These days, there are more and more volatility indices and futures than

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1 THE OPTION STRATEGIST McMillan Analysis Corporation P. O. Box 1323, Morristown, NJ Volume 21, No June 1, 2012 Editor: Lawrence G. McMillan Our 21 st Year of Publication Research: Ryan Brennan IN THIS ISSUE... Next issue: 6/14/2012 (Thur) You can follow us on Twitter: or like us on Facebook at T he publication schedule will revert to the normal 2 nd and 4 th Thursdays in June. As usual, there will be a Hotline update every Thursday night. The feature article concerns the topic of volatility futures premium and term structure but it incorporates markets that we don t often discuss: foreign volatility markets. It turns out that the U.S. term structure is the lone wolf as far as its steepness. The article postulates as to why that is the case. Our market opinion (page 6) is that the market is deeply oversold, but intermediate-term indicators remain on sell signals. So rallies will be shortlived until buy signals arise. We are not trading the first day of June in our first day of the month system. See page 6. On page 7, in addition to a call buy in RPRX, we rant about how the media distorts the profit aspects of the Bond market. Also, there is a discussion of the difference between a volatility ETF and an ETN. On pages 8 and 9 are several volatility-based recommendations: a put sale in CLF, a dual calendar spread in KORS, and ratio spreads in Gold futures and Mastercard. There are three put-call ratio based call buys on page 10. On page 12, there is a variation on the $VIX/SPY hedge, but using minifutures instead, so that time value expense for options is only a minor consideration.# Volatility: U.S. vs. The World These days, there are more and more volatility indices and futures than ever. One can observe the same sorts of things about them that we do with $VIX futures in particular, the futures premium and the term structure. We thought it would be an interesting exercise to see how these other markets futures constructs compare to that of $VIX. The $VIX construct, for a long time (see chart, page 12) has been that of large futures premiums and a steep upward slope to the term structure. Historically, that sort of construct has been associated with bullish markets, although it has persisted throughout the current market decline as well. How do these other markets line up in comparison to the $VIX futures construct? McMillan s Upcoming 2012 Speaking Schedule McMillan Live, Online Webinar Series Announcing a new series of live, paid seminars Cost: $49, each Previously Recorded: Detecting and Trading Takeover Rumors Strategies For A High Volatility Environment Understanding & Trading $VIX Options, Parts1& 2 Risk Management The B.E.S.T. Option Strategy, by Stan Freifeld Gamma Scalping, by Stan Freifeld Forex & Options Expo, Las Vegas September 13-15, Metastock Users Conference, Las Vegas October 14, Traders Expo, Las Vegas November 15-18,

2 Background Volatility Futures In these articles, we like to lay out the definitions, so that readers who are not familiar with the terms can understand the article without having to refer to back issues. The premium on a $VIX futures contract is merely the futures price minus the value of $VIX. Premium is a positive number if the futures are trading at a higher price than $VIX, but premium can also be a negative number particularly in bearish markets. The term structure of any group of futures describes their relationship to each other. The term structure is said to have a positive slope if each successive futures contract is trading at a higher price than its immediate predecessor. The following prices are an example of a positive slope: $VIX June futures: $VIX July futures: $VIX Aug futures: $VIX Sept futures: $VIX Oct futures: The term structure has a negative slope if each successive contract is trading at a lower price than its immediate predecessor, as in this example: $VIX June futures: $VIX July futures: $VIX Aug futures: $VIX Sept futures: $VIX Oct futures: These term structures naturally arise in a trending market. In a bullish stock market trend, the positive slope occurs; in a bearish trend, the negative slope persists. Thus it is erroneous to say that traders are predicting that volatility will move to some specific level a few months out in time. Typically the slope is steepest in the near-term futures, and then it flattens out where the longer-term futures are concerned. The above examples only show five futures months, but in $VIX futures, there are eight months traded. Volatility Options In order to have listed volatility options, it is necessary that 1) there be an underlying volatility index (such as $VIX), and 2) that there be futures on that index. The index itself cannot be traded directly, but the futures can, of course. The option contracts are based on the futures prices. In effect, until expiration is reached, the futures are the underlying contracts for the options. Hence June $VIX options have a different virtual underlying security (the $VIX June futures) than do July $VIX options (whose virtual underlying is the $VIX July futures). Volatility ETN s