per contract or $1,000 for the five contracts, Friday, the Spyder was trading at $123 and the strangle was offered at approximately $2.20.
Over time we might look to add more butterfly spreads. Remember these are just combinations of vertical spreads, which will provide a larger base across a greater number of strike prices for leveraging short-term trading opportunities.
I will update these calls in email alerts sent to subscribers.
Steven Smith is a senior columnist for TheStreet.com. An options specialist, Steven writes several columns a week for TheStreet.com and RealMoney.com, and has been a contributor to TheStreet.com's Short Advisor since its inception and is author of TheStreet.com Options Alerts. Prior to joining The Street.com, Steven was a seat-holding member of the Chicago Board of Trade (CBOT) and The Chicago Board Options Exchange (CBOE) from May, 1989 to August, 1995. During that six-year period Steven traded multiple markets for his own personal account and acted as an executing broker for third party accounts.Steven spent two years as the senior finance writer at Ziff-Davis Media's The Net Economy publication. Before Ziff, Steve spent three years writing for Individual Investor.com. Steven wrote extensively on options, technical analysis and a variety of trading strategies. He also wrote a weekly feature column. While Steven cannot provide personalized investment advice or recommendations, he invites you to send him your feedback.