Dr. Duke's Blog
Do you know any trading coaches who publish the results of their trades daily? Dr. Duke posts the trading track records of his Flying With The Condor™, Conservative Income, Dr. Duke's Trading Group, and The No Hype Zone Newsletter services in the free downloads section of this web site. If you have questions about any of the trades, Ask Dr. Duke.
Is the Sky Falling?
- Written by Dr. Duke
The markets are up over 14% since the election, and that's a huge run in anyone's book. So it isn't surprising that concern has been growing that this rally has run too far, too quickly. We begin to think that there must be a correction lurking around the corner. Yesterday's strong decline across all of the major market indices brought out the "sky is falling" folks. SPX did decline $29 or 1.2%, so it wasn't a trivial down day. More troubling to me was the fact that the sell-off strengthened into the market close. There was no market rally to end an otherwise dismal day and give traders hope.
But today was a different day for traders. SPX opened at $2348, and closed at $2348, up $4 on the day. The small cap stocks, as represented by the Russell 2000 Index, didn't fare quite as well, but today's trading didn't extend yesterday's losses. RUT was essentially unchanged at $1346, down less than a dollar.
Both SPX and RUT have been trading in a sideways channel for about three weeks. Today's little mini-rally almost pulled SPX back to its support level at $2355. RUT was more successful, essentially closing at the support level held for the last few weeks.
Was today just a temporary pause before we go over the cliff? That is hard to answer with much certainty, but let's consider the evidence:
The trailing 12 month price to earning ratio for the S&P 500 is at record levels. We have to go back to 2009 to find higher numbers.
The CBOE SKEW ratio measures the demand for far out of the money put options. The thinking is that the large institutional traders will see the storm coming and buy protection. SKEW did reach very high levels this past Friday, at 153, higher than the first quarter correction of 2016 or the correction in the fall of 2014. But SKEW declined to 136 today, still moderately high, but not quite as scary.
I follow the volatility index for the S&P 500 (the ticker symbol is VIX). Normally we see VIX tracking steadily higher in the days just before a correction, but VIX has been pretty quiet. Even during the scary decline yesterday, the high of VIX was 12.9%, and VIX closed at 12.8% today. These remain historically low levels of volatility. During the market decline preceding the election last year, VIX hit a high of 23%. The big players aren't panicking just yet.
Where does that leave us? I think today's price action shows that the bulls remain firmly in control of this market. Traders remain optimistic about the future of our economy. Don't get me wrong. We should be cautious, but it would be premature to move largely to cash. It does raise an interesting question. Do you have trailing stops entered to protect those gains you have enjoyed since the election?
Waiting On The Fed
- Written by Dr. Duke
Here we are once again, with the market treading water as we await the results of the meeting of the Federal Open Markets Committee (FOMC), or as we usually say, "the Fed". Fed watchers are rather confident we will see another rate increase on Wednesday. As always, the question is whether this interest rate increase is already baked into current market prices, or whether the market pulls back in response. The huge bullish run we have enjoyed since the election last year seems to have flattened out after the Standard and Poors 500 Index (SPX) hit a high of $2396 on March 1st, slowly declining and closing at $2373 yesterday. Trading volume has also dropped off since March 1st, closing at 1.9 billion shares yesterday, well below the 50 day moving average (dma).
The market futures are suggesting a lower open this morning, so it appears this waiting game will continue today, and probably through tomorrow afternoon.
Economic data have been strengthening recently, but the bulk of the market gains are based on expectations of gains yet to be realized: tax reform and trimming of bureaucratic regulations, to name a couple. Will an interest rate hike dampen that enthusiasm?
I was invited to write a chapter on the diagonal spread for a new e-book that was just published. That will make for good reading while we wait on the Fed.
Can The Bulls Continue?
- Written by Dr. Duke
The S&P 500 roared higher this week, closing yesterday at a new all-time high of $2351. I must say this has caught me by surprise. Conventional wisdom believes this strong bullish run has arisen from the prospects of individual tax reform, lower corporate taxes, and a reduction in the regulatory burden on business. Each day brings news reports of political resistance to many of these campaign proposals. I think the market has gotten ahead of itself, but the price is the price. My rationale one way or the other isn’t relevant.
