Know Your Volatility and Remain Nimble
By Kevin Davitt, International Futures Group

In my last article, I addressed the velocity of implied volatility as well as the pervasive complacency after the second quarter earnings cycle came to a close.

I try to focus my attention on options strategies, and have an affinity for small delta sensitivity positions with positive theta (decay). In my experience, which includes years on the options floors in Chicago and Philadelphia, most markets remain relatively range bound in the near term. As such, time decay strategies can be employed in an effort to capitalize on this tendency.

I would be remiss not to point out that every strategy, whether long, short, or delta neutral, positive or negative theta has inherent risk. Also, I think it’s imperative to cite that approaches predicated on time decay may be more or less "appropriate" depending on the implied volatility environment.

For example, the middle part of the past decade, specifically 2004-2006, was arguably the ideal trading climate for Index premium collection. The broad market didn’t experience high variance



(2004 weekly low S&P futures 1060 and high 1220; 2005 weekly low 1136 and high of 1285). The high to low spread between 2004 and 2005 was 225 points. Consequently, implied volatility was fairly low by historical measures.

By comparison, between October of 2007 (broad market highs-1590) and March of 2009 (market lows-665) the S&P futures had a 925 point range. In October 2007, the VIX futures traded as low as 16.53. At the height of the credit crisis upheaval (October 2008), the VIX futures traded as high as 69.40. From high to low, the S&Ps lost about 58% of its value and volatility went up by over 300%.

In his seminal work, Reason and Common Sense, George Santayana wrote, "those who cannot remember the past are condemned to repeat it".

The question then becomes, what lessons can we take from the past, and because I work with clients in the commodity markets ... how might they be applied to potentially profit in the future?

*PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS*

Here are a handful of things I know:

Historically, September is the most difficult month for the broad market with an average decline on the S&Ps of 0.70% (DJIA -1.1% on average) since 1950. Many investors/traders associate October with underperformance because the "crashes" of 1929 and 1987, but the aggregate data points toward September as the worst month for market "longs".

This past month was the worst August performance for the broad market in 9 years. Coming into today, the S&Ps were off by 5.8% and following today’s rally, they are off by 3.13%. The 2010 highs for front month S&P futures were 1216 and the 2010 lows were 1003. Today the S&P futures (September) closed at 1081.75.

Here is what I think right now:

I expect the "tug of war" between the double-dip recession/doom and gloom crowd and the V (quickly becoming U) shaped recovery types to continue in the near term. I anticipate that day to day market fluctuations will be sensitive to particular data points.

Take for example, the combination of poor weekly jobless numbers on August 19th (where the 4 week moving average turned up) and an abysmal Philly Fed report which led to a 25 plus point pullback on the S&Ps. Compare that to today’s decent ISM manufacturing number, and "in-line" ADP jobs number, and somewhat supportive data out of China and a 30 point rally on the S&Ps.

On 8/19 the Sept. futures settled at 1071.25
Today the Sept. futures settled at 1080.75

We will get another market moving data point on Friday with the monthly Non-Farm payrolls numbers and unemployment rate. Non-Farm Payrolls is expected to decrease by 100,000 according to Bloomberg consensus surveys. Private Payrolls, on the other hand, is expected to increase by 43,000 people. Furthermore, the Unemployment Rate is expected to tick up by a tenth of a percent from the last release, to 9.6 percent.
 
What, if anything, to do?

When speaking with clients of late, I continue to point out that the current environment is placing and increasing premium (pun intended) on being nimble. Before assuming any position, we talk about how long we are willing to be in a position (which should always be part of the discussion, but is now at the forefront). After that, we discuss profit objectives and risk tolerance.

In the past, it seemed difficult to project out a couple of months. At present, it seems difficult to project out a couple of weeks.

Nevertheless, most of the markets I follow have remained relatively range bound. The S&P futures are bound by 1020 on the downside and 1130 on the high side. Until they break that range, it will be a trading market as opposed to a trending market.

Crude oil has low end support between 70 and 71 and resistance between 80 and 82. The same interpretation applies – until proven otherwise, I would look to be skewed slightly delta long when we flirt with the low 70s, slightly delta short if trade brings us toward 80 and agnostic (delta neutral) with Crude trading between 74 and 77.

Natural gas broke multi month support going into last month’s expiration. In my mind, the combination of poor industrial demand, a break in the domestic heat wave that blanketed most of the country in early in August, and waning hurricane threats (at least in the Gulf/production area) led to massive long liquidation.

It is interesting to note that in 2009, nat gas futures made their annual lows in the first week of September. Being short puts in Natural Gas is not for the faint of heart, but if we see any kind of short covering or trough activity, they could work out well. Alternatively, you could look at ratio call spreads on the way up in either October or November.

In the Metals complex, I find the relationship between Platinum and Gold to be an excellent proxy for double-dip recession verses tepid economic growth. Again, you need to ask yourself whether it is a position trade (fundamental) or a technical trade before entering. Generally speaking, Platinum tends to outperform on "risk appetite" days (like today) and Gold tends to outperform on "risk aversion" days (like yesterday). The spread is volatile, but I associate that with opportunity. Feel free to call to discuss pertinent support, pivot, and resistance levels.

In conclusion...

My background lends itself to options trading and I feel most adept discussing what I’m seeing in the options world as well as potential trading ideas. Approaches vary from client to client and are always mindful of the fickle nature of implied volatility. Perhaps I focus too much attention on volatility, but since late 2007 risk has been re-priced across all asset classes and ignorance may be bliss in some situations, but when trading options, it’s a recipe for disaster.

Consider this afternoon ... with S&P futures at 1078.00 and 16 days until expiration if you trade the September 1100 calls on a 20 vol, they are "worth" 8.75 and the 1060 puts are "worth" 9.76 on a 20 vol. That makes the 1100 call/1060 strangle "worth" about 18.50 points ($925.00 on the Minis, $4,625 on the big contract). That same strangle priced at a 25 vol is "worth" 26.50 points ($1,327.50 on the Minis, $6,637.50 on the Big S&P). With vol trading at 30, the same 1100 call/1060 put strangle is "worth" 34.75 points, which equates to $1,738.50 on the Minis or $8,692.50 on the pit traded contract.

Are you aware of what volatility level you are trading?

Kevin P. Davitt
International Futures Group
150 S. Wacker # 775
Chicago, IL 60606
312-384-1174 Direct
800-786-4475 Toll Free
312-384-1195 Fax
Kevin@ifgfutures.com
www.ifgfutures.com

There is significant risk involved in trading futures and/or options on futures.  Futures and/or options of futures trading may not be suitable for all investors.  Investors should consider these risks and evaluate their suitability based on their financial conditions. Past performance is not indicative of future results.