and ETF s Various ETF issuers (Barclays, Direxion, Guggenheim) have introduced ETN s and ETF s, based on volatility. These products were first listed in early 2009 and are becoming more and more popular with each passing day. Most of these are ETN s, because they don t fit into the classic definition of an ETF (where underlying securities are deposited in escrow and can be used to give the ETF a definitive value at any time). ETN s, on the other hand, are a credit risk of the issuer (Barclays, etc.), so if the underwriter should go out of business, the ETN itself may become a creditor of the underwriter s bankruptcy. Hence an ETN could lose much of its value in such a negatively extreme situation. See the related article on page 7. Listed Volatility Markets We all know that $VIX is really the $SPX VIX. In other words, the $VIX calculation is based on $SPX options. There are quite a few other volatility indices, but most of them do not have listed derivatives. We have mentioned most that do, in various issues of this newsletter, as they have been listed. These included: Emerging Markets $VIX Brazil $VIX Gold $VIX Crude Oil $VIX New $VIX Product On May 23 rd, the CBOE began trading futures on the CBOE s NASDAQ-100 Volatility Index ($VXN). The $VXN VIX is calculated based on $NDX options. The $VXN index has been in existence for a long time (over 10 years), but this is the first time that traders can actually trade NASDAQ volatility. Most of the contract terms are the same as $VIX futures: futures on $VXN are worth $1,000 per point of movement; the expiration day is always a Wednesday 30 days prior to the next expiration of $NDX options; the final settlement value is determined by an a.m. settlement process on expiration day; and the last trading day is the day before. The base symbol for these $VXN futures is VN. So far, trading activity has been minimal, and the open interest for the four current trading months of VN futures is a mere 15 contracts, total. Foreign Volatility Markets We have not previously discussed foreign volatility markets, but three other countries have listed volatility futures in a manner similar to $VIX. These are VSTOXX (European volatility), Hong Kong, and Russia. VSTOXX futures and options trade on the Eurex Exchange. Quotes are at Hong Kong volatility futures can be quoted at (click on Volatility Index Futures in list) Russian volatility futures are found at: (click forward to end of list symbols start with VX). Liquidity can be sporadic. In Hong Kong, open interest is 26 contracts for the three futures months listed. In Russia, it s better: 174 open interest in two futures contracts. In VSTOXX, though, there is liquidity: open interest of over 140,000 contracts in eight contract months. June 1, 2012 There is risk of loss in all trading Page 2

3 For the purposes of this discussion, we are only interested in the price quotes. The following table shows the premiums on (U.S.) $VIX futures. The Premium column is the futures price minus the $VIX price. The % Premium column is the premium divided by $VIX. Table 1: U.S. $VIX Futures Premium Contract Price Premium % Prem $VIX n/a n/a June futs % July % Aug % Sept % Oct % Nov % Dec % Jan % Table 1 shows the upward-sloping term structure of the (U.S.) $VIX futures. It is not nearly as steep as it has recently been, but it is clearly sloping upwards. Let s compare that with the other markets. Table 2 shows the percent premium on the various other futures markets mentioned earlier in this article. Note that the first numerical column in Table 2 is the same as the % Prem column in Table 1. Table 2 then proceeds to show the futures premium levels for all of the other markets. For example, consider the VSTOXX (European) data. The VSTOXX volatility index closed at most recently (3 rd row, 2 nd column). Its June futures, however, settled with only a 2.6% premium. From there, looking farther out on the futures spectrum, the premiums actually shrink. In fact, the term structure is inverted for VSTOXX. The longestterm, January, futures are trading at a discount to VSTOXX itself ( 0.6%). This is certainly a stark contrast to the $VIX futures. In Hong Kong, a similar situation exists: the futures are trading at slight discounts to the Hong Kong volatility index, and the term structure is slightly inverted. Russia, with only two futures, confirms the same pattern: the futures premium is relatively small, and the term structure is inverted. Brazil has a slight upward slope, but futures that trade at a discount. You cannot say that these are foreign markets, and they aren t reliable. Brazil volatility products trade here in the U.S. recently listed by on the CBOE Futures Exchange (CFE). European futures (VSTOXX) are very active and are traded by sophisticated hedge funds and other smart players. Still referring to Table 2, the remaining two Emerging Markets and NASDAQ aren t the same as the ones mentioned in the foregoing paragraph. Emerging markets ($VXEEM) has a positive-sloping term structure, but the premium levels are quite a bit lower than that of $VIX. The only one of the other markets that is similar to $VIX at all is the newly-listed $VXN. Frankly, it hasn t been trading long