Weekend Portfolio Analysis (November 21, 2015)

Market Conditions

Despite last week’s terror attacks in Paris, the financial markets were unaffected. The week of November 16th was the strongest of the year for the S&P 500 with the index closing just 41.65 points below its all-time high. Much of this week’s strength can be attributed to perceived certainty that the Federal Reserve will raise rates in December, because the minutes from its last meeting stated that delaying the first rate hike “could be interpreted as signaling lack of confidence in the strength of the U.S. economy.” This is contrary to what is happening in the overseas markets as Japan had a second straight quarter of contraction, and the European Central Bank is leaning towards expanding its stimulus program in December in response to deflationary risks. Volatility indexes also dropped this week. Chicago Board Options Exchange Volatility Index (VIX) fell below 16 from 20 this past week. The SPX opened Monday at 2,022.08 and closed Friday at 2,089.17, up 67.09 or 3.32% for the week.

Chart_112015_SPX

The rally has carried the SPX back above all of the key moving averages. Ultimately, there is resistance from 2115 to 2135, where the market tops have been made in the last year.

It is interesting to note how accurately the McClellan Oscillator has predicted reversals when the SPX has become oversold in 2015. Looking at the chart below, we see that nearly each time the oscillator dropped below -150, the market reversed and headed higher.

Chart_112015_McClellan

On Monday, crude oil prices dropped as low as $40.06 per barrel, their lowest level in nearly three months. The $40 price level remains a psychologically important level for oil traders and has not dropped below that except in periods economic crisis. U.S. crude inventories grew by 252,000 barrels last week, according to data from the Energy Information Administration (EIA) that came in below a 2 million barrel build forecast by analysts. The smaller-than-expected stockpiles growth convinced some traders and investors to cover short positions helping oil prices recover. On Friday, weekly data from Baker Hughes showed that the number of U.S. oil-drilling rigs fell by 10 to 564. WTI crude opened on Monday at $40.92 per barrel and closed Friday at $41.46, up 0.54 or 1.32%.

Chart_112015_CL

December natural gas futures contracts plunged by over 12% this week due to long-term oversupply concerns and rising natural gas inventories as mild temperatures persist.

Chart_112015_NG

Trade Activity This Week

On Wednesday, I finally closed the /ES Dec 2025 straddle that I had opened back on October 20th. Early in the week, the straddle started showing signs that it might be extremely profitable, however, as the market rallied, I decided that I needed to exit the position before it became a huge loss as with the previous straddle. After commissions, I exited the trade with a meager $39.36 profit (1.1% return on capital).

On Thursday, I closed the /GC Jan 1250/930 strangle for an $85.76 profit (11.6% return on capital) after fees in just 13 days. After having a run of losing trades, this small success was a confidence booster. The trade was successful because I returned to a strategy that has worked consistently for me in the past – selling a high probability strangle when implied volatility is high.

With a fair amount of capital available after closing these two positions, I began looking for new trade opportunities. As volatility has contracted in the equities markets it has made new trades less attractive. However volatility has been expanding in the oil and natural gas markets. On Thursday I opened two new positions.

The first trade was a strangle in crude oil.

Trade Details:

SELL 1 /CL Mar 16 30 Put @ 0.24
SELL 1 /CL Mar 16 60 Call @ 0.25

Credit: 0.49 ($490.00 per contract)
Max Risk: Unlimited (Breakeven Prices: 29.51 / 60.49)
Margin Required: $790.00
Days to Expiration: 90
Probability of Profit: 87.31%

I plan to exit this trade at 50% of maximum profit and have already entered a GTC buy order to close the trade at my target price of 0.25. I have also established an exit point should the trade move against me. I will plan to exit if the strangle trades at or above 1.13 per contract. This will limit my loss to an amount that is less than 5% of my overall portfolio. The risk profile for this trade is displayed below.

Analyze_111915_CL

Natural Gas has also had a big increase in volatility as the heating product has declined substantially. /NG has been in a bear market for over seven years, declining nearly 85% from its highs of 13.694 per MMBtu in July of 2008 to just 2.141 per MMBtu this past Friday. However, I believe that /NG is in a short-term oversold condition. That coupled with the high implied volatility looked like a good opportunity for a trade. Although prices have been declining, I skewed the strangle to provide more room to the upside in case of unexpected spike in prices.

Trade Details:

SELL 1 /NG Jan 16 1.85 Put @ 0.009
SELL 1 /NG Jan 16 3.4 Call @ 0.008

Credit: 0.017 ($170.00 per contract)
Max Risk: Unlimited (Breakeven Prices: 1.833 / 3.417)
Margin Required: $660.00
Days to Expiration: 39
Probability of Profit: 81.76%

Analyze_111915_NG

Note that with /NG futures, the multiplier is 10,000 (whereas /CL is 1,000, /GC is 100, and /ES is 50). As usual, I will plan to exit at 50% of max profit. After opening the trade, the price of /NG continued to drop and the volatility expanded even more into the close. When opening the trade, I also set a point to exit the trade if the loss exceeds $170 per contract. As of the close on Friday, it was right at this point due to the volatility expansion. I will watch it carefully this next week to determine the best course of action. I may have not left enough room on the downside when I skewed the strangle, and, if that is the case, I will exit and re-position if I still like the trade.

Finally, on Friday I added the call side to the /CL puts that I sold several weeks ago. I sold the /CL Feb 63 calls for $0.07 each. I now have a /CL Feb 63/28 strangle for a total credit of 0.12 per contract.

Plan For Next Week

The /ES Mar 1825 put, which is the last in a series of many trades to defend the /ES Nov 1950 straddle, is showing a nice profit. My plan is collect around 80% of the available premium (providing that the market continues to rally towards the previous all-time high) which would offset more than 50% of the losses currently listed for November. Additionally, I will be closely watching the /NG position to determine whether or not it needs to be exited. I have no concerns about the /CL positions at this point. The YUM stock is once again trading well above the strike of the covered call, but due to the high amount of extrinsic value remaining in the option, I am not likely to see the stock called away anytime soon.

The portfolio is up 14.28% for the year versus 1.47% for the S&P 500 (see Trading Results).   The portfolio is currently 41% in cash.

  • Hi Aram,

    “It is interesting to note how accurately the McClellan Oscillator has
    predicted reversals when the SPX has become oversold in 2015. Looking at
    the chart below, we see that nearly each time the oscillator dropped
    below -150, the market reversed and headed higher.”

    I will have to look into this indicator as it is probably pretty close to what I have been using these last few years. As you know, I follow my own proprietary indicator that has predicted every single oversold condition this year. In fact, it has predicted every oversold signal since 1990.

    “The trade was successful because I returned to a strategy that has
    worked consistently for me in the past – selling a high probability
    strangle when implied volatility is high.”

    The best traders I know are the most boring ones who have been doing the same type of strategies for years. Do you want be a bright shining star that flames out in a year, 3 years, or 5 years? Or do you want to be an investor that can consistently pull money from the market for the rest of your life? Study the market, develop a trading plan, thoroughly test it and re-test it and re-test it until it is consistently profitable, then implement it, fearlessly, emotionlessly, with discipline.