THE OPTION STRATEGIST™ © McMillan Analysis Corporation P. O. Box 1323, Morristown, NJ 07962–1323

Volume 22, No. 6 Editor: Lawrence G. McMillan

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n case you missed our recent live webinar on Portfolio Protection, please note that it was recorded, and the recording can now be purchased. Since Friday was a market holiday (Good Friday) and the regular publications won’t be received by subscribers until Friday, we published an interim hotline update late Wednesday night, to deal with matters that needed to be taken care of on Thursday, March 28th (in particular, see page 5) There are two articles of note in this issue. The first is an article on the feasibility of the new mini options (options on 10 shares of the underlying). It turns out, they can be useful in certain situations. On page 3, an article discusses using the ratio of Copper to Gold as an stock market indicator. It can be quite useful in identified broad market turning points. It recently issued a sell signal. Our market opinion remains bullish, at least until some of our main indicators begin to generate sell signals and until there is a breakdown in price (page 7). Three straddle buys are recommended on page 9 (Coffee, THC, and KBH). A $VIX put backspread is recommended on page 12.#

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Our 22 Year of Publication

March 29, 2013 Research: Ryan Brennan

Mini Options? What’s The Point?

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he new mini options began trading on March 18th. We held off writing about them for a little while so that we could see how volume and open interest were trending. A mini option is for 10 shares of the underlying stock or ETF, rather than 100 shares as is the case with “regular” options. So far, there are mini-options only on five stocks: Amazon (AMZN), Apple (AAPL), Google (GOOG), Gold ETF (GLD), and S&P 500 SPRDs (SPY). Are these options worth using, or are they just another example of a product that the marketplace doesn’t really need? In this article, we’ll try to answer that question (hint: there’s not a simple “yes” or “no” answer) by looking at volume, pricing, strategy, and other considerations.

McMillan’s Upcoming 2013 Speaking Schedule NEW!! McMillan Live, Intensive Option Webinars Live! Speculating With Options Saturday, May 18th; 9am – 1pm, Eastern time Cost: $265.00; This webinar will be recorded and availalbe for purchase http://www.optionstrategist.com/products/category/live-webinar

Recorded: Modern Portfolio Protection Two hour webinar recorded 3/16/2013 Cost: $79.00; This webinar was recorded and will be available for purchase http://www.optionstrategist.com/products/category/live-webinar

AAPTA 2013 Annual Conference American Assoc. of Professional Technical Analysts McMillan talk: The Truth About Volatility Derivatives New Orleans Marriott Hotel, 555 Canal St. May 10-11, 2013 http://www.aapta.com

All events: http://www.optionstrategist.com/products/category/events

Basic Definitions On March 18th, all of the major option exchanges began trading mini options on three stocks and two ETFs (AAPL, AMZN, GLD, GOOG, and SPY). A mini option is an option on 10 shares of the underlying instrument. They trade with a slightly different symbol. For the time being, the symbol for the mini-option is merely the regular underlying symbol with “7" at the end (AAPL7, AMZN7, etc.). The mini options have the ability to trade all of the expiration dates: monthly, weekly, quarterly, and LEAPS. It is unclear if all of these will be listed for all of the underlying instruments. The obvious attraction of these options to the small retail investor is that they are one-tenth the price of a “regular” stock option. Of course, commission costs are probably not one-tenth as much, since commissions are generally based on how many contracts one trades – not on what those contracts cost. Even if one has a commission rate based on the total dollars in the trade, there is likely to be a minimum commission, and a trade in these mini options would likely be below the minimum. Mini-futures have been around for quite some time, and there is a large discrepancy in performance for trading systems based on the “big” contracts as opposed to the “mini” contracts. All of that performance difference is due to commissions. The same will be true of the minioptions unless the brokers give special discounts, which – so far – they have not been doing. In effect, the commission rate for a mini option trade is 10 times the rate for a “regular” option trade. Trading To Date So far, these options have been a modest success. Here is the trading volume since March 18, comparing the mini options to regular option volume. Table 1: Option Volume Since March 18, 2013 Underlying Mini Opt Regular Opt Volume Volume AAPL 85K 3,664K AMZN 27K 415K GLD 19K 1,077K GOOG 13K 549K SPY 198K 1,761K

Pct% 2.3% 6.5% 1.8% 2.4% 11.2%

SPY seems to be the big winner – both in terms of total volume and in the percentage of regular option volume. That seems a bit strange. It makes some sense to me that small traders would want to utilize mini options in AAPL and GOOG, where the underlyings trade for 450 and 800,

