Three Strategies for Bearish Sentiment & Low IV 11-23-2010

Cusick's Corner
This Corner will focus on three strategies appropriate for those who have bearish sentiment and believe that the option implied volatility is low: 1) Buy put. 2) Buy at-the-money bear put spread. 3) Buy in-the-money call calendar spreads. If you buy an at-the-money bear put spread, that means you are buying the at-the-money put and selling the out-of-the-money put. This strategically mitigates the time decay of the long option and any drop in volatility (the two largest risks with owning options). It also allows you to stay in a trade a little longer than if you were simply naked long an option. Again there are tradeoffs. The biggest is that if the stock drops dramatically, below the strike of the option that you sold, you give up those profits. But this might be a small price to pay when markets get choppy. The calendar spread works a lot like a covered call -- the option that you bought covers the option you sold. The differences between the covered call and the calendar spread are that the option you bought has time value and the stock does not, and that time values are the risk of the trade. While that is a trade off, the cost of the option is a lot less than the purchase of the stock. Tomorrow we will discuss bearish trades in high implied volatility environments.

The stage was set for early losses on Wall Street after Asia's equity markets slid on concerns about escalating military conflict between North and South Korea. The two countries exchanged artillery fire Tuesday, killing two South Korean marines. Meanwhile, uncertainty about the European Debt Crisis continues to weigh on markets across the Euro-zone and the euro. The European currency slipped to 1.332 against the buck, from 1.357 late-Monday. Events overseas continue to dominate the financial headlines and overshadow the day's other news, which included better-than-expected GDP and Existing Home Sales data. Investors are also grappling with uncertainty about problems in the financial world, as brokerage firms and fund managers are being scrutinized over insider trading and the major banks are still feeling the weight from the ongoing mortgage crisis. At the end of the day, bulls didn't have much to cheer about. The Dow Jones Industrial Average finished the day down 143 points. The NASDAQ lost 37.

Bullish Flow
Alpha Natural Resources (ANR) lost $1.08 to $50.46 and options volume was double the usual for the coal producer. 15,000 calls and 4,570 puts traded on the day. March 55 calls were the most actives. 10,500 changed hands and, with 79 percent trading at the ask and existing open interest of only 221 contracts, it appears that call buyers were dominating the action and looking for ANR to move beyond $55 by the March expiration. Shares rallied 8.1 percent Friday on news ANR is looking to expand its metallurgical coal holdings, perhaps through acquisitions (Bloomberg).

Bullish options action was also seen in Nuance (NUAN), Toll Brothers (TOL), and Walgreens (WAG).

Bearish Flow
AMR shares lost 17 cents to $8.05 Tuesday ahead of a busy travel period for the airlines. Anxiety levels are bit higher this year after TSA recently changed procedures for screening airline passengers. New rules in some airports require controversial full body scans or law enforcement style pat downs. Some groups have called for a boycott of body scans tomorrow in a move being called “National Opt-Out Day.” Potential travel disruptions could ensue and, if so, hurt the airline companies over the holiday. For that reason, perhaps, some defensive action was seen in AMR, the parent of American Airlines, Tuesday. One player bought a block of 7,550 January 7.5 puts at 50 cents per contract. 11,175 contracts traded total.

Bearish flow also picked up in SunPower (SPWRA), Lowe's (LOW), and International Flavors (IFF).

Index Trading
Trading in the index market turned a bit more defensive Tuesday. The S&P 500 Index (.SPX) lost 17.11 to 1,180.73. Meanwhile, 352,000 puts and 180,000 calls traded on the SPX, according to Trade Alert data. 518,000 puts and 369,000 calls traded across all the cash indexes. SPX December 1,180 puts and CBOE Volatility Index (.VIX) January 35 calls were the most actives. The VIX, which tracks the expected volatility priced into SPX options, hit a high of 21.45 and finished the day up 2.26 to 20.63. Increasing SPX put volume and a higher VIX are signs that demand for portfolio protection is on the rise and investors are buying index options to hedge stock positions.

ETF Trading
Consumer Discretionary Select Sector Fund (XLY) lost 54 cents to $35.87 and options volume jumped to 4X the recent average daily Tuesday, with 32,000 puts and 2,150 calls traded on the fund. The top trade was a block of 17,500 December 35 puts at 51 cents per contract. At the end of the day, 26,680 had changed hands. Since XLY holds all of the consumer discretionary names from the S&P 500 – like Home Depot, Disney, and McDonald's – some investors were likely buying these short-term out-of-the-money puts on concerns about additional weakness in that particular sector of the market.