Global Market Comments
April 2, 2018
Fiat Lux
Featured Trade:
(MARKET OUTLOOK FOR THE WEEK AHEAD, or GOODBYE THE QUARTER FROM HELL),
(SPY), (INTC), (AMZN), (CSCO),
(MONDAY, JUNE 11, FORT WORTH, TEXAS, GLOBAL STRATEGY LUNCHEON),
(THE HARD/SOFT DATA CONUNDRUM)
Global Market Comments
March 27, 2018
Fiat Lux
Featured Trade:
(DON'T MISS THE MARCH 28 GLOBAL STRATEGY WEBINAR),
(TEN MORE UGLY MESSAGES FROM THE BOND MARKET),
(TLT), (TBT), (USO), (GLD), (GS), (SPY)
(FRIENDS WHO WILL EXECUTE MY TRADE ALERTS FOR YOU)
The market has been chattering quite a lot about the massive downside bets on the S&P 500 being placed by some of the industry?s best known players.
That is something I would expect from my long time client and mentor George Soros.
But Warren Buffett as well? He is one of the greatest long term, pro America bulls out there.
It is the sort of news that gives investors that queasy, seasick feeling in the pit of their stomachs. You know, like when a new Tesla owner shows off his warp speed ?ludicrous mode??
That is unless you are running heavy short positions in stocks, as I am.
Every technical analyst in the world is pouring over their charts and coming to the same conclusion. A ?Head and Shoulders? pattern is setting up for the major indexes, especially for the S&P 500 (SPY).
And if you think the (SPY) chart is bad, those for the NASDAQ (QQQ), and the Russell 2000 (IWM), look much worse.
This is terrible news for stock investors, as well as owners of other risk assets like commodities, oil and real estate. It is wonderful news for those long of Treasury bonds (TLT), the Euro (FXE), gold (GLD), and silver (SLV).
A head and shoulders pattern is one of the most negative textbook indicators out there for financial markets. It means that there is only enough cash coming in to take prices up to the left shoulder, but no higher.
There is not even enough to challenge the old high, taking a double top decidedly off the table.
The bottom line: the market has run out of buyers. Be very careful of markets where everyone is bullish long term, but no one is doing any buying.
When the hot, fast money players see momentum rapidly fading, they pick up their marbles and go home. Some of the most aggressive, like me, even flip to the short side and make money in the falling market.
If we make it down to the ?neckline? and it doesn?t hold, then the sushi really hits the fan. Right now, that neckline is at $204.60 in the S&P 500 (SPY). Break that, and it?s hasta la vista baby. See you later.
Stop losses get triggered, the machines takeover, and shares move to the downside with a turbocharger. Distress margin calls on the most levered players (usually the youngest ones) add further fuel to the fire. We might even get a flash crash
This is when the really big money is made on the short side.
There is a new wrinkle this year that could make this sell off particularly vicious. To see a formation like this setting up during May is particularly ominous. It means that ?Sell in May? is going to work one more time
?It?s not like we have any shortage of bearish headlines to prompt a stampede by the bears.
The turmoil in Europe, one of the largest buyers of American exports, could cause the US to catch a cold. This is what the latest round of earnings disappointments has been hinting at.
Margin debt to own stocks has recently exploded to an all time high.
It could well be that the market action is just the dress rehearsal for a deeper correction in the summer, when markets are supposed to go down.
If markets do breakdown, it won?t be bombs away. The (SPY) might make it down to $181, $177, or in an extreme case $174. But to get sustainably below that, we really need to see an actual recession, not just a growth scare.
Remember that earnings are still growing year on year, once you take out the oil industry. That is not a formula for any kind of recession.
It is a formula for a 10% sell off in an aged bull market. That?s where you load the boat with the best quality stocks (MSFT), (FB), (GOOG), (CELG), etc., which should be down 25-35%, and then clock your +25% year in your equity trading portfolio.
If you are NOT a trader, but a long-term investor monitoring you retirement funds, just go take a round-the-world cruise and wake me up on December 31. You should be up 5% or more, with dividends, and skip the volatility.
Ignore It at Your Peril
Volatility? What Volatility?
I have been to Greece many times over the past 45 years, and I?ll tell you that I just love the place. The beaches are perfect, the Ouzo wine enticing, and I?ll never say ?No? to a good moussaka.
