The Value of Selling Covered Calls

One subject that gets less attention than it deserves is the value investors can extract from selling covered calls. To be fair, a covered call strategy sacrifices what can sometimes be considerable upside in exchange for a fixed return, but this can be a highly effective strategy in a range-bound market.

The chart below is a weekly chart that shows the CBOE S&P 500 Buy-Write Index (BXM), which is designed to replicate a buy-write or covered call strategy for the S&P 500 Index. Note that during the recent bull market, a buy-write strategy resulted in roughly the same returns as owing the SPX, but with less volatility.

[source: StockCharts]

More importantly, over the course of the last year, a buy-write strategy has significantly outperformed the SPX. The details can be seen in the next chart, where a relatively new ETF, the PowerShares S&P 500 BuyWrite Portfolio (PBP) has lost value at less than half of the rate of the losses in the SPX.

In sideways markets, in down markets, and even in up markets, a buy-write or covered call approach like that of the PBP (or first cousins BEP and MCN) can be an excellent way to increase returns and reduce risk.

[source: BigCharts]

Global Equities Falling Through Support

The U.S. markets may look ugly right now, but the global picture is even worse. Pull up a chart of the South Korean KOSPI if you really want to see an ugly market.

For an ETF with global perspective, I am a fan of the iShares S&P Global 100 Index ETF (IOO), which is comprised of 100 large cap (average $10 billion) multinational companies that are selected based on the firm’s percentage of foreign assets, revenues, and employees. For more details, check out the S&P 100 holdings.

As the weekly chart of the IOO shows, the deterioration in the global equity picture has accelerated dramatically this week, with stocks falling through technical support and bringing the IOO back to levels not seen since July 2006. If IOO cannot hold the 2006 support level of 61.00, then another even uglier leg down is certainly a distinct possibility.

[source: StockCharts]

Mortgage Resets: COFI Numbers Improving

There have been countless graphics floating around the media outlining the large quantity of adjustable rate mortgage (ARM) rate resets that are anticipated in the coming months and years. For some excellent background and analysis on the subject of ARM resets, I encourage readers to investigate what Calculated Risk has to say on the subject.

One of the silver linings in the global economic slowdown is that as interest rates continue to fall, these ARM resets are going to be executed at rates which are increasingly favorable to borrowers. Setting aside the flip side – that lower rates will be less favorable to already struggling lenders – the prospect of lower ARM rates may help to accelerate the formation of a housing bottom and will certainly provide consumers with additional disposable income.

In the chart below, I have constructed a ten year history of the 11^th District Cost of Funds Index (COFI) data. The COFI is one of the most widely used ARM indices. As the graphic indicates, COFI has fallen from 4.4% in September to 2.7% in July. It has dropped 1.3% since the beginning of the year and is now at one of the most affordable levels of the past decade.

[source: VIX and More]

VIX Binary Options

Back on July 1^st, the CBOE launched binary options on the VIX. Essentially the CBOE’s binary options are the same as the pioneering ‘fixed return options’ launched by the AMEX earlier in the year.

As the name implies, a binary option is an all or nothing security that pays off a fixed cash settlement amount if the underlying settles at or above a specified strike price at expiration. If the underlying settles below the specified strike price, the binary option will expire worthless. If you are familiar with Intrade.com, then you are already familiar with binary options.

In the case of VIX binary options, these are European style (no early exercise) options, currently consisting only of calls (no puts are available), and settled in cash. The CBOE specifies the settlement as follows:

"The exercise-settlement value for VIX Binary Options will be the same as the exercise-settlement value ("VRO") for CBOE Volatility Index Options. VRO is a Special Opening Quotation (SOQ) of VIX calculated from the sequence of opening prices of the options used to calculate the index on the settlement date. The opening price for any series in which there is no trade shall be the average of that option's bid price and ask price as determined at the opening of trading. Exercise will result in delivery of cash on the business day following expiration.

The exercise-settlement amount for VIX Binary Call Options will be 1) $100, if VRO is equal to or greater than the VIX Binary Call Option strike price; or 2) $0, if VRO is less than the VIX Binary Call Option strike price."

I checked with my two favorite options brokers, thinkorswim and optionsXpress, to determine the availability of VIX binary options. thinkorswim has not yet implemented VIX binary options, but is “working on adding them.” optionsXpress does have VIX binary options available to trade. To access the optionsXpress VIX binary options chain, just pull up the chain for options on VRO (the VIX special opening quotation ticker).

