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How to Trade the Friday Options Expiration

We currently have two options positions that are deep in the money, and I just want to explain to the newbies how to best maximize their profits going into tomorrow?s January options expiration.

These comprise:

The S&P 500 SPDR?s (SPY) January $185-$190 in-the-money vertical bull call put spread with a cost of $4.58

The IShares Barclay?s 20 Year+ Treasury Bond Fund (TLT) January $125-$128 in-the-money vertical bear put spread with a cost of $2.70.

Here?s the easy part:

As long as the (SPY) closes at $190 or above at the close, the position will expire worth $5.00 and you will achieve the maximum possible profit. The nine-day gain on the trade will be 9.2%.

In addition, as long as the (TLT) closes at $125 or below at the close, the position will expire worth $3.00 and you will achieve the maximum possible profit here as well. The seven-day profit will be 11.1%.

Since the bond market closes at 3:00 PM EST on Friday, don?t expect much price movement after that.

Better than a poke in the eye with a sharp stick, as they say, especially in these difficult trading conditions.

In this case, the expiration is very simple. You take your left hand, grab your right wrist, pull it behind your neck and pat yourself on the back for a job well done.

Your only problem now is to figure out how to spend your winnings.

Your broker (are they still called that?) will automatically use the long (SPY) call to cover the short (SPY) call, and the long (TLT) put to cover the short (TLT) put, entirely cancelling out the positions.

The profit will be credited to your account on the following Monday, and the margin freed up.

If doesn?t, get on the blower immediately, because broker computers sometimes make mistakes, and they will always try to blame you first.

If an unforeseen event causes the (SPY) to collapse to the downside before the Friday close, such as if oil decides to crater once more, then things start to get complicated.

If the (SPY) expires slightly out-of-the-money, like at $189.90, the position can become a headache.

On the close, your short put position expires worthless, but your long put position is converted into a large, leveraged outright naked long position in the (SPY) with a cost of $185.58.

This position you do not want on pain of death, as the potential risk is huge and unlimited, and your broker probably would not allow it unless you wired in a ton of new margin immediately. It is more likely that they will execute a forced liquidation of your account.

This is to be avoided at all cost. It is not what moneymaking is all about.

Professionals caught in this circumstance then sell short a number of shares of (SPY) on expiration day equal to the short position they inherit with the expiring $185 call to hedge out their risk.

Then the long (SPY) position in the $185 calls is cancelled out by the short (SPY) position in the shares, and on Monday both disappear from their statement.

To minimize risk, traders attempt to sell these shares right at the close. As you have thousands of people attempting to do this at the same time, price action on expiration closes can be wild.

So for individuals, I would recommend just selling the January $185-$190 vertical call debit spread outright in the market if it looks like this situation may develop and the (SPY) is going to close very close to the $190 strike.

Keep in mind, also, that the liquidity in the options market completely disappears, and the spreads widen, when a security has only hours, or minutes until expiration. No one wants to be left holding the bag.

This is known in the trade as the ?expiration risk.?

Don?t worry if you lose money on this one position. Your loss will be more than offset by profits in your February $190 puts and February 187 puts which you independently bought last Friday and Monday. That will give you a generous overall profit.

The logic is the same if the (TLT) looks like it is going to close over $125 tomorrow.

One way or the other, I?m sure you?ll do OK, as long as I am watching my screens like a hawk, which I will be. If I think any action is required on your part, I will send out the Trade Alert in seconds.

One way or the other, you will make money on these trades.

Well done, and on to the next trade.

A Mad Hedge Strategy Change

Diary, Newsletter

Followers of my Trade Alert service have noticed some unusual activity during the last two days. Instead of recommending put spreads, I have started advising the purchase of outright puts.

Coming on top of big declines in the S&P 500 (SPY), you may have thought that I have lost my mind, if I hadn?t already done so a long time ago.

My kids would agree with you.

However, there is a method to my madness.

The truly brilliant aspect to the option spread strategy that I have been using for the past four years was that the positions had an embedded short volatility aspect to them.

While you were long volatility with your long leg, this was offset by the short volatility in your short leg.

This gave you a net volatility exposure of close to zero, a great thing to have during a time of secular declining volatility, as we have seen since 2012. Think of the first eight months of 2015, when index prices barely budged.

It also meant that you could achieve your maximum profit when the underlying stock remained unchanged, or moved only a few percent against you.

The nice thing about this low volatility was that it gave time to followers to get in and out of positions before large price changes occurred. Moves of only a few cents before you received trade alerts were common.

By focusing on front month options I also took maximum advantage of accelerated time decay going into each expiration. It was like having a rich uncle write you a check every day.

