Rosy labor report?

The jobs report this morning caused the S&P 500 to hit new highs of the year, a few points short of its all time high set in May 2015.  It is tempting to pretend like all is well, and just buy stocks, and hope for the best.  Yet, perhaps the best way to protect your nest egg is to take a closer look with a critical eye.

I heard a few unconfirmed things today from traders regarding that report:

  • June was revised down from 38k jobs to 11k jobs
  • A large portion of the new jobs were people 55+

Note that gold and bonds soared today (my two favorite investments of the year).  #1 on the selling into strength list for most of today was SPY (S&P 500 ETF), with the IWD (Russel 2000) at #4.  This is post-brexit profit taking which is common when they believe the market is reaching another top.

ZeroHedge has an interesting critique of the jobs report that soared the markets today:

The Bearish David Rosenberg Reemerges: “What If I Told You Employment Actually Declined 119,000 In June”

Selling into strength:

sellingStrength-2016-07-08

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Building a long-term position in gold via NUGT

I and others I know have found ourselves chasing gold.  We periodically get a nice position, take our profits, and then find ourselves missing out on the next big move because we cannot find good entry.

This has been driving me nuts all year.  While I finally just bought a gold fund in my 401k in April so I never miss out on an up move again, I’m still far from fully benefiting from the continued rise in gold.

Typically, I prefer gold futures (/GC) as a vehicle.  However, they suffer from two major limitations.  They do not have weekly options, and their options only go out a couple of months.

Thesis: Target for gold is 1600 before the end of 2016.

This is a thesis I’ve held for 2016 since mid-2015.  The first half of the year sure has confirmed the thesis.  I won’t get into all the reasons gold is soaring this year in this post.  But, the positions I’m describing here are based on capturing profits if this thesis continues to prove true.

There is good news.  While gold has risen from 1060.50 since the beginning of the year, gaining over $300, or 30%, in order to hit $1600, gold has about $230+ more to go.  That’s still a nice gain to capture.

So, how do we capture it without constantly chasing price and hoping gold doesn’t soar while we ‘re sleeping in the Asia and European sessions, or looking for a pullback that never comes while it rips in front of us?

Fortunately, in addition to being a 3X leveraged ETF of gold miners with a high correlation to the price of gold, NUGT also has weekly options, and has options all the way to January covering our time frame.

There are some principles to options you’ll want to understand for this strategy:

  1. The further out in time they expire, the lower the delta and theta.  The former is good when it is going against you.  The latter is the cost of having lower short-term price volatility.  We’ll leverage this lower delta to scale our position when we think /gc could ultimately retreat quite a bit, yet know we can’t guarantee how far it will pull back either.
  2. Because we’ll primarily begin by building a position that decays extrinsic value, it is important to understand that extrinsic value is highest at the money (ATM).  The further out of the money (OTM) or in the money (ITM) you go, the less potential profit from the position.
  3. Because NUGT is a 3X ETF, it consumes a lot of buying power even for margin accounts.  We’ll address this by ultimately looking to create verticals.

Long via short puts

At 1357, and having only been in the 1300s for a short while, we view /GC as being 1/2rd through a 1300-1400 range.  Many are betting it will hit 1400 soon, and plan to short it there.  So, it has a decent probability of racing back to support near 1308.  Yet, due to the reasons it is soaring (bonds having negative returns, currencies unstable, and brexit), there is never a guarantee it will come back down that far.  We want to be sure we have a position in case it soars without an ideal pullback.  Yet, we don’t want to be too exposed in case it does drop back near 1300; and, want to be able to add to our position if it does.

Thus, at this level, we’ll begin our position with low delta short puts by going out to December expiry.  For the strike, I choose to be near the money to maximize extrinsic value.  The good thing about December is the premium is high enough to easily get a break even of $100.  Selling a 160 Dec for $55 means your break even at expiry is $105.

The delta on Dec 160 is currently -.29.  That means that the option price is expected to decrease by .29 per share for ever $1 gain in NUGT, presuming volatility doesn’t change, and not taking into account theta burn.  That is what we like being so far above what we currently consider strong support.  We’ll take a lot less heat than a put that will be expiring soon at the same strike if /GC drops $60.

Our goal is to turn this into a vertical, as we believe /GC has a high probability of shooting for $1400 before coming down.  If you are not comfortable opening a naked option position, or don’t like the buying power reduction (BPR), you can just begin with a vertical.  However, I’m choosing to open the short side first, then the long side if /GC goes higher in the near-term.