March 29, 2013

roughly. One 3-month, at-the-money “regular” call option on AAPL costs almost $2,400; on GOOG, it costs nearly $3,000. In our seminars and in our risk management writings in the newsletter, we often encourage speculators to limit each speculative trade to 3% or so of his speculative trading account. Hence, in this newsletter, we often position the trades so that one spends about $1,500 (3% of a theoretical $50,000 speculative account). Moreover, one generally likes to be able to buy more than one option when speculating, so that he can take partial profits along the way. Clearly, one AAPL or GOOG “regular” option – costing $2,400 or $3,000, respectively – would not fit within those risk parameters. But a mini option would. Instead of buying one 3-month at-the-money “regular” call on AAPL for 24, one could instead buy 6 mini options for 2.40 each, spending $1,440 and staying within the $1,500 risk metric. For this reason, I think mini options make sense when the underlying is very high-priced, causing a single option to cost more than a retail investor might want to risk in a speculative trade. Hence AAPL, AMZN, and GOOG mini options serve a useful purpose (a 3-month “regular” at-the-money call on AMZN costs $1,500) However, that is not the case with GLD or SPY. Those options trade at fairly normal prices. A 3-month “regular” call option on either GLD or SPY costs about $400. That should leave enough room to buy multiple contracts with incurring the larger commission rate. Perhaps those GLD or SPY mini options – which cost about $40 each – would be attractive to very small accounts. In that case, I would say that the mini options are useful if one is truly using risk management techniques on his account. This is often a problem for a very small account – say one with $5,000 or $10,000 in net asset value. An account that small can’t really use the “no more than 3% in any one position” rule, where “regular” options are concerned. But with mini options, he possibly could (whether he would or not is another matter). Summary There are benefits to mini options for smaller accounts, especially those who understand and want to implement risk management techniques. However, the drawback is the likely increased commission rate, since commission dollars do not decrease. For those with the discipline to use risk management techniques, the mini options are useful.#

There is risk of loss in all trading

Page 2

The Ratio of Copper to Gold

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he ratio of the price of copper to that of gold is used by some as an economic indicator. It can also sometimes be useful as a stock market indicator. This is something that I have only looked at peripherally over the years, but I decided to do some more serious research. For the purpose of this study, the continuous futures prices of Copper and Gold were used, and not the cash prices. I don’t think that makes any difference at all. You will see that these charts are quite long-term and only major trends and turns are meaningful. Hence, a small daily difference in the ratio is insignificant – if there even is any difference between the ratio of continuous futures price and the ratio of cash prices. The general theory is that when the economy is expanding (and hence when the stock market is rallying, more or less), the ratio of copper to gold will move higher. Copper is an economic barometer of sorts, while gold is a defensive commodity. Hence traders buy copper and sell gold when times are good. However, when during bearish times – either for stocks or for the economy, the ratio begins to fall as traders reverse their actions: now buying gold and selling copper. Hence peaks in the ratio should coincide with peaks in the economy and/or the stock market, and troughs should coincide with market bottoms or the beginning of an economic recovery. There are three graphs that we will be discussing with respect to this topic. The first graph on the right – Figure 1 – shows the ratio since the beginning of 2010. The peaks are at points A (shortly before the stock market decline associated with the “flash crash” began), C (slightly before the stock market topped in May, although the serious market decline didn’t begin until late July), and at point E (more or less coincident with the 10% market correction that took place in the Spring of 2012). So the peaks were good indicators of “trouble ahead” for the stock market. In a similar fashion, the troughs were important, too. Point B occurred almost simultaneously with the market lows of 2010, after which a strong stock rally occurred. Similarly, in 2011, Point D marked an excellent buy point for stocks following the problems of late summer and fall, 2011. Finally, point F coincided with the bottom just last November (2012), which was also a good buy point for the stock market.