enough (one week since inception) or in enough size to say that the futures are correctly priced. It may be the case that market makers are pricing the $VXN term structure similar to $VIX, for lack of a better pricing model. What is causing this discrepancy? So, the net effect of all of this is that the $VIX futures construct is the only one in the world that has such a huge premium on its futures and such a wildly upward-sloping term structure. Why? Why would Americans be so willing to pay up for protection in $VIX derivatives but not in other markets around the world? It certainly seems to me that there is probably more risk in Europe and Russia et al than there is in the U.S. That s not to say there isn t risk here in the U.S., but the other risk derivatives markets should show similar symptoms. Table 2: World-wide Volatility Futures Percent Premium Market: US Europe HongKong Russia Emerging Brazil NASDAQ Symbol: $VIX VSTOXX VHSI RTSVX $VXEEM $VXEWZ $VXN Index prc: June 6.5% 2.6% -2.5% 6.5% -1.0% -2.8% n/a July 11.4% 2.6% -1.7% -1.4% 4.9% -1.7% 8.1% Aug 12.5% 1.7% -1.0% 5.5% -1.3% 10.3% Sept 14.5% 1.1% 8.6% -0.8% 13.0% Oct 16.8% 1.3% 15.6% Nov 18.3% 0.9% Dec 17.6% -4.1% Jan % -0.6% June 1, 2012 There is risk of loss in all trading Page 3

4 One argument might be that these other venues have already seen a large increase in their volatility index, and that is what has caused the term structure to invert. That doesn t really hold water, though. For example, the VSTOXX volatility index has risen from about 24 to 35 this year a nice increase, but hardly one of such magnitude that it would account for the completely different patterns of its term structure vis-a-vis $VIX. The rises in the Hong Kong, $VXEEM, Russian, and $VXEWZ are all similar to VSTOXX. If that were the real reason behind the inversion in the term structure, it would imply that a small additional rise in $VIX would result in the same inversion. That is not going to happen. It will probably take a relatively large rise in $VIX from here in order to invert the term structure. So what could it be? What does $VIX have that nothing else has? Well, for one thing, it is tied to $SPX. Clearly the $SPX options in the later months are trading with the same term structure as the $VIX futures, else there would be arbitrage opportunities for sophisticated traders. But that s not really an answer. It s more of another way of asking the same question because saying that the $VIX futures term structure is the way it is because the $SPX option term structure is the same way, still doesn t answer Why? Could it be that Americans, and all other investors of the world who invest in the U.S., are so convinced that they need volatility ($VIX) or price ($SPX) protection that they almost don t care what they pay for it? I think that s getting towards the answer. But, still, why pay so much for it? What if they aren t exactly aware that they are paying so much for protection? What if the products they are buying are masking the actual term structure? The products that exist on $VIX and do not exist on any of the other foreign volatility markets discussed in this article are the volatility ETN s and ETF s that use the $VIX futures as their underlying. All of these eventually come down to a futures position. From the simple ones, such as VXX (long the two front month $VIX futures) to the more complex ones, such as XVIX (long a double package of $VIX mid-term futures and short a single package of the front month futures), these are all trading futures. The more the interest in the ETN, the more $VIX futures trading volume is generated. ETN Mechanics We have quite a few new subscribers this month, so I want to spend just one more brief moment reviewing how these ETN s and ETF s work. Longer-term subscribers can skip this section if they have a working knowledge of the volatility ETN s. Let s use VXX (the Barclay s short term volatility ETN) as an example. When a buyer buys new shares of VXX, Barclay s creates those shares by buying the two near-term $VIX futures months in the appropriate ratio. For example, at the current time, VXX is long the June and July $VIX futures. As each day passes, the quantity of June futures diminishes and that of July futures increases. Hence, each day at the close of the trading, the Barclay s manager has to sell June futures and buy July futures. This has the effect of pushing the near-term futures down and pushing the second-month futures up, all other things being equal. This sort of daily rebalancing is being done all across the futures spectrum. VXZ the Barclay s intermediate-term volatility ETN does the same thing with the fourth through seventh month $VIX futures. Other ETN s and ETF s behave in a similar manner, and the cumulative effect can be substantial. Over 63 million shares of VXX traded today, as well as 23 million shares of TVIX (double-speed VXX) and 21 million shares of XIV (inverse VXX). You can correctly say that VXX and XIV net each other out, but that still leaves 42 million net long VXX that has to be rolled. The effect on the term structure The purchase of new shares certainly contributes to, and might largely account for, the overall large premium