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Opportunities In Options

The big news in Oct. was, of course, the stock market. The last week of the month began with a moderate decline on Monday morning, then the stock market began to deteriorate mid-day and moved to the first “limit down” of 350 points lower in the Dow at about 2:30 EST; thereafter, when the market re-opened it quickly plunged to the next “limit down” of 550 points lower. This was quickly followed by a “limit down” move overnight, where the market opened the next morning. However, the market began to slowly recover, picking up momentum late in the day, causing the largest single point move down to be followed by the largest point rally in history.

This volatility is being caused by the competing fundamental forces of combining the relative overvalued nature of the stock market after the extended move for the past five years without a substantial correction; along with continued investor demand both in the U.S. and from other countries which may have a less stable stock market or currency, mixed with the normal offering of fear and greed that is always in the marketplace and you are looking at a very volatile situation. This is reflected by the relative volatility index showing how volatility more than doubled at the beginning of the week.

While we normally say that volatility leads to opportunity, it's like over- eating your favorite dessert; too much of anything can cause pain. In this case, excessive volatility made it difficult to trade at times to take advantage of the seemingly high option prices that were reflected by the screens, but out of reach of traders as these prices were either old or impossible to fill because of the deluge of orders and fast market conditions.

This volatility will begin to subside, and leave us with “normal” high option volatility which should present significant option selling opportunities. Not only did S&P option volatility double during the last week of Oct., but other markets were also effected, such as bonds with volatility up about 25%, and gold, where volatility rose almost 50%. An additional benefit to the option seller is that we normally see a seasonal slackening of volatility beginning around Thanksgiving and accelerating throughout Dec..

High Volatility In Bonds Should Begin To Subside After The Payroll Report And

FOMC Meeting

Bonds started Oct. with a move to new highs after the Payroll Report. After a mild retreat mid-month, the Asian turmoil and “flight to quality” buying drove bonds to highs not seen since early 1996. From a technical perspective, the weekly chart is making higher highs and lows, and those previous long-term highs near 122 have become a “magnet” for prices. Bonds will be trying to find fundamental support to challenge those important tops. Bulls are also claiming that a deflationary environment would be bullish for bonds; “The risk here is that supply growth will outstrip demand growth and that we'll actually have a deflationary end to the expansion. Which will mean that the Fed, instead of ending the expansion by tightening, will actually have to ease to cushion the slowdown. Deflationary pressure is unambiguously good for bonds, and its a double whammy for stocks.”(Barron's Oct. 27, interview with John Makin.) One of the big questions remains the outlook for the dollar, which will have to stay at least steady to support continued foreign investment in the U.S. bond market. A long- term trading range is another good possibility that could unfold over the coming months. The recent rise in volatility will be good for selling premium, and we recommend bullishly oriented neutral option positions.

Short-Term Premium Is High Providing Opportunities In Nov.. S&P Call Credit

Spreads, Which Will Have Rapid Premium Decay

Volatility in the futures and options was evident here, with the market rising to new highs for the S&P early in the month, then proceeding to crumble into the mini-crash that we discussed. We have now had the first “official” correction of over 10% on a closing basis for the major indexes, although Jul., 1996, and Apr. of this year saw much more sustained selling and broader deterioration.

Given the fact that the fundamental outlook has actually deteriorated in terms of potential corporate-earnings growth and global-economic vitality, it would seem that the market may have more downside potential before a truly meaningful bottom is in place.

To date, the stock market has regained much of the ground lost to the global market turmoil. However, there is no clear evidence that “the coast is clear” and a new buy signal has been established. Far from it. Although reaching extremes of oversold levels on a short-term basis, the recent decline did not create enough selling to generate good intermediate signals, nor there much of the sustained fear and worry that exemplified the last two good bottoms in July 1996, and April 1997. Until the market proves itself by moving through formidable resistance at 980-982, basis Dec. S&P, and then the highs at 992.25, it is likely that we will see continued large swings and volatility, and a probable test of at least the last low near 900. The case for a “volume reversal” has been made here, with the NYSE and NASDAQ volume on the recovery day nearly double the previous records. However, the last time we had a record volume reversal on July 16, 1996, the market came within 2% of those lows 6 trading days later in the S&P, Dow, and NASDAQ.

Larry McMillan also mentions this tendency in the market: “There is normally a retest of the lows after a deeply oversold situation. Most Oct. deeply oversold markets have seen a sharp rally followed by a retest, and then a secondary retest around Thanksgiving (this happened in 1974 and 1987 as well as several other times).” (Larry McMillan's Daily Volume Alert, Oct. 29.) There is plenty of upcoming news for the market to worry about, and we recommend taking advantage of the potential for another move down. Remember that as of Nov. 3, the multiplier for the S&P 500 has been changed to $250 from $500.

