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Trader Notes: Trading the Volatility. Part 1

One of the concepts most used, and perhaps less understood, in the world of trading is the volatility, that is, the degree of variation of the price of a stock in time, in both direction and speed. This variation is directly proportional to the risk. This makes a volatile stock more attractive for trade it (for short-term or swing traders in particular), but also riskier. Knowing how to use volatility in favor of obtaining benefits is one of the arts of stock trading.

Options and Implied Volatility

Known and used by all traders, the options are the best financial instrument to make money investing a fraction of the capital that we would use in stock as such. They are the right, not the obligation, to buy (option: call) or sell (option: put) an asset at a specific price within a specified date, through the paid of a premium. That is, the options involve price and time, the two variables that define volatility, which make it, its main protagonist. (Please refer to Bill Johnson's book "Options Trading 101: from Theory to Application" for a complete understand of the world of options. I believe it has the best explanation: clear, and avoiding some complex terms for later studies). So, thanks Investopedia, let see at a glance, the main characteristics of this incredible financial instrument, from the concept of implied volatility, the basis of the option-pricing equation.

- Option premiums (its current price) have two components: intrinsic and time value.
- Intrinsic value is an option's inherent value. The only factor that influences an option's intrinsic value is the underlying stock's price versus the option's strike price. No other factor can influence an option's intrinsic value.
- Extrinsic value (time value) is the additional premium that is priced into an option, which represents the amount of time left until expiration. The price of time is influenced by various factors, such as time until expiration, stock price, strike price, and mainly the implied volatility.
- Implied volatility affects directly price options, and represents the expected volatility of a stock over the life of the option. As expectations change, option premiums react appropriately.
- Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise, or as the demand for an option increases, implied volatility will rise. So, options that have high levels of implied volatility will result in high-priced option premiums.
- Conversely, as the market's expectations decrease or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in cheaper option prices. 

- So, a change in implied volatility for the worse can create losses, however, you are right about the stock's direction. That's why options are very difficult for traders: you need to know not only direction but speed.
- Each listed option has a unique sensitivity to implied volatility changes. For example, short-dated options will be less sensitive to implied volatility, while long-dated options will be more sensitive. This is based on the fact that long-dated options have more time value priced into them, while short-dated options have less.

- The "Greeks" (Delta, Theta, Vega, and Gamma), a set of risk measures, help to value this sensitivity, or exposition, of the option to time decay, implied volatility, price. Its use is ideal for analyzing more complex option spreads as calendars, verticals, straddles, butterflies or iron condors.
- Each strike price will also respond differently to implied volatility changes. Options with strike prices that are at the money ATM are most sensitive to implied volatility changes, while options that are further in the money ITM or out of the money OTM will be less sensitive to implied volatility changes.

- Implied volatility fluctuates the same way prices do. Implied volatility is expressed in percentage terms and is relative to the underlying stock and how volatile it is. So, each stock volatility should not be compared to another stock volatility range.
- Implied volatility moves in cycles: high-volatility periods are followed by low-volatility periods, and vice versa. If you can see in its chart where the relative highs are, you might forecast a future drop in implied volatility or at least a reversion to the mean. Similar to its relative lows.- In the process of selecting option strategies, expiration months or strike prices, you should gauge the impact that implied volatility has on these trading decisions to make better choices. This knowledge can help you avoid buying overpriced options and avoid selling underpriced ones. In fact, to be profitable, you need to be aware of the amount of implied volatility (IV) that each option traded carries.

This useful chart shows the suggested trade (buy or sell) for options (calls, puts, and spreads) according to its implied volatility (low, neutral or high), and the market direction (bear, neutral or bull). Use only as a reference, the theory is more complex than this.

Determining if the IV of your stock is High or Low

In order to evaluate the implied volatility and considered at a high, medium or low level, traders should take into consideration some aspects:

- Overall Market Analysis:
Analyze the VIX index to have a big picture of the implied volatility of the market as a whole. The "fear index" gauges the market's expectation over the next 30 days, and trends exactly the reverse of the SP500 SPX. A high VIX means a high volatile market, and so, a rise in the options' price. Compare this value with the IV of your particular stock, to consider it higher or lower than the VIX value.

- Implied Volatility of the Underlying Security Traded:
Compare the current IV to the past IV over a period of a year, to identify if it's in a relatively high or low range to the past. If IV is high, try to understand the reason: news, earnings, acquisition rumors, other events. Keep in mind that after the event occurs, the IV collapse and always reverse to the mean when it reaches extreme highs or lows. So, when you see options trading with high IV, or higher than typical, consider selling strategies. The opposite for lows IV.

- Relation between Implied and Historical Volatility:
Historical volatility (HV) is the volatility experienced by the underlying stock. So, in contrast to HV which looks at actual asset prices in the past, the IV looks ahead. Compare these two indicators over a period of a year, and in the same chart. There are three possible scenarios:

IV > HV: options may be regarded as relatively expensive and it's convenient to sell.

IV < HV: options may be regarded as relatively cheap and it's convenient to buy.

IV = HV: options are not so expensive and not too cheap. You may either buy or sell options.

