Week of the Flip Flop

Two words describe the market we find ourselves in right now- flip flop! The market, S&P 500, has been in a trading range floating between 1200 and 1270. Only one time since mid October has it gone above and once below. So how do you make money when the market does nothing? Options.

A few things to highlight as we close out the week.

• The EU  . . . . well . . .you guessed it, they flip-flopped! They have a plan, they don’t have a plan. England isn’t going to touch the EU with a 10 foot pole, now they will listen and engage.
• The VIX (volatility index) was down while the market was down. Huh? Normally the VIX is down while the market is up. So what does this mean? One possible reason for this is that money managers are buying back their long puts as they begin to call it quits on the year. Getting hurt by time decay isn’t worth it if you are closing out long positions.
• Santa Claus Rally? We have yet to see the anticipated Santa Claus rally. We still believe that this is going to take place by year-end as history has dictated. However, if it doesn’t, we are still fine to collect option premium by selling calls.
• Rating Agencies. Moody’s, Fitch, S&P are all warning our EU friends that a downgrade may be coming. What does this mean? The US market is up a little more than 8.5% since its downgrade.

Good news . . . in this market?

Ask your neighbor, ask your friends, ask your co-workers, heck even ask your dog about the market and everyone will act like the world is crumbling beneath them. Well, we actually think otherwise. Here’s a list of the good news!

• Unemployment is dropping and past data is being revised upward
• US auto sales had a killer November beating expectations
• 73% of S&P 500 companies beat earnings in Q3
• Inflation is moderating in Emerging Market countries

All of this and more support the idea of a bullish end to 2011.

Here comes Santa Claus, Here comes Santa Claus . .

Today six central banks led by the Federal Reserve joined forces and provided emergency funds to troubled nations. The Bank of England issued a statement explaining the reason for the action:

“The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.”

The market responded with an explosion to the upside. The S&P 500 was up over 4%, Europe, as measured by the EFA, was up over 5%. The capital markets are anticipating an infusion of cash as the rate that banks can borrow is now .05% compared to 1%. It is now expected to soften the disaster that is the global markets, more specifically Europe. Whether that is going to happen or not we shall discuss at a later time . . . . now is the time to talk Santa Claus!!

Since 1928 the stock market has posted a December gain 63 out of 83 years or 76% of the time. This December track record is known as the “Santa Claus Rally.” This move today is based on a news event, but it’s also a part of history that if understood and acted upon would have led to one of the best single days in years for bullish investors. It is our opinion at Beating the Benchmark that we will continue to see a positive move leading through the end of the year. Don’t fight history, take advantage of it! As I’ve told my kids and their kids for years . . . “don’t believe, don’t receive.”

Not Priced in…

There is constantly news happening, at least CNBC, CNN, FOX and a few others would like us to think so. But how much news is really newsworthy? And if it isn’t newsworthy, are we at risk of over trading based on some random comment from someone that knows no more than we do, but can say it authoritatively? Of course we are! The news we should care about is what is NOT already priced into the market, not what everyone knows or is already worried about.

So, China growth slowing? Europe showing fiscal and monetary ineptitude? Politicians from all the states meeting in Washington unable to agree on which direction the sun rises in? Petrobras over spending at the demand of the government? Japan demographics driving fear in the fixed income markets? That is not news. That is all well known, understood, and priced. So, anything about these issues to be news has to change what we know, otherwise it is as impactful to our portfolio as 13 year old girls passing secrets in the bathroom. No one outside of their clique cares. Hmm, comparing 13 year old girls to the news networks, guess that isn’t fair to the girls…

Once something is priced in, then we watch to see if something major changes. In Europe, a rumor of a plan that might address part of the problem is not news. A talking point document in a second tier newspaper released as a test of reactions is not news. But a significant change in a debt auction from what was expected and priced is news. The difference might seem slight. But for investors, understanding news vs. noise is critical.

So, how do we avoid getting whipsawed by the news cycle and still stay informed? Turning off the source doesn’t help, because sometime there really is something newsworthy. Wisely picking sources helps avoid the worst purveyors, but we find that it is better to have a list of things to pay attention to, and to use the list to create triggers to help us trade on the news instead of trying, in the heat of the news cycle, to filter the news from the opinions of all the talking heads.

At Beating the Benchmark we set our posture like most people; we divide the world by geography and also by Industry. Then we create a posture for each, and underweight where the combination is bearish, and overweight where things are bullish. This year that has meant shorting European financials, and over weighting gold and US Utilities. A boring process, but one that helps identify the news we need to pay attention to more closely.