March 29, 2013

Figure 1

Figure 2 There are other, more minor, peaks and troughs on the graph, but I have tried to identify the major trend changes. It is unclear to me whether the exact height (or magnitude) of the ratio is important or not. I don’t think it is, although we will address this topic again in the longer-term chart on page 4. This brings us to the current time. As you can see from the right side of Figure 1, the ratio topped in February, about a month ago. When considering points A and C, we see that the ratio sometimes peaks in advance of

There is risk of loss in all trading

Page 3

any actual stock market decline. So, this is yet another indicator that is indicating a market top. Let’s look at some longer-term charts, for I think they are instructive as well. Figure 2 shows the ratio going back to the beginning of 2006, so that it encompasses both the last bear market and the current bull market. Points A and B are marked on Figure 2, and are the same points as on Figure 1 – just for perspective. Points C through F are not repeated on Figure2. Rather, concentrate on the earlier action in 2006 through 2009. Points G, I, and K once again identified substantial market tops. Point G occurred near November 1, 2006. That was early, but eventually the market broke down sharply in February, 2007. After that, at point H, the stock market and the ratio simultaneously moved higher. But the ratio peaked again at point I, in the summer of 2007, preceding not only the first sharp break in the “subprime debt crisis” of July-August, 2007, but the eventual market peak in October. From there, stock the market declined sharply (about 280 $SPX points) into point J. Point J was, in retrospect, a bit of a dangerous place to buy the market, but a rally did unfold into about May, 2008. About that time, the ratio peaked again – at point K. That one preceded the biggest drop of all, in the financial crisis of late 2008. From there, the ratio plunged to Point L, eventually bottoming just before the eventual market bottom in early 2009. Long-Term Chart Finally, consider Figure 3, which shows the ratio from 1998 through 2013. Points G and A are marked on Figure 3 as reference points for Figures 1 and 2. What is more important on this chart, though, is to consider points M through P. Since this was the end of a roaring bull market, the ratio was quite low in comparison to where it went in the 2005-2009 period. It was lower then than it is today, but again I contend that the peaks and troughs are what is important and not the absolute levels of the ratio. Point M was a peak and was a good warning of the nasty bear market that took place in August-October of 1998 (the Russian Debt Crisis, which was followed by the Long-Term Capital Hedge Fund Crisis). Point J was late as a buy point, but still was early enough to allow one to participate in the strong rally of 1999. If you look closely at the chart, I have marked Point O in late 2000, which preceded the sharp stock market drop of 2001 and eventually, the bear market of 2002. However, there is a peak on the chart in late 1999, between points N and O that, if observed, would have

March 29, 2013

Figure 3 alerted one to what eventually became the tech stock massacre of April 2000. Perhaps in real time, with a shorter-term chart, these points would have been more obvious (and tradeable), but at the distance imposed by a 15-year chart, it’s not clear that one would have acted then. In that vein, there is a minor trough (minor, in the context of a 15-year chart) between points O and P. But I have only marked the extreme low at Point P, which was an excellent buy signal right near the bottom of that bear market. It allowed one to be long for the excellent strength from 2003 to 2006. The ratio never really wavered much during that time, so it would have kept one long all through that bull market. Summary The above charts clearly show that the trend of the ratio of copper and gold coincides with that of the stock market (I really don’t care much about “the economy,” because I can’t trade that). Since the ratio peaked about a month ago, this seems to be a warning sign for the current market advance. I don’t know whether there is anything to be gleaned from the fact (see Figure 1) that this strong stock market rally – especially in the last year – has not been accompanied by a strong rising copper-to-gold ratio. My first thought would be that the economy is not strong, and hence the ratio hasn’t risen strongly. Rather, the Fed’s actions have propelled the stock market, separate from the economy. But what do I know or care about fundamentals? Not much. All I can say for sure is that ratio has peaked and that is a warning for stocks.#

There is risk of loss in all trading

Page 4

“First Day Of The Month” System

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e sometimes trade the first day of the month, since this is a profitable seasonal trading system dating back more than 20 years. The first trading day of April is a strongly positive day, or has been in the past, at least. The summary of the first trading days of each month since 1990, in terms of $SPX profit is shown below: Total Gains by month: Jan 86.5 Feb 125.0 Mar 21.8 Apr 108.5 May 139.5 June -34.4 July 109.4 Aug 4.7 Sept 67.8 Oct 15.4 Nov 3.3 Dec 2.6 Sum

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oming soon, all three of the major technical analysis societies in this country will be having their annual conferences. These are generally open to the public, albeit at a slightly higher cost than members are charged. This year, these conferences are spread out across the country, so you may find one in your general area of the country: New York, New Orleans, and Denver. Check the web sites below for agendas, speakers, topics, and so forth.