in $VIX futures. Every time some new buyer comes into the ETN, a new set of shares is created by buying the appropriate $VIX futures contracts. That elevates futures premium. But that alone wouldn t account for the steep upward slope in the term structure. What would account for the term structure, though, is the fact that these ETN s and ETF s need to be re-balanced every night, at the close of trading. This constant upward pressure on the term structure certainly abets the steepness that we see. This is not a new argument from us. We have said for some time that these ETN s are affecting the term structure in ways that have not been seen before. What the ETN buyer does not see are the details of buying and rolling the $VIX futures. He doesn t care, particularly, as long as the VXX ETN, say, behaves as he expects. That may be the rub, though. Recently, VXX rose from 16 to nearly 23, and is now at 20.5 (+28%). $VIX rose from 16 to 25 and is above 24 (+50%). That s a big nonperformance. June $VIX futures rose from 20 to 28, and now are at (+29%) similar to VXX. Much has been made in the media in the past of how the $VIX futures don t perform as well as $VIX itself when the market collapses. Well, neither will these ETN s. But they will provide some protection, and maybe that s all their owners want. For the rest of us, it creates opportunities to sell the overpriced futures and hedge that sale somehow. However, in the past, such hedges would profit as soon as demand for volatility slackened. In these times, however, with the continued demand for the volatility ETN s, the hedge doesn t really profit until expiration approaches or the stock market makes a big move. This can be a bit frustrating, as one is forced to hold such hedges for a longer time than required in the past.# June 1, 2012 There is risk of loss in all trading Page 4

5 FOLLOW-UPS TO PREVIOUS RECOMMENDATIONS The following figures represent hypothetical performance; these positions were not actually traded in an account. NOTE: on this page, all stops are mental closing stops unless otherwise noted. Position C434: the AFL put sale expired worthless. Position C439: the CRM put sale expired worthless. Position C443: the PCAR put sale expired worthless. Position F395: we exited the S&P put ratio spread for a credit of Position E929: we exited the CAT put ratio spread for a credit at expiration. Position E936: the JCP dual calendar was stopped out after the earnings report. Position E937: we exited the CRM dual calendar after the earnings report for a profit. Position E939: we established the JOY dual calendar. If it cannot be removed for a profit today, then sell out the call spread, and roll the June (1 st ) puts out to June 8 th puts at the 55 strike. Position I450: we exited the SPY put ratio spread at a credit. Position I452: we established the SPY put ratio spread for a 0.30 credit. If SPY trades at before expiration we will roll the entire spread down to lower strikes. Position I453: we established the VIX/SPY put hedge, exit if premium shrinks below Position 1173: the GLD 155 puts were stopped out on May 18 th. Position PC1183: lower the stop for the ICE puts to 125. Position PC1184: we lowered the stop on the GS puts to 100. Position PC1185: FDX June 87.5 puts were stopped out May 24 th. Position PC1186: raise the stop on the FXY calls to Position PC1190: we got stopped out of the UNG calls for a small profit, on May 29th Position PC1192: we raised the stop on the /LCM2 116 calls to and were stopped out on May 30th. Position PC1197: the GOOG calls were stopped out the same day the spread was established. Position S610: the $VIX May 27 calls expired worthless. We replaced them by buying the $VIX June 30 calls. Position W1: the SPY weekly calendar spread. The spread was rolled to June-June(1st) spreads, with strikes of 132 for the calls and 128 for the puts. If the position needs to be re-centered, buy June calls and sell June(8th) calls, using strikes +/-2.5 points from the SPY closing price.. Otherwise, roll to June 8 th calls. Category Position Recent Mark Comment Cov. Write: C435: RRD cash&mgn (S 10 Jun 10p) +80 Stop: 9.50 C441: FII cash&mgn (S 5 Jul 17.5p) +115 Stop: C442: CHK cash&mgn (S 5 Jun 13p) +100 Stop: C444: JPM cash&mgn (S 4 Jul 27p) +24 Stop: intraday C445: IRM cash&mgn (S 5 Jun 25p) 60 Stop: C446: OXY mgn sale (S 2 Jun 72.5p) 4 Stop: 72 Equity: E924: NTRI call calendar L 30 Sep 12c, S 30 Jun 12c E925: MMR call calendar L 12 Aug 14c E935: CRM put ratio spread +124 Stop: intraday L 2 Jun 130p, S 2 Jun 125p, S 2 Jun 120p E938: TIF dual calendar +71 $200 S 4 Jun 67.5c, S 5 Jun 55p, L 4 Aug 67.5c, L 5 Aug 55p E939: JOY dual calendar 51 See comments S 3 Jun(1) 65c, S 4 Jun(1) 55p, L 3 Jul 65c, L 4 Jul 55p Futures: F396: July Cocoa Call ratio spread +210 Stop: 2565 intraday L c, S c, S c F397: May S&P put ratio spread S p, S p, L p Index: I452: SPY put ratio spread S 12 Jun 122p, S p, L p I453: VIX/SPY put hedge 472 Exit if 0.50 premium L 4 Spy Jun 132p, L 5 VIX Jun 26p Put-Call: PC1183: L 2 ICE Jun 125p Stop: 125 PC1184: L 3 GS Jun 95p Stop: 100 PC1186: L 6 FXY Jun 124c +624 Stop: PC1195: L 10 LOW Jul 27c 140 Stop: Spec: S604: Strategic Alternatives 4062 Results