IN THIS ISSUE...Next issue: 8/11/2011 (Thurs)

You can follow us on Twitter:http://twitter.com/optstrategist

or “like us” on Facebook at http://www.facebook.com/optionstrategist

Due to travel commitmentsduring the week after LaborDay, we will be revising our

publishing schedule in September. Wewill publish on the 3rd and 5th

Thursdays instead of the 2nd and 4th.Regular publication dates will resumein October.

I will be speaking at the ContraryOpinion Forum in Vermont this year.This conference is now 49 years oldand has some very interesting speakers– not to mention that it is located at aquaint, famous club on LakeChamplain, about 28 miles south ofBurlington. See details in box onright.

The feature article discusses a$VIX call hedge that has receivedsome publicity this year. I don’t thinkit’s as good as advertised.

Our market indicators have losttheir bullishness, but there are somesevere oversold conditions at workcurrently (page 6).

On page 7, we update the status ofthe Total put-call ratio.

Recommendations on pp. 8 and 9include a naked weekly put in Visa(V), a dual calendar in Priceline(PCLN), and put buy in ICE.

Also, we recommend twovolatility-based positions as $SPXAugust options have gotten veryexpensive. Article begins on page 12.

THE OPTION STRATEGIST™© McMillan Analysis Corporation

P. O. Box 1323, Morristown, NJ 07962–1323Volume 20, No. 14 email: info@optionstrategist.com July 29, 2011Editor: Lawrence G. McMillan Our 20th Year of Publication Research: Ryan Brennan

Another Strategy For Volatility Protection

There has been something of a “buzz” in volatility forums and in somemedia articles about a backspread strategy that is designed to take theloss out of using $VIX options for protection or speculation. As you

know, we are running a “perpetual call buy” strategy for long $VIX calls(Position S610). Also, this week we recommended the purchase of $VIXcalls as protection for stock portfolios, for those who were worried aboutwhat might happen in the event of a downgrade of U.S. debt or a failure toraise the debt ceiling. However, this backspread strategy purports to bebetter because it allows you to exit before much, if any, loss occurs. As allthinking traders know, however, there is no free lunch. If there’s really norisk, then something else has to give. You’ll see what we mean.

McMillan’s Upcoming2011 Speaking Schedule

McMillan Live, Online Webinar SeriesAnnouncing a new series of live, paid seminars

Cost: $49, eachPreviously Recorded:

Seminar #1: Detecting and Trading Takeover RumorsSeminar #2: Strategies For A High Volatility Environment

Seminar #3: Understanding & Trading $VIX Options, Part 1Seminar #4: Understanding & Trading $VIX Options, Part 2

Seminar #5: Risk Management The B.E.S.T. Option Strategy

http://www.optionstrategist.com/products/category/recorded-webinar

49th Annual Contrary Opinion ForumWednesday-Friday, October 15-17, 2011

Basin Harbor Club, Vergennes, Vermont“Measuring Contrary Opinion With Derivatives”

http://www.fraser.com/cof.html

Traders Expo, Las Vegas NVWednesday-Saturday, November 16-19, 2011

Caesar’s Palacehttp://www.moneyshow.com/tradeshow/las_vegas/traders_expo/main.asp

July 29, 2011 There is risk of loss in all trading Page 2

The Basic 2x1 $VIX Backspread Strategy

The strategy that is being espoused is based on a 2x1call backspread, such as this example using actualprices from a couple of months ago:

$VIX: 17.07 on 5/13/2011July $VIX future: 20.25S 1 $VIX July 25 call @ 1.60B 2 $VIX July 32.5 calls @ 0.80Outlay: $0 debit

So, what we are attempting to do here, is – on May$VIX derivatives’ expiration date – set up a callbackspread: selling one out-of-the-money call andbuying two further out-of-the-money calls, where theprice of the one being sold is approximately twicethat of the one being bought. Note that the optionsexpire two months hence, not one. If one has to paya small debit for the spread – say, up to 15 or 20cents – that would work nearly as well.

The main idea behind using this position isthat – at least for a while – a 2x1 call backspread actsjust like a long call, until the position gets too closeto expiration, in which case the losses near the higherstrike can become large.

Now, using the McMillan Analysis Corp.Expected Return Calculator, we can evaluate thisposition. Figure 1 shows the results.

There are three lines in Figure 1. The black lineshows what would happen if the position were heldall the way to July expiration: There is no gain orloss (except commissions) below 25. Between 25

and 32.5, losses begin to grow, reaching theirmaximum of 7.5 points ($750) at 32.5 at expiration.Above 32.5, losses diminish until the upsidebreakeven point is hit at 40. Above there, unlimitedgains are possible.

