Weekend Portfolio Analysis (July 8, 2017)

Market Analysis

After a relatively quiet first half of 2017, U.S. stocks kicked off the second half with a volatile start, with the major market indexes taking their cues from oil prices, tech stocks, and the latest jobs data. Trading volumes were predictably very light early in the week, given the abbreviated trading session on Monday and the Fourth of July holiday on Tuesday. Jobs and the Federal Reserve were in focus this week. ADP reported that nonfarm payrolls rose a stronger-than-expected 222,000 in June, beating estimates for a gain of 174,000. Despite the solid employment gains, wage growth remains muted. The unemployment rate rose 0.1% to 4.4% as jobseekers reentered the labor force.

Last week, minutes from the recent Fed meeting began to outline the next phase of withdrawing stimulus – winding down its balance sheet. This entails reducing the amount of assets (bonds) it has purchased over the years. This shift in tone from the central bank helped send yields higher. The fed funds futures market still points to the December FOMC meeting as the most likely time for the next rate-hike announcement with an implied probability of 59.1%, up from last week’s 54.4%.

The S&P 500 (SPX) opened Monday at 2,431.39 and closed Friday at 2,425.18 down 6.21 points, or 0.26%.

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The SPX broke below the 2420 support area again this past Thursday, but rebounded on Friday. It appears that a downtrend may be setting up on this chart. At the same time, it looks like the VIX might be trying to establish an uptrend. If that were the case, it would definitely be a bearish sign for stocks.

On the surface, things may seem fairly muted in the SPX. After all, the S&P 500 index has remained well within the expected move again this week as implied by the SPX options. In fact, the index ended the week nearly at the same level that it closed at the previous week. However, a look at the 5 minute chart (below) tells a slightly different story. Within each day, there has been a fair amount of volatility. The magenta horizontal line represents the price at which the index closed at the previous week.

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This week’s oil price rally started to unwind on Friday as a result of rising OPEC exports, increasing U.S. shale output and a rising rig count. Oil prices slid so far in the last three trading sessions that it has canceled out more than half of the past two-week’s rally. Most of the issues impacting oil prices this week are the same as they have been for months – the ineffectiveness of major output cuts by the world’s biggest exporters and rising U.S. production.

The U.S. Energy Information Administration (EIA) reported crude levels in U.S. storage fell by 6.3 million barrels in the week ended June 30, nearly three times what analysts had predicted. However, the data also showed a sharp rise in U.S. production, and bearish traders took advantage of the rally to return to the market and sell from a higher price. Further pressuring prices was the report by Baker Hughes that the number of oil rigs in operation increased by 7 to 763, putting to rest any lingering optimism that last week’s decrease in rigs was a sign of an upcoming downward trend in the number of active rigs.

Crude oil futures for August delivery opened Monday at $46.28 per barrel and closed Friday at $44.33, down $1.95 or 4.21%.

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Wheat prices continued to rally early in the week hitting two-year highs. By the latter half of the week, profit taking drove prices back down again. Drought conditions in the Dakotas are impacting wheat prices. However, there is an abundance of wheat from last season, so any further rallies should be short-lived.

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Gold prices continue to drop, a victim of encouraging economic reports. What makes the recent drop a bit interesting is the fact that the U.S. Dollar has also been dropping. Typically, the dollar and gold move inversely to one another. The chart below shows the daily gold prices as compared to the U.S. Dollar (in magenta). The inverse correlation has been in sync until June 26th when both the dollar and gold began to drop. At this point, it is just a data point, but there will be a reversion at some point in the not-too-distant future. The expectation of rising interest rates and tighter monetary policy has been driving down demand and prices for bonds, which pushes up bond yields. Gold is also inversely correlated to bond yields and responds negatively to rising rates as it does not offer any income and so its opportunity cost increases. August-dated gold futures dropped $29.80, or 2.4% this week, to settle at $1,211.90 an ounce — a fifth straight weekly loss.