In the Nov. S&P, we recommend the call-option credit spread of selling the 980 call, and buying the 990 call for a credit of about 200 points ($500). These options expire on Nov. 21. We recommend closing the trade if the premium triples on a closing basis; this allows for changes in values as time decay affects the trade near expiration. Full margin is $2500.

In the Dec. S&P, we recommend the put-option spread of buying the 930 put, and selling the 900 put for a cost of about 800 points ($2000). We recommend a risk of half the premium. These options expire on Dec. 19. We would evaluate the trade for profits if the market tests the 910-900 area.

Fundamentals And Technicals Improving, With Volatility At 3-Year Lows, Providing

Opportunities For Option Purchases

Cotton spent the month of Oct. consolidating sideways, building a strong support base. Option volatility moved to new 3-year lows and is very favorable for buying premium. The cotton market presents a great opportunity to enter a market with explosive potential at very favorable prices. This market warrants taking bullish positions at current levels, and risking the trade to a close below recent lows. “Export sales have remained strong over the past three weeks. China was an active buyer again. Given the technical action and the move to record high open interest last week, the market remains vulnerable to a strong short-covering rally over the near term.” (CRB Futures Market Service.) The dynamics between the speculative funds and the commercial interests has created the potential for an explosive move; multi-year highs in open interest will “add fuel to the fire”. The history of commercial trading in this market indicates that the next trending move may be up. “The one thing we do know is that commercials usually win these battles. We would use the current setback to look for a low-risk entry (ahead of the crowd) for what is setting up as a potentially explosive initial advance. Once set in motion, cotton is among the most consistent of trending markets.” (Bullish Review of Commodity Insiders.)

Technically, the daily, weekly and monthly charts are all showing positive divergence in oscillator readings; this in itself would indicate that we are near an intermediate low that could move the market back to the top of the 15-month trading channel. Seasonal analysis by Moore Research shows a marked bullish seasonal trend in the 5-year averages emerging at the end of Oct.. For contrarians, sentiment is at multi-year lows. Cycle analysis shows that the market could be trying to put in a 5-year cycle low.

In Mar. cotton, as long as the market is trading above recent lows at 7235 CTH, we recommend purchasing the very well priced 77 call option at about 80- 100 points ($400-500). These options expire in 14 weeks. We recommend a risk of half the premium as your stop-out point, or a close below 7200, basis Mar.. This trade can be used for both free-trade potential or for short-term profits on a sharp rally.

We also recommend the Jul. cotton 80 call at about 130 points ($650). These options have 31 weeks until expiration. We recommend the same risk and stop-out parameters.

New Contract Highs And Long-Term Trend Continues. Option Volatility Is Low And

We Recommend Call Purchases And Option Backspreads

Sugar ended the month of Oct. with a bullish breakout from its consolidation pattern, moving to the highest levels since Jul. 1996. This breakout occurred on high volume with rising open interest, lending further confirmation that this breakout is likely to be the start of the next leg up in this longer-term bull market. The longer-term supply/demand issue, production setbacks and El Nino concerns lended support to the new advance. “The slow harvest activity of the Russian beet harvest leaves the crop that is still in the ground vulnerable to an early frost. Cane damage is still uncertain from the typhoon which hit the Philippines early last week. Thailand crop estimates also continued to slip. Recent significant buyers on the world market include India, Iran, South Korea, Japan, and Indonesia...longer term fundamentals (potential El Nino damage to Asian, Australia or South Africa crops and a significant world production deficit even without the weather problems) may keep the market in a gradual uptrend.” (CRB Futures Market Service.) This important breakout may bring new speculators into the option market, driving up the volatility, which would be beneficial to our recommended trades. Currently, option volatility is just rising from 3-year lows, and remains very favorable for initiating both call purchases and option backspreads.

In Jul. sugar, we recommend the call option backspread of buying (3) 1250 calls, and selling (1) 1100 call for a cost of about 15 points ($168). Margin is about $350. Recommended holding period is abut 4 months.

We also recommend the very well priced July sugar 1250 call options at about $500. These options expire in 32 weeks. We recommend a risk of half the premium as your stop-out point. Our intent will be to turn these into free trades by selling higher strikes on a rally.

Winter Freeze Potential Keeps Option Volatility High

OJ continued its consolidation near historic 20- year lows throughout the month of Oct., followed with a bullish outside reversal and breakout in early Nov.. It has moved above a 3-month downtrend line, and closed above the chart gap from early Oct.. Even though prices have remained suppressed due to record production and supply, we are in the season that can spark sudden rallies. If lower prices start to generate increased demand, we could see more industry buying. Option volatility remains near 3-year highs; with the potential for quick market rallies during the freeze season, we recommend two strategies.