There is nothing particularly attractive aboutthe black line itself. The blue line shows how theposition would perform on July 10, 2011 – ten daysprior to expiration. Again, relatively large losses of$300 or so are possible near 32. That isn’t veryattractive, either.

The true attractiveness of this position is thepink line. It shows how the position would behave onJune 14th – the last trading day of the June $VIXderivatives (or about one month before the Julyderivatives expire). With this much time left untilexpiration, the pink line barely dips into negativeterritory at all. The worst point is a small loss ofabout $60 near 25, with a month to go (see the boxinside of Figure 1). Yet, it has plenty of upside profitpotential (as do all three lines) because two calls areowned in this spread, and only one has been sold.

If you just look at the pink line alone, it looksvery much like the profit graph of owning a long callat some point prior to expiration. The pink line turnssharply upward at a price of about 31 or 32, so July$VIX futures would have to rise to there or above inorder for this position to start generating profits witha month to go.

This backspread could thus theoretically beused for strategies where one would normally buy$VIX calls – mainly, as either protection for a stockportfolio, or as outright speculation on a largeincrease in volatility.

As longer-term subscribers know, we havedone research on the subject of buying $VIX calls asprotection or speculation, and we proved that, to date,one could have made money – good money – bymerely buying the one-month $VIX call, three strikes(7.5 points) out of the money, and rolling it over atexpiration. The profits from the two explosive movesin $VIX – October, 2008, and May 2010 (the “flashcrash”) – were more than enough to offset the longlist of small monthly losses.

In Volume 19, Issue 13 of this newsletter, weexplained the “perpetual call buy” of $VIX calls andbegan Position S610, which does exactly that – buysthe near-term $VIX call three strikes out of the money

Figure 1: Simple $VIX Call Backspread

July 29, 2011 There is risk of loss in all trading Page 3

and rolls it over each month. Figure 2 shows the profit graph of the

“Perpetual Call Buy” since inception of $VIX optiontrading in February, 2006. The dark blue line is theone that shows the profits and losses of buying thecall that is three strikes out of the money. Itperforms best for the simple reason that, in losingmonths, you spend less on the deepest out-of-the-money of the three calls shown, but in times of crisis,$VIX explodes so far to the upside that all threestrikes go deeply into-the-money.

Figure 2 only shows the results through June,2010. At that time, the blue line showed a profit of30 points ($3,000) per contract. Since then, $VIXhas not made a major move upward, and thepurchase of one near-term contract has lost about$750, so the net result to date for this strategy wouldbe a gain of $2,250 per contract. That’s still a hugereturn, considering that the average monthly cost forone contract is about 60 cents ($60), and themaximum drawdown was about $1300 (Feb 2006 toAugust 2010).

We don’t have a comparable track record forthe backspread strategy because its construction is abit more complicated than “buy one call three strikes

out of the money.” If time permits, I may try to puttogether such a track record for the backspreadstrategy, but I am not terribly motivated to do so,because of what I am about to discuss.

Drawbacks

So, is this 2x1 backspread really better than buying ashort-term call? I would argue that it might not be.

The entire strategy behind the 2x1 backspreadis more complicated than just described. There arearticles about it on the internet, although most arewritten by financial reporters and not strategists. One,written after the Futures & Options World EuropeanEquity Options Conference in Amsterdam this pastApril is available from the FOW web site1 (click toread).

But the crux of the strategy is simple: oneestablishes the 2x1 backspread and then rolls to thenext expiration before losses start to set in.Simplistically, this means that the position isestablished two months before expiration and thenrolled one month before expiration.

The strategy was also presented at the CBOERisk Management conference this past spring, in apresentation by Societe Generale (SocGen) and Peak6 – both noteworthy “think tanks” in the volatilityspace. They, too, concluded that an out-of-the-money2x1 call ratio spread using the second month androlling one month prior to expiration was better thana systematic long only volatility position. At thatconference, one discussion of the strategy waspresented by Societe Generale. A pdf of thatpresentation can be found here.1

On the surface, the backspread strategy seemsvery attractive. Perhaps if one is merely looking tospeculate on volatility, it might be appropriate, but Ithink there are two major flaws in this strategy. Oneflaw has to do with the term structure of $VIXfutures. As we know, the options trade off the futuresand not $VIX. Furthermore, in a severe bear market,when $VIX explodes to the upside, the term structure

1 For those reading a paper copy of thisletter, the reference links are:http://ftalphaville.ft.com/blog/2011/04/08/541101/the-bernanke-1x2-call-spread/http://www.cboermc.com/Hedberg.Wien%20-%20Final.pdf

Figure 2: Perpetual $VIX Call Buy

July 29, 2011 There is risk of loss in all trading Page 4

turns negative (i.e., all the futures trade at a discountto $VIX). When that happens, the backspreadstrategy – since it is the second month and not thefront month – may not produce the desired gains.

