Weekend Portfolio Analysis (October 24, 2015)

Market Conditions

Up, up and away! The mid- and large-cap indexes continued their rally from last week landing the S&P 500 in positive territory for the year. On Thursday, the SPX soared 1.7%, closing above the 100-day moving average for the first time since August 17, as hopes for more stimulus overshadowed mixed corporate earnings. This was all in response to comments from European Central Bank President Mario Draghi, revealing that the governing council had discussed lowering the deposit facility rate. On the heels of that, China announced a surprise rate cut on Friday, lowering it’s one-year lending rate by 25 basis points to 4.35% and cutting its reserve requirement ratio by 50 basis points for qualifying institutions. The SPX opened on Monday at 2,031.73 and closed Friday at 2,075.15, up 43.77 or 2.15%, marking the fourth week in a row that the index has climbed higher.

Chart_102315_SPXFib

It is interesting to note that the high on Friday respected the 78.6% fibonacci level. Additionally, even on the way down, the fib levels were respected.

crstusmExcessive crude oil inventories continue to put downward pressure on prices. In its Weekly Petroleum Status Report released on Wednesday, October 21st, the Energy Information Administration reported an increase of 8 million barrels in crude oil inventories for the week ended October 16, 2015. Analysts were expecting inventories to rise by a much smaller 3.75 million barrels. Baker Hughes released data showing the U.S. oil rig count fell by only one rig last week. WTI Crude opened the week on Monday at $47.72 per barrel and closed Friday at $44.73, down 2.99 or 6.27%.

Chart_102315_CL

Market Commentary

The past several weeks have been challenging for those of us with a short bias in our portfolios. The melt-up of the past four weeks seems over-extended and irrational. However, it is very possible that the market could continue climbing higher. A few things just don’t make sense to me, though. Please allow me to share my thoughts but do not construe my comments below as market predictions as I have not yet obtained a crystal ball.

China, which is the world’s second largest economy, appears to be in trouble. Last month their stock market melted down. Yet, last weekend they reported their most recent GDP figures at 6.9% growth. That growth rate is respectable. So, why do they find themselves needing to engage in quantitative easing? Is it possible that they have cooked the books with regards to their GDP numbers? The ECB is also engaging in quantitative easing. As the rest of the world is easing, the U.S. Dollar is getting stronger. If the Federal Reserve increases interest rates, it will provide even more support to the U.S. Dollar. As the dollar becomes stronger, our exports become much less competitive in other parts of the world. U.S. manufacturers are already starting to feel the pinch as exports begin to drop off. This can’t be good for the bottom line of U.S. manufacturers which ultimately will affect corporate earnings negatively. And yet, the market is having a love affair with QE.

Now let’s talk about crude oil for a moment. As crude oil soared last year above $100 per barrel, an unprecedented amount of drilling and fracking commenced in areas such as the Bakken Formation in North Dakota. To fund the huge growth in the drilling, an incomprehensible amount of loans were written. The energy sector currently accounts for one-half of the five trillion dollars of debt outstanding in junk bonds. With oil at these depressed levels, many defaults will begin to occur in the energy sector. Keep in mind that the housing and financial crisis was brought about by just one trillion dollars of bad mortgages. The energy sector debt is significantly larger than that. This is why (except for the past two days) we have seen the unusual positive correlation between crude oil prices and the SPX recently. Higher oil prices may not be good for the consumer, but they are good for the energy and finance sectors (lenders and banks that are holding all that paper).

Finally, what about the divergence between the large/mid cap stocks and the small cap stocks? As the SPX has increased 2% this past week, the Russell 2000 has remained flat. The RUT is… well… in a rut!

Chart_102315_RUT

Trade Activity This Week

On Tuesday, I closed the SkyWest (SKYW) Nov 15 put that I sold about a month ago for a $56 profit (18.98% return on capital). With most of the premium collected, I chose to exit the position before next week’s earnings report. After earnings, I will likely open another position. Also, with Cree, Inc. (CREE) reporting earnings on Tuesday after the close, I sold the Oct4 25 straddle for $2.09 and closed it the next morning for $0.94 resulting in a $109 profit (21.5% return on capital) after commissions.

On Wednesday, I also closed out the /ES Nov 1875 call. I detailed this trade in Wednesday’s post, Managing an /ES Straddle. This may have been the best decision that I have made in a while as the strong moves up in /ES on Thursday and Friday would have been very painful to endure with this deep in-the-money call.