However, I don?t let Greece dictate my investment strategy.
Greece, in fact, accounts for less than 2% of Europe?s GDP. It is not a storm in a teacup that is going on there, but a storm in a thimble. Greece is really just a full employment contract for financial journalists, who like to throw around big words like bankruptcy, default and contagion.
I have other things to worry about.
In fact, I am starting to come around to the belief that Europe is looking pretty good right here. Cisco (CSCO) CEO, John Chambers, announced that he was seeing the early signs of a turnaround.
Fiat CEO, Sergio Marchionne, the brilliant personal savior of Chrysler during the crash, thinks the beleaguered continent is about to recover from ?hell? to only ?purgatory.?
Only a devout Catholic could come up with such a characterization. But I love Sergio nevertheless because he generously helps me with my Italian pronunciation when we speak (aspirapolvere for vacuum cleaner, really?).
What are the two best performing stock markets since the big ?RISK ON? move started last Thursday? Greece (GREK) (+5%) and Russia (RSX) (+7.5%)!
And here is where I come in with my own 30,000 foot view.
The undisputed lesson of the past five years is that you always want to own stock markets that are about to receive an overdose of quantitative easing.
Since the US Federal Reserve launched their aggressive monetary policy, the S&P 500 (SPY) nearly tripled off the bottom.? Look how well US markets have performed since American QE ended 18 months ago.
Europe has only just barely started QE, and it could run for five more years. Corporations across the pond are about to be force-fed mountains of cash at negative interest rates, much like a goose being fattened for a fine dish of foie gras (only decriminalized in California last year).
Mind you, it could be another year before we get another dose of Euro QE, which is why I just bought the Euro (FXE) for a short-term trade.
A cheaper currency automatically reduces the prices of continental exports, making them more competitive in the international markets, and boosting their economies. Needless to say, this is all great new for stock markets.
Get Europe off the mat, and you can also add 10% to US share prices as well, as the global economy revives. The Euro drag dies and goes to heaven.
Buy the Wisdom Tree International Hedged Equity Fund ETF (HEDJ) down here on dips, which is long a basket of European stocks and short the Euro (FXE). This could be the big performer this year.
Praise the Lord and pass the foie gras!
Those of a certain age can?t help but remember that things for the US went to hell in a hand basket after 1963.
That?s when President John F. Kennedy was assassinated, heralding decades of turmoil. Race riots exploded everywhere. The Vietnam War ramped up out of control, taking 60,000 lives, and destroying the nation?s finances. Nixon took the US off the gold standard.
When people complain about our challenges now, I laugh to my self and think this is nothing compared to that unfortunate decade.
Two oil shocks and hyper inflation followed. We reached a low point when Revolutionary Guards seized American hostages in Tehran in 1979.
We received a respite after 1982 with the rollback of a century?s worth of regulation during the Reagan years. But a borrowing binge sent the national debt soaring, from $1 trillion to $18 trillion. An 18-year bull market in stocks ensued. The United States share of global GDP continued to fade.
Basking in the decisive victories of WWII, the Greatest Generation saw their country account for 50% of global GDP, the largest in history, except, perhaps, for the Roman Empire. After that, our share of global business activity began a long steady decline. Today, we are hovering around 22%.
Hitch hiking around Europe in 1968 and 1969 with a backpack and a dog-eared copy of Europe on $5 a Day, I traded in a dollar for five French francs, four Deutschmarks, three Swiss francs, and 0.40 British pounds.
When I first landed in Japan in 1974, there were Y305 yen to the dollar. Even after a strong year, the greenback is still down by 75% against these currencies, except for sterling. How things have changed.
We now live in a world where the US suddenly has the strongest economy, currency and stock market in the world. Are these leading indicators of better things to come?
Is the Great American Rot finally ending? Is everything that has gone wrong with the United States over the past half century reversing?
The national finances are hinting as much. Over the last four years, the federal budget deficit has been shrinking at the fastest rate in history, from $1.4 trillion to only $483 million.
If the economy continues to grow at its present modest 2.5% rate, we should be in balance by 2018. Then the national debt, which will peak at around $18 trillion, will start to shrink for the first time in 20 years.
And since chronic deflation has crashed borrowing costs precipitously, the cost of maintaining this debt has dramatically declined.