The low volatility delivered only small changes in the value of your portfolio from the day-to-day movements in the market, tiny enough for the novice investor to live with.

This is what enabled me to produce huge, outsized double digit returns while most other managers were sucking wind.

Since August 24, we have been in a completely different world. The long-term trend in volatility isn?t falling anymore. It has been rising.

What this brought to my trading book was a series of stop outs on options spread positions, whether they were call spreads or put spreads, and painful losses.

This is why I lost money in two out of three months in the recent quarter, a rare event. Having an embedded short volatility position was alas costing me money.

So it is time to adjust our strategy to reflect this brave new, and more volatile world.

So instead of running positions into expiration, I am going to start hedging them with options when a breakdown in the market appears imminent.

This is why I picked up the February $190 puts on Friday to hedge my January $185-$190 calls spread. It is also why I bought the February $187 puts to hedge my January $182-$187 call spread.

Why the mismatch in expirations? It ducks the problem of final week super accelerated time decay with my long puts. It also means I can continue with the short positions after the Friday January expiration, if I choose to do so.

There is one complication with this approach. Individual options are vastly more volatility than option spreads. So it won?t be unusual for an option to move 5%-10% by the time you receive the Trade Alerts. To be forewarned is to be forearmed.

Let?s look at out current positions as examples. For further analysis you have to be familiar with the concept of on option delta. Delta is a letter of the Greek alphabet used by traders to refer to the movement of an option relative to its underlying security.

A delta of 10% means that a $1 move in the underlying produces a 10-cent move in the option, which you see in deep out-of-the-money options. A delta of 90% means that a $1 move in the underlying produces a 90-cent move in the option, which is found with deep-in-the-money options.

The January $185-$190 vertical call debit spread had two legs, and the delta can be calculated as following:

A long January 185 call with a delta of +19%
A short January 190 call with a delta of -39% (negative since you are short)
This gives you a net delta of (39% - 19%) = -20%.

In other words, a $1 move down in the underlying (SPY) index only moves the $185-$190 call spread south by -20 cents.

In the case of the $182-$187 call spread, the net delta is only 14%, giving you a move in the spread of only 14 cents for the $1 (SPY) move.

Let?s say that the market looks like it is going to pieces and I want to hedge my downside exposure. That means I need to buy puts against my long call spread.

Since my net delta is only -20% on the January $185-$190 vertical call debit spread, I only need to buy 20% as many puts to neutralize the position, or 0.2 X 22 = 4.4 options.

To be more aggressive on the downside I increased my put purchase to 13 contracts to also provide extra downside protection of my short volatility (XIV) position. I then repeated this exercise on Monday for the $182-$187 vertical call debit spread.

What we end up with is a portfolio that is profitable at all points with a Friday January 15 (SPY) options expiration between $187-$194. Now you don?t have to touch the position, unless we break out of that range.

This prevents you from attempting to trade every triple digit ratchet in the market between now and then. This is a hopeless exercise. I know because I have tried it many times, to no avail.

Yes, I know this all sounds complicated. But this is how the pros do it. This is how they make money. It?s all about preserving your capital and making incremental profits on top of it. Watch, and learn.

Learn from my errors and prosper.

You Get Used to Them After a While

Volatility Here is Peaking

Diary, Newsletter, Research

It is often said that the stock market has discounted 12 out of the last four recessions.

While the market is discounting another recession now, I believe it is one of the many previously forecast that will never happen, a lot like to 18% swoon in the futures markets we saw last summer.

If anything, the reported hard data are showing that the economy is strengthening now, not weakening. The December nonfarm payroll hit a one-year high at 292,000. Christmas sales were off the charts for online merchants.

Auto production topped an 18 million rate. And this is an industry that was bankrupt only seven years ago.

But what else would you expect from a global economy that just has a $2 trillion annual tax cut dumped in its lap, thanks to lower energy prices.

I therefore think we are within days of the final capitulation of this move. That means the Volatility Index (VIX) will peak as well, probably around $30, the top that defined the top of every spike for all of 2015, except for the August 24 flash crash day. That apex is probably only days away.

I am one of those cheapskates who buys Christmas ornaments by the bucket load from Costco in January for ten cents on the dollar, because my eleven month theoretical return on capital comes close to 1,000%.

I also like buying flood insurance in the middle of the summer when the forecast here in California is for endless days of sunshine.

That is what we are facing now with the volatility index (VIX) where premiums have just doubled, from $15 to near $30. Get this one right, and the profits you can realize are spectacular.

Watch carefully for other confirming trends to affirm this trade is unfolding. Those would include a strong dollar, collapsing stocks, and oil in free fall, and a weak Japanese yen, Euro.