Finally, and no less important, traders need to complete its analysis comparing HV at this time with HV in the recent past. The HV chart can indicate whether current stock volatility is more or less than typically is. If current HV is higher than typical in the past, the stock is now "more volatile than normal". If the IV is low that didn't match this higher-than-normal volatility, the trader can capitalize on the disparity by buying options price cheap. Same on the contrary case.

- The Implied Volatility Range
It's about to identify the IV trend, up or down, and its turning points. Usually can be considered cheap options those that are traded at the low of their IV range, priced at less than the volatility of the underlying. On the other side, can be considered expensive options those that are traded at the high of their range, priced at more than the volatility of the underlying security.

- The Effect of Time Decay
Generally, the value of IV become higher as options approach to expiration, its percentage change more quickly due to an increased degree of uncertainty. The fact is that this is directly related to the amount of time left on the option. So, the IV has a stronger impact on the price on long-term options due to the higher amount of time value left till expiration.

Knowing these basics of options and volatility, in the next "Trader Notes" I will analyze some ideas on how to trade the VIX indicator and play the market in these months of high volatility (VIX >20% is considered a volatile market).

Disney's price is shown with its implied and historical volatility in a chart below, for a better comparison. As you see, today its IV=26.12% and HV=33.05%. The first thing I check is that its value is greater than the market VIX, currently at 22%, which is logical considering that DIS is a "value stock", which tend to have lower volatility than "growth stocks".
Its implied volatility reached highs in late December and then, as expected, reverse to the mean, and now is almost at its 50%, so it may be regarded as neutral. Finally, as its HV is higher than typical in the past, the stock is now "more volatile than normal". As its IV didn't match this, and also is in a downtrend toward lows, we have here a signal that its options are relatively cheap.
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Ideas from my Stock Watchlist for this Week

Market Pulse.

Stocks climbed to new highs this week after the FED suggested it would give a Rate-Cut in as soon as next month, to keep the Trade War from stopping economic growth. The rally comes after trade tensions and uncertainty over FED policies worried investors last month, with stocks posting their worst May since 2010. Dovish feelings in the FED and a probable meeting between Trump and Xi during next G20 summit, helped share prices this month, putting the SP500 SPX on pace for its best June since 1955, and now testing a crucial resistance at 2,950 level. A consequence of the central bank decision is that US Treasury’s yields remain near multi-year lows: the 30-year yield TYX is near 2.6%, while the benchmark 10-year yield TNX is below 2%, the lowest level since 2016.

As usual, crude oil prices climb when geopolitical tensions increased. Now fears come due of a U.S. military attack on Iran after it was reported that Iran shot down an unmanned U.S. surveillance drone over the Strait of Hormuz. Iran claimed that the drone was impeding on its territory. Oil futures /CL ended the week at $57.60 a barrel with a 6% up that day, the largest one-day rise since December. Metal prices shot up since Thursday, lifted by FED decision affect a weaker dollar: Gold futures /GC gets its biggest one-day advance since June 2016 and its highest settle since 2013, overcoming the $1400 level. Definitively, gold is (one of) the best instrument for trading this month, through its popular ETFs like GLD, GDX or those at triple velocity JNUG, DUST, and NUGT.

Ideas for this Week

Next, some brief ideas and technical notes of stocks from my June watchlist, for this week, June 24 to 28th.

1. Cree CREE $57.15

Its daily chart shows a stronger downtrend line (price touches it 4 times). This week again is approaching it, and a breakout could happen if market confirms its recent rally. Low Put/Call show a bullish sentiment of investors in this good company.

2. Dropbox DBX $25.01

Last Thursday its price breaks its downtrend line with heavy volume. Now it's overbought, and I will check if price retest this line, now support. As its implied volatility is low, seems a good moment to buy cheap options. The bullish sign could be the golden cross that is near to happen in its daily chart.
3. Fiserv FISV $91.48

Touches its resistance at $91.50, but clearly overbought. Recent outperform ratings by Wells Fargo and then Raymond James, with a price target of $110 and $103 force me to check carefully this stock this week.

4. Gilead Science GILD $69.38

Its price, ranging in a channel during all the year, last week breaks an important resistance, with confirmation include. Also overcomes its crucial SMA200 average. Good stock for options due to its low volatility. Only waiting for a pullback for entry long here.

5. PayPal PYPL $116.21

I'm paying attention to a bearish evening doji star candlestick in its daily chat, confirmed last Friday. In an amazing rally for 2 years, with a PE of 63, this stock needs a technical correction, probably a retest to $110 level.

A next golden cross (when SMA50 crossover the SMA200 average) will reinforce the bullish bias in Dropbox DBX after its recent breakout.

6. Atlassian TEAM $132.87

Same as Paypal, shows a bearish evening star in its daily chart, and its MACD decaying, signals some exhaustion in its long rally.

7. Twitter TWTR, $35.02

The level $35 is recurrent for this stock in the last two years. Its price does not finish taking off: always return to that level after up and down movements. A crossover below this level is forecast in the short-term due to its weak MACD, its recent removing accounts (that Wall Street dislikes), and also, Moffett Nathanson arguing that Twitter isn't spending enough to deal with the security issues that are plaguing tech giants, reiterating its sell rating.

