enewsletter In This Issue... February 2010

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Kristin Gray
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1 In This Issue... Dear Options Trader, > DiscoverOptions Letter > Viewing and Using the VIX Premium Indicators By Len Yates > Option Strategy of the Month: Long Iron Condor Steve Lentz Director of Education On January 13th of this year, I met online with several DiscoverOptions mentoring students and we discussed Len Yates's VIX Premium indicator. What a great session! Len created the $VXX indicator in OptionVue 6 to reflect the extent the $VIX futures are priced above or below the $VIX itself, i.e. at a premium or a discount. Extreme levels can be a good indication of an impending market top or bottom. Now, Len had written that a 4-day average $VXX reading of over 2.5 is often indicative of a soon-to-occur market top. And since the $VXX had recently climbed to 2.83, our discussion revolved around timing the bearish entry, what option strategy to use and what stops would be appropriate. Look at the chart for the SPX on the following page and see what good that timing it was. Although I cannot represent that every student who traded this signal made money, I can certainly assure you that every mentoring student in attendance learned something. (continued on page 2...) Page 1 February 2010

(continued from Page 1) To watch the meeting yourself, go to: http://www.discoveroptions.com/public/pages/education/archived_web casts.html.

2 (continued from Page 1) To watch the meeting yourself, go to: casts.html. If you would like more information regarding the $VXX indicator, please read Len Yates article in this issue. Best Regards, Steve Lentz Director of Education Page 2 February 2010

By Len Yates President and Founder The VIX (CBOE Volatility Index) is a measure of the implied volatility of S&P 500 index options and is a popular index for options traders to follow.

Often referred to as the fear index, it represents one measure of the market's expectation of volatility over the next 30-day period.

We start by Figure 1 VIEWING AND USING THE VIX PREMIUM INDICATORS calculating a VIX Premium, which is the amount by which the price of a hypothetical 30-day VIX forward price (derived from VIX

3 By Len Yates President and Founder The VIX (CBOE Volatility Index) is a measure of the implied volatility of S&P 500 index options and is a popular index for options traders to follow. A high value corresponds to a more volatile market and therefore more costly options, which can be used to defray risk from this volatility by selling options. Often referred to as the fear index, it represents one measure of the market's expectation of volatility over the next 30-day period. At OptionVue we have created proprietary indicators related to the VIX (available to all clients in the OptionVue 6 software). We start by Figure 1 VIEWING AND USING THE VIX PREMIUM INDICATORS calculating a VIX Premium, which is the amount by which the price of a hypothetical 30-day VIX forward price (derived from VIX futures prices) exceeds the VIX itself. The VIX futures 30-day forward price is computed by taking the weighted average of two futures contract prices - the contract expiring short of 30 days and the contract expiring beyond 30 days. If the implied futures price is greater than the VIX, then the "VIX premium" is a positive number. If the implied futures price is less than the VIX, then the VIX premium is a negative number (and therefore not at a premium at all, but rather a discount). The first indicator we use is the VXX (using the symbol $VXX in OptionVue 6, which gives a current quote and has a historical price chart available as well). The $VXX is computed by subtracting the VIX from the interpolated 30- day VIX futures price, then adding 100. A negative VIX premium is bullish, while a positive VIX (continued on page 4...) Page 3 February 2010

February 2010 There is the question of just how positive or negative the VIX premium must be in order to constitute a signal.

4 (continued from Page 3) premium is bearish. We add a factor of 100 before storing and broadcasting the number so that it will always be a positive number and can be sent through our quotes system as an ordinary price (Figure 1). February 2010 There is the question of just how positive or negative the VIX premium must be in order to constitute a signal. This is up to individual interpretation, but the most extreme levels have given accurate signals in the past. This indicator can be relied upon to accurately call intermediate term bottoms, plus some of the intermediate term tops. (Intermediate term, here, means a period of several months.) Figure 2 Though it may seem like this would be taking the difference between two items in different time frames, it is actually comparing two items in the same time frame, because an interpolated 30-day VIX futures price represents the expected VIX price 30 days from now, and the VIX is inherently a 30-day number. As a result, the $VXX very simply compares what the futures market is saying to (continued on page 5...) Page 4 February 2010