to date L 4 HGSI May 13 calls 140 Hold L 4 ONXX Jun 42 calls +772 Hold L 6 WCRX Jun 20 calls 1182 Hold S610: Perpetual call buy 4804 Hold L 4 $VIX Jun 30 calls Weekly: W1: SPY weekly calendar Roll: see instructions L 5 Jun 132c, S 5 Jun(1) 132c, L 5 Jun 128p, S 5 Jun(1) 128p PC1192: Live Cattle calls 690 PC1197: GOOG call spread 1044 Spec: S658: SPY May 131 calls 610 SPY > 134: re-center as noted above. SPY : sell 133 calls and 128 puts SPY : sell 132 calls and 128 puts SPY : sell 131 calls and 127 puts SPY : sell 131 calls and 126 puts SPY < 125: re-center as noted above POSITIONS CLOSED SINCE LAST ISSUE Category Position Profit/Loss Naked puts: C434: AFL margin sale +228 C439: CRM margin sale +346 C443: PCAR margin sale +99 Equity: E929: CAT put ratio +358 E936: JCP dual calendar 576 E937: CRM dual calendar +414 Futures: F395: May S&P put ratio Intermarket: I450: SPY put ratio Put-Call: PC1173: GLD Jun 155 puts PC1185: FDX Jun 87.5 puts 880 PC1190: UNG Jun 16 calls +326 HYPOTHETICAL PERFORMANCE SUMMARY 1 Breakdown by general investment strategy: All Hedged Speculative Positions Positions Number of Closed Positions Avg Holding Period (days): Average Investment: $7669 $2089 Average Gain: +$223 +$41 Average Gain at Annual Rate 15.1% 17.2% 1: Commissions assumed: $15/futures option, $2/stock option, 4 cents/share of stock. No management fee is assumed. Profits are not compounded. See Disclaimer, on page 10. Past performance is not a guarantee of future results June 1, 2012 There is risk of loss in all trading Page 5

6 SENTIMENT INDICATORS... Oversold conditions persist, but intermediateterm indicators remain negative. T he market just cannot get a rally together that is strong enough to erase the oversold conditions. Sellers are rampant, and so it almost seems that oversold means sell more to worried traders. On May18th, the oversold conditions peaked, and there has been a meager rally attempt since then. The rally extended to 1335 on $SPX this week, but failed there near previous support (now resistance) at 1340 and near the declining 20-day moving average. But sellers smacked the market down from there, and then smacked it down again today when a decent rally was underway. There is support at 1290 in the short-term and at below that. Equity-only put-call ratios continue to plow higher on their charts. The 21-day moving averages of these ratios have now climbed to heights last seen in the sharp selloffs of last August and September. However, the actual value of the ratio is relatively meaningless. Rather, a buy signal will not occur until the averages roll over and begin to trend downward something that hasn t begun to happen yet. Stocks Only Data Date Adv Decl Net % Days are shown in red The Total put-call ratio has issued a number of short-term buy signals (on days when it is above 1.00). Meanwhile, the 21-day moving average of the Total ratio keeps rising, so that longer-term, strong buy signal is unfulfilled. Market breadth has been quite negative, and that is one of the major oversold conditions. The stocks only breadth oscillator fell below 1000 on May 18 th, a level that should have supported a stronger rally than actually occurred. Both breadth oscillators remain on sell signals and are oversold (just not as oversold as they were). One positive fact: a 90% down day was finally registered this week on Wednesday, when the market fell sharply. That is a short-term positive, of course, but it might have already played out with the intraday rally on Thursday. Volatility indices ($VIX and $VXO) have remained stubbornly high. $VIX has adhered to the general outline that we described previously: as long as it is above 21, that is bearish for stocks. $VIX pulled back to 21 during the recent rally attempt, but now is higher again. The construct of the $VIX futures remains positive, although from the feature article, one can see that it is perhaps under undue influence from volatility ETN buyers. The futures are all trading with fairly large premiums, and the term structure continues to slope steeply upward. In the past, this is the type of structure that has persisted in bullish environments, so we will give it that rating even though it seems incapable of reversing while demand for protection is so high. If the term structure inverts, it will be extremely negative for stocks, that is certain. In summary, the oversold conditions persist and should still be able to generate a sizeable rally. But as long as intermediate-term indicators remain negative, any such rallies will be short-lived.# T omorrow is the first trading day of June. As subscribers know, we have been trading the first day of the month system with modest success recently. However, the first trading day of June has a poor track record. Dating back to 1990, the first day of June has produced a total loss of 2.1 $SPX points. The last two years, the first trading day of June has produced a total loss of 49.4 $SPX points. So we are not going to trade the first day of the month system for June, 2012.# June 1, 2012 There is risk of loss in all trading Page 6