In the SocGen paper, the comparison is madebetween the 2x1 backspread and buying a .20-delta$VIX call in the same month as the backspread. That last phrase is the key; they didn’t compare thebackspread to buying a .20-delta call in the frontmonth.

The simplest way to illustrate this is to lookat the worst bear market since $VIX derivatives havebeen listed – that of October, 2010. At one point, thefollowing prices existed, roughly:

$VIX: 70 on 10/10/2010Oct $VIX future: 56Nov $VIX future: 38

A long Oct $VIX call is 18 points farther in themoney than a November 2x1 call backspread!

As October expiration approached, $VIXstayed near 70, and so the Oct futures sucked rightup to 70. Meanwhile, November futures rose onlyinto the mid-40's.

I suppose a counter-argument would be tobuy more of the November 2x1 backspreads asopposed to outright long October calls. That’s fine,but there is also a big difference in the marginrequired.

The margin for a backspread is the differencein the strikes, plus any debit incurred in establishingthe spread. Obviously, the only requirement for anoutright long call is merely to pay for the call. Evenif the 2x1 backspread is using strikes 5 points apart(not always possible, if one wants to pay only asmall debit for the spread), this is how thecomparison would look vs. an outright long call at0.60:

Margin Comparison2x1 Call OutrightBackspread Long Callfor $0 debit: For 0.60: $500 $60

So, it might be easy to say “do more backspreads,”but it’s more costly to do so, in terms of margin

requirements. This could be significant, say, if onewere trading long stocks fully margined, or sellingnaked index or equity puts with the full equity in theaccount. In that case, one would likely have to closedown some of the account’s “main” strategy in orderto fund the backspreads.

The term structure wasn’t so critical during theother big move in $VIX – May of 2010. The termstructure remained amazingly flat during that timeperiod, so there was very little difference between theJune and July futures. Even May futures traded at adeep discount to $VIX itself, with less than a week togo until expiration.

The Most Important Flaw?Term structure is important. But I think the

major flaw is where the profit potential arises. Wesaw from Figure 1 that, using the backspread, theprofit potential kicks in at just below the level of thehigher strike in the backspread (31 or 32 in theexample). That is likely to be much farther out of themoney than the “three strikes” we are recommendingfor our long call purchases.

Using the data from the example for Figure 1,an outright long call would have used the Junefutures, and they were trading at 18.65 at the time.Three strikes out of the money would be the 25 strike(one: 20; two: 22.5; three: 25). Thus, you’d be longa June 25 call. The outright June call would startmaking profits well before the backspread did.

I said earlier that if there is really no risk, thensomething else has to give. As you might expect, that“something” is the profit potential. You just can’t getaway from the fact that less risk means less profitpotential, no matter how creative your derivativesstrategy might be.

Follow-Up Strategies

Something that is addressed in some of the blogs isthat the 2x1 strategy would be difficult to continuallyroll – especially after $VIX has moved up sharply.This is certainly a valid concern, although I’m sure adecent amount of thought has gone into that situation,by the designers of the strategy.

In the simple long call, one would merely use(Continued on page 7)

July 29, 2011 There is risk of loss in all trading Page 5

Category Position Recent Mark Comment

Cov. Write: C384: SHLD cash&mgn put (3 Sep 60p) +216 Stop: 57.5C393: FSLR cash&mgn put(2 Aug 110p) –236 Stop: 108C394: CRM margin put (2 Aug 130p) –46 Stop: 129C395: WYNN mgn put sale (2 Aug 130p) +158 Stop: 129C396: ATI margin put sale (3 Aug 55p) –96 Stop: 54.5

Condor: D51: S&P Condor spread +5 Hold L 2 /SPQ 1145p, S 2 /SPQ 1150pEquity: E874: COO straddle buy –258 Calls stopped out

L 2 COO Aug 80c, L 2 COO Aug 70p Hold putsE879: SMH straddle buy –325 HoldL 5 SMH Aug 37cE880: AGU synth backspread –164 Stop: 88L 4 AGU Aug 85c E885: CREE call calendar +70 Exit >= 2.90L 5 CREE Dec 35c, S 5 CREE Aug 35cE886: FFIV dual calendar –31 Sell callsL 4 Oct 125c, S 4 Aug 125c, L 5 Oct 95p, S 5 Aug 95pExit puts <91 or >101E887: NFLX dual calendar +865 Exit nowL 4 Sep 305c, S 4 Jul (29) 305c, L 5 Sep 245p, S 5 Jul(29) 245p

Futures: F263: Nat. Gas straddle buy +25825 HoldL 1 /NGZ1 45c, L 1 /NGZ1 45p

F385: SP Put Ratio Spread +110 Stop: 1187L 2 /SPQ 1270p, S 2 /SPQ 1250p, S 2 /SPQ 1210pF386: Soybean call ratio spread +705 Stop > 1517L 2 /SU1 1500c, S 2 1460c, S 2 1420c

