Taking a Look at Index Options 05-09-2011

Cusick's Corner
A few readers have asked me to explain the definition of an index. An index is a grouping of stocks used to track and represent a sector, segment of the market, or a broad market, such as the Standard & Poor's 500. The S&P500 (SPX) is one of the world's best known indexes and is the most commonly used benchmark for the US stock market. There are literally hundreds of different indexes traded throughout the world with many tied to securities on US exchanges. There are several advantages associated with trading the indexes themselves, as well as a number of different investment vehicles available with which to trade them. Some of these investment vehicles include: managed index funds, index tracking securities (also known as Exchange Traded Funds or ETFs which trade like a stock on an exchange), and index options. Here are a few key elements to trading index options: Understand American vs. European style settlement. Last trading day for index options is usually the Thursday preceding the Third Friday of that expiration month. Most index options are cash settled. Index options have higher potential returns and higher potential risk and can be very volatile. Most index options are heavily traded and carry large premiums which can make them more ideal for incorporating into strategies that sell time premium. See you Tuesday.

Stock market averages finished with modest gains on a slow trading Monday. With no economic data to guide the early action, some of the morning focus was on the day's story stocks. Dollar Thrifty (DTG) shares rallied after Hertz (HTZ) made a new $72 per share offer the company. The earnings news was mixed. While Tyson (TSN) shares fell on disappointing earnings, Sysco (SYY) and Valeant Pharmaceuticals (VRX) moved higher on better-than-expected results. Meanwhile, Alcoa (AA) rose 2.2 percent and was the best gainer in the Dow Jones Industrial Average following a sharp rebound in the metals markets. Gold gained $21.70 to $1513.30 and silver added $2.66 to $37.95. Chevron (CVX) and Exxon (XOM) also helped the Dow after crude oil added $5.84 to $103.02 a barrel. The industrial average finished the day with a 46-point gain. The tech-heavy NASDAQ added 15.7.

Bullish
Wendy's (WEN) traded down 9 cents to $4.82 ahead of earnings. The fast food chain is due to release its results tomorrow morning. Options action was interesting, as 9,500 calls and 65 puts traded in Wendy's today. Investors snapped up May 5 calls at 10 and 15 cents per contract. 4,880 traded. August 5 calls were the second most actives. 3,700 traded. June and November 5s were busy as well. $5 calls are now 3.7 percent out-of-the-money and it appears that some premium buyers were initiating positions, possibly looking for a post-earnings rally to lift Wendy's shares beyond $5.

Bullish trading was also seen in Sysco (SYY), Dollar Thrifty (DTG), and LSI Logic (LSI).

Bearish
Research In Motion (RIMM) shares remain under pressure. Shares, which fell 14 percent when the company lowered earnings guidance on 4/29, lost 98 cents to $45.01 and closed at six-month lows today. In options action, the June 40 puts were the most actives. More than 14,000 traded. Another 10,940 June 47.5 calls changed hands. The volume included some risk-reversals, in which the investor bought June 40 puts and sold June 57.5 calls. The combination traded 5000X midday at 72 cents, that trader may potentially believe that RIMM's losing ways will continue through the June expiration in 39 days. The strategist is selling the 47.5 calls to help pay for 40 puts, which are $5 out-of-the-money.

Bearish flow also surfaced in Tyson Foods (TSN), H&R Block (HRB), and Longtop Financial (LFT).

Index Trading
The CBOE Volatility Index (.VIX) slipped 1.24 to 17.15, as trading was very quiet on Wall Street Monday. The S&P 500 Index (.SPX) traded in 9-point range and finished up 6.09 to 1,346.29. There was very little volume as well. For example, 395,000 calls and 303,000 puts traded across the SPX, VIX and other cash indexes, which is only 65 percent the recent average daily volume, according to Trade Alert data. VIX May 20, 25, and 27.5 calls were the most actives, as some spread traders might have been exiting positions in VIX out-of-the-money calls after the index fell Monday. VIX May options expire next Wednesday and have 8 days of life remaining.

ETF Action
Trading was relatively quiet in the exchange-traded fund market as well. Share volume across the ETFs was about 913 million. Average daily volume is roughly 1.07 billion. Meanwhile, 4.42 million options traded across all exchange-traded funds today, which compares to a recent average daily of 6.1 million. One fund that did see increasing activity was the PowerShare Bullish Dollar Fund (UUP). Shares, which track the performance of the dollar against the euro, yen and other major currencies, lost 3 cents to $21.40. Meanwhile, 106,000 calls and 3,770 puts traded in the name. Volume in the June 22 calls approached 40,000. May 21 and Sep 22 calls saw heavy trading as well. Some players might be taking positions in OTM calls on the UUP on hopes for a short-term rebound in the US dollar.