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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.
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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.
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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.
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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.
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I expected this market to be volatile and choppy leading up the election. But the weakness in the markets over the past two weeks has surprised me. Is this a harbinger of even more bearishness next week? Or will the market “get over this” and settle down quickly after the election?
I wouldn’t have predicted the wild market reaction to BREXIT or its rapid recovery just a couple of days later. The market’s reaction to the election results can’t be predicted either, although I am sure many will try. The key isn't predicting the move. Success in trading comes from managing the risk.
SPX closed today at $2085, down $3 and RUT closed at $1163, up $7. But the larger picture is much more dire. Since the most recent market peak on October 24th, SPX has declined 3%, while RUT and the NASDAQ Composite have dropped almost 5%. Will these declines continue or even accelerate next week?
If we draw the Bollinger bands on the SPX price chart, we will see that today’s close was the fourth successive close below the lower edge of the Bollinger bands. The Bollinger bands are drawn at two standard deviations around the 20 dma. We would expect about 95% of the data to be contained within the bands, and that generally holds true. It is common to watch stock or index prices oscillate within the bands, but when prices move outside the bands, they are usually pulled back within the bands in short order. The number of closes below the lower edge of the Bollinger bands during a correction is usually pretty small, typically three or four. The fact that we have already observed four lower closes this week might tempt us to think that we are close to “hitting bottom”. But this market perturbation may be unusual. We are setting every other record with this election. Why not in the market as well?
Stock market risk is very high as we go into this election. We can't predict who will win the election and we certainly can't predict the market's reaction to the election results. What we can do is manage the risk. I closed all of the positions in my Conservative Income service today. As my most conservative trading service, it makes sense to go entirely to cash in advance of the election. In my No Hype Zone newsletter, we closed our TSLA iron condor a couple of weeks ago for a nice 26% gain, but I have been reluctant to add any new positions in this market environment. My November iron condors in the Flying With The Condor™ service are over two standard deviations out of the money, so I may leave them open, but that judgment may change on Monday or Tuesday. The feared "black swan" moves of three and four standard deviations may be a very real possibility next week.
The easiest way to control your market risk is to simply go to cash. But you may have a large stock portfolio that would have significant tax liabilities triggered by selling. Hedging the portfolio with a few out of the money index put options is the answer. Use the option price calculator on your broker's web site to estimate the gains of those put options under a couple of "what if" scenarios. Based on the gains you project for the puts, you may estimate how many puts will be required to hold the losses in your portfolio to a reasonable level. Whatever you do, don't just sit and hope for the best. Take control. Manage the risk.