A country with high economic growth, no inflation, generationally low energy costs, a strong currency, overwhelming technology superiority, a strong military and political stability is always a fantastic investment opportunity.
It certainly is compared to the highly deflationary, weak currency, technologically lagging major economies abroad.
You spend a lifetime looking for these as a researcher, and only come up with a handful. Perhaps this is what financial markets have been trying to tell us all along.
It certainly is what foreign investors have been telling us for years, who have been moving capital into the US as fast as they can (click here for ?The New Offshore Center: America?).
It gets even better. These ideal conditions are only the lead up to my roaring twenties scenario (click here for ?Get Ready for the Coming Golden Age?), when over saving, under consuming baby boomers enter a mass extinction, and a gale force demographic headwind veers to a tailwind.
That opens the way for the country to return to a consistent 4% GDP growth, with modest inflation and higher interest rates.
Which leads us all to the great screaming question of the moment: Why is the US stock market trading so poorly this year? If the long term prospects for companies are so great, why have shares suddenly started performing feebly?
Not only has it gone nowhere for three months, market volatility has doubled, making life for all of us dull, mean and brutish.
There are a few short-term answers to this conundrum.
There is no doubt that the Euro and the yen have fallen so sharply against the greenback that it is hurting the earnings of multinationals when translated back to dollars.
This has cut S&P 500 earnings forecasts for the year. And these days, everyone is a multinational, including the Diary of a Mad Hedge Fund Trader, where one third of our subscribers live abroad.
Another short-term factor is the complete collapse of the price of oil. Again, it happened so fast, and was so unexpected, that it too is having a sudden deleterious influence of broader S&P earnings.
Go no further than oil giant Chevron, which just announced a big drop in earnings and a massive cut in its capital spending budget for 2016.
The final nail in the Q4 coffin has been bank earnings, which all took big hits in trading revenues. Virtually all were taken short by the huge, one-way rally in bond prices in recent months and the collapse of interest rates.
This happens when panicky customers come in and lift the banks? inventories, and trading desks have to spend the rest of the day, week and month trying to get them back at a loss.
I have seen this happen too many times. This is why the industry always trades at such low multiples.
With no leadership from the biggest sectors of the market, financials and energy, and with the horsemen of technology and biotech vastly overbought, it doesn?t leave the nimble stock picker with too many choices.
The end result is a stock market that goes nowhere, but with a lot of volatility. Sound familiar?
Fortunately, there is a happy ending to this story. Eventually, all of the short-term factors will disappear. Oil prices and bond yields will go back up. The dollar will moderate. Corporate earnings growth will return to the 10% neighborhood. And stocks will reach new highs.
But it could take a while to digest all of this. This is a lot of red meat to take in all at one time. If the market grinds sideways in a 15% range all year, and then breaks out to the upside once again for a 5% annual gain, most investors would consider this a win.
Once again, index investors will beat the pants off of hedge fund managers, as they have for the past seven years.
In the meantime, I doubt the stock indexes will drop more than 6% % from here, with the (SPY) at $189, and we have already seen a 6% hair cut from last year?s peak.?
Knock a tenth off a 16.5 X forward earnings multiple with zero inflation, cheap energy, ultra low interest rates and hyper accelerating technology, and all of a sudden, stocks look pretty cheap again.
As the super sleuth, Sherlock Homes used to say, ?When you have eliminated the impossible, whatever remains, however improbable, must be the truth?.
It?s All Elementary
Suddenly, the consolidation turned into a correction and maybe even a bear market.
A crucial part of trading a crash is knowing what to do at the bottom. Don?t worry. You?ll receive a flurry of text alerts from me right when that happens.
Many individual investors simply run to the bathroom and lock the door, hoping nobody knocks on the door for a couple of days.
Worse, they dump every stock they have. That?s what makes market bottoms.
Trades that once seemed impossible can now get done, provided you use limit orders.
Let me get this right. Stocks are crashing because:
1) The Federal Reserve isn?t going to raise interest rates anymore.
2) The price of oil has dropped 84% in five years.
3) Commodities have reached multi-decade lows.
4) The US dollar has suddenly stabilized.
5) Investors are yanking money from abroad and pouring it into the US on a flight to safety trade because it is the only place they can obtain a positive return, especially in stocks.
May I point out the screamingly obvious right here?