Index: I420: VIX calendar long combo –222 HoldL 3 Aug 24p, L 3 Sept 18cI421: SPY put ratio spread –24 Stop: 118.70L 12 Aug 127p, S 12 Aug 125p, S 12 Aug 121p

Put-Call: PC1139: L 5 SLV Aug 37c +420 Stop: 37PC1140: L 2 /WU1 710c, S 2 800c –355 Stop: 670PC1141: L 15 BAC Sept 10c –420 HoldPC1142: L 3 GS Sept 135c +39 Stop: 130

Spec: S604: L 8 DTG Aug 70c –1408 Hold L 2 GPRO Aug 80c –32 Hold(Total of all “strategic alternatives” to date: –$1610)

S610: Perpetual call buy –1392 HoldL 4 $VIX Aug 27.5c

S627: L 5 SPY Sept 132c –430 Stop: 129.5 L 3 SPY Sept 134c –477S628: L 4 SUG Aug 42.5p, S 4 Aug 45p –156 HoldS629: L 5 DTG Aug 65p, S 5 Aug 70 p +80 HoldS630: L 3 IDCC Aug 57p, S 3 Aug 67p –297 Hold

Weekly: W1: SPY Weekly Calendar +205 Roll short weeklysL 5 Aug 136c, S 5 Jul(29) 136c, L 5 Aug 132p, S 5 Jul(29) 133p

FOLLOW-UPS TO PREVIOUS RECOMMENDATIONSThe following figures represent hypothetical performance; these

positions were not actually traded in an account.NOTE: on this page, all stops are mental closing stops unlessotherwise noted.Position E874: the COO calls were stopped out; hold the puts.Position E883: LO broke out to the upside, so we exited the puts.

But the breakout was false, as poor earnings drove the stockback down, and we were stopped out of the calls.

Position E886: in FFIV, exit the call calendar now. Hold the putcalendar, but exit if FFIV closes below 91 or closes above 101.

Position E887: the NFLX dual calendar has profited, since theweeklys were so expensive. Exit the position now, if youhaven’t done so already.

Position PC1139: raise the stop for the SLV calls to 37.Position PC1140: raise the stop for the Wheat bull spread to 670.Position PC1142: raise the stop for the GS calls to 130.Position S610: the perpetual $VIX call buy. We don’t usually

trade against this, but I think we can do a little at this time: if$VIX closes more than 3 points below its most recent intradayhigh (that high is currently 23.99, set on Thursday 7/28/11),then sell your $VIX calls. Buy them back is $VIX thensubsequently exceeds its previous high.

Position S627: the total put-call ratio buy signal has been stoppedout, since the 21-day moving average dropped below 0.90 andthen rose back above it again. All stop-outs of this systemeventually lead to another buy: Technically, we now need toform a new 10-day peak before the buy signal resumes. Set astop for these calls at 129.50, basis SPY.

Position W1: If SPY is below 130 at Friday’s close, the entirespread should be closed and shifted out. At this time, onewould have to buy regular Sept options on the long side andsell the weeklys, with the strikes 2 points above and belowSPY.

Otherwise, hold the longs and sell the following strikes:SPY<130: close entire position and re-establish new strikes130<SPY<131: put strike 131; call strike 135131< SPY<134: put strike 132; call strike 135134<SPY<137: put strike 133; call strike 136137<SPY<138: put strike 133; call strike 137138<SPY: close entire position and re-establish new strikes

HYPOTHETICAL PERFORMANCE SUMMARY1

Breakdown by general investment strategy:All Hedged Speculative Positions Positions

Number of Closed Positions 2026 1505Avg Holding Period (days): 71 41Average Investment: $7572 $2097Average Gain: +$192 +$56Average Gain at Annual Rate 13.0% 23.5%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

POSITIONS CLOSED SINCE LAST ISSUECategory Position Profit/LossNaked Puts C391: CF cash&mgn put sale +266Condor D50: S&P Condor spread +115Equity E883: LO dual calendar –1629Futures F384: SP Put Ratio Spread +1410Index I418: SPY put ratio spread +288

I419: VIX put backspread –688Spec: PC1130: L 10 AKS July 15c –690

PC1135: AAPL Bull Spread +6561PC1137: L 2 ICE Aug 125c –162PC1138: L 6 RIMM Aug 27.5c –1212S604: BJ call buy –660 TYC call buy –2815

July 29, 2011 There is risk of loss in all trading Page 6

. . . . . . . . . . . . . . . . . SENTIMENT INDICATORS . . . . . . . . . . . . . . . .