8. Ulta Beauty ULTA $35.81

The cosmetic giant is again testing its all-time highs at $365, with a recent fine earnings report and some buy ratings along. Need to confirm its behavior at that level, probably rebounds on it or breakouts. In my radar.

9. VMWare VMW 173.39

I can´t understand why this stock falls after its decent Q1 earnings report in late May. It beats EPS and sales, maintaining its guidance for 2020, and confirm a$1.5B stock buyback. Partnerships with Amazon AMZN and Dell DELL reinforced my bullish view in this company. Three analysts raised its price target versus one (Morgan Stanley) who cuts it. Technically form a double-bottom pattern at $165.60 level, rebounding now from his. VMWare looks like a bargain today for the long-term.

10. US Steel X, $14.67

What a difficult stock to trade! Due to its volatility and usual uncertain moves in the struggling steel sector, I only use this stock for day-trades, checking if have a strong pre-market move, that usually continues some hours during the regular session, for a quick profit. It's daily chart show a bearish engulfing candlestick, but last Barron bullish report views finally some good news in the steel sector.

As you see in this weekly chart, the $35 level is critical for Twitter TWTR in the last two years. Good opportunity for traders after the stock decides where to move. Seems a bearish bias is more probable.

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Trader Notes: InterMarkets Analysis. Part 2

John Murphy

This post complements the previous one published a few days ago and aims to give a summarized idea of what intermarket analysis is about, study developed by John Murphy in his two classic books 'Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity and Currency Markets '(1991) and' Intermarket Analysis: Profiting from Global Market Relationships '(2004). Although they may seem out of date because it does not deal with recent events such as the crisis of 2007, its reading is indispensable for a trader because it gives us a global vision and a better outlook when explaining in very detail the relationship between the four markets (currency, commodities, bond, stocks) and how they influence one another. This will allow us to establish our portfolio, telling us the best place to start investing in instruments for the medium and long term.

Inflation and Deflation

A basic idea of Murphy's book is to understand that the correlation between markets depends on the environment, which is stronger: inflationary (like the current one, with the general level of prices increasing), or deflationary (the opposite). Both extremes can be harmful to the economy: the first decreases the value of money over time, the other causes one to postpone his purchasing decisions ('I do not buy today, the next week will be cheaper'), situation which ends up increasing unemployment. The ideal is to maintain price stability, with a low and stable inflation, never close to zero, being the order of 2-3% the usual target.

Main correlations

There are several but I only summarize the main ones. In an inflationary environment, stocks and bonds move in the same direction or have a positive correlation. The useful fact here is that bonds usually change direction before stocks. Another key correlation is the inverse between the dollar and the commodities, being the best known and used by the traders the inverse gold-dollar relationship. Again, the useful fact for the trader here is that commodities usually change direction after stocks. As a complement, in inflation, a fall in i-rate drive up stocks (stimulate the economy, as in 2009-2016) and also bonds (lowers its yield, which is the inverse of the price).

The intermarkets relationships during deflation are largely the same in inflation, except for one: stocks and bonds have a inverse correlation.

In deflation, the fear of it moves the money from the stocks to the bonds, especially towards the safe Treasury Bonds that raise their price, lowering their yield. Observed that the relationship between stocks and bonds is here, inverse. What a central bank usually does as a solution is to increase the i-rate to decrease the deflationary effect in the economy.

The charts are explained alone: the best hedges according to the environment, inflationary and deflationary: gold and bonds, respectively.

Dollar vs. Commodities (or USA vs. China...)

It is understandable that when an economy strengthens and inflation begins to rise, commodities begin to have more demand and raise their price. The main reason for the inverse relationship between the dollar and the commodities is that this is quoted (exchanged) in dollars. When the price of the dollar falls, emerging markets importers will have more purchasing power and therefore, demand for these products will increase, which in turn will cause a rise in the prices of products. So, commodities have a positive relationship with stocks and i-rate, and inverse with bonds, both in an inflationary or deflationary environment.

One of the best lessons of intermarket analysis: the inverse relationship between the dollar and commodities. This 2018, the crisis of emerging markets, very linked to commodities, is generating the strengthening of the dollar.

Remember, a strong dollar will always be a problem for a commodity, given that these are always traded with that currency, while a weak dollar is usually a stimulus for exporters and therefore for commodities. Thus, in 2015, China devalued intentionally its currency (falling its exchange rate through a rise of the dollar/yuan pair) to lower its exports (and make imports more expensive) and therefore accelerate its growth to the annual target of 7%. For 25 years China lives with a trade balance in surplus (exports> imports), with reserves and a fixed exchange rate.

In the USA, in 2017 the dollar remained under great pressure, as it was expressed Trump's intention to keep it weak in the short term as a government strategy, to favor exports and weaken imports. Totally different this 2018 with the dollar strengthening towards the long term with the beginning of the Trade War and the tax reform, as was the initial express wish of Mnuchin. Definitely successful Trump's strategy with the dollar, complicating all its global peers and emerging markets.

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