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Issue No. 18 – March 21, 2005 Prescott, Arizona Systems@WiserTrader.com
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1.0 Trading
Look for a new option alert about mid week. Let me know if there is any additional alert information or follow up that would assist you in deciding to make a trade. Only 10 days are left in the free period for Option Alerts with a 40% savings on enrollment. Trading results listed in Section 4 were very encouraging this week.
1.1 The CBOE 10 Year Treasury Yield Index
The CBOE 10 Year Treasury Yield Index needs more explanation. The portfolio is long the TNX December $45.00 Call with the symbol TNX LI. The trade is based on the speculation that 10 year Treasury yields will rise at least one percentage point a month before the option’s expiration. If this occurs, the trade will profit by more than 100%, as explained in the next section. Last week’s requirement for a rise to a 6% yield were conservative. The current TNX index price is $45.11 reflecting a yield on the 10 year US Treasury Note of 4.511%.
It was incorrect to state last week that the normal yield curve would be a sufficient force to keep Treasury yields above overnight rates. Figure 1A shows a 10 year history of inflation, overnight rates (labeled FOMC) and 10 year Treasury rates. The chart shows that overnight rates actually exceeded the 10 year Treasury yield in 2000. The condition was referred to as an inverted yield curve.
Still the odds that 10 year yields will rise another percentage point by November remain very high due to effective yields on the 10 year note. The effective yield is obtained by subtracting the current inflation rate of 2.97% from the published yield of 4.511%. The result is 1.54%. Rising inflation reduces effective yields, forcing bond holders to sell. Mass selling causes prices to fall and restore effective yields to some minimum acceptable positive value. The need to maintain a minimum acceptable effective yield is a strong force that keeps the 10 year yield above the rising inflation rate shown in Figure 1A.
© 2005 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent trades made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser
FIGURE 1A
In addition to inflation, Treasury yields are also being forced upward by international currency exchange forces. Asian central banks, large holders of US bonds, are reducing their percentage of US bond holdings. China recently announced a 25% reduction. Korea and Japan have recently announced plans for diversification, as well. Newly issued Treasuries will need to carry higher yields to maintain bond sales at the $2 billion/day rate needed to support current deficits. If bond sales are not maintained, the dollar will fall faster pushing inflation further upward. This will require Treasury yields to increase anyway.
The government’s need to raise yields at bond auctions combined with a natural equilibrium that maintains a minimum acceptable effective yield with rising inflation are two factors that make the TNX call option trade worth considering. The next section focuses on selecting the best option.
1.2 Profit Diagrams
Profit diagrams are used to estimate returns and analyze the relative advantages of purchasing various options. There are many ways to draw these diagrams with varying levels of accuracy. This discussion will focus on three levels of approximation that may be more of interest to the beginning options trader than to those who have more experience. Once the basic principle is understood, it becomes easier to estimate profits and losses without needing to put anything on paper. The example option used for this discussion will be the TNX December $45.00 call having the symbol TNX LI. The underlying instrument is the TNX Index that was discussed above. The discussion will treat the underlying TNX Index exactly as if it were an ordinary stock. The option is European, meaning that it can only be exercised on the last day before expiration. Otherwise, it works the same way as the American Style option.
The option expires in the 3rd week of December. At that time the option owner has the right to buy the underlying at the $45 strike price. If the underlying price is greater than $45, the option is said to be in the money and have an intrinsic value equal to the underlying price minus the $45 strike price. The current bid and asking premiums for the option are $6.00 and $6.30, respectively.
Curve 1, the lower curve, in Figure 1B is a plot of the difference between the intrinsic value and the $6.30 premium. If the option is purchased when the underlying is less than $45, the option has no intrinsic value. The flat portion of Curve 1 reflects only the option’s cost of $6.30. The sloped portion of the curve indicates the option’s increasing intrinsic value as the underlying price increases above the $45 strike. When the underlying price reaches a value of $51.50, a break even point is reached. Above an underlying price of $51.50, the intrinsic value exceeds the premium. The kind of diagram represented by Curve 1 gives a reasonable approximation of profit and loss when you are going to exercise an option to buy the underlying at the strike price. We can refer to Curve 1 as a first approximation.
FIGURE 1B
Curve 1 is too conservative if you plan to trade the option before expiration, as most of us will. Consider that you can sell the option at the bid price of $6.00 immediately after purchasing it at $6.30. You have not totally lost the purchase price of $6.30, only $0.30 of it. This situation requires a second approximation using Curve 2 that represents the trading value of the option. Curve 2 is the same as Curve 1 but is shifted upward by the difference between bid and asking prices. Curve 2 is the second approximation used for trading options without exercising them.
Both Curves 1 and 2 assume that each dollar of increase in intrinsic value will increase the value of the option by exactly one dollar. This is an approximation. The curves are optimistic in that the sloped portions may increase only $0.6 to $0.99 for each dollar increase in the underlying, as determined by delta, an option parameter that characterizes option price sensitivity to changes in the underlying price. Delta, ranging from 0 to 1, depends on the time and volatility components of an options value. The effects of delta are shown by Curve 3 for an option at the money, purchased when the underlying was priced at the $45 strike price. The dashed portion below the left end of Curve 3 is just to show that the curve is not a straight line. Delta in this case is 0.59. If the option had been purchased when the underlying was at a lower value, Curve 3 would be shifted to the left so that its vertex would coincide with the point at which the option was purchased.
All three curves are conservative in that they ignore time and volatility components of an option’s price. Differences between the three curves in estimating profit-loss are more glaring when percentages are taken into account as shown in Figure 1C. This chart shows that if the 10 year Treasury yield increases from the current 4.511% to anything above 5.25%, the TNX LI trade can be expected to return greater than 100% profit. That is a change of only 0.739 percentage points.
FIGURE 1C
With that in mind, we can compare several options for the same underlying based on the trading value estimated with the second approximation in Figure 1D where four options having different premiums and strike prices are compared.
FIGURE 1D
The same data in Figure 1D is viewed in terms of percentages by dividing the profit-loss values by the asking premiums. Now interesting things are seen, as shown in Figure 1E. Options having lower strike prices tend to have lower bid-ask spreads. When purchased at the money, they begin to increase in value immediately as the underlying increases in price.
FIGURE 1E
Options having higher strike prices that are well out of the money tend to have higher bid-ask spreads. They require a higher underlying price before they begin to show a profit. But when they do show a profit, their rates of increase are greater than lower strike priced options. Their total profit eventually equals and exceeds the lower strike profits. This feature is purely due to the fact that out of the money options have a lower premium. The chart of Figure 1E is easy to produce in an Excel spreadsheet and is helpful when choosing options. If you need help with this, or would like a copy of the spreadsheet, email me at jaa1@cableone.net .
1.3 Alerts
An alert will be issued by Wednesday evening. I need time to assess the market’s reaction, or lack of one, to serious economic news that is due out this week in the form of Monday’s Producer Price Index, Tuesday’s FOMC rate meeting, and Wednesday’s Consumer Price Index. All of these will have a bearing on the inflation picture.
2.0 Market Analysis
Industry leadership in Table 1 below continues to take a short term view. Leading industries are ranked from highest to lowest. The tendency for gold to advance in all the major trading currencies is an indicator of global inflation.
Table 1