On Friday, with the breakeven on the /ES Nov 1950 straddle being breached as the /ES marched above 2068, I decided to make an adjustment to the position. This adjustment was similar to the one that I initially made on the 1875 straddle. I bought back the almost worthless 1950 put and sold the 2065 put bringing in an additional credit of 21.00 ($1,050 premium received).

Analyze_102315_ES1950Straddle

This results in an inverted strangle with breakevens at 1925.50 and 2089.25. As long as /ES remains between these points, there is potential for substantial profit.

Finally, my dumb trade of the week – I deserve a dunce cap for this one. In the mid-afternoon on Friday, I decided to sell a close-to-the-money credit put spread on Amazon (AMZN). Amazon had been strong all day and there was reasonable (I thought) premiums on the options expiring in just a few hours. With the stock trading around 607, I sold the Oct4 600/595 credit put spread for $1.01. Shortly after making the trade, I had a profit of $87. I thought about closing it, but decided against it (bad move). With less than 30 minutes to the close, AMZN started dropping quickly. I exited the trade with a $272 loss and a very bruised ego. This truly was revenge trading. After watching my P&L drop all day on my screen, I wanted to do something positive. Not smart.

Plan For Next Week

I will be watching the /ES straddles like a hawk. The strategy does not appear to be working well for me at this point, so its time to go back to the drawing board before trading more of these. I will return to the proven strategies that are more suitable for my temperament – /CL strangles, /ES credit put spreads, etc.

YUM has been trading north of my short call, so I am hopeful that the stock is called away at some point prior to expiration resulting in a profitable earnings trade (after adjustments).

The portfolio is up 46% for the year versus 0.79% for the S&P 500 (see Trading Results).   The portfolio is currently 5% in cash.

  • Hey Aram,

    I’m not an expert on trading straddles, but have you ever considered moving them or adding to the position? I know the size might make adding prohibitive, but what about putting on a second straddle in the same expiration when your break even is breached and then rolling after that? In order for adding to make sense you might need to be trading a smaller size because you’d be averaging down with big dollars. The guys who sell a straddle every week are essentially diversifying out their directional risk. When we take one trade in an expiration, we don’t have that liberty so it makes sense to move the position with the market.

    An alternative to adding might be rolling the entire position higher after violating some level (maybe the break even). Yet another alternative is just closing them at some predefined loss point.

    Essentially what I’m wondering is if there are some trade management ideas from the Butterfly world that might be helpful. I’m always adding and rolling my positions higher, but I don’t usually convert to a Condor. Part of why I avoid going into the condor is that it makes future adjustments more challenging and removes the potential for high yield. When you create the inverted strangle, it’s similar to condorizing the trade.

    Interesting stuff.

    Dan

    • Aram Basmadjian

      Dan, you make some good points. Yes, the real successful straddle traders are putting on a trade every week with as many as 7 or 8 trades on at one time. My account size does not permit that. I had the 1875, 1950 and 2025 straddles on simultaneously which is all my account could handle (barely). Although there IS a possibility (although remote) that the 1875 straddle could still become profitable prior to expiration, I chose to manage it in a way that will likely result in a scratch. The 1950 straddle also has been managed in a way that, at this point, still allows for a respectable profit assuming that the market does not continue much higher. Again, I could have chosen not to manage it and play the wait-and-see game, but I am no longer secure in my trade assumption being correct, so I am managing it.

      My rule for managing the straddles (and turning into an inverted strangle) is triggered when one of the breakeven points is breached. I then roll the untested side to just outside the at-the-money strike.

      I had some early success with these straddles and that has been my downfall. The reality is that these trades are too big for my account size. To properly trade the strategy would require an account about ten times the size of my trading account.

      • You’re right that those trades tie up a large amount of capital. That’s part of why I never pursued them more thoroughly. I wasn’t comfortable trading them on futures due to the size and on SPY they gobbled up too much margin for the return I wanted to target. I sometimes end up in a similar margin position with the Butterflies, but I’m targeting more money with defined risk.

        Your comment about not trusting your trade assumptions being correct made me laugh. I totally get it.

        I really like what you’re doing with Crude. Thanks for the commentary!

  • Great commentary. Thanks for sharing your trades.

  • Aram Basmadjian

    This article was just posted on WSJ.com regarding the negative impacts of China and the strengthening U.S. dollar on U.S. manufacturing companies. It is definitely worth reading. http://www.wsj.com/articles/u-s-companies-warn-of-slowing-economy-1445818298?alg=y

  • Pingback: Weekend Portfolio Analysis (October 31, 2015) • Trade with Aram()

  • Pingback: Weekend Portfolio Analysis (November 7, 2015) • Trade with Aram()