7 Contest: Predict the percentage of assets that will be returned to an MF Global customer. Special Biotech Situations & Strategic Alternatives Stock Expensive Comment Symbol Month(s) AMLN June-July Strategic Alternatives IDIX July Unknown ONXX Aug Strategic Alternatives + FDA 6/20/2012 RPRX June-July Trial results VVUS July FDA 6/27/2012 Amylin Pharm (AMLN) AMLN is supposedly about to receive bids from its strategic review process from Tehada Pharm or BMY. A day or two later after those names were floated, a negative rumor emerged: an internet article suggested that some companies were dropping out of the bidding for AMLN. Conflicting rumors such as these often make the rounds just before bids are made. Positive rumors allow traders to sell stock, and negative rumors allow them to buy it. Idenix Pharm (IDIX) is interesting, even though there is no news. Option volume has been heavy over the past week. Option implied volatility has risen as well. These are signs of a takeover rumor, but there has been none, nor has there been any news. Stock volume patterns are positive, and there is support at 9. Repros Therapeutics (RPRX) has had very heavy option activity several times during the month of May. Something certainly seems to be going on here, although there really hasn t been any news since earlier in the month, when earnings and a positive FDA announcement combined to jump-start the stock. Stock volume patterns are very strong now, and the stock continues to make new relative highs. There is support at 8. Position S659: Buy 8 RPRX July 7.5 calls At a price of 1.50 or less. RPRX: 8.34 July 7.5 call: 1.50 Stop yourself out on a close below 7.# Bond Rant T here has recently been heavy call option activity in two bond ETF s (IEF and TLT). Both are making all-time highs (in price). ETF volume patterns are very strong. Here is the point that all the stock market bulls (especially on TV) seem to miss: yes, government bonds are yielding small amounts because interest rates are so low, but if you own them, they are rising in price as the yield falls. In the last year, IEF (the Barclays 7 10 year Treasury bond ETF) is up 15% in price, and TLT (the 20-year Treasury Bond ETF) is up 35%!!! So what if they only yield 1.6% and 2.7%, respectively? This point is rarely made on television, and as a result, they are implying that stocks are a better place to be. This can be extremely misleading to the average retail customer. The TV bulls never seem to mention the total return just the yield. This doesn t imply, of course, that the next year will produce similar total returns. But, a year ago, the stock market bulls were whining about how low Treasury bond yields were (implying that one should jump ship from there and go into stocks), and they will probably still be whining next year as well. It doesn t appear that the Fed is going to raise rates any time soon.# ETN vs. ETF? W e have written about the volatility ETN s and ETF s quite a bit in the past few issues. It has been pointed out that the ETN structure is one that exposes the owner of the ETN to the credit risk of the underwriter (it is unsubordinated debt). For example, Barclays Bank has issued a number of very popular ETN s with VXX (the short-term volatility ETN) at the head of the list. But if Barclays should fail (a la Lehman Brothers or Bear Stearns), holders of the ETN might find themselves in line with all the other creditors of the firm, hoping to recoup cents on the dollar. An ETF on the other hand, does not have such problems, for the underlying assets are put in escrow. If the underwriter should fail, the assets can be sold and the ETF holders made whole. There is only one volatility ETF the VIXY, the ProShares short-term volatility ETF. In reality, the ETF structure in the volatility ETF has more unwanted problems than you might imagine. Apparently it is constructed as a partnership, so you get a K-1 at the end of the year and have to file your taxes from that (if you buy and sell VXX or other ETNs, it s just a straight capital gain like buying and selling stock). They did this so that the Section 1256 rules (any trade is 60% long-term and 40% short-term) apply. But Dodd-Frank might eliminate that anyway, and furthermore, frequent trading will make the K-1 a real adventure to read. So, the ETN structure is a lot simpler, and shouldn t be a problem as long as the credit worthiness of the underwriter remains solid. By the way, VXX and VIXY have performed in an identical fashion# June 1, 2012 There is risk of loss in all trading Page 7

8 Month INDEX OPTIONS & VOLATILITY SKEWING OEX Implied Volatility At-the-money Options Current Data & Recent History Volatility% 5/31/2012 5/17/2012 4/26/2012 June July Aug Sept Dec Dec When we last published, $VIX was near the yearly high. Since then, it has backed off a little, as can be seen from the above boxes, and from the graph on the right where the average stock s options are now in the 58 th percentile of implied volatility (down from the 65 th when we last published).