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Trade Activity

Despite the shortened trading week, we were very busy making adjustments to the portfolio.

/CL October 60/35 Strangle
On Sunday evening, we closed this strangle for $0.17. We originally sold it on June 14th for $0.28. Normally we would wait to collect 40-50% of maximum profit. However, I had several reasons for closing the trade just a bit early. First, I was going to be leaving on a short trip over the Fourth of July holiday and knew I would have limited access to trade. Also, with the increase in volatility in the agricultural products and possibility of needing to make adjustments, I wanted to free up more capital in case I needed access to it.  After commissions, we net a profit of $95.56 per contract, or 14.48% return on capital in 18 days.

/CL September 49/39 Strangle
As we had indicated in last week’s blog post, I had planned to close the put side of this trade on Sunday evening when the market opened back up. We originally sold the strangle on May 19th receiving $0.22 for the put side of the trade. We have been tested on both sides of this trade, but we were able to buy the put back for $0.11 (our target profit level of 50% of maximum profit). This resulted in a profit of $102.78 after commissions on the put side of the trade. We still have the September 49 call in the portfolio (see below).

/ZW September 580/420 Strangle and /ZW October 600/450 Strangle
On Sunday evening, we also closed out the put side on both of our wheat strangles. With wheat prices rallying quite rapidly, the puts had very little value. We had originally sold the September 420 puts for $2.00 and bought them back for $0.625, so we took in a profit of $121.26 on this half of the trade. On the October 450 puts, we had sold them last week for $3.25 and bought them back for $1.125, a profit of $98.13. However, that is where the good news ends. In last week’s blog post, I stated that, “Although we are likely to see wheat prices increase a bit more, I believe the rally will be short-lived.” Well, my presumption was correct, however I was unable to follow through as planned. On Wednesday, July 5, we saw wheat prices hit two-year highs nearly breaching our short calls. Sometimes, despite your convictions and your trading plan, you just can no longer take the ‘heat’. As I was on a short vacation with my family and had limited access to trade, I decided that it was best to just exit the positions and re-establish them at higher levels, eliminating the need to worry about them. I ended up closing out the calls as wheat prices were hitting their highs for the week. The September 580 calls which we sold for $3.125 were bought back for $28.25 (a loss of $2,528.74). The October 600 calls which we had sold for $4.875 were bought back for $31.25 (a loss of $1,326.87). This is a huge loss to the portfolio and has wiped out our profits for the past 6 months. However, I am confident that I can quickly return to profitability and we took steps to do that with the next trade.

/ZW December 770 Call
With wheat prices at two-year highs, volatility at an extreme, and a huge loss in wheat, I wanted to get an adjustment trade on to offset the losses, but also wanted to give myself plenty of room in case wheat prices started to run up further. We utilized the December options which allowed us to get really far out-of-the-money, but also collect a decent premium. With volatility this high, if we see a contraction in that volatility, we will be able to exit the trade rather quickly and not need to wait all the way until expiration. We sold these calls as wheat prices were coming off their highs and collected a nice premium. Volatility has not yet contracted, but prices have reversed significantly and these calls are already at 25% of maximum profit.

Trade Details:
SELL 2 /ZW Dec 770 Call @ 5.00
Credit: 5.00 ($250.00 per contract)
Max Risk: Unlimited (Breakeven Price: 775.00)
/ZW Current Price: $573.75
Margin Required: $536.00
Days to Expiration: 142
Probability of Profit: 94.37%
IV Percentile: 100%
Implied Volatility: 29.34%

/ZS September 1100/1120/900/880 Iron Condor
The rise in volatility of wheat options also helped fuel the volatility in soybean options. The portfolio currently has a /ZS strangle, which, due to the higher volatility, is showing a loss. I wanted to add another position and originally thought about just adding to the number of contracts for the /ZS strangle. However, I was concerned about margin requirements should volatility continue to expand. So, on Wednesday, I added a new iron condor position which requires a much smaller amount of margin.