American Assoc. of Professional Technical Analysts (AAPTA) 2013 Annual Conference Friday-Saturday, May 10-11, 2013 New Orleans Marriott Hotel, 555 Canal St. http://www.aapta.com

650.11

You can see that April is a strongly profitable month – the fourth best of the year, but virtually the same as July. So far this year, January and February have been very strong “first days.” The results in the above table assume that one bought $SPX on the close of trading on the last day of the previous month, and then sold at the close of trading on the first trading day of the new month. This year, the first trading day of April presents a bit of a problem, though, in that one is forced to hold for three days (over the 3-day weekend) before the first trading day occurs. That is a lot of time for negative events to unfold in Europe or elsewhere. However, if one waits until Monday morning to buy, he could well be too late, if there is positive news out of Europe or elsewhere that causes a gap higher over on Monday. So, not seeing any real need to fiddle with a system that has been working, we are going to play it “straight:” Position S657 (we are using the same Position number as previous “first day” trades) At the close of trading on Thursday, March 28th, Buy 6 SPY April 5th (weekly) calls One strike in-the-money Sell the entire position at the close of trading on Monday, April 1st. If SPY rises by 2.00 points or more at any time on Monday, April 1st, sell half of your calls.#

March 29, 2013

Technical Analysis Conferences

Mr. McMillan will be speaking at this conference: “How Does One Really Use Volatility?” The talk includes 1) using $VIX as a technical indicator, 2) overview of available volatility ETFs and ETNs, 3) $VIX futures and options, and 4) applying the theory: the Volatility Capture strategy used by our RIA in our managed accounts.

National Association of Active Investment Managers (NAAIM) Uncommon Knowledge 2013 Annual Conference Sunday, April 28 – Wednesday, May 1, 2013 The Westin Denver Downtown, 1672 Lawrence St. 888-261-0787 email: [email protected] http://www.naaim.org/events/annual-conference

Market Technicians Association (MTA) Annual Symposium 2013 Thursday-Friday, April 4-5, 2013 Convene Conference Center, 730 Third Ave., New York http://symposium.mta.org These conferences generally have industry experts as the speakers, and all of the talks revolve around technical analysis to one degree or another. Mr. McMillan will only be speaking at AAPTA this year. In addition, these talks are not promotions or advertising, as is often the case at more general investment conferences.#

There is risk of loss in all trading

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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. Naked puts: all of the March naked puts expired worthless. Position E974: we exited the APOL Apr 17 puts since the stock was no longer declining. Position E977: we set a stop at 209.50 for the IBM calls. Position E978: raise the stop for the K June 60 calls to 62.75 Position E984: we sold the HAL calls and set a stop for the puts Position F410: we added 7 VIX Apr 22 long calls. Position F411: the Long July Coffee 137.5 straddle. If you were unable to buy this straddle at our stated limit, increase your limit to 12.10. Hold without a stop initially. Position I483: we rolled the SPY Apr 152 calls up to 155. Position I484: we added 3 VIX Apr 22 long calls. Position PC1238: we raised the stop for the WFC calls to 36.75. Position PC1245: the CHK April 22 calls were stopped out on March 22nd. Position S691: the May Sugar futures were stopped out on March 26th. Position S692: lower the stop for the FXE April 129 puts to 128.5. Position S694: we bought the FXY May 104 calls when June Yen futures closed above 106. Set the stop at 101.50. Position S695: we were stopped out of the May Sugar 185 calls today. Position S696: we bought the GLD Apr 145 calls on Mar 21st. Position W1: The SPY weekly calendar spread. We are long "regular" April options and short April 5th options with the calls having strikes of 158, and the puts having strikes of 153 and 154. If it is necessary to roll the entire position, buy regular April options and Sell April 12th options, using strikes +/-2.5 points from the SPY closing price on Friday. Otherwise, roll the March 28th options to April 5th options, per the following table:

Category

Recent Mark

Spec:

S604: Strategic Alternatives –4666 Results to date S645: VXX System Trade +4140 Results to date S657: First of the Month System +1100 Results to date -18 L 6 SPY Apr (5th) 156c S692: L 8 FXE Apr 129p +2840 Stop: 128.5 S694: L 8 FXY May 104c –256 Stop: 101.50 S696: L 5 GLD Apr 156c –475 Stop: 153 S697: L 2 /SBK3 1850c –186 Stop: 17.70 S698: L 3 /XWK3 –1087 Stop: 680 S699: L 4 SPY May 154p –244 Hold W1: SPY weekly calendar +845 Results to date L 5 Apr 158c, S 5 Apr(5) 158c, L 5 Apr 153p, S 5 Apr(5) 153p

POSITIONS CLOSED SINCE LAST ISSUE Category Cov. Write:

Equity:

Futures: Index:

Speculative: Put-Call:

Position C477: STZ put credit sprd C478: LMT put sale C479: KMB put sale C480: MRK put sale E964: AB strangle E972: CHTR strangle E974: APOL diagonal sprd E976: FB dual calendar F409: Mar SP put ratio I478: $VIX/SPY put hedge I480: $VIX call backspread I481: SPY Mar put ratio I485: $VIX/SPY diagonal S691: L 1 /SBK3 S693: L 8 DE Mar 90c S697: /SBK3 1850c PC1239: FXB Apr 150p PC1245: CHK Apr 22c

March 29, 2013

Profit/Loss +135 +159 +144 +99 +3188 –958 +140 –1440 –754 –742 –546 –72 –211 –1146 –16 –1463 +3150 –1212

Comment

Cov. Write: C481: KMB put sale (mgn only) +114 Stop: 84 C482: BIIB put sale (mgn only) +246 Stop: 158 Equity: E969: CCJ straddle –490 Hold L 5 June 19c, L 5 June 19p E977: IBM strangle buy +516 Stop: 209.50 L 3 Apr 215c E978: K strangle buy +1122 Stop: 61 L 3 Jun 60c E979: MCHP straddle buy –365 Hold L 5 Jul 37c, L 5 July 37p E980: PAAS strangle buy –456 Hold L 9 Jul 16c, L 12 Jul 15p E981: MPWR straddle buy –495 Hold L 5 Jun 25c, L 5 Jun 25p E982: APO strangle buy –392 Hold L 8 Jun 25c, L 8 Jun 22.5p E983: HRB straddle buy +56 Hold L 8 Jul 28c, L 8 Jul 28p E984: HAL straddle buy –150 Stop puts > 41. L 5 Jul 43p Futures: F410: Apr SP put ratio spread +413 Roll @ L 2 1540p, S 2 1520p, S 2 1500p, L 7 VIX Apr 22c, L 7 VIX Apr 40c Index: I482: $VIX call backspread –538 Hold L 10 Apr 15c, S 4 Apr 10c I483: $VIX/SPY call hedge –75 Hold L 3 SPY Apr 152c, L 6 $VIX Apr 17c Put-Call: PC1238: L 8 WFC Apr 33c +1824 Stop: 36.75

Weekly:

SPY > 160: re-center as noted above. SPY 159-160: sell 159 calls and 154 puts SPY 156-159: sell 158 calls and 154 puts SPY 153-156: sell 157 calls and 153 puts SPY 151-152: sell 157 calls and 152 puts SPY < 151: re-center as noted above

Position

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Status of VXX/XIV Strategy

here has been considerable interest in this strategy we developed, since it was first introduced in Volume 21, Nos. 3 & 4.

Current Position: Flat; stopped out on 12/21/12 Entry Criteria: VX3 – VX1 >= 3.00 (currently 2.38) The differential between the first and third months is 2.38 – too low for entering the trade. Besides, we would not enter with $VIX at such a low level.#

There is risk of loss in all trading

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SENTIMENT INDICATORS

Our indicators remain bullish, but somewhat overbought, as $SPX has apparently broken out to the upside once again.

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hankfully, the Standard and Poors 500 Index ($SPX) has finally closed at a new high, exceeding the market from October, 2007. In the last two weeks, $SPX has been confined to a narrow range between 1540 and 1565. Today, it closed near 1569, so that is apparently an upside breakout. However, it still hasn’t taken out the all-time intraday high near 1575, but that should occur soon. Once that happens, there is no resistance, per se, since prices have never traded that high. However, traders are often wont to sell at round numbers, so 1600 on $SPX may represent a resistance level. Equity-only put-call ratios have been of dubious value of late, due to the heavy amount of put buying that traders were establishing as hedges. Normally, call buying would be dominant as a market reaches all-time highs, but the cheap availability of $SPX puts as a hedge has caused large institutions to buy a lot of those puts. It appears that this period of hedging and distortion may be coming to an end, for recently, the put-call ratios have started to plummet again. They are trending sharply lower, and that is bullish for stocks. Hence these ratios are on buy signals. They will only turn bearish if they roll over and begin to rise.