The forward-looking P/E for the S&P 500 is now 17.6, the highest level since June 2004. The five-year average P/E is 15.2 and the ten-year average is 14.4. Higher stock prices have been driving this ratio higher because forward estimates for earnings are not growing as rapidly as prices. This suggests that the market’s exuberance since the election may be a bit overdone. In my opinion, there is substantial evidence for a bullish market outlook; I don’t disagree with that assessment. But the prospects of a pull back or correction appear to be increasingly probable.
The S&P 500 volatility index (VIX) rose on Wednesday this past week, but then declined to close on Friday at 11.5%. Wednesday presented a classic VIX divergence, i.e., when the market index and index volatility are running in the same direction. In this case, VIX ran from 10.8% to 12% on Wednesday, while The S&P 500 traded higher by $13, closing at $2349, a new all-time high (until Friday). VIX divergences are high probability indicators. In this case, with a rising VIX in a rising market, a pull back is highly probable, and in fact, did occur on Thursday. The S&P 500 followed through with a lower open on Friday, but then the bulls reasserted themselves and pushed the index higher.
More and more overbought signals are appearing, but markets can and have continued to rise in overbought conditions before. This is where the market adage originated, “Markets climb a wall of worry.” Trades positioned with a bullish posture make the most sense in this environment, but keep your stops tight. The probability of a pull back or correction is increasing, but that may be well into the future.
A New Administration
- Written by Dr. Duke
President Trump was inaugurated yesterday. Normally, the market would not be too concerned about that event, but this year was different. Trump’s strong talk about trade has the market worried about a trade war. On Friday morning, the markets traded higher until Trump’s inaugural address, then the major indices gave up most or all of their gains after Trump reiterated some of his trade rhetoric. I am presuming his comments are only a negotiating tactic. Business people always ask for the moon, but never expect to receive that extreme. The Standard and Poor’s 500 Index (SPX) opened Friday at $2270, and traded as high as $2277 before pulling back to close at $2271, essentially flat on the day.
SPX has been trading in this sideways channel of $2240 to $2277 since early December. The market has paused to reflect on the probabilities of the new administration’s economic proposals becoming a reality. It is hard to predict how long we may trade within this sideways channel. This market has proven very resistant to bad news, having withstood recent terrorist attacks both domestic and abroad. So I am not in the doomsday camp. This market needs some solid economic news to push it higher, e.g., passage of a tax reform bill. This sideways trading action is also reflected in SPX’s trading volume, which has been running below average all year. This underscores the “treading water” we have observed in market prices.
The S&P 500 volatility index (VIX) declined all of last week, even dipping below 11% on last Friday, 1/13. But the VIX started rising earlier this week, hitting an intraday high of 13.3% on Thursday, presumably reflecting some uncertainty leading up to the inauguration. But the VIX fell Friday, closing at 11.5%, down 1.2 points on the day.
It fascinates me to see the bipolar response of this market to a Trump presidency. On the one hand, his comments about lowering taxes and reducing bureaucratic regulations are received enthusiastically. But some of his other comments, notably about trade tariffs, make the market nervous. Layered on top of these issues may be some concern about the “establishment” politicians resisting the changes Trump has proposed and creating a legislative stalemate.
The overall market has been trading sideways since early December, but we aren’t seeing much negativity in the market’s technical indicators. The dividend yield of the Dow Jones stocks is roughly in the middle of its five-year range. The CBOE put/call ratio is a little high, but this is a contrarian indicator so a high put/call ratio is actually bullish. Consumer sentiment levels are near record highs, and the willingness of consumers to spend money is a basic requirement for a strong economy. Despite the harsh rhetoric and the anarchy in the streets, the Trump administration is creating positive expectations on the part of ordinary working people. Unless we see support levels begin to be broken, we should assume continuation of the bullish market trend.
This market remains nearly ideal for classic delta neutral options strategies, such as iron condors and calendar spreads. A diagonal bull call spread is also a good strategy for stocks with strong price patterns that may be on the verge of breaking out higher if and when this sideways market breaks, e.g., AMAT, CGNX, and BA.
The Elusive Dow $20,000
- Written by Dr. Duke
The talking heads on the financial networks have been talking about about breaking $20,000 on the Dow Jones Industrial Average for several weeks now. The Dow touched $20,000 this past Friday, but could not hold it, closing at $19,964. SPX broke out to a new all-time high on Friday, closing at $2277. But trading yesterday and today confirmed that the markets remain in the sideways trading channel in effect since early December.