These are all reasons for 90% of US companies that borrow money and consume energy and commodities to increase earnings and to boost their share prices.
Only the 10% that derive revenues from ripping oil and commodities out of the ground should get hurt here.
Of course the market doesn?t know that. It is anything but rational when we hit big triple digit declines. There was only one direction on, and that was OUT.
And that is where you make your money
Margin clerks rule supreme, squeezing every bit of leverage out of their clients they can find.
The Dow and (SPY) are already posting large negative numbers for 2016.
Of course, I saw all of this coming a mile off.
I have been banging drums, pulling fire alarms, shooting off flare guns, and otherwise warning readers that the technical situation for the market was terrible ever since I went 100% into cash in December.
When the breakdown appeared imminent, I shot out Trade Alerts to sell short the S&P 500 (SPY) in size as fast as I could write them. And I started buying outright (SPY) puts for the first time in ages.
As a result of these sudden tactical moves, my model-trading portfolio has been keeping its head above water all month, up 2%. The Dow Average is off by a nausea inducing -10.7% at today?s low.
Yes, yes! All the hard work and research is paying off!
Ignore my musings at your peril!
What is even more stunning is that these declines are occurring in the face of US macro economic numbers that are going from strength to strength. The blockbuster December nonfarm payroll report of 292,000 is the real writing on the wall.
Housing, which accounts for about one third of the US economy, has been on fire. I?m sorry, but if you can?t find a parking space at Target, there is no recession.
Another crucial leg of the US economy, auto manufacturing, has been in overdrive. Auto sales are at a record 18 million annual rate, and some summer production shut downs have been cancelled.
That is, everywhere except Volkswagen.
With two of the most important legs firing on all cylinders, it?s clearly not about the economy, stupid!
There certainly hasn?t been a geopolitical event to justify moves of this magnitude.
As far as I can tell, Hitler has not invaded Poland, nor have the Japanese attacked Pearl Harbor.
Sure, there is whining about China, which has the Shanghai Index approaching the 2,900 level once again, down 40% from the top.?
Which leads me to believe that all of this is nothing more than a temporary hiccup. A BIG Hofbrauhouse kind of hiccup, but a hiccup nonetheless.
In a zero interest rate world, stocks only have to fall back from a price earnings multiple of 18 to 15 to flush out a ton of buying, and they will have done just that when the (SPY) hits $174.
THAT IS MY LINE IN THE SAND.
If nothing else, corporate buybacks should reaccelerate here, which could reach $1 trillion in 2016. Some 75% companies exit their quiet period by February 5 and can resume buying.
That could signal an interim market bottom.
The great thing about this selloff is that the best quality companies have fallen the most. This has been a function of the heavy sovereign wealth fund selling the bridge oil deficits.
After all, when share prices are in free fall, you have to sell what you can, not what you want to. It is only human to realize profits rather than incur losses, so quality has been trashed.
I am therefore going to give you a list of ten of my favorite stocks to buy at the bottom, highlighting the sectors that will lead us into a yearend rally.
The themes here are home builders, consumer discretionary, autos, solar, old technology, and international. I?m sorry, but the entire interest sensitive sector is on hold for the rest of the year, thanks to likely Fed inaction.
Watch out, because when I sense that the market has burned itself out on the downside, the Trade Alerts are going to be coming hot and heavy.
You have been forewarned!
Read ?em and weep with joy!
10 Stocks to Buy at the Bottom
Lennar Homes (LEN)
Home Depot (HD)
Microsoft (MSFT)
General Electric (GE)
Tesla (TSLA)
Apple (AAPL)
First Solar (FSLR)
Palo Alto Networks (PANW)
Wisdom Tree Japan Hedged Equity (DXJ)
Wisdom Tree Europe Hedged Equity (HEDJ)
Finally, All the Hard Work is Paying Off
I did not buy the rally in stocks this week for two seconds.
Once the S&P 500 (SPY) bounced off of the $190 level the first time, it was only a question of how soon to sell again. When I said ?Sell every rally in stocks this year,? I wasn?t kidding.
As it turns out, I caught the absolutely top tick in the (SPY) at $195.
That?s where I quickly bought the (SPY) February $202-$207 vertical bear put debit spread. Within hours, the index cratered an awesome $70 handles, and I was already looking at 70% of the maximum potential profit.
