VIX spot is nearing single digits this month, close to all-time lows. Realized volatility in the S&P 500 index has fallen dramatically in the past month, with 10 day realized volatility now around 5. Volumes have been light, the market remains in an uptrend, and the World Cup is starting on Thursday.
Perhaps the FOMC meeting next Wednesday might be one source of potential volatility, but aside from that, the calendar is quiet until earnings season starts in mid-July. With this backdrop, single stock implied volatility is also near multiyear lows. But even with relatively cheap options prices, we have been wary of putting on long premium structures willy nilly in a low volatility environment.
CC wrote about a similar environment in a March 2013 post, with the following conclusion:
So what this means is until the market’s trend changes and volatility spikes for more than a few days at a time, the best defense is to be either short gamma outright in the form of defined risk range trades (ITM flies are great for this) or if wanting to get long volatility at such low levels, selling near term gamma as a defense against killer decay in the form of calendars.
This is obviously a strategy that works until it doesn’t. What would change is if the market hit turbulence for any sustained period of time at which point the actual volatility could be much higher than what options are pricing. In that case long gamma is the preferred structure. But until that happens it’s best to be on defense as far as decay goes.
Our strategy over the past couple of weeks has been similar. With a couple exceptions (GE and CRM), we have been focused on calendars and butterflies (which we have not executed, but considered in many name that trade posts) in order to offset the lack of near-term volatility.
Today, we wanted to develop a list of names where a short gamma trade looks attractive over the next month with an eye towards pulling the trigger in the coming week if the setup works out: [private]
1. MA – We detailed the range setup in MA in an early May NTT post, with the following thoughts:
Given the strong business prospects but elevated valuation and technical break, it looks like a period of consolidation is in store for MA. Zooming into the 1 year daily chart, the range to watch is $65 to $80:
The 50 day ma is downward sloping, around $75, and the stock has gapped above it today, though that happened for a few days in mid-March before the selling resumed. On the upside $80 is the obvious resistance level. On the downside, $65 is longer-term support. Expect consolidation in that range after the stock’s break of the long-term uptrend.
At this point, MA range trades don’t look great (for example the MA July 66/70, 80/84 iron condor is only around $1.30, and the MA July 70/75/80 call fly costs 1.55ish), but we want to keep an eye out on MA in case implied volatility has another spike in the coming weeks, or MA tests either end of the 65-80 range.
Fast forward to today, and MA has remained rangebound:[caption id="attachment_41467" align="alignnone" width="600"] MA daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg[/caption]
Interestingly, the MA July 70/75/80 butterfly has only appreciated to $1.75 from around $1.55 over the past 5 weeks, and the trade structure will appreciate more quickly over the next few weeks if MA remains between $72 and $78. Since MA does not report earnings until late July, this structure might be a good way to take advantage of continued low volatility.
2. CAT – Caterpillar has rallied nearly 20% so far in 2014. That rally has taken place against a relatively tepid fundamental backdrop. CAT fell 3.6% on May 20th after yet another weak monthly sales report, but the stock has promptly rallied back to a 2 year high as the broader market has lifted most boats.
However, CAT’s technical position suggests the possibility of a rangebound trade over the next month before earnings in late July, given the ample upside supply above $110 from 2011 and 2012:
[caption id="attachment_41469" align="alignnone" width="600"] CAT weekly chart, Courtesy of Bloomberg[/caption]
Meanwhile, the options market is offering the Jul19th 110/105/100 put butterfly at around $1.40, implying a break-even of $101.40 to 108.60, encompassing the range of the past 2 months. Those seem like decent odds for a stock in a decent technical position but a stagnant fundamental situation, and a rally in 2014 that indicates higher expectations going forward.
3. GILD – The stock is down 4% today after Merck bought Idenix, which will expand Merck’s experimental pipeline for Hepatitis C. That could be potential future competition for Gilead’s own Sovaldi, though Gilead has a healthy head start. While the news headline might be relevant in the very long run, the stock’s short-term reaction is likely a poor guess by the market on the real impact.
In any case, GILD’s decline today looks like a move back into the stock’s 6 month range, and makes a range trade focused on the $75 to $85 area more attractive in my view:[caption id="attachment_41471" align="alignnone" width="600"] GILD daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg[/caption]
Gilead is a $120 billion market cap company, so a 10% move in either direction would be quite big, especially in a quiet market and with no catalyst until earnings in late July. Today’s move, however, has led to a mini-spike in implied volatility, so the Jul19th 75/80/85 call butterfly sets up around $1.45, a trade with decent odds considering the technical support and resistance on the chart above.