5 (continued from Page 4) February 2010 what the $SPX options are saying -- looking 60 days out. This approach came about as the result of trying several different approaches to find the one that seemed to make the most reliable signals over the past two years. The $VXX makes very reliable signals, in my opinion. The second most valuable indicator is the $VIX36, which compares $SPX options IV levels in a 60-day and 30- day time frame. It is derived by comparing the 60-day VIX to the 30- day VIX. There is no published 60-day VIX, so we compute it ourselves and publish it as $VIX60. As for a 30-day VIX, this is the highly popular $VIX itself. We calculate $VIX36 by dividing the 60-day VIX by the 30-day VIX and then adding 10.0 so that it will always be a positive number, again so we can send it through our quote system as an ordinary price (Figure 2). Figure 3: The $VXX at a high level, corresponding to an intermediate top in the market. The $VIX36 is to be interpreted as follows: If above 10 - bearish, if below 10 - bullish. Seen over history, extreme values of the $VIX36 have been almost as valuable as the $VXX in calling turns in the market. When looking at these indicators for a signal of a market top, it is advisable to use a 3-6 day average, because singleday spikes are not reliable. Also, the actual top often happens several days following the signal, so be aware of this possible lag effect. On the other hand, when using these indicators for a signal of a market bottom, it is best to use instantaneous readings. Now I would like to tell you what steps I take to view these two indicators and how to interpret them to detect signals of possible market tops and bottoms. I compare a price chart of the SPX (S&P 500 Index) with a 4-day smoothed $VXX value over history. All that matters is absolute levels. Notice that when the $VXX was high (i.e. at or above 2.50), then it has signaled several important tops. For instance, in May 2008 the VXX was at 3.50, and look at what the market did during the next 8 weeks. It does not matter that the $VXX held its high level for only a few days. Once set in motion, the sell-off goes to completion. The VXX can help you know when the bottom (continued on page 6...) Page 5 February 2010

(continued from Page 5) February 2010 has been reached with a reading in the area of -3.50.

6 (continued from Page 5) February 2010 has been reached with a reading in the area of However, when watching for a bottom it is important not to smooth the $VXX, but rather to look at instantaneous readings. By the way, you'll notice that the VIX premium indicators were showing wildly negative numbers during the worst period of the crisis -- from 9/12/08 to 12/05/08 -- and were useless during that time. I do not know why this happened or if it could ever happen again. What the $VXX does during the selloff does not seem to matter much. It can swing between and and do all kinds of things but these movements do not seem to be useful. In my experience, the only things that matter are when the $VIX makes (and holds for a few days) an extremely high level (signaling a top) or when the $VXX is at an extremely low level (signaling a bottom). The VIX36 also has value as an indicator and should be interpreted in much the same way. The most reliable kind of trade you can use with this information is simply to take a long term (i.e. approximately 8 weeks) short position and leave it on the whole time. If you try to jump out at certain times and back in at certain times, you might be able to achieve better returns but you might not. I enjoy trying to play the daily moves, but I have to admit that I do not always succeed in enhancing my returns by doing so. Having said that, I want to bring your attention to the remarkable "topping" signals that were recently given by the VIX premium indicators, first by the $VXX and then by the $VIX36. The $VXX was seen to have readings in the area of to for several days between December 29th and January 8th. These are extremely high levels and match two similar instances back in both of which were followed by significant sell-offs lasting several weeks. The persistence of these high $VXX levels over a period of several days is also significant, in my opinion. Therefore the $VXX has given a definite signal to go short. Following directly on the heels of that, the $VIX36 spiked to on Jan 11, This is the highest level ever seen during the history of collecting this index (since August 2007). Such a high reading adds confirmation to the bearish signal from the $VXX. And now we see that the market has actually begun to sell off. Thus we will be playing this for further downside until we see a signal from the $VXX that the selling is over (Figure 3). Page 6 February 2010

7 DiscoverOptions Personal Mentoring Program Page 7 February 2010

Option Strategy of the Month - Long Iron Condor The Long Iron Condor is a strategy for stocks that are range-bound. It is in fact the combination of a Bull Put Spread and Bear Call Spread.

8 Option Strategy of the Month - Long Iron Condor The Long Iron Condor is a strategy for stocks that are range-bound. It is in fact the combination of a Bull Put Spread and Bear Call Spread. The combination of these two income strategies also qualifies this as an income strategy. Traders often will leg into the Long Iron Condor, first trading a Bull Put Spread just below support, and then as the stock rebounds off resistance, a Bear call Spread is added, thereby creating the Long Iron Condor. To construct this position you need to: 1. Buy one lower strike (OTM) put. 2. Sell one lower middle strike (OTM) put. 3. Sell one higher middle strike (OTM) call. 4. Buy one higher strike (OTM) call. All options share the same expiration date for this strategy, and there should be equal distance between each strike price. The stock price should generally be between the two middle (sold) strikes. Figure 1 (continued on page 9...) Page 8 February 2010

9 (continued from Page 8) Ideally the stock will remain between the two middle strikes with the maximum profit occurring if all four options expire worthless, and you get to keep the credit received from placing the trade. The investor writing a condor should firmly believe the stock is not going to move up or down a lot in price! If the underlying price moves higher than the strike price of the call sold, the seller will be assigned and required to sell the stock at the sold call's strike price. If the underlying price moves lower than the strike price of the put that was sold, the seller will be assigned and required to buy the stock at the sold put's strike price. To view 75+ other FREE options articles, visit DiscoverOptions.com. The DiscoverOptions Education Center offers a broad range of instructional material for all levels of options traders, from the beginner to the professional. You can easily search through more than 70 articles to find the topic you re looking for... Start Searching Now Page 9 February 2010

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