The market’s meteoric rise since the election couldn’t continue, so taking a breather is to be expected. The economic proposals being promoted by the new administration are very encouraging to both small and large businesses. And this carries over to broad consumer confidence as well. All of the consumer confidence surveys are either near or above several year highs.
The S&P 500 volatility index (VIX) has been steadily declining since the first of the year, closing today at 11.5%, levels we haven’t seen since July and August. The common interpretation would be bullish, based on a consensus among large institutional traders for higher markets and minimal need for hedging their portfolios. The contrarian viewpoint would be that this is simply the calm before the storm. I am inclined to the former viewpoint.
In summary, all three market indices, SPX, RUT, and NASDAQ, have been trading sideways for some time and the possible breakouts from last Friday have now been nullified. The inauguration is still about ten days away and we are just starting to see the legislative battle lines begin to be drawn. It isn’t too surprising to see the market take a breather as this action unfolds.
Even as the overall market indices have slowed, the financial stocks remain strong. Some, like GS and MS, have flattened and are trading sideways; SCHW and others continue to climb, but at a slower rate. Buying diagonal call spreads is working well on these stocks, but be sure you know when the earnings announcements are scheduled. Carrying those positions through an announcement is risky.
- Written by Dr. Duke
The implied volatility of the S&P 500 index (SPX) is measured by its volatility index, VIX. Similarly, the implied volatility of the Russell 2000 index (RUT) is measured by RVX and the NASDAQ 100 (NDX) has VXN. Most commonly the volatility indices vary inversely with the values of the corresponding index, so higher levels of volatility normally accompany lower prices on the index. When one sees a divergence from this relationship, it is worth noting. Today's trading took the broad market indices higher, but their volatility indices also moved higher - a volatility divergence.
SPX closed at $2269, 0.2% higher, but the VIX closed at 12.0%, for an increase of 4.6%.
RUT closed at $1378, 0.5% higher, but the RVX closed at 17.4%, for an increase of 3.6%.
NDX closed at $4966, 0.5% higher, but the VXN closed at 14.2%, for an increase of 7.4%.
One interpretation is that the large institutional players were buying protection and driving up the option prices at the same time that the index prices were trading higher. Perhaps they are concerned about a pull back? That wouldn't be too surprising. After all, SPX is up 8% since November 7th and the small caps are up even more, with RUT up over 18%. So a bit of a breather would not be too surprising. It could be argued that this increase in volatility is simply reflecting the consensus of professional traders who are expecting a bit of a pull back after such a strong run higher.
So what is the average retail trader to do? I suggest two courses of action:
1) Look over your portfolio and identify the stocks that you think have traded much higher than you think is warranted - of course, that can be a difficult judgment. Sometimes stocks just continue higher in spite of our best judgment. Taking profits on at least a portion of those positions might be prudent.
2) Don't get too far out over your skis. This is probably a good time to wait on the market. Allow some of the Trump euphoria to dissipate.
Happy New Year!
Thoughts About Settlement
- Written by Dr. Duke
This is the time of year when we begin to see a myriad of articles about the year in perspective. Let me start the wave with some observations about the 2016 settlement prices for the Standard and Poors 500 Index, SPX. As you may know, the last time one may trade SPX options is on the Thursday of expiration week. But SPX options do not settle at the closing prices on Thursday or Friday of expiration week. A special settlement price is determined on Friday morning, based on the opening price of each of the 500 companies that make up the index. I have been keeping a spreadsheet of the settlement prices for the Russell 2000 Index and the Standard and Poors 500 Index since 2006. You may download a copy of the spreadsheet in the free downloads section of my website.