A graphic of the current optionsXpress VIX binary option chain is below. As you can see, volume and open interest are negligible at this stage, which has translated into bid-ask spreads generally in the 0.06 – 0.10 range. For the month of August, the 22,162 VIX binary options contracts traded accounted for 1.8% of all VIX call options and 1.1% of all VIX options transactions.

For additional information, check out the VIX binary contract specifications at the CBOE’s web site.

[source: optionsXpress]

August Sector Recap

August was a month in which the S&P 500 largely drifted sideways, but there was a good deal going on in the various sectors that make up the index. The graphic below shows sector performance for the nine sector SPDRs for the first eight months of 2008 (bottom) and for the month August (top).

On the plus side, the turnaround in the consumer discretionary sector (XLY) is clearly responsible for much of the recent positive momentum in the SPX. Also worth noting is that four other sectors outperformed the index in August: consumer staples (XLP), health care (XLV), industrials (XLI), and technology (XLK).

As has often been the case during the past few months, when the SPX has been moving up, energy (XLE) and materials (XLB) have been moving in the opposite direction. In August, the financial sector (XLF) was also pulling the index in the wrong direction.

Watch the consumer for more clues about sector leadership and overall market strength in the month of September.

[source: StockCharts]

Portfolio A1 Performance Update: 8/31/08

As previously promised, I am now providing a monthly performance update for Portfolio A1, which I launched live on the blog a little over 1 ½ years ago.

The chart below shows the equity curve and some summary performance statistics for Portfolio A1 since the equities only (no ETFs or options), long only portfolio was created on February 16, 2007. During the 18 ½ months since inception, Portfolio A1 has posted a cumulative return (exclusive of dividends) of 4.2%, while the benchmark S&P 500 index has declined 11.9%. This adds up to a net performance of +16.1% for the portfolio vs. the benchmark.

As of August 31, Portfolio A1’s holdings included: Cleveland-Cliffs (CLF); ENGlobal (ENG); Cash America (CSH); EnerSys (ENS); and Centene (CNC). For the record, Portfolio A1 also shares some common ancestry and has a stock ranking system that is similar to the VIX and More Focus Aggressive Trader model portfolio – one of the four model portfolios that I update transaction by transaction for the VIX and More subscriber newsletter.

As a reminder, Portfolio A1 was created with tools developed by Portfolio123.com and is managed via Portfolio123.com’s tool set. For more information on Portfolio123.com, please refer to an earlier post on the subject, Portfolio123.com: The Engine Behind Portfolio A1.

[source: Portfolio123.com]

Best Hurricane Blog Out There?

I am by no means a weather junkie, although many years of sailing have helped transform my curiosity about weather systems and related phenomena into just enough knowledge to get me into trouble.

As I am also interested in market volatility and the commodities markets, each hurricane season gives me an opportunity to scour the web to update my favorite hurricane links, which seem to increase in quantity and quality each year.

There is one hurricane blog out there that strikes me as the undoubtedly best in the business: Dr. Jeff Masters Wunder Blog. Masters is one of the founders of The Weather Underground (that would be the meteorologists, not the radical bombers) and his blog is well written and filled with top notch content. The Wunder Blog has also attracted the attention of quite a few aficionados who do a surprisingly good job of augmenting Masters’ content in the comments section.

Side note: if you ever wanted to know what it is like to fly into the eye of a major hurricane, check out Masters’ harrowing account of Hunting Hugo

Gustav and the Oil Volatility Index (OVX)

Since first becoming a tropical depression on the morning of August 25^th, Gustav became a tropical storm, then a hurricane, and is now back to being a tropical storm – at least for the time being. Most models have Gustav reaching hurricane strength again later today, perhaps as soon as the next National Hurricane Center (NHC) update, which is only a half hour away.

If anyone is interested in watching a movie of the evolution of Gustav and the evolution of the five day forecast cone, I can highly recommend the Gustav graphics archive at the NHC web site.

At least as interesting as the changing fortunes of Gustav and predictions for Gustav’s future has been the market’s reaction to crude oil and natural gas prices. In the graph below, courtesy of StockCharts.com, I have captured the change in crude oil prices (via the USO crude oil ETF) as well as the change in the new ‘Oil VIX’ (OVX) that was recently launched by the CBOE. Note how volatility (the candlesticks) has generally followed the underlying up and down, though it has remained elevated as oil prices (the gray area chart) trended down this morning.

Those who are looking at options plays on oil and gas are likely to see long positions facing an uphill battle against time decay in the current highly speculative environment. As a result, spreads and short volatility plays should look more attractive as alternatives.

Where Will Gustav Land?