TThe stock market action in the last month or so has

been both interesting and somewhat frustrating. Aftera six-week decline generated major oversold

conditions and buy signals in mid-June, we saw the marketrally. So far, so good. After that, it’s been a bit of a non-sequitur. That is, technical indicators have remainedgenerally bullish, but first there was a sharp correction inearly July ($SPX lost 60 points in little over a week).Having weathered that, the market started to march higheragain, through last Thursday (a week ago). Suddenly, thestock market started to develop “religion” about the U.S.debt situation, and sold off sharply this week. Perhaps theearly July decline was attributable to the debt problem aswell. The media has stirred the pot with a myriad ofnegative reports, essentially scaring buyers away.

In one sense, this is like any other “event” – an FDAhearing or a potentially volatile earnings report: the

underlying has trouble moving decisively in either directionuntil the event has passed. So perhaps volatility skew-basedstrategies, such as we utilize for events, are more aproposthan directional strategies at this time.

In any case, let’s review the directional indicators, forthey will certainly regain their importance as soon as theobvious headline-chasing stops. The chart of $SPX wasretaining a bullish bias until Wednesday, when it sliceddown through its still-rising 20-day moving average. Thatpretty much turned the $SPX chart neutral. Sometimes acontra-trend move will slice through the moving average,but then quickly recover. That doesn’t seem to be the caseright now. There is still support in the 1295-1300 area(today’s lows and mid-July lows). Below that, there is alarge support area down to the June lows at 1260. As forresistance, there is now a series of declining highs (1370,1355, and 1345), and while it would not be hard to blowthrough all three, the fact is that it just hasn’t happened.

Equity-only put-call ratios are turning bearish (seecharts above). They have finally been affected by thisweek’s decline. The standard ratio is a confirmed sell, asis QQQ weighted. The weighted equity-only is not yet aconfirmed sell signal. Notice that they are all now ratherlow on their charts – in an area from which previous sellsignals have arisen. So, for as high as they got, there wasn’treally all that great of a stock market rally.

Market breadth has been very responsive to short-termmarket movements, for the simple reason that – with hedgefunds in control of much of the volume – everyone is doingthe same thing at the same time. You can see from the tableon the left that it is more common to see a +/-2000 “net”day than not. At the current time, the breadth oscillators areon sell signals and are extremely oversold. We know that“oversold does not mean buy,” but if breadth does improveon the next leg upward (whenever that takes place), thesebreadth oscillators will give actual buy signals for the firsttime since the June lows.

Volatility indices ($VIX and $VXO) have finally takennotice that a potentially volatile event lies on the near-termhorizon. After trading in a narrow range for weeks, $VIXis now on an upside tear. There are higher highs and higherlows on its chart, which means that it’s in an uptrend. That

(Continued on page 10)

“Stocks Only” DataDate Adv Decl Net

20110715 2018 978 104020110718 380 3077 -269720110719 3081 388 269320110720 1413 1640 -22720110721 2687 674 201320110722 1570 1431 13920110725 560 2767 -220720110726 1025 2066 -104120110727 223 3461 -323820110728 1165 1851 -686

90% Days are shown in red

The market is being held hostage by ourelected representatives. Many of the

indicators are deeply oversold, so it seemslikely that a reasonable resolution to the debt

ceiling problem will launch a strong rally.

July 29, 2011 There is risk of loss in all trading Page 7

Another Volatility Strategy(Continued from page 4)

the same strategy as with any long call – a trailingstop and perhaps also rolling the long calls up to ahigher strike, in order to extract some credit out of theposition. We used that strategy successfully inOctober of 2010, and there’s no reason to feel itwould be any different at any other time.

In essence, the same thing could be done with the2x1 backspread for, if the underlying rises far enough,the backspread eventually behaves just like one longcall. There might a bit of a problem if the long callswere rolled up to a higher strike, for that would raisethe margin requirement in the backspread (thedifference in the strikes is the major portion of themargin requirement).

Summary

The 2x1 backspread strategy is certainly interesting,and has a certain appeal because losses are minimal ifthe position is rolled well before expiration. TheFOW reporter predicted that “You‘re going to starthearing a lot more about the 1x2 [sic] in 2011.” Iguess this article proves he’s right about that.However, in the most dire crisis, the strategy will notperform nearly as well as a front-month call purchasedoes. In my mind, that makes all the difference in theworld. I would rather pay the small amount for theoutright long call in order to have my protection “kickin” at a lower volatility level and to more closelyadhere to movements in $VIX on the upside.#

Total Put-Call Data

Date comes off Date comes on Value coming off

6/29/2011 7/29/2011 1.023

6/30/2011 8/01/2011 0.983

7/01/2011 8/02/2011 0.858

7/05/2011 8/03/2011 0.628

7/06/2011 8/04/2011 0.933

7/07/2011 8/05/2011 0.881

Total Put-Call Ratio

The total put-call ratio buy signal was confirmedon July 14th, when $SPX closed at 1308.87. Atthat time, the 21-day moving average of the total

put-call ratio had peaked ten days earlier (onWednesday, June 29th).