“Stocks Only” Data Date

Adv

Decl

Net

20130315 20130318 20130319 20130320 20130321 20130322 20130325 20130326 20130327 20130328

1322 860 1102 2604 784 2026 1191 2222 1486 1991

1777 2386 1981 666 2487 1007 1817 911 1422 1146

-455 -1526 -879 1938 -1703 1019 -626 1311 64 845

90% Days are shown in red March 29, 2013

Market breadth has managed to remain on buy signals, but just barely. That is, breadth has slacked off in the past couple of weeks. Perhaps that was just a result of the market being in a tight trading range. But even after today’s action, the breadth oscillators are not that far from a sell signal. One strong down day or two modestly down days would probably be enough to generate sell signals. Volatility indices have remained at very low levels, and are thus bullish. The spike peak buy signal that was generated back on March 19th has proven to be effective. As long as $VIX stays below 14, the bulls have an “all clear” signal. Even on probes above 14, $VIX would only become bearish if it were to develop a true uptrend. The construct of $VIX futures continues to remain bullish, as it has for a long, long time. The term structure hasn’t had an inverted shape since November, 2011. $VIX futures are trading with premiums – more modest premiums than they had for most of 2012, but still a premium. The front-month April futures are settled at a premium of 1.49, and the longest-term December (2013) futures settled with a premium of 6.75. Thus, the term structure continues to slope upward. That, coupled with the futures’ premium levels, presents a generally bullish picture for stocks. Let’s quickly review a couple of other indicators. First there is the Composite Implied Volatility (CIV). The average stock’s CIV is in the 8th percentile, and that is overbought. But it won’t generate a sell signal until it rises above the 17th percentile. Also, the frequency of “90% days” has dropped to zero. That is, there hasn’t been a single “90% day” – either up or down – in the last 50 trading days (not since January 2nd) . That, too, is overbought. It will generate a sell signal when it rises to 2. Finally, as a follow-up to the article we published in the last issue about the distance from the moving average, $SPX is currently 13.9 standard deviations above its 200day moving average. That is an extreme amount and is commensurate with readings that have marked intermediateterm tops in the past. In summary, the indicators remain bullish, but somewhat overbought. This market probably needs fewer doubters before it can really top. That may take a while.#

There is risk of loss in all trading

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INDEX OPTIONS & VOLATILITY SKEWING OEX Implied Volatility At-the-money Options Current Data & Recent History Month Volatility% 3/28/2013 3/14/2013 2/28/2013 Apr 10.2 9.8 12.8 May 11.0 10.7 13.0 Jun 11.8 11.5 13.1 Sep 12.9 12.5 Dec’13 13.5 13.2 14.6 Dec’14 15.2 15.1 16.2

OEX Implied Volatility Skewing Near-Term Options (Recent History) Strike 3/28/2013 3/14/2013 2/28/2013 At – 25 14.4 13.4 18.0 At – 15 12.9 11.8 15.7 At – 10 11.9 11.1 14.6 At – 5 11.1 10.4 13.6 At-money 10.2 9.8 12.5 At + 5 9.7 9.3 12.0 At + 10 8.9 8.9 11.2 At + 15 8.5 8.2 10.5

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olatility has increased by a small amount since we last published. Note the leftmost column versus the center column in the above boxes. On the right, you can see that the average stock’s options are in only the 8th percentile of Composite Implied Volatility (CIV). Another general market sell signal will be generated when the average stocks’ CIV rises above the 17th percentile.#

Covered Writes/Naked Put Sales

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here are no covered writes that we deem acceptable at this time. The only ones that seemingly pass muster in terms of expected returns are those that are going to declare earnings before the options expire (AAPL, AMZN, CLF, GOOG, ISRG, MON, and PCLN). Of course, the computer doesn’t know that, but we do. So those potential writes are rejected.#

Are you familiar with our other services? (Visit http:/ /www.optionstrategist.com) Money Management: we manage individual option accounts. Performance and Disclosure documents are available upon request. 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.

March 29, 2013

Volatility Skew Table Underlying Symbol Price Rating DJIA /DJM3 14510 75.48 Cocoa /CCK3 2190 65.73 Emini S&P 500 /ESM3 1561 47.62 Sugar #11 /SBK3 17.80 38.74 Biogen Idec BIIB 190.11 35.18 Silver /SIK3 28.40 33.38 Mastercard MA 539.10 33.31 Nasdaq 100 /NDM3 2806.5 29.33 Intl. Bus. Mach. IBM 212.39 24.59 Kimberly Clark KMB 97.48 21.43 Coffee /KCK3 137.15 18.68 Berkshire Hath BRK.B 103.19 17.96 S&P 500 ETF SPY 156.45 17.02 Google Inc. GOOG 794.93 15.96 Cotton #2 /CTK3 89.34 15.34 Apple Inc. AAPL 444.16 14.12 Chip. Mex. Grill CMG 323.11 13.45 Amazon Inc. AMZN 265.19 13.40 Intuitive Surg. ISRG 494.36 11.52 Time Warner TWC 96.07 11.12