# Covered Writes/Naked Put Sales OEX Implied Volatility Skewing Near-Term Options (Recent History) Strike 5/31/2012 5/17/2012 4/26/2012 At At At At At-money At At At F inally, there are some choices for covered writes and put sales that satisfy the statistical requirements. Position C447: Naked Put Sale in Cliffs Natural Resources (CLF) Sell 3 CLF June 41 puts At a price of 0.42 or more. CLF: June 41 put: 0.42 This write is viable for both cash and margin accounts. The expected investment on margin is $1,030 per naked put sold (on cash, it s the full value of $4,058). Expected annualized returns are 11% on cash and 45% on margin. Stop yourself out if CLF trades below 40-1/2 at any time.# Are you familiar with our other newsletters? Daily Volume Alerts: published daily before the market opens, this letter looks for unusual option volume as a key to what smart money is doing. Recommendations are nearly all option buys. The Daily Strategist: published twice per day, includes market comment plus analysis of put-call ratios, momentum trades, straddle buys, volatility skews, and naked put sales. One-time free trials are available for each newsletter. Volatility Skew Table Underlying Symbol Price Rating E-mini S&P500 /ESM Sugar /SBN Midcap 400 /MDM Nasdaq 100 /NDM Euro FX /ECM Chipotle Mex CMG Vera Bradley VRA Prudential PRU Soybeans /SN Autozone AZO Disney DIS Natural Gas /NGQ Vivus VVUS Silver /SIN S&P 500 ETF SPY Corn /CN U.S. Dollar /DXM Mastercard MA Avon Products AVP Omnivision Tec OVTI Verifone Sys PAY June 1, 2012 There is risk of loss in all trading Page 8

9 Volatility Skews T here is one stock that is reporting earnings in the next two weeks that is worth a play via the dual calendar spread strategy. Earnings season has wound down almost completely, but not quite all the way. The stock is Michael Kors Holdings (KORS). Earnings are due to be reported on June 12 th. Even though there will be a Hotline publication between now and then, we are including this recommendation in this issue because we realize that not everyone checks the hotline each week (although you should). We are using the dual calendar spread strategy. Since we have a number of new subscribers, we ll briefly describe the strategy. We buy a call calendar spread using a striking price above the stock price, and we buy a put calendar spread using a striking price below the current stock price. We space the strikes out by a distance equal to the near-term at-the-money straddle, because that is the option market s best estimate of the gap movement the stock will undergo when earnings are announced. We only utilize these situations when the nearterm options are very expensive, in terms of implied volatility, but the longer-term options are trading more or less with a volatility that is not too influenced by the event (i.e., earnings announcement) that is to take place. We establish this spread as close as possible to the earnings announcement, so that the stock is centered between the two strikes when the earnings are announced. We make the recommendation in a generic fashion, so that the strikes can be adjusted when the spread is actually established. An example follows. Position E940: KORS Dual Calendar Spread On the afternoon of Monday, June 11 th, Using strikes that are 5 to 6 points out-of-the-money Buy 4 call calendar spreads and Buy 6 put calendar spreads Using August options on the long side and using June options on the short side Earnings are to be reported before the market opens on Tuesday, June 12 th, which is why we buy the spread near the close of trading on the 11th. Example: suppose that KORS is trading at 39 late in the day on June 11 th. Then the position would be: Buy 4 KORS August 45 calls and Sell 4 KORS June 45 calls and Buy 6 KORS August 33 puts and Sell 6 KORS June 33 puts If you have a profit at any time on June 12 th or 13 th, then remove the position. Otherwise, we will give further instructions on the 14 th, in the next newsletter. The best profit points are at the two strikes. There will be losses if the stock moves up too far or down too far. In theory, the entire debit of the spread (about $1,570 at current prices) is at risk, although that would only be the case if the stock made a huge move (profit graph below). Put Ratio Spreads We were not able to establish either the British Pound nor the Soybeans ratio spreads recommended in the last issue, and those recommendations were canceled in the Hotline. We will re-use the position numbers. Position F398: July Gold Futures Put Ratio Spread Buy 2 July Gold 1540 puts and Sell 2 July Gold 1515 puts and Sell 2 July Gold 1490 puts For a credit of 3.00 points or more per 1x1x1 spread. One point move = $100 Options expire on June 26, 2012 /GCN2: July 1540 put: July 1515 put: July 1490 put: Allow $9,000 in margin per naked put sold. The position makes money anywhere above 1462 at expiration. Below there, large losses are possible, so exit the entire spread if July Gold futures trade at 1462 at any time. The max profit of $2,800 per spread would be realized if July Gold futures were between 1490 and 1515 at expiration. Finally, we are going to recommend a put ratio spread in Mastercard (MA). Again, this requires a good deal of margin because the stock is expensive, and there are naked puts involved. Position E941: Mastercard Put Ratio Spread Buy 2 MA July 360 puts and Sell 2 MA July 350 puts and Sell 2 MA July 335 puts For a credit of 1.00 or more per 1x1x1 spread. MA: July 360 put: 5.75 July 350 put: 4.05 July 335 put: 2.55 Allow $8,400 in collateral margin per naked put sold. The downside breakeven is 324, so exit the entire position if MA should trade at or below 324 at any time. The maximum profit of $1,100 per spread would be realized if MA were between 335 and 350 at July expiration. There is some profit as long as MA is above 324 at expiration.# June 1, 2012 There is risk of loss in all trading Page 9