After selling this put.  I created an order to buy the 140 Dec for $20 less than I received for the 160.  If I’m super lucky, and it fills, then I just locked in max profit on the spread!  Realistically, though, I’ll look for resistance on /GC, notably 1400, and do a cancel/replace for whatever I can get then, because I anticipate a pullback there on first touch.  Regardless, it is likely to be a lot better than what I’d pay today, both because it will be worth less due to the delta, and because time will pass, burning theta.

Note that you are never locked in.  Let’s gold hits 1400, we buy the put creating our spread, then gold drops $90.  We could, at that point, close the long put for a profit, or roll it to a different strike to widen our profit potential.  The idea of putting it on is to lock in a higher probability of profit while creating some downside protection.  Once we’ve used that downside protection, we can choose to remove or reduce it.

If /GC drops before I get a chance to do it, then I’ll just be stuck with a naked put for awhile, and wait until /GC runs again.  Like I said, if this isn’t for you, you can just open a short vertical and be done with it.  I’m just trying to maximize potential profit and probability of profit by putting some swing trading into how the position is created.

If the naked put is a little uncomfortable, but you want to try to time the sides of the vertical, you could start with the long side first.  The down side it will be decaying while you wait for entry on the long side.  The good news is that the decay will be relatively slow since you went out to December.  That Dec 160 currently has a theta of -.16.  Contrast that to the 160 expiring in two days with a theta of -$1.30.  If you do the long side first, then you’ll be hoping for a nice pullback to complete with the short side instead of waiting for /GC to go higher.  If you feel strongly about which direction it is likely to move in the next few days, this can also factor into which side you do first.

Scaling Based on /GC price

What do we do as /GC comes down towards our major support, but isn’t there yet.  Remember, there’s no guarantee it will get there.  So, we want to balance the possibility it can just drop to 1340 and bounce and never go below it again for the rest of the year, with increasing risk and potential profit as it approaches 1300.  To do this, I’ll use closer expiries as it drops.  Perhaps Nov in 1340-55 range, Oct in 20-40 range, etc,…  The closer it gets to the bottom of it’s potential range, the more delta we’ll be willing to risk to collect more from theta burn.  🙂  This is optional.  You could stick to Dec.  I just like to increase reward/risk as it approaches support.

Note that once it gets down to 1300-15, even a short OTM put spreads can be very lucrative.  Analyze these and decide if they aren’t good option for you.  I just don’t think they are lucrative enough until /GC is down there to be worth the heat.  But, they are on my list of potential positions to open there.

Long Calls to Maximize Profit Potential

The next part of this strategy is what we’ll do if /GC pulls back near 1300, where we believe there is strong support and it will likely bounce like the last time it came near 1308.  For one, you can immediately sell short puts that expire in the near-term for quick profits on that bounce, or even if it ranges there for a bit, as theta will decay fast.  Then, take the cash you raise from that, and buy some Dec calls.  You’ll have to pick the strike you like and are willing to pay for.  But, here’s where you turn a potentially profitable position into a really potentially profitable position.  The potentials gains of Dec NUGT calls if /GC goes from 1300 to 1600 by then are huge.  The good thing is you’ve effectively financed these with short puts.

To be clear, there is a lot of downside risk to this position.  I have strong conviction so am not too concerned about that.  Yet, once your put side consists primarily of verticals, your risk will be limited.  If you timed it will, then you really reduced your risk.  If you get lucky and the difference between price you collected from short side and long side is same as spread, you have NO RISK on that spread as you already collected max profit, and will just wait for payday!

Variations

To be sure, you can use different underlyings and combine them in different ways.  The important thing is you are capturing both delta and theta burn on anticipation of an up move in gold, with little to no risk if gold doesn’t climb, and you are managing and limiting risk to the downside.  You’re also timing it to obtain the best position given the uncertainties.

Alternatives include using /GC options, GLD options, or anything else that moves with the price of gold.

 

 

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US Commercial Real-Estate Storm Brewing?

One counter I hear to the possibility of a recession coming to the US before the end of the year is that real-estate is booming.  Is it?  It has for 6 years, but this year doesn’t look as rosy.

In this Bloomberg article, the article suggests there are several reason this market could drop within the next 12 months:

Pimco Says ‘Storm Is Brewing’ in U.S. Commercial Real Estate

Signs of a cooling real estate market have emerged across the country since the start of the year. Commercial-property values in big U.S. cities, which have seen the largest increases during the recent boom, have declined 3 percent in the past three months, Moody’s Investors Service and Real Capital Analytics Inc. said in a June 6 report. Real estate transactions in New York, the biggest U.S. property market, are forecast to decline by as much as 30 percent this year, brokerage Cushman & Wakefield said in April.