There is risk of loss in all trading

Page 8

Special Biotech Situations

Stock Symbol EXAS SGMO THRX

Expensive Month(s) Apr May June

Comment

Drug trial data Drug trial data Postponed FDA

RPRX reported positive drug trial results today. The stock jumped 7 points, which outdistanced the straddle, which had been selling for about 4. This report apparently came a bit earlier than the option market had been expecting, for May options were the most expensive (by a small amount), not April, heading into the report. ZIOP announced that they were terminating an important drug test due to poor results. The stock dropped more than 60% in response, but that’s a distance of only 3.30 points, which was almost exactly the price of the April 5 straddle preceding the announcement!#

Extremes in Sentiment

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e have often mentioned the worth of following the Daily Sentiment Index (DSI) readings on the various futures markets, as determined by Jake Bernstein’s trader surveys in those markets: www.trade-futures.com. Before getting into the current state of DSI readings, I’d like to take a minute to talk about the Grain Stocks report that came out today. It showed far more grain on hand than had been thought, and prices plunged dramatically (apparently, because of last year’s drought, crop estimates were way too low). Wheat, which was on a recent DSI signal, plunged sharply – wiping out the unrealized gains we had in place, but not yet stopping us out. This is just an unfortunate side effect of trading; no technical system can account for gap-inducing news. It’s really no different than owning a stock with a strong chart (or even strong fundamentals), only to see it gap sharply downward on a news item. It doesn’t mean you give up on the trading system you’re using. Currently, there are two oversold commodities – Sugar (where we were recently stopped out) and Coffee (which is struggling to produce a buy signal). There were recent sell signals in Cotton and the Nikkei futures. There is not a recommendation this week based on extreme sentiment.#

Volatility Trades Thisfirst recommendation was originally made on last week’s Hotline. It was to buy July Coffee straddles. Last week’s recommendation should have been filled, but if not – or if you did not take the recommendation last

March 29, 2013

week – then pay up to 12.00 for the July Coffee 137.5 straddle. Position F411: July Coffee Straddle Buy Buy 2 July Coffee 137.5 Calls and Buy 2 July Coffee 137.5 puts For a price of 12.00 or less. Options expire on 6/14/2013 One point = $375 /KCN3: 139.10 July 137.5 call: 6.68 July 137.5 put: 4.98 Note:: if you already bought the 137.5 straddle as recommended last week, do not buy it again now. As noted in the naked put section on page 8, there are several stocks about to pay earnings soon, and that has caused the near-term options to be very expensive. But none of these earnings dates occurs in the next week, so we are not making any earnings-based spread recommendations now. We continue to like straddle buys, although even as cheap as the options have been, only about a third of the very cheap straddles have been profitable (yet). Position E985: Tenet Healthcare (THC) Straddle Buy Buy 3 THC Aug 48 calls and Buy 3 THC Aug 48 puts For a debit of 7.40 or less. THC: 47.58 Aug 48 call: 3.50 Aug 48 put: 3.90 Position E986: KB Home (KBH) Straddle Buy Buy 3 KBH Jul 22 calls and Buy 3 KBH Jul 22 puts For a debit of 4.05 or less. KBH: 21.77 Jul 22 call: 1.86 Jul 22 put: 2.17 Hold both without a stop.#

Put-Call Ratios

T

here were new buy signals in ABX_w, AMZN_w, APA, CAT, CIE, CRM_w, MA_w, NEM _w, NTAP_w, POT, V, XOM_w, FXI, GLD_w, $XAU_w, and British Pound futures_w. There are oversold conditions, which will eventually become buy signals, in CAH, DNDN, RIG, SD, VHC, TBT, and the following futures: Coffee_w, Gold_w, Lean Hogs_w, and Silver_w. There were new sell signals in HES, HPQ_w, MBI, ORCL_w, SNDK, UAL, UPL, and the following futures: Corn, Cotton_w, Lumber_w, and Sugar_w. There are a lot of overbought conditions, which will eventually become sell signals: ATK_w, AMTD, BA_w, BRKB, CME_w, COP, DIS, DVN, FCX, GNW, HD, HIG, KO_w, PBR, QCOM, RDN, UNH, WM, WMT, YHOO_w, SLV, and Nat Gas futures_w.