I don?t know about you, but I am seeing seven out of seven cross asset confirming price action.

The CBOE Volatility Index (VIX) is a measure of the implied volatility of the S&P 500 stock index, which has been rallying hard since oil began its precipitous slide three weeks ago.

You may know of this from the many clueless talking heads, beginners, and newbies who call this the ?Fear Index?. Long-term followers of my Trade Alert Service profited handsomely after I urged them to sell short this index three years ago with the heady altitude of 47%.

For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expiration's.

The (VIX) is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. You will recall that this is the equation that derives from the Brownian motion of heat transference in metals. Got all that?

For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don?t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.

The (VIX) is expressed in terms of the annualized movement in the S&P 500, which today is at 1,800. So a (VIX) of $14 means that the market expects the index to move 4.0%, or 72 S&P 500 points, over the next 30 days.

You get this by calculating $14/3.46 = 4.0%, where the square root of 12 months is 3.46. The volatility index doesn?t really care which way the stock index moves. If the S&P 500 moves more than the projected 4.0%, you make a profit on your long (VIX) positions.

Probability statistics suggest that there is a 68% chance (one standard deviation) that the next monthly market move will stay within the 4.0% range. I am going into this detail because I always get a million questions whenever I raise this subject with volatility-deprived investors.

It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the ?hedge? in hedge fund.

But wait, there?s more. Now, erase the blackboard and start all over. Why should you care? If you sell short the (VIX) here at $24, you are picking up a derivative at a nice overbought level. Only prolonged, ?buy and hold? bull markets see volatility stay under $14 for any appreciable amount of time. That?s probably what we have now.

If you are a trader you can sell short the (VIX) futures somewhere over $20 and expect an easy profit sometime in the coming weeks. If we get another 5% rally somewhere along that way, that would do it.

If you don?t want to sell the (VIX) futures or options outright, then you can always sell short the iPath S&P 500 VIX Short Term Futures ETN (VXX). Better yet, you can buy a short (VIX) ETN outright, the Velocity Shares Daily Inverse VIX Short Term ETN (XIV).

If you make money on this trade, it will offset losses on other long positions.

No one who buys fire insurance ever complains when their house doesn?t burn down.

Volatility Can Be Your Friend

Here Comes the Final Bottom in Oil

Diary, Newsletter, Research

I had a fascinating dinner last week at Morton?s, San Francisco?s best steak restaurant, with one of John Hamm?s original investors.

You remember John, the legendary Texas oilman who saw fracking coming a mile off and made billions?

Since some of what my friend had to say came true in a matter of days, I thought I?d pass on the essence of our conversation.

The oil storage facility at Cushing, Oklahoma is full, at 480 million barrels. The US Strategic Petroleum Reserve has been full for a long time, with 713 million barrels (36 days of US consumption).

Contangos are exploding. It might as well be the end of the world for the oil industry.

The oil Armageddon is here, and the final flush is upon us.

There is a 50% chance we will bottom at $32/barrel, and another 50% chance that we go all the way down to $20. If we go down to $20, the last three ticks of the move will be $22?.$20?.$22. Then a saw tooth bottom will unfold between $24 and $32 which will last for several months.

There will be many chances to buy this bottom. There isn?t going to be a ?V? shaped bottom in oil this time, like we saw in past energy crashes.

The margin clerks and risk control managers are in control now, so we may see the final low sooner than you think. But it could be some time before we break $40 again to the upside and hold it.

The industry was really drinking the Kool-Aid with both hands to get it this wrong. Ultra low interest rates drove in billions in capital from first time oil investors looking to beat zero interest rates. They also saw China continuing an endless economic boom forever, and the energy demand that went with it.

In the end, they got both the supply and demand sides of the equation completely wrong on a global scale, always a recipe for disaster.

Many of the fields drilled in places like North Dakota would never have been touched during normal times. Then Saudi Arabia came out of left field with a grab for global market share that has yet to play out.

The seeds of this recovery are already evident. Chinese auto sales are up 19% YOY. China is buying all the cheap oil it can to fill up its own strategic oil reserve. Miles driven in the US are already up 4.6% YOY, which is a huge gain.

All of this will contribute to a higher US GDP in 2016.

Once we put in a final bottom in oil, don?t expect $100 a barrel any time soon. The ma and pa investor in the oil patch will not be back in this generation.

Marginal sources, like high cost Canadian tar sands, deep offshore, and some in North Dakota aren?t coming back either. These supplies needed $100/barrel just to break even.

Personally, my friend does not see oil topping $80/barrel this decade. He see?s a $62-$80 trading range persisting for a long time.