Trade Details:
SELL 1 /ZS Sep 1100 Call @ 10.00
BUY 1 /ZS Sep 1120 Call @ 8.50
SELL 1 /ZS Sep 900 Put @ 5.25
BUY 1 /ZS Sep 880 Put @ 2.75
Credit: 4.00 ($200.00 per contract)
Max Risk: $800.00 (Breakeven Prices: 896.00 / 1104.00)
/ZS Current Price: $974.25
Margin Required: $186.00
Days to Expiration: 51
Probability of Profit: 68.70%
IV Percentile: 93.25%
Implied Volatility: 27.14%

/ZW September 620/640/460/440 Iron Condor
As wheat prices continued to drop, but volatility remained very high, I decided to open another position to take advantage of the high volatility. Normally with volatility this high, I would look at an undefined risk trade such as a straddle. However, with higher margin requirements, and the recent large loss that was sustained, I decided to play it just a bit safer and define the risk on this trade. The iron butterfly was the strategy that I would have preferred, offering the benefits of a straddle, but with defined risk. However, I could not get the breakeven points far enough away from the current price to feel comfortable with the trade. So, I ended up putting on an iron condor. Again, this trade will help offset losses from the wheat losses we sustained by closing the /ZW calls on Wednesday.

Trade Details:
SELL 2 /ZW Sep 620 Call @ 8.00
BUY 2 /ZW Sep 640 Call @ 5.50
SELL 2 /ZW Sep 460 Put @ 3.25
BUY 2 /ZW Sep 440 Put @ 1.75
Credit: 4.00 ($200.00 per contract)
Max Risk: $1,600.00 (Breakeven Prices: 456.00 / 624.00)
/ZW Current Price: $541.25
Margin Required: $196.00
Days to Expiration: 50
Probability of Profit: 73.26%
IV Percentile: 98.41%
Implied Volatility: 37.08%

Current Portfolio

/CL September 49 Call
$440.00 Credit. 40 days to expiration. 17 deltas on the calls. Currently at 13% of maximum profit. The dead-cat bounce we talked about has played out and poor fundamentals are driving oil prices back down again. This trade looks real good at this point.

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/GC September 1400/1150 Strangle
$280.00 Credit. 51 days to expiration. 11 deltas on the puts and 1 delta on the calls. Currently has a loss of $50.00. We have plenty of room on this trade and the probability of profit is still over 90%, but the move down in gold prices has affected our P&L negatively.

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/ZC September 390 Straddle
$1,937.50 Credit. 48 days to expiration. 47 deltas on the puts and 53 deltas on the calls. Currently at 15% of maximum profit. At this point, the trade looks real good, but we will watch it closely. If corn prices start to look like they are going to run up, we will close the trade.

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/ZS September 1100/860 Strangle
$450.00 Credit. 48 days to expiration. 3 deltas on the puts and 20 deltas on the calls. Currently we have a loss of $168.75 on this trade in part due to the increase in volatility and also the increase in soybean prices. At this point, the trade still looks good, but we will keep an eye on it.

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Plan For Next Week

We will continue to watch the grain prices carefully this coming week. Most of our current positions are profitable and in good shape.

It is always an awful feeling to watch a trading loss unfold right before your eyes. Everyone strikes out from time to time and you can’t beat yourself up about it. The fact is, losses do happen. However, it is important to focus not so much on the loss, but on making the loss back and continuing on. In the end, a trader only really loses time. The most important thing is to live to trade another day. Rather than roll the dice and hope that wheat prices might reverse, I took decisive action that resulted in a large loss, but also preserved capital should the rally have continued further. As a fellow trader friend continually reminds me, you are always only a commission away from re-entering a trade that you have exited as a precaution.

The portfolio is currently down 12.19% year-to-date versus up 7.71% for the S&P 500 (see Trading Results). The portfolio is currently 61% in cash.

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