For a call spread in orange juice, we recommend buying the Mar. 80 call and selling the 100 call for a cost of about 400 points ($600). Volatility skewing in the Mar. options is favorable for bullish call spread strategies. Also, on a more significant rally, a higher call can be sold, turning these into ratio spreads. These options have 15 weeks until expiration. We recommend risking half the premium.

We also recommend selling the Mar. orange juice 65 put for a credit of about 300 points ($450). This is a strategy to collect premium, or “buy the futures at a discount”. If assigned a long futures at expiration, the net cost will be about 62 JOH (if 300 points credit are collected now). The margin is about $600. These options have 15 weeks until expiration.

Market Stalled At Important Resistance; Pullback Or Breakout? Low Option

Volatility Good For Put And Call Purchases

This market has reached an area of critical resistance, with the potential for a breakout or failure from these levels. Option volatility is low, and favorable for purchasing both puts and calls. Our previous positions in soybean oil worked very well, with the market moving up steadily; as we approached critical longer- term resistance from the weekly charts, we recommended taking profits on those trades. We feel that the market is at a critical juncture, positioned for either a significant pullback, or a breakout through important resistance that could start a potential major trend change. Commercials have taken heavy net short positions against the current rally, at levels which have usually turned back this market over the last few years. Even with a bullish fundamental tone, and a positive look to the weekly and daily charts, they have become overbought, and a pullback is overdue.

However, if the market manages to ignore these negatives, a new breakout could send it sharply higher. With option volatility at favorable levels for purchases, we recommend buying both puts and calls.

In Mar. soybean oil, with the market trading near 2600, we recommend buying the 27 call and 25 put for a cost of about 125 points ($750). These options have 15 weeks until expiration. We recommend risking half the premium, evaluating the trade if either side reaches prices that pay for the entire position, or a holding period of about 8 weeks.

Low Option Volatility And Market Can Make Big Moves. With Mixes Fundamentals,

We Recommend Buying Puts And Calls

This market is a good candidate for option buying strategies, as option volatility is very low and this market can make big moves. After a strong rally of more than a year, feeder cattle have been pulling back on the weekly charts and are now poised to continue their breakdown, or rally from support levels. Option volatility is rising from lows in September, and remains very favorable to this type of strategy. Fundamentals show tight near-term supply, but the prospects of a massive total meat supply later in the year; this should create a market move that can make this trade work. With the market in an established downtrend, we would look to take profits on calls on a good rally, and hold the put options.

In January feeder cattle, with the market trading near 78 cents, we recommend buying the 82 call and 74 put for about 130 points ($650). These options have 12 weeks until expiration. We recommend evaluating the trade if either side reaches price levels that would pay for the entire position, or market action dictates closing one side. For money management, we recommend a risk of half the premium. Our initial recommended holding period is about 7 weeks.

Upcoming USDA Report Critical; Use Any Pullbacks To Establish Long-Term Bullish

Trades

The next USDA Crop report is due Nov. 10th, and this should set the tone for the grains in the weeks ahead. The longer-term global supply/demand picture remains very bullish, but the markets are dealing with near-term pressure from some producer selling and fund liquidation. We would prefer to take advantage of stronger pullbacks in soybeans and corn in order to establish long-term positions, but will recommend going with a breakout if that should occur. Option volatility remains at mid-range levels for both beans and corn, and very reasonable for wheat.

In soybeans, the market is now poised to pull back from a short-term double top or break through this resistance and continue the trend. Another pullback to the 675-685 area, basis Mar., would likely provide a great buying opportunity, whereas a breakout through the Oct. highs at 741 SH would show a bullish continuation on the weekly charts.

Corn moved up to a higher trading level early in Oct. then spent the rest of the month consolidating. Like beans, it is currently ready for a move in either direction, and we would view pullbacks to the 275-285 area, basis Mar., as a good buying opportunity, while a move through Oct. highs at 304 CH would warrant going with the breakout and following the trend.

Wheat remains range-bound in a tight trading pattern bounded by the Oct. highs and lows. Until now, the market has held above the Jul.-Oct. uptrend line. We'll wait for more technical action to “let the market tell us” when to enter new trades.

The very strong El Nino weather pattern will continue to put a “weather premium” into these markets, as new developments in various global production regions can have large effects on the already delicate supply/demand balance for the grains.

November, 1997Opportunities In Options

Financial Plaza

300 Esplanada Drive, Ste. 200, Oxnard, California

Options Opportunities In Options

Spread Trading
Consensus National Futures and Financial On Line Index

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