10 Put-Call Ratio Charts Crude Oil: lots of pessimism Gold: extremely oversold Lean Hogs: high level buy signal Apple: new buy signal Coach: recent buy signal IBM: very oversold Lowes: new buy signal Pfizer: recent sell signal Financial ETF: new buy signal T here are new buy signals in AAPL_w, ACI, BRCM, CAT, COH, GS, HD, HPQ, KGC, LOW, EFA, XLF, OIH, XLB, XLI, Orange Juice futures and Lean Hog futures. There are once again a lot of oversold conditions: AMZN, BG, BIDU, C_w, CELG, CLF, CNX, CTSH, IBM_w, MCD_w, ORCL_w, PAY, PCX, POT_w, SD, X, EEM, FXI_w, $sox, SPY, and especially the following futures: Crude Oil, Gold, and Silver. There are new sell signals in GG, MRVL, MSFT, PAY, PFE_w, and Cocoa futures_w. There are overbought conditions in BKS, $VIX_w, and Japanese Yen futures. Futures market continue to be under a lot of pressure, both from natural selling and from the U.S. Dollar rally. Jake Bernstein s Daily Sentiment Index has 15 commodities trying to build bottoms, while T-Bonds are extremely optimistic (95% bullish). Put-Call Ratio Charts Position PC1196: Cancel the conditional call buy in McDonalds, made on last week s Hotline. Both COH and XLF have a good track record of put-call ratio buys, but we don t want to buy them until the stock charts can improve. Position PC1196: IF COH closes above 70, THEN Buy 4 COH July 70 calls. If bought, stop yourself out on a close below 68. Position PC1197: IF XLF closes above 14.25, THEN Buy 10 XLF July 14 calls. If bought, stop yourself out on a close below Position PC1198: Buy 2 August Lean Hogs 90 calls at a price of 3.75 or less. One point = $400. Options expire 8/14/2012. Stop yourself out on a close below # June 1, 2012 There is risk of loss in all trading Page 10

11 S&P 500 Index ($SPX) CBOE s Volatility Index Michael Kors Holdings Limited Cliffs Natural Resources Incorporated Mastercard Incorporated June Gold Futures Coach Incorporated Financial SPDR ETF June 1, 2012 There is risk of loss in all trading Page 11

12 Volatility Derivatives Update $VIX Remains Elevated, But The Decline Is Orderly D espite a rally attempt over the past week or so, $VIX has remained above the 21 level, which keeps it in bearish territory as far as the stock market is concerned. Intraday volatility has picked up in $SPX, but end-of-day historical volatility has not. The 20-day historical volatility of $VIX remains at 13%, meaning the difference between that figure and $VIX is still greater than 10 points a rather lofty level. The difference has been above 10 for most of the time over the past two weeks. On one day, it shrunk to 9, but that was the low. Our past studies of this phenomenon have shown that once the differential drops below 10 and stays there, the stock market itself becomes much more volatile. However, so far, the decline from the highs has lasted two months (the last month of which has been more steadily down), but has been orderly. The evidence of this orderly decline is not only in the low levels of actual volatility. For example, the only 90% down day of the entire move came just two days ago. It is highly unusual to see $SPX decline by 130 points, as it has, and not see a single 90% down day. This calmness has also allowed the term structure and premium levels to remain at elevated levels, even though $SPX is declining (although, as suggested in the feature article, the heavy demand for volatility ETN s may also be a factor in the persistent positive slope of the term structure). The graph on the right shows how the term structure has sloped upward, as the colored lines are spread evenly apart (red square on chart). As a result of the above factors, the premium on the front month (June) futures remains quite high, at As long as this is the case, the hedge of buying $VIX puts and SPY puts simultaneously is an attractive position. There is an alternative strategy, though, which involves less option time value premium, as in this recommendation: Position I454: SL 3 Jun $VIX mini-futs SL 1 S&P e-mini futures and Buy 1 SPY June atthe-money calls Only enter if June futures premium is >= Note the use of mini-futures in both cases. The long SPY call is for some protection in case $VIX increases in a rising market. Exit if the premium on the June $VIX futures is <= The margin is $6,700 plus the call cost.# VX Expiration Dates 6/20/2012 7/18/2012 8/22/2012 9/19/ /17/ /21/ /19/2012 1/16/2013 2/13/2013 3/20/2013 4/17/2013 5/22/2013 Implied Volatility of $VIX Options: On 5/31/12, with $VIX = and $VXO = Implieds (average of bid iv% & asked iv%) Strikes Months... Jun 12 Jul 12 Aug 12 Sep 12 ATM-1 111% 97% 85% 76% ATM 121% 101% 87% 77% ATM+1 127% 104% 90% 7980% ATM+2 132% 109% 93% 81% ATM+3 138% 112% 95% 83% Futures day HV 92% 61% 49% 39% June 1, 2012 There is risk of loss in all trading Page 12