There are several excellent sources which will provide the latest updates on hurricanes and the various potential paths that a number of computer models are projecting. These sites include the National Hurricane Center, Weather Underground, AccuWeather, and others. The most common graphical depiction of these projections come in the form of a probability cone that projects the most likely path of the eye, with an increasingly large cone farther into the future to reflect the increased uncertainty about the forecast.

You can study these probability cones, computer projections and other data and adjust your portfolio accordingly. There is another tool that I don’t believe many know is out there. Intrade, the prediction market site, has recently added a number of contracts covering possible landfall locations for Gustav. The graphic below highlights the current landfall contracts associated with Gustav. These range across the Gulf of Mexico and also include Georgia, South Carolina, and “any other state”. Note that all these contracts stipulate that landfall has to be as a category 2 hurricane (winds 96-110 mph) or higher. Finally, there is also a contract that Gustav does not make first landfall in the U.S. as a category 2 or higher hurricane.

These may not be the ideal trading vehicles for hurricanes, but they can be interesting data sources as volume picks up in these contracts, enhancing the value of their informational content.

Energy ETFs and Katrina

With Hurricane Gustav now packing 90 mph winds and apparently headed in the direction of the Gulf of Mexico, this seems like a good time to pull up some data from the Hurricane Katrina period to get a sense of what happened to energy stocks during this time.

Recall that of Katrina was the fourth strongest Atlantic hurricane ever recorded and the most intense hurricane ever to enter the Gulf of Mexico at the time it made landfall on August 29, 2005. Amazingly, just three weeks later, Hurricane Rita turned out to be even stronger than Katrina, reaching maximum sustained winds of 180 mph on September 21, before losing strength and making landfall on September 24 with 115 mph winds. While Katrina ended up doing most of the damage, the appearance of an even stronger Rita headed toward an already damaged energy infrastructure almost certainly had a much stronger psychological impact on the markets. Katrina, which strengthened considerably just before making landfall, arrived with much less fanfare than Rita.

In the chart below, I have captured the relative performance of crude oil, natural gas, the broad energy select sector SPDR ETF (XLE), and the oil services HOLDRs ETF (OIH) for a period of a little over six months leading up to and following Katrina and Rita. Note that there was very little net change in crude oil, XLE and OIH from the end of July to October/November; almost all of the action was in natural gas.

New Contrarian Sentiment Indicator?

My father lives in suburban Connecticut where the deer are plentiful, but there is little else in the way of large mammals. Or so I thought. Apparently a neighbor saw a bear walking up my father’s driveway yesterday.

Out of curiosity, I went to Google to check for bear sightings in the area and was surprised to find a story about another bear sighting several days ago in a neighboring town, Simsbury, with the accompanying photo snapped from inside an insurance agency by an alert Kris Anderson. Now I really began to wonder: just how many bears no longer have enough room to wander around in lower Manhattan and have moved to Connecticut to take up residence? While the exact number is a mystery, I was surprised to see that according to the Connecticut Department of Environmental Protection, there have been 1349 black bear sightings in the state over the course of the past year. Granted, it has been 30 years since I have lived in the state, but that number is about 1330 more than I would have guessed. Incidentally, Simsbury appears to be the bear capital of Connecticut, with 229 sightings – or about two every three days.

Investors take note: Stamford and Greenwich, where hedge funds are a dime a dozen, have not reported any bear sightings in the past year.

SPX and VIX Three Month Futures Premium

Friday’s post, VIX Slips Below 19, appears to have raised some interest in VIX futures premiums (or “premia” for the more scholarly inclined).

Looking three months out, the VIX November 2008 futures contract (VIX/X8) has been open since November 2007 and reached a settlement high of 26.25 on March 14, 2008, just before the bottom of the equities market. By contrast, the all-time settlement low for the VIX November futures contract was 21.35 on May 2, 2008, a month and a half after the markets moved off of the March bottom and about two weeks before the markets topped. These VIX futures peaks and valleys just happened to precede important intermediate-term market tops and bottoms and may have hinted that a reversal was coming soon, in a manner similar to that of the VIX:VXV ratio.

Keep in mind that the VIX:VXV ratio is a ratio of the VIX (CBOE [S&P 500 1-Month] Volatility Index) to the VXV (CBOE S&P 500 3-Month Volatility Index). The six month chart below (courtesy of FutureSource.com and StockCharts.com) captures the difference (i.e., "futures premium") between the VIX November 2008 futures (VIX/X8) and the VIX index or cash/spot VIX. As the chart demonstrates, highs and lows in the VIX futures premium also coincide with tops and bottoms in the SPX.