When we are looking at making changes that affect our trading posture, we look for things that affect our over weights first, then our underweights, then the normal weights. This provides some balance to the hype. So, if there is bad news about European Financials, we can ignore it. We simply don’t care. If there is great news about Europe, then we have to read it to see if there is real news, but that is a lot easier than reacting to everything. Same with geographies. With the horrific disaster in Japan we could read as caring people, but didn’t have to worry about our trades since we were underweight. That provided time to think through which companies would be most affected and place some trades in a very controlled and still timely way.

In Japan, for example, we didn’t leap into CAT, the Japanese were a long way from affecting the CAT purchase pipeline. We did look at the autos, though, and created a short on TM as their supply chain is the most heavily dominated by production in Japan, and they were already under tremendous pressure due to the yen for the same reason.

We are watching other parts of the world for real news; things not priced into the market yet. This doesn’t eliminate mistakes, no matter how hard we try. One of us over reacted to problems in Yemen and Bahrain thinking this was a precursor to problems in Saudi Arabia this past spring. Saudi Arabia is on our list of places to watch. Saudi Aramco is about 3 times the size of XOM, and problems there would cause a huge spike in oil prices immediately. The $149 a barrel of WTI of mid 2008 would have been a minor pausing point on the way to $250 oil. But the King returned, threw Billions at the masses and everything calmed down. And I took some losses.

Generally, though, being prepared for what might occur makes reacting easier, more thoughtful, and a lot more profitable. For now, the things we watch for, and hope do not occur include mostly bad news. Russia re-invading some past satellite country, with special fear with respect to the Ukraine, though even Georgia would be a minor problem. Russia shutting down gas shipments to the EU countries. Anything in Saudi Arabia. China creating a border dispute with India. India taking advantage of the problems in Pakistan to escalate their border disputes. Israel attacking Iran. A major oil spill in a less developed area that causes a major disruption in shipments instead of drilling. (Nigeria, Indonesia, Brazil are easy example of this).

In the US, the politicians deciding the sequestration already agreed to for 2013 and beyond is too onerous and backing away would be a problem. Anywhere in the world a natural disaster can cause problems. We are seeing the impacts of flooding in Thailand right now. How many of us knew the disk drive industry had almost completely migrated there? With any natural disaster looking at the import and exports of that part of the world makes sense. That is why problems in the Philippines would be hugely problematic in other parts of the high tech markets.

There is always potential for Good News as well. We just have found that it is a lot less likely, and when it happens is much less likely to have quick impacts. The Q3 earnings season is just ended with huge surprises to the upside, and next year we could easily have SPX earning in the $103-110 range. But the market is happily ignoring that. We could be surprised by the politicians sent to Washington deciding to act like adults prior to the election, but we aren’t holding our breath. The Europeans could decide to plan ahead and either kick the weak out or build a reserve to keep the union and the Euro together, but that is as unlikely as Bachman and Pelosi sharing cookie recipes or agreeing on how to move the country forward.

So, what to do? Audit your portfolio to see where you are at risk and then make some plans for news in those areas. Look at what news you might be able to profit on and create triggers in advance. And ignore any “news” where three people are asking teaser questions of 2 or more people trying to create news.

And with your free time, enjoy your spouse, kids, your hobbies, and your charities.

Priced In

There are so many things to worry about these days; it is easy to forget that once everyone is already worried about it, I don’t have to. That is the simple fact of a semi-efficient market. Not totally efficient. But close enough that traders have to worry, but investors can pretty much count on the fact that worries spread fast and get priced in quickly. Then the price continues down a bit because momentum is a hard thing to overcome, and eventually we get a nice equilibrium at a new price point.

So, what is priced in?

Obviously right now we have Europe driving the downward pricing pressures. Greek default, Italian potential default, the breakup of the Euro, a restructuring of the EU… These are all priced in, and are working to set the channel we are in. The risk is perceived to go up, the market goes down a bit, the risk is perceived to go down, and the market goes up a bit. In each case on most days the financials are the most affected. There is no real news here, but there is a lot of noise being treated like news. When something eventually happens, the market will break out of the range.

The US economy outside of financials is slowly improving and no one cares. The improvement is being ignored in most cases due to asset shifts and the overwhelming fear and noise about Europe. Earnings are up, GDP rose a bit in Q3, inventory didn’t rise as much as expected providing a small boost to Q4, and housing is finally finding a bottom. Foreclosures are lurching to a steady state, housing stock is becoming steady, and interest rates are lower than ever. And the market knows all this, but simply doesn’t care due to the focus on Europe.

Balancing that we have the likely noise of the Congress kicking the can down the road like no time since Reagan was in the White House. We also have 4% more people out of work than a few years ago and about 8% more underemployed than during the last boom that need the safety net the states and Federal governments provide.