The great luxury of the S&P 500 SPDR?s (SPY) February, 2016 $202-$207 in-the-money vertical bear put spread is that it allows you to cash in on continued extremely elevated levels of the Volatility Index (VIX).
This is why the potential return is so high for a front month options spread already 7 handles, and now 12 handles in-the-money.
In the meantime, I continued to run big shorts in the (SPY) with my February 187 and $190 puts.
This was on the heels of cutting by half my (XIV) position at cost, and taking profits on my (SPY) January $182-$187 vertical bull call debit spread during the rally.
Since yesterday, I have cut the net exposure of my sizeable trading book from 40% to 0%. This is how you do it.
My lack of faith in this market can be measured by the bucket load.
I believe that oil (USO) hasn?t bottomed yet.
All we are seeing here is a round of natural short covering you would expect as the price bounces off the big round number of $30, something which computer driven algorithms love to do.
There are many more visits to the $20 handle for oil to come. Brent is already there.
If you have some magical insight into the price of oil, better than the entire industry combined, and are convinced that Texas tea bottomed yesterday, then you shouldn?t touch the S&P 500 SPDR?s (SPY) February, 2016 $202-$207 in-the-money vertical bear put spread. In that unlikely scenario, stocks rocket from here.
Then there?s China (FXI), whose continued turmoil will bring further US stock losses. I assure you, not even the Chinese know what?s going on in China. They are more like the unfortunate deer that is frozen in the headlights.
If the stock markets of the Middle Kingdom were either up or down 10% tomorrow, I wouldn?t be surprised.
I?m quite happy with the performance of the Trade Alert service so far in 2016.
Here we are only 8 trading days into the New Year and many traders have already blown up, including quite a few trade mentoring newsletters. We should be hauling in some big numbers in January and February.
This is how you trade a crash. Watch and learn. The opportunities are legion.
We currently have two options positions that are deep in the money, and I just want to explain to the newbies how to best maximize their profits going into tomorrow?s January options expiration.
These comprise:
The S&P 500 SPDR?s (SPY) January $185-$190 in-the-money vertical bull call put spread with a cost of $4.58
The IShares Barclay?s 20 Year+ Treasury Bond Fund (TLT) January $125-$128 in-the-money vertical bear put spread with a cost of $2.70.
Here?s the easy part:
As long as the (SPY) closes at $190 or above at the close, the position will expire worth $5.00 and you will achieve the maximum possible profit. The nine-day gain on the trade will be 9.2%.
In addition, as long as the (TLT) closes at $125 or below at the close, the position will expire worth $3.00 and you will achieve the maximum possible profit here as well. The seven-day profit will be 11.1%.
Since the bond market closes at 3:00 PM EST on Friday, don?t expect much price movement after that.
Better than a poke in the eye with a sharp stick, as they say, especially in these difficult trading conditions.
In this case, the expiration is very simple. You take your left hand, grab your right wrist, pull it behind your neck and pat yourself on the back for a job well done.
Your only problem now is to figure out how to spend your winnings.
Your broker (are they still called that?) will automatically use the long (SPY) call to cover the short (SPY) call, and the long (TLT) put to cover the short (TLT) put, entirely cancelling out the positions.
The profit will be credited to your account on the following Monday, and the margin freed up.
If doesn?t, get on the blower immediately, because broker computers sometimes make mistakes, and they will always try to blame you first.
If an unforeseen event causes the (SPY) to collapse to the downside before the Friday close, such as if oil decides to crater once more, then things start to get complicated.
If the (SPY) expires slightly out-of-the-money, like at $189.90, the position can become a headache.
On the close, your short put position expires worthless, but your long put position is converted into a large, leveraged outright naked long position in the (SPY) with a cost of $185.58.
This position you do not want on pain of death, as the potential risk is huge and unlimited, and your broker probably would not allow it unless you wired in a ton of new margin immediately. It is more likely that they will execute a forced liquidation of your account.
This is to be avoided at all cost. It is not what moneymaking is all about.
Professionals caught in this circumstance then sell short a number of shares of (SPY) on expiration day equal to the short position they inherit with the expiring $185 call to hedge out their risk.
Then the long (SPY) position in the $185 calls is cancelled out by the short (SPY) position in the shares, and on Monday both disappear from their statement.