Why would I keep updating this spreadsheet every month for eleven years? I have been trading iron condor spreads on the broad market indices since 2004. One of the reoccurring questions facing me over these years has been: Is it safe to allow these options to enter expiration and expire worthless, or should I close them now? As an empirical attempt to answer this question, I started keeping this spreadsheet, comparing the closing price on Thursday of expiration week with the settlement price determined sometime on Friday (usually by noon for SPX, but a couple hours after Friday's close for Russell). A key question for index option traders on Thursday of expiration week is how far might the index move between Thursday's close and settlement on Friday? The average of the difference between Thursday's close and the settlement price is $8.09 for SPX over the eleven years of 2006 through 2016. The range of movement is from a low of $3.68 in 2013 to a high of $14.82 in 2008. The third highest average occurred this year at $10.01. So it wasn't just your imagination, it was a volatile year in the markets. Therefore, the empirical answer is pretty simple. If your short SPX option is less than ten dollars from expiring in the money on Thursday of expiration week, you would be well advised to close it while you can on Thursday. By the way, if you repeat this calculation summary with percentages to account for the growth of the indices, the highest and lowest years don't change, but 2016 is closer to the eleven year average.
Of course, that answer of ten dollars as a guideline is a very rough approximation. The most accurate method would be to compute the standard deviation of the option expiring in the money. Higher values of implied volatility lead to larger values of the standard deviation and therefore higher probabilities of the index moving far enough between Thursday's close and settlement to result in your short option being in the money. Let's look at a couple of examples from this year. The low volatility example is from December expiration. SPX closed at $2262 on Thursday, 12/15 and the volatility index (VIX) for SPX was 12.8%. The standard deviation for one day's price move may be computed as $15. The probability of having less than a two standard deviation move is about 95%. Therefore, if our option's strike price was over $30 out of the money, we had a 95% probability of the option remaining out of the money at settlement. January expiration came during the correction this year, so volatility was much higher. On the Thursday before January expiration (1/14), SPX closed at $1922 and VIX was 23.95%. This results in an one-day standard deviation of $24. In January our option's strike price would have to be at least $48 out of the money to allow it to enter expiration with a 95% probability of expiring worthless.
This illustrates why I formulated my "Two Sigma Rule" for closing index spreads in advance of expiration. On the Friday before expiration week, I calculate one standard deviation (one sigma). If the short option of either of my spreads is less than two sigma out of the money, I close the spread. Consequently, I have never been surprised by a short option expiring in the money at expiration. If you choose to carry your index option position to the Thursday of expiration week, the ten dollar guideline is a "quick and dirty" approximation, but calculating the standard deviation and using the Two Sigma Rule would be safer.
Bulls or Bears?
- Written by Dr. Duke
After posting an impressive bull run after the election, the markets pulled back this week, prompting traders to wonder whether the run was over. Some analysts are arguing that the prospects of an interest rate hike are applying the brakes to this rally. I am more inclined to think we are looking at a simple case of profit taking.
If we back up a moment and look at the overall market for 2016, this has been a tough year for traders of all stripes to make money. SPX had only gained a little over two percent when we hit that low on November 4th. That isn’t a very pretty picture to present to your institutional clients. However, when the market hit that high on November 25th, the year to date gain was suddenly a much more respectable 8.6%. Maybe it’s time to lock in some gains. The large players were predictably nervous and ready to take profits the minute any softness appeared. The trading volume in SPX supports this viewpoint. The two strongest down days this week were Wednesday and Thursday, and trading volume spiked way above average both days. Anecdotal evidence comes from individual stocks. Some of the best recent stock runs abruptly ended this week for no apparent reason, e.g., NVDA, VMW, VEEV and others. Traders were locking in profits before they got away.
The prospects of lower corporate tax rates and a more business friendly administration has fueled this recent market run higher. But now the market is taking a bit of a breather. I think this is principally profit taking, so I don’t expect prices to trend lower from here. However, that doesn’t mean we can ignore the relatively weak economic data and modest levels of corporate profitability reported most recently. By most measures, this market is at least fully priced and may be nearing an overbought stage.
But we shouldn’t forget the calendar. The so-called Santa Claus rally during the last week of the year is thought to be triggered by large funds unloading losers for tax purposes. This may lower the prices of some attractive stocks that are quickly bought up, resulting in a short-lived rally. The Stock Traders Almanac has noted the historical pattern of small cap stocks outperforming the large caps in January and terms this the “January Effect”. This effect tends to begin around mid-December and lasts well into February.
Therefore, we are entering a time of the year that tends to be bullish, whatever the explanation. I will be watching the market on Monday to see if today’s modest gains signaled the continuation of a sideways to slightly bullish market. The strong run of late November couldn’t continue to the moon, but I don’t see any evidence of the bears taking charge of this market.