There is risk of loss in all trading

(Continued on page 10)

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Put-Call Ratio Charts

British Pound: recent buy signal

Amazon: new buy signal

Salesforce.com: new buy signal

China ETF: recent buy signal

Hewlett-Packard: new sell signal

Mastercard: recent buy signal

Sandisk: recent sell signal

United Air: double sell signal

Visa: recent buy signal

Put-Call Ratio Signals (Continued from page 9)

In line with our stated policy this year of only considering the most extreme signals, the rather lengthy list on page 9 reduces considerably. Of the buy signals, the only extremes are ABX, GLD, NEM, $XAU (all four of which are related to gold), and British Pound futures. We already have a position in GLD, but will consider adding one in NEM if it can break out over 43. Position PC1246: Newmont (NEM) Conditional Call Buy IF NEM closes above 43, THEN Buy 8 NEM May 43 calls. NEM: 41.89 May 43 call: 1.08

March 29, 2013

In addition, we just concluded a successful trade (Position PC1239) in the British Pound, based on the last (sell) signal. Now a buy signal has been issued, so we’re going to take a position – but in the Pound ETF (FXB), as before. Position PC1247: Pound ETF (FXB) Call Buy Buy 6 FXB May 150 calls At a price of 1.65 or less. FXB: 150.16 May 150 call: 1.65 Of the sell signals, only one meets these extreme criteria, and that is SNDK. However, it’s due to report earnings next Thursday, and it often gaps on earnings, so we are going to pass. In effect, we don’t know if the recently heavy call volume is speculative excess or insider knowledge of positive earnings.#

There is risk of loss in all trading

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S&P 500 Index ($SPX)

CBOE’s Volatility Index

Newmont Mining Corporation

CurrencyShares British Pound ETF

KB Home

Tenet Healthcare Corporation

Profit Graph of Position I485

July Coffee Futures with implied volatility

March 29, 2013

There is risk of loss in all trading

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Volatility Derivatives Update Even the Volatility of Volatility is Low

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he last line of the table in the box on the right shows the 20-day historical volatilities of the first four months $VIX futures. Months two through four have never been this low, in my recollection. If you look at the colored lines in the first graph below, you will see that the higher ones on the graph (i.e., the later months) have been virtually flat for quite some time now. This is a result of $VIX being so low. In that case, longer-term futures are priced towards an average longterm volatility and not really based much on $VIX at all. Returning to the table on the right, you can see that the implied volatilities of the options VX Expiration Implied Volatility of $VIX Options: Dates (the higher rows of the table) are much higher, of On 3/28/13, with $VIX = 12.70 4/17/2013 course, because option traders expect that and $VXO = 12.04 5/22/2013 volatility could easily increase. No one wants to Implieds (average of bid iv% & asked iv%) 6/19/2013 sell $VIX options at too low of a volatility. 7/17/2013 Strikes Months... Even so, the discrepancy between historical and 8/21/2013 Apr’13 May’13 Jun’13 Jul’13 implied volatilities is astounding. Normally the 9/18/2013 ATM-2 50% 68% 70% 67% strategy that one would employ in such a ATM 78% 81% 85% 78% 10/16/2013 situation is to either buy straddles or – in the case ATM+2 98% 88% 92% 83% 11/20/2013 of a heavy forward volatility skew, such as exists ATM+4 111% 95% 96% 87% 12/18/2013 here – put backspreads (if $VIX were higher; ATM+6 122% 99% 101% 91% 1/22/2014 i.e., if volatility were higher, then call ratio Futures 14.19 15.56 16.57 17.33 2/19/2014 spreads might make sense, but not at these 20-day HV 41% 29% 22% 17% 3/19/2014 levels).

Position I485: $VIX Put Backspread Buy 8 $VIX May 15 puts and Sell 4 $VIX May 20 puts For a credit of 2.30 per 2x1 spread /VXK3: 15.56 May 15 put: 1.50 May 20 put: 5.30 The profit graph of this position is shown on page 10. If $VIX is above 20 at May expiration, the options will all expire worthless, and the position will profit by the amount of the initial credit (2.30). Losses would occur if $VIX is between 12.70 and 17.30 at May expiration. Outside of that range, profits will exist. The collateral margin is equal to the maximum loss: $270 per 2x1 spread. That loss would only occur if $VIX were at exactly 15 at May expiration. #

March 29, 2013

There is risk of loss in all trading

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