To minimize risk, traders attempt to sell these shares right at the close. As you have thousands of people attempting to do this at the same time, price action on expiration closes can be wild.
So for individuals, I would recommend just selling the January $185-$190 vertical call debit spread outright in the market if it looks like this situation may develop and the (SPY) is going to close very close to the $190 strike.
Keep in mind, also, that the liquidity in the options market completely disappears, and the spreads widen, when a security has only hours, or minutes until expiration. No one wants to be left holding the bag.
This is known in the trade as the ?expiration risk.?
Don?t worry if you lose money on this one position. Your loss will be more than offset by profits in your February $190 puts and February 187 puts which you independently bought last Friday and Monday. That will give you a generous overall profit.
The logic is the same if the (TLT) looks like it is going to close over $125 tomorrow.
One way or the other, I?m sure you?ll do OK, as long as I am watching my screens like a hawk, which I will be. If I think any action is required on your part, I will send out the Trade Alert in seconds.
One way or the other, you will make money on these trades.
Well done, and on to the next trade.
Followers of my Trade Alert service have noticed some unusual activity during the last two days. Instead of recommending put spreads, I have started advising the purchase of outright puts.
Coming on top of big declines in the S&P 500 (SPY), you may have thought that I have lost my mind, if I hadn?t already done so a long time ago.
My kids would agree with you.
However, there is a method to my madness.
The truly brilliant aspect to the option spread strategy that I have been using for the past four years was that the positions had an embedded short volatility aspect to them.
While you were long volatility with your long leg, this was offset by the short volatility in your short leg.
This gave you a net volatility exposure of close to zero, a great thing to have during a time of secular declining volatility, as we have seen since 2012. Think of the first eight months of 2015, when index prices barely budged.
It also meant that you could achieve your maximum profit when the underlying stock remained unchanged, or moved only a few percent against you.
The nice thing about this low volatility was that it gave time to followers to get in and out of positions before large price changes occurred. Moves of only a few cents before you received trade alerts were common.
By focusing on front month options I also took maximum advantage of accelerated time decay going into each expiration. It was like having a rich uncle write you a check every day.
The low volatility delivered only small changes in the value of your portfolio from the day-to-day movements in the market, tiny enough for the novice investor to live with.
This is what enabled me to produce huge, outsized double digit returns while most other managers were sucking wind.
Since August 24, we have been in a completely different world. The long-term trend in volatility isn?t falling anymore. It has been rising.
What this brought to my trading book was a series of stop outs on options spread positions, whether they were call spreads or put spreads, and painful losses.
This is why I lost money in two out of three months in the recent quarter, a rare event. Having an embedded short volatility position was alas costing me money.
So it is time to adjust our strategy to reflect this brave new, and more volatile world.
So instead of running positions into expiration, I am going to start hedging them with options when a breakdown in the market appears imminent.
This is why I picked up the February $190 puts on Friday to hedge my January $185-$190 calls spread. It is also why I bought the February $187 puts to hedge my January $182-$187 call spread.
Why the mismatch in expirations? It ducks the problem of final week super accelerated time decay with my long puts. It also means I can continue with the short positions after the Friday January expiration, if I choose to do so.
There is one complication with this approach. Individual options are vastly more volatility than option spreads. So it won?t be unusual for an option to move 5%-10% by the time you receive the Trade Alerts. To be forewarned is to be forearmed.
Let?s look at out current positions as examples. For further analysis you have to be familiar with the concept of on option delta. Delta is a letter of the Greek alphabet used by traders to refer to the movement of an option relative to its underlying security.
A delta of 10% means that a $1 move in the underlying produces a 10-cent move in the option, which you see in deep out-of-the-money options. A delta of 90% means that a $1 move in the underlying produces a 90-cent move in the option, which is found with deep-in-the-money options.
The January $185-$190 vertical call debit spread had two legs, and the delta can be calculated as following:
A long January 185 call with a delta of +19%
A short January 190 call with a delta of -39% (negative since you are short)
This gives you a net delta of (39% - 19%) = -20%.
In other words, a $1 move down in the underlying (SPY) index only moves the $185-$190 call spread south by -20 cents.
In the case of the $182-$187 call spread, the net delta is only 14%, giving you a move in the spread of only 14 cents for the $1 (SPY) move.
Let?s say that the market looks like it is going to pieces and I want to hedge my downside exposure. That means I need to buy puts against my long call spread.
