- Volatility is on the rise - again.
- Recent patterns of volatility movements might suggest further market declines.
- Longer term option contracts may be more desireable to secure premiums and ride out short term market weakness.
Barely a month ago there was much talk about rising volatility in the face of a declining market. Those that would tend to use charts to predict the future suggested that the then rise in volatility was the precursor of the correction we had all been expecting.
Now we're at it again.
A month ago there were clearly identified catalysts that were weighing heavily on the markets. Disappointing economic news from China coupled with the unfolding crisis in Crimea mixed the economic realm with the geo-political one.
However, back then it appeared that the rise in volatility may have been reminiscent of previous smaller "mini-VIX" rises that occurred on a regular basis, nestled between larger rises that also came on a regular basis.
As it turned out, that was precisely the case, as the volatility rise seen at that time quickly gave way and the market did what it has repeatedly done over the past 18 months. It simply recovered from short lived setbacks and went on to new highs.
An extension of the chart presented last month to illustrate the cyclic nature of the "maxi-VIX and mini-VIX" pattern shows that what was a possible "mini-VIX" in the making turned out to be exactly that and as short lived as its predecessors and its rise ended at a level right where previous smaller VIX rises had ended.
Now, the question has evolved into whether the current rise in volatility is part of a developing "maxi-VIX" formation. The timing is right and certainly few would disagree that it has been a long time since we've had a downward move that could be classified as a "correction."
The significance, of course, is that the market tends to go lower as volatility rises. While people may disagree as to whether volatility is predictive in nature or simply a by product of events, it does paint a picture of the health of markets.
The glaring difference between this month's rise and that of last month is that there are no obvious catalysts, although that would never stop those from offering hypotheses.
The past week saw a 600 point reversal in the DJIA in the latter half of the week. That move was framed in the context of elation tied to an FOMC that appeared to be supportive of continued lower interest rates to the fears that interest rates would rise.
It was a week that saw clear flight to safety before the elation and "risk on" behavior the very next day, which then gave way to universal flight.
Whatever the cause for the abrupt turnaround it did validate the old aphorism that you shouldn't count your chickens before they're hatched, as this past week was a rare one in which I had no positions assigned, after having already plotted exactly how I would be spending all of that money that at mid-week I knew would be pouring in from assignments.
While the coming week may have even more of the "bargains" that have been lacking lately, I'm neither as anxious to commit toward their ownership nor do I have as much in my cash reserves as I would like to really capitalize on opportunities.
If a "maxi-VIX" pattern is in the making it would be reasonable to expect even lower prices in the coming weeks. Although this past week was fairly dreadful, mitigated somewhat by hedging positions, the 4.1% decline from the recent high is still far from satisfying the expectations of those awaiting a standard correction. I've been waiting for one of those so long that I may also learn the truth of another aphorism and learn to regret what I had been wishing for.
The potential benefit of increasing volatility for the option seller is that premiums are likely to perk up and that may especially become apparent for the longer term options, such as for the standard monthly variety. During a period of uncertainty the use of longer term contracts can help to ride out any near term weakness while paying you to wait.
While the aphorism "there's no such thing as a free lunch," may be true, at least the premiums from those option sales offer a bit of a discount.
As usual, the week's potential stock selections are classified as being in Traditional, Double Dip Dividend, Momentum or "PEE" categories.
In a week that was fairly indiscriminate in which stock was dragged lower the one that really received my attention was one that I was certain would be assigned on Friday. MetLife (NYSE:MET) was one of those that fell victim to fears of rising interest rates and fell more sharply than it had risen on the immediately preceding belief that rates would remain low. Whether the elation or the fears were warranted sometimes it is possible to simply have an overly exaggerated reaction and MetLife had them in both directions during the week as it went along for the rides. Any respite in interest rate theories, regardless of what direction, should allow MetLife to show some stability, which in the past has made it an excellent covered option position.
Perhaps it's just an unintended juxtaposition that would have discussion of the merits of an insurance company precede discussion of Lorillard (NYSE:LO). Since Lorillard only offers monthly option contracts I'm especially drawn to it during the final week of a monthly cycle or before an ex-dividend date. In this case it's the former, but its appeal goes beyond the time of month. Potentially in play as a take over target die to its reported lead in the e-cigarette area, much of that premium in its price has now been discounted, due to the tangled web of relationships between the various tobacco companies. Instead, Lorillard is simply a cash machine that is seeking to expand its user base, despite denials of that strategy.