The buy signal can be stopped out in one of 2 ways:1) the 21-day moving average makes a higher high

than it did on June 29th (that has not happened), or2) the 21-day moving average drops below 0.90 and

then rises above 0.90 again. That did happen this pastWednesday, July 27th. Actually, what transpired wasthat the 21-day moving average fell to 0.892 onTuesday, July 26th, and then rose back to 0.912 the nextday.

Hence the rather fledgling buy signal in the totalput-call ratio has been stopped out, via the second rule.You might say, “it was only one day; is it really thatimportant?” There is usually very little argument forignoring the rules of a system – especially the stops.Moreover, this system automatically returns to a buysignal in a fairly short period of time. But if things getnasty, the system is temporarily out of the market. Thatwas built into the backtesting we did, and we arestanding by that approach.

If you’ll recall, the initial way that a buy signaltakes place is for the 21-day moving average to riseabove 0.90 and then either:

a) form a 10-day peak, orb) fall back below 0.90 again.

So, no matter which rule stops us out, we areautomatically started towards another buy signal, sincethe moving average is above 0.90 when stopped out –and that is the initial criteria for setting up a new buysignal.

If the market doesn’t improve quickly, it’s not goingto be that easy to establish the next buy signal, for therearen’t a lot of “high” numbers in the 21-day movingaverage right now. Consider the table on the left.

The average of the six numbers in the table is 0.884.So the total put-call ratio is going to have to averageless than that to drive the average down over that timeperiod. After that, the numbers coming off are larger,and thus it will be easier for the average to peak andgive that next buy signal.#

July 29, 2011 There is risk of loss in all trading Page 8

OEX Implied Volatility SkewingNear-Term Options (Recent History)

Strike 7/28/11 7/14/2011 6/23/2011At – 25 24.5 22.3 20.2At – 15 23.2 20.4 18.4At – 10 21.9 19.3 17.6At – 5 21.1 18.5 16.9At-money 20.5 17.6 15.9At + 5 19.4 16.8 15.4At + 10 18.9 15.7 14.4At + 15 18.2 15.0 13.4

L

Volatility Skew Table Underlying Symbol Price Rating

Sep S&P /SPU1 1296.8 45.44Sep Rough Rice /RRU1 163.90 43.31

Sep Gold /GCU1 1614.2 31.03Verisign VRSN 32.03 30.07

General Cable BGC 40.41 28.36S&P 100 $OEX 584.27 28.23EOG Res. EOG 103.43 27.05Expedia EXPE 28.99 25.25

Sep Pound /BPU1 163.36 22.75Sep Soy Meal /SMU1 357.60 22.66

Priceline PCLN 522.29 21.77Harbin Elec. HRBN 16.30 21.63Hansen Nat. HANS 77.30 19.56Cerner Corp. CERN 62.02 18.77

Emerson Elec. EMR 49.62 18.75Sep Soybeans /SU1 357.60 18.26MasterCard MA 306.90 18.14

S&P 500 $SPX 1300.7 17.82Sep Yen /JYU1 128.83 17.77

Russell 2000 $RUT 799.34 17.4610-Year Note /TYU1 124.50 16.17

WebMD WBMD 35.63 15.79

INDEX OPTIONS & VOLATILITY SKEWING

Stock option implied volatilities continue to increase, butrather slowly. The graph on the right shows that the CIVComposite Implied Volatility) of all stock options has now

risen to the 38th percentile. The 20-day historic volatility of $SPX, though, continues

to remain low. It has risen to a mere 16%. It’s ironic that theaverage investor and the average financial media reporter arecalling this market “volatile.” It’s nothing of the sort – yet!

Also, note in the box on the left above that the $OEXoptions implieds have inverted – at least from August throughDecember (‘11). This is a more bearish picture than the $SPXoptions (i.e., $VIX futures) are painting.#

Covered Writes/Naked Put Sales

Even though $VIX is higher, put writes on equitiesdon’t appear to be any more attractive than theyhave been in recent weeks. Without getting too

specific, this is because the underlying volatility has risen,too, so the expected returns are about the same. As aresult, we still do not find any cash-based put writes thatwe like.

In fact, even though there are margin-based writesthat satisfy the mathematical criteria, I do not find therelative charts to be supportive. That is, there is too muchtechnical risk of falling below the striking price. One wayto limit the risk would be to sell a weekly option, ratherthan the traditional monthly option.