 

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Major Economies Are Not Raising Rates in 2016

If the US raises central bank (CB) rates this year, it looks like it would be the only major economy to do so.  So far in 2016, major economies are either lowering rates, or leaving them steady.  The ECB, for instance, hasn’t changed rates yet in 2016.  But, that’s because they are at all time lows of 0%.  Other European countries, such as Sweeden, Denmark and Switzerland, have been experimenting with a so-called Negative Interest Rates Policy (NIRP).

So, who is raising rates?  Looking at the list of rate changes in the first 5 months of 2016, the two largest countries to of raised rates are Argentina and Denmark.

Argentina.  According to the IMF, at less than 1/30th the size of US GDP, Argentina is ranked 21 in the world for GDP in 2015.  But, not only is the largest economy to raise rates this year relatively small, it is raising rates to combat hyperinflation after years of printing their currency, a result of years of political corruption of populist leaders printing to meet campaign promises. So, it should not surprise anyone that they raised rates from 35.43% to 36.9%.  On the plus side, this is lower than their all-time high of 1390%.  I also heard from a resident of Argentina that they recently elected a leader who is restoring a free market to Argentina, and trying to reign in the craziness that lead to constant depreciation of their peso.  That friend cautioned, however, that it will take years for the reforms to take hold and restore this economy.  I was a bit more optimistic about the pace until I saw that they had to raise rates again.

Denmark.  At half the size of Argentina, the IMF ranks them in 36th place for GDP.  If you believe that central bank depository interest charges are “negative interest rates”, then they kicked off the year by raising their CB rate from -0.75% to -0.65%.  Many don’t expect another increase until next year, and don’t expect to see positive rates until at least 2018.

The two largest economies to raise rates so far this year are, in fact both relatively small compared to the US, EU, China and Japan.  And, clearly, they are both in extreme situations, one fighting hyperinflation, the other fighting deflation.  Neither move is an ordinary increase designed to cool off an overheating economy to smooth out the business cycle, the primary justification for why the US has claimed it raised rates in the past.

If the US raises rates this year, it looks like it could be very much alone in the world.  In my lifetime, I have never seen such a context.  Not sure it mattered prior to my lifetime as the economy wasn’t globally connected back then.  This is history in the making.  Can the US raise rates in a global context where the world is combating slowing growth, deflation, and in a few countries, currency printing induced hyperinflation?

 

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Investing and Trading Resources

UPDATE July, 23, 2016: This post was moved to and is now being updated at Trader Central, a team of traders helping traders.

Here is a collection of valuable resources for Investors and Traders.

Links

TraderCentral Mail List – Traders helping traders.  An email list where traders can discuss ideas, help each other learn, and just have fun.

Weekly EIA Petroleum Report – Crude oil inventories typically released weekly on Wednesday morning.

CME FedWatch – Current interest rate change expectations, calculated via 30 day fed fund futures pricing.

Forex Economic Calendar – Schedule of global economic releases, including ratings of impact.

SEC Edgar – SEC filings.

Benzinga –

AgWeb – Agriculture information for the futures trader.

LBMA – Current spot price of gold.  They set it via an auction process.

VIX Central – Quick current and historical view on volatility.

Best Times To Trade Futures – Blog post with global open/close in EST.

Benzinga – Market news, analysis and pre-market preparation resources.

Videos

James Dalton

The First Hour of Trade: How Important Is It?

Books

A Complete Guide to Technical Trading Tactics

 

 

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Market Update: U.S. stocks see worst opening week ever

We witnessed history this week, as 2016 was kicked off with a market plunge.  Of course, if you followed the posts the previous week, and hopefully created a position to profit from long volatility, your portfolio should of reaped some nice profits, as UVXY 9,21 +0,24 +2,68% roared from under 26 to 45.

As noted in Sunday’s blog, the key to watch on Monday was the support that held the markets in a range since October 22nd.  That broke Monday, and predictably plunged after that.  For those who receive Invest Wisely emails, you hopefully enjoyed the updates Sunday night and Monday morning preparing you for the breakout.

The biggest problem I had this week was because my positions have limited profits in order to reduce risk by lowering the break even point, benefiting from time decay, and having a higher probability of success, I was able to take profits quickly, and found myself mostly in cash by Thursday.  No wanting to be on the sidelines while volatility continued to spike, I took out a 22/34 long call spread on UVXY, and closed half my position the next day for an 18% return on capital (ROC)!