We also have China deciding on whether it is time to loosen the purse strings again. We have a couple quarters of slower growth (all the way down to about 8.5% GDP growth – Oh the horrors of such pitiful growth). We have their inflation rate dropping a bit, but still something that has their wonderful Politburo concerned. Nothing new there either.

All this is known, debated argued about, and fully priced into the markets. We can argue whether the potential for a double dip being erased in the US caused the recent bounce up from the October lows, but the timing was at least “coincident”. Once again, the market prices in the new data pretty darn quickly.

Why care if the market is semi-efficient?

The places we can catch a market move early is when we see things that are not yet priced in, but will be if they either happen or are rumored to be a bigger potential than what the market currently perceives. Recently the Italian debt auction went badly; the market didn’t anticipate it and reacted quickly. But not so quickly that a normal investor with Italy on their list of potentials couldn’t profit. The market opened down a little, but mid-day took off to the downside. You didn’t need sub5ms latency links to profit, you needed to be awake sometime between 9:30 and 11:30 ET. AND you needed to have Italy on the list of things you are looking for.

So, what isn’t priced in?

That is indeed the question, and we’ll talk about that later this week…

Tech Check

Bullish or bearish? According to our rules, in order to be bullish (long) the markets the 10 EMA needs to be trading above the 40 EMA.

The US market is the strongest market of the three and was flirting with a crossover which did not come. Although the fundamentals seem to be improving in the US, at this point we are still bearish according to our rules.

Emerging Markets have been slowing down due to the rest of the globe.

Europe and developed Asia are a complete disaster. The EFA is heading toward support at $44. It should be interesting to see if it holds. Don’t hold your breath!

Back from Colorado Springs in time for a bit of a volatile week…

Well, that was an interesting week, eh? An awful lot of sound and fury for a pretty small move. I have entered several directional calendars this past week. I can’t see placing verticals despite the great premiums with the possibility of an 800 point move taking me out. And with expiration coming up quickly, an even bigger chance of getting hit on the short side, and then bouncing away from me.

I was asked about posting a tool I use that helps calculate when to roll a long in a diagonal. The concept is very simple. If you are long, you want more time, contracts, deltas while pulling cash off the table!. You rarely get all four, but a tool to help you figure out if yoiu should roll closer to the money, or how much you have to give up if anything to move out three months is attached. Nothing great, you have to put in the numbers from the chain yourself, but if making it easy helps you manage the trade, then have at it.

Strike Delta calc V2

Don’t overtrade!

I have been getting a lot of private Skype messages lately about trades people are in and how to adjust them. What I notice first is that while we are down a “whopping” 1.7% for the recent peak, and up significantly for the year, people are quick to worry. And the opportunity to worry for traders and investors with two legged trades like diagonals are twice what they would be with a one legged trade.

Interestingly, if they had only a long equity trade on, they would be holding and not even noticing this minor flag. And certainly, most people are not over trading, but too many new traders do it. So, how can we together recognize small moves are not important?

Man, I wish I knew how to make people comfortable!

But I do see one thing I have been doing wrong. In diagonals, I talk about the short providing income and the long providing capital gains. Sometimes things go against you and the income side does better than you expect and the capital gains side does worse. While this is true, it comes from how to analyze the parts of the trade. Not the whole trade. Darn!

While it is true that the short is much more of an income and technicals trade and the long is a fundamentals trade that grows capital, IT IS ONLY ONE TRADE. How did I forget to emphasize that?

Just as you don’t buy a lousy stock to get a good dividend, you don’t buy a lousy long call on a company so you can sell a short. But perhaps we need to think a lot more of the short as a hedge. It doesn’t provide a lot of income, and when it does, it is because the trade is losing money as a whole.

When the short loses money, the trade made a bundle! So, what to do?

I think I and others need to emphasize profits at the trade level, and analyze the components almost as a simple exercise in 1) arithmetic and 2) recognizing support and resistance. Buy longs below support when you are bullish with a delta near .7. Find a delta near .3 and then identify the strike closest to that above resistance.

I am going to try this when people call and post, and let’s all try to not over trade. Brokers and market makers already have enough of our money!

Trade well, have fun, give back,

Matt

First look at portfolio results – yeah!

I recently posted the results up through February 18 for the Diagonals portfolio. I’ll post the results as of the Friday of expiration week. I use expiration Friday because as options traders that is the critical day of the month.

The link is here Tactics – Portfolio Details – Diagonals and both Beating The Benchmark portfolio summaries are posted. The Covered Call portfolio is managed by Touchstone Trader, and I manage the Diagonals portfolio. Let’s take a short tour through the numbers. There are several important issues to review, and as investors using trading strategies, we need to make sure we understand what is affecting our returns.