Of course, while e-cigarettes may or may not enhance the need for fastidious oral hygiene, the real thing does and while Colgate-Palmolive (NYSE:CL) certainly makes products other than toothpaste, as a one time Pediatric Dentist, that's the one that I can readily associate with Colgate. What I can also associate with its shares is its dividend and potential refuge for those seeking safety. It goes ex-dividend this week and offers an attractive premium. The single caveat is that shares are trading near the yearly highs and earnings are reported the following week. However, as with some other positions being considered this week, there is added reason to consider the sale of May 2014 option contracts to secure additional premium and insulate oneself s a little from near term market weakness.
The Gap is yet another company that I had expected to be assigned this past week. For some reason it continues to provide monthly same store sales statistics and for me, their timing is usually less than fortuitous. However, The Gap always seems to have a way of reversing the disappointments and has been a very reliable covered option trade, despite the histrionics displayed by an investing community that interprets each month's worth of data as being reflective of the company's prospects in perpetuity.
L Brands, on the other hand is a company that simply executes among its various brands, although it, too, provides those comparable sales statistics. Down about 8% in the past week in part as a result of lower same store sales, L Brands is a company that I frequently like to consider owning during the final week of a monthly option cycle, as with Lorillard, particularly if its price has moderated. A nice dividend, good option premiums and reliable management is a good combination, especially when the market itself can't be trusted to act rationally.
Best Buy (NYSE:BBY), while certainly a volatile stock over the past few years has lately settled into somewhat of a comfort zone, punctuated by flights higher and lower. While I may not want to be holding shares in advance of earnings, that is still 5 weeks away and in the interim there's not too much reason to believe that it will be disrupted for long from its recent path. After weakness last week it's price is at the lower end of that range and seems to be offering a good entry point even in a rocky market.
Yahoo has fallen about 15% in the past month and it's not likely that they will be in a position to blame the winter weather for their quarterly results. Other than the promise of riches from its piece of Ali Baba which will be coming public, it's hard to know what drives Yahoo forward, just as it's hard to know whether its CEO, Marissa Mayer, warrants accolades for any initiatives that are increasingly difficult to categorize. A weakening IPO market may disproportionately impact Yahoo share prospects and would certainly detract from Mayer's scorecard.
With the option market implying an approximate 7% earnings related move in shares, there may be some opportunity in the sale of puts outside of that range, but the opportunities, that is the risk/reward balance would be more enticing if the overall market was not in continued deterioration.
SanDisk, on the other hand is also seeing an implied move of 7%, however, it does offer a slightly improved reward for the risk. Perhaps more importantly, in contrast to Yahoo, its strategic direction is clear. While Yahoo passively rescued itself from oblivion through its Ali Baba stake, SanDisk rescued itself from the oblivion of commoditization through active and creative product development. Since shares also go ex-dividend later in the month, if making this earnings trade through the sale of puts and being faced with assignment, I might consider that possibility, whereas ordinarily I would seek to roll over puts and await a price turnaround and subsequent exit from the position via expiration.
Finally, to me it almost seems ironic that during a week that saw a less than gracious welcome for IPO offerings, one of the most recently memorable disappointing IPOs, that may have signaled a market top comes to mind. Blackstone (NYSE:BX) reports earnings this week and has been increasingly responsible for this era's new initial public offerings. This week, for example, La Quinta (NYSE:LQ) went public again to less than enthusiastic demand. The cynical might suggest that Blackstone's use of the IPO process for its own properties is an example of opportunism at its very finest and might suggest that a market top is in the vicinity.
To that I would argue that opportunism at its finest is when you use IPO proceeds to completely cash out. While that may not currently be the case, one does have to wonder whether there will be enough dinghies for all of us once we come to realize what Blackstone has in the past so well demonstrated that it is capable of doing.
Meanwhile, as opposed to many earnings related trades that I would make via the sale of put contracts and prefer to execute only as part of a very short lived strategy, Blackstone is one that I could envision a longer relationship. While in general reluctant to take possession of shares if put to me, Blackstone is one that is far more than a vehicle to exploit excesses in option premiums.
Traditional Stocks: L Brands, Lorillard, MetLife, The Gap
Momentum Stocks: Best Buy
Double Dip Dividend: Colgate Palmolive (ex-div 4/17)
Premiums Enhanced by Earnings: SanDisk (4/16 PM), Yahoo (4/15 PM)
Remember, these are just guidelines for the coming week. The above selections may become actionable, most often coupling a share purchase with call option sales or the sale of covered put contracts, in adjustment to and consideration of market movements. The overriding objective is to create a healthy income stream for the week with reduction of trading risk.
Disclosure: I am long GPS, MET. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I may buy/add shares or ell puts in BBY, BX, CL, GPS, LB, LO, MET, SNDK and YHOO