What’s Next?

To put it simply, I consider it likely that we’ll have two more down days.  What happens in Shanghai will impact the volatility of the next two days as it remains our daily wild card.  Yet, the bigger factor is simply technicals clearly visible on charts.

The vast majority of traders are expecting the market to retest August lows.  As you can see on this daily Nasdaq 100 futures chart, we’re probably a day or two away from that.  It most recently just broke a minor trend-line support that it bounced on Thursday.

Nasdaq 100 futures - daily

Nasdaq 100 futures – daily

On this chart, we’re looking at August support around 4000, with the 8/24 close at 4002.5.  Of course, this was after an intraday low of 3908.25, with a strong pull-back above 4000.

On the S&P 500 (SPX 2.743,79 +61,62 +2,30%), we’re looking at an 8/25 close of 1867.61 for a possible bottom.  Note, by the way, that while I’ve been using the Nasdaq 100 futueres chart a lot recently due to how the Nasdaq has been leading the markets both higher and lower, the S&P really does a great job of showing that we’ve been on a downtrend with lower highs since July.  Don’t wait for “official” TV talking heads to tell you when we are in a bear market.  Look at this chart and decide for yourself.

S&P 500 Daily

S&P 500 Daily

Note, that it was in July that I began to move my 401k to cash.  As a result, while the markets closed 2015 negative, I managed to hold onto my gains, ending 2015 in my very limited 401k with an 11.9% return.  Yes, you can time the market.

Bounce Coming?

Yes, most traders, myself included, expect a nice bounce, probably beginning Wednesday.  Keep in mind, if you are looking to sell long assets, or re-position for long volatility again, this bounce is very unlikely to return to the Oct-Dec range it was in.  That range is now what we call a “topping pattern”.  Those patterns, especially when they take months to form, tend to repel the underlying back down when it tries to approach it.  Thus, if I had long assets I wanted to sell at this point, I’d wait for that first attempt to approach it, which, on the S&P, is around 2000.

The red and green arrows on this S&P 500 chart show the most probable path the markets are likely to follow, with the bounce in green.

Probable bounce in S&P 500

Probable bounce in S&P 500

Of course, “probably” is not “guaranteed”.  Markets could just return to 2008 behavior, plunging on below its August low.  Or, alternately, it could reverse before reaching it, or just spend time near it trying to decide what to do next.  You’ll want to watch it closely for confirmation.

Nevertheless, this is the path most technical analysts expect it to follow.  Expectations are important, because they drive the decisions that ultimately drive the day to day market gyrations.  Overall, economics (including government and central bank decisions) drives the big picture, and news can change daily direction. Yet, technicals remain a powerful factor in deciding how the market bounces around.

Rally In Oil Coming?

Not too many people can agree, or will even attempt to call a bottom on oil.  However, oil does follow technicals very well, as one of the last things on earth that the central banks and governments cannot impact the way they’ve impacted the markets as a whole, with interest rates and quantitative easing.  Thus, oil has a strong tendency, like the dow does on numbers divisible by 1000, of having strong support and resistance on numbers being divisible by 10.  You can see this on any historical oil chart.

Thus, I believe, as we are rapidly falling to 30, the setup is in play for a strong bounce off of 30, or something close to it.   Note that, it is the FIRST time it hits this that matter.  In March, when it came close to 50, it had a huge long bounce to 67, and didn’t see 50 again until August.  But, the 2nd time, in August, this was a dead cat bounce, taking it into 40s.  The first time it approached 40 in September, it quickly bounced to over 50.  But, the 2nd time, in December, it ran right through it, stuck under 40 since.

Also, when it bottoms, it may be a similar setup.  Looking at Nov 2001 to Feb 2002, it didn’t go far below 20, and then closed and opened each month just below 20. This became a bottom it has not seen since.

Either way, whether a bounce or a bottom, going long oil near 30 just looks like a high probability of success setup.  Perhaps Wednesday, combined with a market bounce, will be a good time to enter such a trade.  With the Crude Inventory report coming out Wednesday at 10:30am, any hint of optimism can light this pent up rally in oil.

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Market Update: Bears 6, Bulls 0

What’s more exciting — what happened today, or what is about to happen?  Let’s start by dispelling the myth that there was hope for bulls today.  Despite it being a choppy day, with plenty of bounces to give bulls who only look at price hope, this was a very bearish day.  I’ll introduce you to the quad display, which includes market internals traders use to see what the market is REALLY doing on the inside.