Since my net delta is only -20% on the January $185-$190 vertical call debit spread, I only need to buy 20% as many puts to neutralize the position, or 0.2 X 22 = 4.4 options.
To be more aggressive on the downside I increased my put purchase to 13 contracts to also provide extra downside protection of my short volatility (XIV) position. I then repeated this exercise on Monday for the $182-$187 vertical call debit spread.
What we end up with is a portfolio that is profitable at all points with a Friday January 15 (SPY) options expiration between $187-$194. Now you don?t have to touch the position, unless we break out of that range.
This prevents you from attempting to trade every triple digit ratchet in the market between now and then. This is a hopeless exercise. I know because I have tried it many times, to no avail.
Yes, I know this all sounds complicated. But this is how the pros do it. This is how they make money. It?s all about preserving your capital and making incremental profits on top of it. Watch, and learn.
Learn from my errors and prosper.
You Get Used to Them After a While
It is often said that the stock market has discounted 12 out of the last four recessions.
While the market is discounting another recession now, I believe it is one of the many previously forecast that will never happen, a lot like to 18% swoon in the futures markets we saw last summer.
If anything, the reported hard data are showing that the economy is strengthening now, not weakening. The December nonfarm payroll hit a one-year high at 292,000. Christmas sales were off the charts for online merchants.
Auto production topped an 18 million rate. And this is an industry that was bankrupt only seven years ago.
But what else would you expect from a global economy that just has a $2 trillion annual tax cut dumped in its lap, thanks to lower energy prices.
I therefore think we are within days of the final capitulation of this move. That means the Volatility Index (VIX) will peak as well, probably around $30, the top that defined the top of every spike for all of 2015, except for the August 24 flash crash day. That apex is probably only days away.
I am one of those cheapskates who buys Christmas ornaments by the bucket load from Costco in January for ten cents on the dollar, because my eleven month theoretical return on capital comes close to 1,000%.
I also like buying flood insurance in the middle of the summer when the forecast here in California is for endless days of sunshine.
That is what we are facing now with the volatility index (VIX) where premiums have just doubled, from $15 to near $30. Get this one right, and the profits you can realize are spectacular.
Watch carefully for other confirming trends to affirm this trade is unfolding. Those would include a strong dollar, collapsing stocks, and oil in free fall, and a weak Japanese yen, Euro.
I don?t know about you, but I am seeing seven out of seven cross asset confirming price action.
The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index, which has been rallying hard since oil began its precipitous slide three weeks ago.
You may know of this from the many clueless talking heads, beginners, and newbies who call this the ?Fear Index?. Long-term followers of my Trade Alert Service profited handsomely after I urged them to sell short this index three years ago with the heady altitude of 47%.
For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expiration's.
The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?
For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don?t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.
The (VIX) is expressed in terms of the annualized movement in the S&P 500, which today is at 1,800. So a (VIX) of $14 means that the market expects the index to move 4.0%, or 72 S&P 500 points, over the next 30 days.
You get this by calculating $14/3.46 = 4.0%, where the square root of 12 months is 3.46. The volatility index doesn?t really care which way the stock index moves. If the S&P 500 moves more than the projected 4.0%, you make a profit on your long (VIX) positions.
Probability statistics suggest that there is a 68% chance (one standard deviation) that the next monthly market move will stay within the 4.0% range. I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.
It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the ?hedge? in hedge fund.
But wait, there?s more. Now, erase the blackboard and start all over. Why should you care? If you sell short the (VIX) here at $24, you are picking up a derivative at a nice overbought level. Only prolonged, ?buy and hold? bull markets see volatility stay under $14 for any appreciable amount of time. That?s probably what we have now.
If you are a trader you can sell short the (VIX) futures somewhere over $20 and expect an easy profit sometime in the coming weeks. If we get another 5% rally somewhere along that way, that would do it.
If you don?t want to sell the (VIX) futures or options outright, then you can always sell short the iPath S&P 500 VIX Short Term Futures ETN (VXX). Better yet, you can buy a short (VIX) ETN outright, the Velocity Shares Daily Inverse VIX Short Term ETN (XIV).
If you make money on this trade, it will offset losses on other long positions.
No one who buys fire insurance ever complains when their house doesn?t burn down.
Volatility Can Be Your Friend