An Historic Market Rally
- Written by Dr. Duke
The S&P 500 Index (SPX) closed today at $2205, up two points. But a glance at the price chart is rather shocking. SPX has rocketed higher since November 4th, up $120 or 5.8%. This incredible run has occurred over 13 trading sessions or less than three weeks! By contrast, S&P 500 was up less than 3% over all of 2015, and that was only if you included the stock dividends.
Let's take a look at the small cap stocks, as represented by the Russell 2000 Index (RUT). These are the high beta stocks that move faster than the blue chips, whether the overall market is trading higher or lower. These are the classic "risk on" stocks. RUT closed today at $1342, up $8. Since November 4th, RUT has gained $179 or 15.4%. Wow! A broad market index is up over 15% in less than three weeks. That must have set a record. RUT broke its old all-time high on November 11th, and proceeded to set eight new all-time highs out of nine trading sessions since November 11th. RUT makes SPX look like an old man trying to keep up with the kids in a hundred yard dash.
Can this incredible rally be sustained? History and simple probabilities would say no. But the statisticians will tell us that the probabilities of any stock making a three standard deviation move is infinitesimally small. But those of us in the market every day find that five and six standard deviation moves are not that unusual. This strong market rally was not a highly probable event, but it happened.
What is driving this rally? Regardless of your politics, one has to give the election of Donald Trump the credit. Market analysts believe that the proposed economic plans, especially corporate and individual tax reforms, will stimulate economic growth. Hence, the financial stocks have been on fire. Take a look at the price chart for Goldman Sachs (GS). Analysts are expecting another booming economic era on Wall Street similar to the mid to late 1980s.
The minutes from the last FOMC meeting were released today, and portions of those minutes appear to make an interest rate hike at the December meeting a near certainty. In the past, even a hint of a rate hike sent the traders scrambling for the exits. The rate hike last December resulted in a 12% correction in the first quarter of this year. Will this rate hike be different?
If traders remain convinced that "happy days are here again", we may easily survive a 25 basis point rate hike. But we have another powerful force that may at least temporarily temper this bull market. As fund managers look at the nice gains that have piled up over the past few weeks and contemplate year end bonuses, the temptation to sell and take profits will be growing. The rate hike coming out of the next Fed meeting on December 14th may be the trigger for that profit-taking. Don't be caught unaware.
Can This Rally Continue?
- Written by Dr. Duke
All anyone on the financial networks could talk about last week was the strength of the "Trump rally". Perhaps we are getting ahead of ourselves. The Standard and Poors 500 Index (SPX) closed today at $2164, unchanged. This is the fourth day that SPX has essentially traded sideways. By contrast, the Russell 2000 index (RUT) closed at 1299, up $16, and set a new all-time high. RUT set its previous high at $1296 on June 23, 2015. Both SPX and NASDAQ have set new highs this year, but RUT stubbornly lagged behind.
From the market lows on 11/4, SPX has gained 3.8% through today's close, but RUT is up 11.7% - wow! The smaller companies, represented by RUT, are largely the high beta stocks, the stocks whose prices tend to outperform the market both in bullish rallies as well as bearish corrections. These are the classic "risk on" stocks. The fact that RUT finally woke up and is now leading this market is very bullish. But can this rally continue?
SPX is looking pretty tepid at this point. SPX traded strongly higher through Wednesday of last week, but has traded sideways since then. Whether one looks at price to earnings ratios of the broad market indices, average dividend yields of the S&P 500 or many other metrics, the answer is the same. The market is at a minimum, somewhat overvalued and perhaps significantly overvalued. After all, corporate earnings are weak, GDP growth is anemic and business capital investment is near historic lows. And don't forget the Fed; an interest rate hike is almost certain next month.
Don't mistake me for one of the perennial bears. But I don't own any rose colored glasses either. I think Trump's economic plan has merit and will drive an economic revival, if it gets implemented. But that may be a large "if".
Non-directional trades are well suited to this market. I opened a large number of SPX Jan 2017 iron condors at 1960/1970 and 2280/2290 today. I am also looking at diagonal call spreads on the financials, like GS and JPM. The beauty of these trades is that they allow for a little slowing or even some pull backs as the market contemplates a new administration taking office. Don't get caught up in the euphoria. As always, manage your risk.