The critical chart here is the top left one: $VOLD.  It begins every day at 0, and represents the volume of shares that went up minus the volume of shares that went down on the S&P 500.  Each candle is 15 minutes.  This thing can normally change direction when the market changes during the day.  But, not today.  All day, it went down, and down, and then down some more.  There is only one green candle on the whole chart, and you need a microscope to find a wick on any of these candles.  It is rare to see this go down virtually non-stop the entire trading day without the market also doing the same.

S&P 500 Market Internals - The "QUAD"

The next important one is the bottom right.  Unlike the other 15m charts, on this one I zoomed out to 1 hour candles so you can see how it has looked since Tuesday.  Note how choppy it has become.  And the right end, you’ll see that at 8pm, the normal Asia induced drop kicked in to bring it down to new lows of 1963. The Nasdaq 100 futures, by the way, despite being a bit more feisty, dropped very near its morning low of 4386, currently at 4390 and dropping as I type (it just hit 10pm as I took the screenshot, so that last 5 second sliver of a bar is green.)

Nasdaq 100 Futures (10pm)

Nasdaq 100 Futures (10pm)

Yet, while oil has dropped to new lows of 32.77, one bullish chart I shall leave you with is gold, which just temporarily went over 1100 for the first time since November 6th.  you can see it has clearly broken above the nice base it has created since then.

Light Sweet Crude Futures (10:05pm)

Light Sweet Crude Futures (10:05pm)

The Plan

Despite all this bearishness, I’m really hoping for a bounce, or at least a sideways day tomorrow, so I can open a really short-term position to benefit from the next drop, which could potentially happen Friday through Tuesday.

I’m leaning towards a long ITM put spread with limited profit, but lower risk than just buying an ITM put; but haven’t sat down to do any calculations, yet.

For next week, I’m hoping to go long oil, perhaps to take advantage of a bounce off 30, for perhaps a week.  I’ll post options I’m looking at for that, probably this weekend.  That, by the way, can potentially fuel a nice bounce rally in the market with lot of short covering, so I plan to be out of my long volatility position completely by Tuesday.  I took more profits today, and will continue to do so this week into the beginning of next week.

To kill boredom, I’m doing some small plays, including short Feb calls on HYG 85,30 -0,38 -0,44% and short puts on GPRO 4,97 -0,21 -4,05%.  Honestly, despite GPRO looking crazily positive this past week, I’m not too excited to be bullish any stock today.  In fact, while my IRA has been up every day the market has dropped, profits have been limited by the few stocks I have in there being among the few things that have gone down.  But, I played GPRO small, at the 16 and 17 strikes, and am OK if I end up owning a few hundred shares.  I’ll just sell calls right away to collect more premium, further lowering my cost basis, and potentially exiting the position if they get exercised.

HYG is something I’ll likely sell calls in throughout the year, rolling as needed, as that has a medium term downward trajectory.

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Where Is The Market Going? (Jan 5, 2016)

This has been a very profitable week. As I’ve been saying, when the market breaks through the supports of the trading range it’s been in since October 22, it could possibly retest its August lows, giving it a lot of room to fall further to get there.  In my last post, I warned it could happen Monday, which it did.  This, my friends, caps off one of the most profitable weeks I’ve had, after going long volatility last Tuesday, primarily via short puts on UVXY.

To summarize, I took 25% of my UVXY position off the table to lock in profits.  This included my long vertical call spread with a delta 1 option.  Otherwise, I remain bearish, and the market could drop further into the beginning of next week.  I hope to close the majority of my UVXY position by next Tuesday.

I have other positions open. They are traditional premium collectors I opened about a month ago with Jan expiration.  They are doing very well.  My GTC limit order on my short vertical call spread on PNRA 314,93 0,00 0,00% filled today, taking 50% max profit on that one.

Where Is The Market At Today?

After breaking through all the supports I had marked on my Nasdaq 100 futures chart, it ended the day with a bounce.  I suspect many thought this was the typical reversal it does when it hits the bottom of the range.  But, this didn’t hit the range, IT BROKE BELOW IT!  So, no, this was not a reversal.

Last Wednesday, longs got pounced.  Believe it or not, some tried to go long again on Thursday, and they were run over by a bus.  So, when Monday came long, longs were wiser and stood on sidelines.  This permitted day trading bears to short the daylights out of the market with no resistance.  Well, only one problem with this scenarios.  Day traders close at the end of the day.  And, instead of having a mix of bulls and bears closing like what you’d see on a normal day, this was all short covering.  So, the market soared in the last 30 minutes of trading.