Position C397: Visa (V)Naked Weekly Put Sale

Sell 2 V Aug (5th) 82.5 putsat a price of 0.40 or more.

V: 86.92 Aug (5th) 82.5 put: 0.40This is for margin accounts only. The expectedinvestment is $1,800 per naked put sold. Annualizedreturns for a one-week investment don’t make much sensebecause it can’t be repeated 52 times in the next 52weeks, but this is an expensive option. Thus, the returnis sufficient, no matter how you measure it.

Stop yourself out on a close below 82.#

OEX Implied VolatilityAt-the-money Options

Current Data & Recent History Month Volatility%

7/28/11 7/24/2011 6/23/2011 Aug 20.5 17.6 16.5 Sept 19.4 18.0 16.9 Oct 18.7 18.3 17.5 Dec‘11 18.5 18.6 18.2 Dec’12 19.4 19.5 19.5 Dec’13 19.9 20.1

July 29, 2011 There is risk of loss in all trading Page 9

L

L

L

Volatility Derivatives(Continued from page 12)

In the dual calendar spread part of this strategy, we willsell August options, of course, and buy Octobers, for theyare “cheaper” than Septembers. How far apart should thestrikes be? While there is no real precedent for this, itcertainly seems feasible that a 4% move could occur inSPY on definitive positive or negative news regarding thedebit ceiling:

Position I423: SPY Dual CalendarBuy 4 SPY Oct 135 calls

and Sell 4 SPY Aug 135 callsand Buy 4 SPY Oct 125 puts

and Sell 4 SPY Aug 125 putsFor a total debit of $1,750 or less

The quantities are equal for puts and calls, which isunusual, but the heavy skew towards the puts makes thisthe correct ratio.#

Volatility Skews

The dual calendar spread involving weekly options onNetflix (NFLX) – recommended on last week’sHotline – worked well, so we are going to try a

similar position in Priceline (PCLN), which is due toreport earnings on Thursday, August 4th.

Position E888: PCLN Dual CalendarBuy 2 PCLN Oct 560 calls

and Sell 2 PCLN Aug (5th) 560 callsand Buy 3 PCLN Oct 480 puts

and Sell 3 PCLN Aug (5th) 480 putsFor a debit of 70 points for the entire position

PCLN: 522.29 Oct 560c: 23.10 Oct 480p: 21.90Aug(5) 560c: 8.90 Aug(5) 480p: 7.10

The true ratio here should be 5 put spreads and 4 callspreads, but that entails a debit of nearly $13,000, whichis really too large for the recommendations we normallymake in this newsletter. However, if you have the fundsto handle that size normally, then you should use the“correct” ratio. Once again, this spread depends largelyon the implied vol of the Octobers after the earnings arereported. This spread should be exited next Friday,August 5th. #

Special Biotech SituationsStock Expensive CommentSymbol Month(s)BPAX Dec & Jan Phase 2 trial dataGILD Sept FDA 8/10/2011ONTY Jan & Feb Trial dataTRGT Nov & Feb Unknown

Takeover Rumors

Despite the fairly negative market of the last week,there have still been some companies looking toexplore strategic alternatives, and there have been

some bids made for others. InterdigitalCommunications (IDCC) announced the desire toexplore strategic alternatives. As a result, werecommended a put credit spread in IDCC in last week’sHotline (Position SS630). GeoEye (GEOY) has notofficially announced “strategic alternatives,” but mediarumors are circulating that the company has hiredGoldman to look at a possible sale.

There don’t seem to be any takeover bids that havebeen made, where the stock is trading higher than the bidprice – expecting a higher bid. Perhaps Dollar Thrifty(DTG) fits that description, but we already have a positionthere.

Carl Icahn is poking around in Clorox (CLX) andnow Commercial Metals (CMC). But these aren’t “real”bids, they are more like plain rumors. So, we’re notadding any new positions in this area this week.#

Futures, Sector, and Stock Sentiment

There were new buy signals ARMH, BAC, BK,PBR, PFE, and SNDK.

There are oversold conditions in FDX, LMT_w,and VECO.

There are new sell signals in AKAM, BHI, ERTS, HAL,HRBN, ICE_w, INTC, MDT, and WLT.

There are overbought conditions in BX, DELL_w,MA, MON_w, WFT, and British Pound futures.

On last week’s Hotline, we recommended the purchase ofthe Bankamerica (BAC) and Goldman Sachs (GS)calls. Both are still viable.