Diagonals Results as of February 18th

A quick glance shows that the total return, 16.90% when compared to the benchmark, ACWI, is pretty good. But good returns can happen for any number of reasons – many of them due to increasing the risks beyond what is tolerable (or least beyond what allows restful sleep)!

First, why the ACWI as the benchmark? Or, what is the ACWI even? As an American, I buy products made around the globe. So, I want to minimize the currency and inflation risk to my family’s income. If I only invest in US based companies, I am taking the risk that the dollar falls, and so I have to use more dollars to buy that new South Korean designed, Chinese assembled of Philippines parts TV. It might be delivered by a truck made in Japan on a crate of Canadian softwoods. If I own stocks in China, South Korea, Japan, Canada and the Philippines, the TV price I pay is insulated from the dollar. We will have a longer and deeper post on that another day.

ACWI ETF is an investable fund that is tied to an index of all the investable companies in the world allocated based on their market capitalization. So, Exxon Mobil is a larger part than a mining company in Nigeria. But both are there in the index and therefore the ETF.

I created the portfolio on January 3rd, the first trading day of 2011. I allocated the funds similarly to, but not exactly as the ACWI is allocated. I purposely over weighted the US through taking SPY from 42% to approximately 50%. I left Canada and the Emerging Markets at their proper allocation and underweighted the other developed countries. This matches my posture as of the beginning of the year as I thought Europe and Japan would not do as well as the US, Canada and the Emerging Markets.

As you can see, I was right that the US and Canada beat Europe, but look how badly I was wrong on the Emerging Markets! I thought it would do similarly to the US, which the SPY proxy increased at just under 6.2%, and instead it went down 3.6%. I difference of almost 10% in returns. Ouch. This is why I take small benchmark risks, but never go “all in” on my posture. The hard right edge affects us all, and I was wrong on one and right on the others. If I had doubled up on EEM as the play on the emerging markets, the returns would have been greatly impacted negatively.

Instead, the results were very acceptable. Using long duration long call options as a replacement for the equities themselves, and selling short calls against the holdings as a simple hedge that also could help with earnings, the invested portfolio returned 16.90% in 45 days. For some people, that is an acceptable year. Here, I totally messed up one call, but using the benchmark as a guide was able to beat it by a factor of 3.76 times.

In the recent week and a half, the market is down, and so are the returns, but we are still way ahead of the benchmark. In future posts we will review the holdings in more detail. Naturally, you can link to the whole trade summary from the link above.

Trade well, have fun, give back,
Matt

Don’t people look at the numbers?!?!

I was in an interesting conversation today where one person was talking about how no one has made any money in the stock market in the last 10 years. Now, we all remember this refrain being parroted by those condemned to watch CNBC for more than a few hours a week. But that was over a year ago. The recent talk on CNBC is all about “too far and too fast”. This of course was following and followed the “double dip” discourse. Great how Double dip got a double play…

All of this is of course nonsense. If you count dividends, you are up about 19 over the past 10 years in the S&P500 ®, certainly not great by any means. But you are at least UP. Doesn’t it frost you when some rather intelligent person repeats what they hear with little regard to the truth? Then, if you try to point out the fallacy, they quote reputable sources? Too bad CNBC doesn’t update their facts occasionally, but that would be too much to ask. Heck, they still let Rick Santelli scream about inflation, the same screed he has been on for over 4 years now, as inflation has come down, and the market he screams from has recognized it and brought rates down right along with the falling inflation rate.

On to the other things I would love CNBC to bring back up. The dreaded double dip. Can anyone point to one? I can, only a brief 70 years ago. The war years of WWII caused a severe “double dip”, entirely due to the necessity of sending most of our productive men off to way. We had a major dip in ’40 and then deeper in early ’42. The market drop in ’74 was deeper than the drop in ’70, but 5 years between them hardly qualifies as a double dip, more like a huge shock due to the exogenous event of the oil crises. From ’75 through the crash of ’01 we managed to bump along to a dividend inclusive increase of 2300% (rounding down). Can anyone find another double dip? And we are fighting two wars now, with an increase in the armed service of over 200,000 otherwise productive men and women. Instead of producing over here, they are fighting for us over there. (Unfortunately with little support from the non-fighting Americans)

How about “too far too fast?” Do they understand the math we teach our 4th graders today? I know it was likely 6th grade back when we were all in school, but my daughter knows it takes 100% gain to cover a 50% loss. And we had a roughly 57% loss in the S&P 500® (counting dividends). Today we closed about 100% higher than the bottom. It took 17 months to drop, and almost 2 years to regain the first 100%. Yet, the increase is too fast? What rate would they like? Do they know profits are higher now than they were then? Do they know GDP is higher?

We all have to watch the sources we listen too. It is too much to ask that the sources get the facts right.