Keep in mind, though, that this was just after breaking major support, and after coming down from a lower high last Tuesday.  Even though it ended the day back above the supports, those supports, like shattered glass, were now very weak.  Traders also knew that the end of day bounce was not a reversal, but a short covering.  Indeed, with the unknown of what was to happen in China Monday night, with the Shanghai market closed prematurely on a breaker after losing 7% the previous trading day, no smart bull was going to open a position late Monday just to leave it open overnight.  That would be CRAZY!  So, there were virtually no bulls buying on Monday.

Tuesday night…  China opens and tanks.  But, the government comes in and props it back up.  Unlike the west, the China government props up markets just like it props up the Yuan.  So, honestly, no one believed the return to unchanged signaled any true calm in China markets.

Today is what we’d call a balancing day.  No real direction.  A bit down.  A bit up.  Profit taking on over inflated profit rich Nasdaq (NDX 6.852,00 -164,00 -2,34%), which, down 0.30%, was the only major index down today.  The S&P 500 closed up 0.20%.

Ordinarily, this bottom after the steep drop would be bullish.  In an individual stock, a long would say it was establishing a base from which to take off from.  But, the bigger picture is that this time the risk is greater to the downside.  This is probably the calm before the next storm.  Thus, I remain bearish, and will watch closely to see what tomorrow will bring.  Because I’ve left the majority of my long volatility position open, I’m betting on a move to the downside.

With the Nasdaq continuing to lead the other indices, currently down, but previously up as well, I will refer to my trustee old Nasdaq 100 futures chart to provide the big picture.  Note the last candle crossing the yellow support.  It is now 9pm.  That last candle is what has happened since 5pm, because that begins the new 24-hour day for the futures.

Nasdaq 100 futures - daily

I do not currently plan to open any positions this week.  This week, for me, is about continuing to profit from the position I primarily created last Tuesday when the market hit that upper yellow line.

If the market clearly begins a quick descent, I might open up a quick delta 1 put position on QQQ, basically shorting the Nasdaq.

 

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Market Futures Begin New Year With Drop

It is easy to get so narrowly focused that one can miss the big picture.  The big picture creating near-term predictability is simple.  The markets have been in a trading range since October.  Until it breaks out of it, it is likely to go near its previous high, then back down to the bottom of the range.

On Tuesday, Nasdaq 100 futures hits its July high, but not its more recent Nov/Dec highs, which does not bode well for the market, as lower highs indicates a bias lower when it does break out of its range.

In the meantime, Wednesday and Thursday’s sell-off brought it to the middle of its range, meaning it still has a ways to go to hit the bottom of the range.  Here is the big picture:

Nasdaq 100 Futures - Daily

On the right, you see 3 red candles.  The third one is market futures since they opened today (Sunday) at 6pm.  The drop really began at 8pm.

The upper yellow line is the July high it hit on Tuesday.  The lower yellow line is the bottom of the range.  If it breaks below that line, we’re looking a possible re-visit of August lows.

Here is a close-up of the drop today that began at 8pm on a 5 minute chart:

Nasdaq 100 Futures - 5 minute chart

Anything can happen before the market opens in the morning.  Yet, if you are positioned for increasing volatility or a drop in the market, you could do well this week.

 

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Going Long Volatility – Puts Vs Calls

As anyone who knows me knows, I’m a premium collector.  I primarily sell options short to collect their premium.  I also try to place directional plays when I do it.  Together, this means that the majority of my profits are from theta decay (premium) and delta (direction).

Because puts typically have higher premiums than calls, premium collectors tend to sell more puts.  When possible, we sell naked puts to maximize profits and the probability of profit by having a lower break-even point than if we sold verticals.

Thus, to play a rise in volatility, I waited for a rally to bring UVXY 9,21 +0,24 +2,68% below $26.  That happened yesterday.  On that trade, I hope to collect 75% of max profit for a 12% ROC in two weeks.

Being in a margin account, my maintenance requirement was lower than in a cash secured IRA.  In the IRA, even with max profit, the ROC is only 8.3% due to the increased capital requirement.  Note that being a 2x ETF, this has twice the maintenance requirement in a margin account that a 1x or stock.