Position PC1143: ICE Put BuyBuy 3 ICE Sept 125 putsAt a price of 5.80 or less

ICE: 123.60 Sept 125 put: 5.80

Stop yourself out on a close above 128.#

July 29, 2011 There is risk of loss in all trading Page 10

Intercontinental: new sell signal Intel: new sell signalFedex: too much pessimism

Bank of NY Mellon: recent buyBank America: recent buy signal

Sandisk: recent buy signal

Arm Holdings: new buy signal

Petrobras: recent buy signalMonsanto: very overbought

L

Put-Call Ratio Charts

Sentiment Indicators (Continued from page 6)is bearish for stocks. $VIX now has a head of steam, buteventually it will peak out (usually in a spike peak), andthat will be a buy signal for stocks. As a specific rule ofthumb, we will be looking for $VIX to close at least 3points below its most recent intraday high. That will bethe buy signal.

The premium on the $VIX futures has deteriorated thisweek. The $VIX futures – as their usual wont – have notrisen nearly as fast a $VIX has (see the article on page 12for a further explanation of this phenomenon). The front-month August futures settled today at a discount of 2.39 to$VIX. Furthermore, all the futures expiring in 2011 aretrading at discounts. This is bearish while the discountsare growing. But eventually, if $VIX makes the spikepeak buy signal when all of the futures are trading atdiscounts, it is an even stronger buy signal. The chart onpage 12 shows how this occurred in March (2011) andwas a strong buy signal.

The term structure of the $VIX futures, though, hascontinue to slope upward – not as steeply as before, but itis still sloping upward. For example, January futures are

trading 2.50 higher than August. During bearish times, theterm structure flattens, and that has happened to someextent this week. If the term structure actually inverts andslopes downward, that is quite negative; it hasn’t seen thatshape since March, 2009.

In summary, the worries over the debt ceiling haveaborted many of the buy signals (all except for the put-callratios). Breadth, some of the put-call ratios, and volatilityare on sell signals, but are reaching oversold status.However, we would prefer not to anticipate these signalsbut rather react to them after they mature.

Speculative Strategy

Position S631:If $VIX closes more than three points below

its recent intraday high, THEN Buy 4 SPY Sept at-the-money calls.

Moreover, we will add to this position if breadth and totalput-call ratios give further buy signals.#

July 29, 2011 There is risk of loss in all trading Page 11

S&P 500 Index ($SPX)

Priceline.com Incorporated

Intercontinental Exchange Incorporated

GeoEye Incorporated

CBOE’s Volatility Index

VISA Incorporated

Goldman Sachs Group Incorporated

Interdigital Incoporated

July 29, 2011 There is risk of loss in all trading Page 12

L

Implied Volatility of $VIX Options:On 7/28/11, with $VIX = 23.74

and $VXO = 23.47Implieds (average of bid iv% & asked iv%)

Strikes Months...Aug’11 Sept’11 Oct’11 Nov’11

ATM-1 109% 84% 69% 61%ATM 123% 92% 75% 67%ATM+1 138% 100% 82% 71%ATM+2 145% 105% 87% 76%ATM+3 154% 111% 92% 80%Futures 21.35 21.70 22.55 22.5520-day HV 63% 46% 39% 35%

Volatility and Variance Futures and Options Update$VIX Outpaces Futures

This week, as $VIX rose on fears of what the government is doing or isn’t doing, the August futures traded at a discountof about 2 points to $VIX. They settled tonight at a discount of 2.39 points. As usual, there seems to be a lot ofmisinformation in print and television media as to why this is occurring. It’s actually quite simple: the composition of

$VIX and the August futures (and all of the other futures, for that matter) is not the same. $VIX is a weighted composite ofthe $SPX August and September options. Since July $SPX options just recently expired, the August options are getting mostof the weight in the $VIX calculation. So $VIXmostly reflects the implied volatility of $SPXAugust options.

Meanwhile, the August futures track theimplied volatility of the $SPX September optionsonly.

Clearly, traders are paying more for $SPXAugust options than they are paying forSeptember options, in implied volatility terms.This is not surprising for two reasons: 1) theshort-term options are usually the mostexpensive, and 2) at this time, with August 2nd

looming as a potential “default” date in the debtceiling negotiations, the August options are theones that expire nearest to,but after, the “event” –and like all event-drivenskews, they are moreexpensive than the later-dated options.

If one looks at theimplied volatilities of$SPX options, he will seethat the Augusts are moreexpensive than theSeptembers – partic-ularly in the case of out-of-the-money puts.

There are two ways totrade this : 1) the$VIX/SPY call hedge,which we haven’t used inquite a while, and 2) adual calendar spread inSPY – treating it as if itwere a biotech stockawaiting an FDA hearing.

Position I422:VIX/SPY hedgeBuy 6 VIX Aug21 calls and

Buy 4 SPY Aug 130 callsFor a total debit of $2700.

(Cont’d on p 9)

VX ExpirationDates

8/17/20119/21/2011

10/19/201111/16/201112/21/20111/18/20122/15/20123/21/20124/18/20125/16/20126/20/20127/18/2012