Whether you are dividing or subtracting VIX futures and the VIX index, I feel obliged to offer a caution that a simplistic analysis of futures premiums can lead to some bad trading decisions. Like many sentiment indicators, however, when VIX futures premiums reach extremes, these can be valuable signals for market timers.

VIX Slips Below 19

One of the interesting side benefits of having a blog is that you can get a sense of what some investors are thinking just by looking at the Google searches that result in people clicking through to the blog. Today, for instance, I note some have found their way to VIX and More with the following Google searches:

• “VIX oversold”
• “VIX call options”
• “trade using the VIX”
• “bull call spread VIX”
• “calendar spread VIX”
• “predict VIX settlement value”
• “September VIX futures”

It certainly appears as if quite a few investors are looking at a VIX that is below 19 and trying to understand that number in the context of headlines filled with gloom and doom. One possible conclusion, which I’m sure accounts for a fair number of the Google searches above, is that it is just a matter of time before the VIX spikes to a level consistent with the fear and anxiety which dominates much of the media coverage of the markets at the moment.

While a VIX of 18.92 (as I type this) sounds low, it is only 7.3% below the 10 day simple moving average and 11.8% below the 100 day SMA. Further, because today is a Friday and we have some low volume days approaching in advance of the Labor Day holiday, there are some calendar reversion effects at work, as Adam at Daily Options Report has detailed nicely in VIX Bicentennial Parade and several previous posts.

A look at VIX futures (see futures quotes from optionsXpress below) shows that futures expectations for the VIX for October to May are generally in the range of 22.50 – 23.20. Anyone considering a VIX options trade needs to get a better sense of how VIX options are priced off of and generally move with VIX futures, not the cash or spot VIX index that is four points lower.

That being said, there is also the case to be made that the VIX is not that low at the moment. Looking at a weekly chart, for instance, the VIX is toward the middle of the typical Bollinger band settings. This is the essence of VIX options: when they look like sitting ducks, it is usually an optical illusion.

Still, with a relatively low VIX and relatively low VIX implied volatility (58.2%), VIX options may be inexpensive portfolio insurance and/or a good leveraged bet against further turmoil in the markets. The key concept to remember is that a 3-4 point move in the cash/spot VIX will have little impact on the VIX futures prices on which the VIX options are based.

Headwinds Index Turns Up

Unless you are Usain Bolt, you are not likely to be in top form – not to mention setting world records – running into a headwind. For that reason, last month I developed something I call the Headwinds Index to calibrate the extent to which oil prices and concerns about financial institutions are providing a drag on stock prices.

In keeping with my desire for simplicity wherever possible, the Headwinds Index is calculated as the price of crude oil divided by the financial sector ETF (XLF). For various reasons, I used the USO crude oil ETF instead of the crude oil front month futures.

The resulting ratio chart, which I have enhanced from the previous iteration presented in Headwinds Index: How Long Can Financials Outperform Energy? now includes a 100 day simple moving average for the USO:XLF ratio and a 50 day SMA for the SPX mini-graph at the top. [I have also inverted the ratio to better align with the headwinds metaphor.] Note that the 100 day SMA served as support for the Headwinds Index last week and the current level is at the 50 day SMA, which is a potential area of resistance. If this index breaks above 5.0, I would expect to see a rush to re-implement many of those long oil and short financials momentum trades.

Finally, note that an upturn in the Headwinds Index has preceded a turnaround in a rising SPX on a number of occasions. Keep an eye on this divergence going forward, as I do not expect to see a sustained rally in the S&P 500 until financials are able to outperform energy on a relative basis.

Put to Call Ratios and Volatility Predictions

Michael at MarketSci is out with another provocative post this morning. Focusing on the CBOE total put to call ratio (CPC) data history, he uncovers an interesting relationship between an elevated put to call ratio relative to the 50 day moving average and next day volatility in the S&P 500 index. In The Put-to-Call Ratio at Extreme Values, Michael draws the following conclusions:

“High and low put-to-call ratios…have done a pretty good job at predicting next-day volatility… High PCR levels indicate a bearish sentiment (high level of puts relative to calls purchased) and have been followed by a significant increase in volatility (+29.7%). Low PCR levels indicate a bullish sentiment and have been followed by a significant decrease in volatility (-17.3%).”

Looking at over a dozen years of data, MarketSci also concludes that the pattern has persisted over time but has been less pronounced over the course of the last two years (see chart for details).

I will leave the reader to ponder the implications of having a one day edge in predicting SPX volatility, but given how active SPX and SPY options are, there ought to be quite a few different ways to profit from this type of insight.