So, when a friend said he was looking for a way to benefit from the rise of UVXY, while still enjoying the lower break-even point of the naked puts strategy, but with lower capital requirements, I came up with another call based strategy that uses a fraction of the capital to have nearly the same risk/reward profile.  Like short puts, your max profit is primarily derived from premium.

This strategy is especially beneficial in UVXY, because unlike most underlyings, long volatility derivatives tend to have more premium on the call side.  This is because many people are betting on volatility taking off when it is relatively low.  In August, for instance, UVXY spiked to $91.  Two weeks ago, it hit $43.  It was in the 20s before each of these spikes.  (Keep in mind, that due to contango loss, UVXY tends to lose 5% of its value each month, typically when the market is bullish.  Do not presume that the 20s will always be a good buy price, or that you can just hold it long-term.  UVXY is a terrible buy and hold, especially in a bull market like 2013.)

The key to this call strategy is understanding delta.  Delta is the amount an option is expected to change in value when its underlying changes by $1.  This value can range from 0 to 1. Far out-of-the-money (OTM) options approach 0.  Deep in-the-money options can have a delta at or near 1.  At-the-money options typically have a delta near 0.5.

It is also important to understand that premium is highest at-the-money.  An option with a delta of 1 has no significant premium, and acts like the stock.  Thus, if the stock goes up $1, the price of this option will typically go up $1.  This alone is a huge advantage in an IRA, as you can buy a delta 1 call to go long the stock at a fraction of the cost of buying the stock, while still having the same gain/loss as owning the stock.  Also, in an IRA, you can buy a delta 1 put, which has the same effect as shorting the stock, even though you can’t otherwise short stocks in an IRA.  Delta 1 options, in addition to using less capital than owning the underlying, have built-in loss protection.  You cannot lose more than the cost of the option.

Currently, UVXY is $26.80, and the strike 19 January call (expires in 16 days) has a delta near 1.  It’s bid/ask is 7.35/8.20.    Its intrinsic value is 7.80 (current price of UVXY minus the strike), which is right between the bid and ask.  This option has no premium, as its price is 100% intrinsic value.  Thus, you do not have to worry about time decay on this option, a normal con to buying options.

Buying this call requires 32.5% of the capital of buying the stock on a cash basis (no margin).  This alone provides an avenue to leverage in your IRA.  This synthesizes buying the stock, then buying a put at 19 to protect from loss, but without the cost of buying a put.  In UVXY, this isn’t that important today as we don’t expect UVXY to see $19 in the next 16 days.  In other stocks that could drop on news or a flash crash, this is an important benefit.

But, just buying the call doesn’t match the short put strategy with a lower cost basis.  If UVXY goes down $1 to $25.80, you are down $100 on 1 contract, the same as if you owned 100 shares.   This is purely directional with no collecting of premium.  So, how do you convert this to simulate a short put?

Simple, you create a long vertical spread by also selling a call nearer to the money, with a delta closer to 0.5.  Let’s consider selling a strike 25 call, currently trading for 3.80/3.90.

There’s one catch.  The vertical has a wide bid/ask spread and it’s hard to get the mid price on this because of the delta 1 option, as market makers only profit from the difference in the buy and sell prices for these options.  I was able to get a fill between the mid price and the ask on the vertical, or 75% between the bid/ask. When I put this in, I got a mid of 3.93, and a NAT or ask price of 4.40.  So, for the purposes of our analysis, we’ll consider obtaining this vertical for $4.15.  This means it will cost us $415 to buy this spread, and this is the most we can lose.  In order to lose $415, UVXY would have to be below $19 at expiration, which is very unlikely to happen in 16 days since it is tied to VIX futures.  In fact, unlike owning a stock, if UVXY did go to $19, but had, let’s say, 1 week to expire, being ATM, that option would have a premium and a delta of 0.50, meaning it still wouldn’t be worthless, yet.

The delta on the 25 strike is currently .65, above .5 because it is in-the-money.  Yet, because this is still near the money, it has a nice premium.  That premium is the difference between the strikes, and what we are paying for the spread.  In other words, the spread is 25 minus 19, or $6.  Yet, we are only paying $4.15.  This gives us a $1.85 premium on this spread.  That is our max profit.

Note that unlike naked puts, where we usually sell OTM options, we’re OK with this being ITM.  In fact, that lowers our break even point.  Our break even point is the strike of the short call, 25, minus the $1.85 premium, giving us a break even of $23.15.  Put differently, it is the lower strike plus what we pay for the vertical, $19 plus $4.15.  With UVXY at $26.80, this is still $3.65 below the current price of UVXY.  We can collect max profit if UVXY expires above our short call, or above $25, but can still potentially make a profit if UVXY is between $23.15 and $25.

You can see that this emulates selling a put with a strike of $25 for a premium of $1.85.  Currently, this put is selling for $2.10.  Thus, with the call spread, due to the lower premium, our break even is 0.25 higher than it would be with the put.  This gives the put a slightly higher probability of profit.  But, still, this difference is very small, and the capital requirement of $415 is much lower than the $2500 that would be required on a cash secured put.  Even with a margin account, where the maintenance requirement might be closer to $1600, $415 is still going to be a lot lower.

Because of the lower capital requirement, the return on capital (ROC) of this position if you make max profit is a whopping 44.5% in 16 days!  Even if you close this at 50-75% max profit, this is still a huge ROC, and might even be higher on a per day or annualized basis if you can close it quickly.

This only works because the long call has a delta of 1 and does not require you to pay a premium, while the short call pays a nice premium.  This means you collect premium on the short call, but don’t have to pay premium on the long call.  While this benefits from UVXY going up, you technically just need for it to stay where it is, above $25.  But, the higher UVXY goes, the quicker that extrinsic value of the short option disappears, permitting you to take profits sooner if your target is 50-90% max profit.

Because you are short an ITM option, you typically do not want to hold this to expiration.  Definitely close it at least a few days before expiration if UVXY is above 25, putting the short option ITM.  Only if it is OTM, that is UVXY falls below 25, does letting it expire worthless become an option.  This is ironically the opposite of a short put, where you could consider letting the put expire worthless if UVXY is above 25.

Typically, being short options ITM is not desired.  But, this one is covered by your long option being further ITM.  In other words, you could exercise your 19 call in order to provide the stock if the 25 call was exercised.  In this scenario, you are paying $1900 for stock you are immediately selling for $2500. That is why this position is relatively safe despite the ITM short call.

You can close the vertical by selling it, just like you opened it by buying it.  If you need to close the legs separately, always close the short call before closing the long call.  Otherwise, you’ll have a naked call.  If your broker has a ticket charge, you’ll save money closing it together in one order, as a vertical is typically treated as one order, and thus incurring only one ticket charge.

A scenario where you might close the short side without immediately closing the long side is if UVXY came down a lot, let’s say to $23, and the short call got cheap.  If you wanted to hold out in hopes that UVXY went up before expiration, you might buy back the short call, then let the long call ride on its own, hopefully going up.  If UVXY then jumps to over $25, your profit will likely be greater than the $1.85 max profit you originally calculated because you won’t suffer the loss of the short call then jumping back up in price as UVXY rises, nor will your profit be limited at that point.  One of the great things about options is it can be easy to turn a loser into a winner by adjusting the position when the opportunity presents itself.

To help you calculate the cost/risk, potential return on capital (ROC), and the break even price of the underlying, I created this Google spreadsheet.  Simply make a copy of the spreadsheet so you can edit it, and enter the strikes of the vertical, as well as the cost to purchase the vertical in the 3 yellow boxes.  It then calculates the rest.

To estimate the cost of a vertical, use your broker’s order system to create the order, then see what the estimate is.  You don’t actually have to place the order.

For instance, using TD Ameritrade’s Think or Swim (ToS) platform, you can see that it presents a mid price of 4.38, and a Nat (ask) price of 5.25.  Because this includes a delta 1 option, to ensure this gets filled, as mentioned earlier, I’d estimate this to be between these two numbers, or $4.85.  When I actually place it, I might try raise it a nickel at a time until it was filled, to try to get filled at the best price.  Note that this screenshot is after hours, so the spread is wider than it was during the regular trading hours (RTH).

Screenshot from 2015-12-30 18-10-28In this case, the values I’d enter in the spreadsheet would be 19, 25 and 4.85.

I originally estimated this trade earlier in the day before UVXY went up significantly.  You can see in row 2 of the table below that the ROC was nearly twice as high then at 42.86%, had a lower break even of 23.2, a higher max profit, all due to a lower cost.  After market close, that ROC was reduced to 23.71% (row 4).

Long Strike Short Strike Cost Risk Max Profit ROC Break Even
19 24 3.7 $370.00 $130.00 35.14% 22.7 Earlier
19 25 4.2 $420.00 $180.00 42.86% 23.2 Earlier
19 26 4.6 $460.00 $240.00 52.17% 23.6 Earlier
19 25 4.85 $485.00 $115.00 23.71% 23.85 After market close
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