As the US has become more energy independent, the geopolitical factors have mattered less and less. That is why oil moved only $1 on an ISIS victory, the Paris attacks, or some other disaster.

To call the bottom in oil, watch the shares of ExxonMobil (XOM), Conoco Phillips (COP), and Occidental Petroleum (OXY). When they revisit their August lows, down 5%-10% down from here, that will be a great time to jump back into the oil space.

None of these companies are going under, and the dividend payouts are now enormous, (XOM) at (3.7%), (COP) at (5.8%), and (OXY) at (4.2%).

Distressed debt is where the smart money is focusing now, where double-digit returns have become common. If the issuer goes bankrupt the equity owners get wiped out while the bondholders get the company for pennies on the dollar.

Energy companies and master limited partnerships (MLP?s) have far and away been the biggest borrowers in the high yield market in recent years.

There is a junk maturity cliff looming, with $145 billion in bonds due for refinancing from 2017-2021. Expect the default ratio to rocket from this year?s 2.8% to 25%. A 12% default rate is a normal peak in a recession.

Individual company research now has a bigger payoff than in any time in history, even the 2008-09 crash.

Small leveraged companies with exposure to the price of oil are toast.

The play is for the toll takers, master limited partnerships that profit from the volume of oil pumped, and not the price of oil. Over time, volumes will increase, and so will the profits at these MLP?s.

In the meantime, everything is getting thrown out with the bathwater, regardless of fundamentals. People just don?t want to be near the space, especially going into yearend book closing.

Nobody wants to be seen as the idiot who owned oil in 2015.

Linn Energy (LINE) is a perfect example of this. It suspended its dividend so it could buy more assets on the cheap. It has plenty of cash, and will be backstopped by Blackrock with additional credit lines, if necessary.

While this raises volatility for the short term, it increases returns over the long term. It?s definitely your ?E? ticket ride.

I pointed out that President Obama did the oil industry the biggest favor in history by dragging his feet on the Keystone Pipeline, and then ultimately killing it. It prevented US consumers from loading the boat with $100/barrel tar sands crude at the top of the market.

My friend conceded that it is unlikely the pipeline would ever be built. The market has moved away.

I have accumulated a variety of odd tastes in my half-century of traveling around the world.

So when I heard we were eating at Morton?s, I brought my own jar of Coleman?s hot English mustard. It makes a medium rare cooked filet mignon taste perfect, but my action always puzzles the waiters. They never have it.

John Hamm gained public notoriety last year when he wrote a $974 million divorce settlement check to is ex wife and she refused to cash the check. I asked if the check ever got cashed?

?She cashed the check,? he said.

Needless to say, my friend picked up the check for the dinner as well. I let him drive my Tesla Model S-1 back to his hotel.

Bring Back QE!

Diary, Newsletter

You wanted clarity in understanding the current state of play in the global financial markets? Here?s your #$%&*#!! clarity.

You should expect nothing less for this ridiculously expensive service of mine.

But maybe that is the cabin fever talking, now that I have been cooped up in my Tahoe lakefront estate for a week, engaging in deep research and grinding out the Trade Alerts, devoid of any human contact whatsoever.

Or, maybe it?s the high altitude.

I did have one visitor.

A black bear broke into my trash cans last light and spread garbage all over the back yard. He then left his calling card, a giant poop, in my parking space.

Judging by the size of the turds, I would say he was at least 600 pounds. This is why you never take out the trash at night in the High Sierras.

Ah, the delights of Mother Nature!

We certainly live in a confusing, topsy-turvy, tear your hair out world this year. Good news is bad news, bad news worse, and no news the worst of all.

The biggest under performing week of the year for stocks is then followed by the best. Net net, we are absolutely at a zero movement, and lots of clients complaining about poor returns on their investment.

I tallied the year-on-year performance of every major assets class and this is what I found.

+16% - Hedged Japanese Stocks (DXJ)
+15% - Hedged European stocks (HEDJ)
+13% - US dollar basket (UUP)
+10% - My house
0% - Stocks (SPY)
0% -? bonds (TLT)
-5% - Japanese Yen (FXY)
-11% - Euro (FXE)
-12% - Gold (GLD)
-18% -? Oil (USO)
-27% -? Commodities (CU)
-27% - Natural Gas (UNG)

There are some sobering conclusions to be drawn from these numbers.

There were very few opportunities to make money this year. If you were short energy, commodities, and foreign currencies, you did very well.

Followers of the Mad hedge Fund Trader can?t help but know and love these ticker symbols. They?ll notice that our long plays were found among the asset classes with the best performance, while our short bets populated the losers.

The problem with that is most financial advisors are not permitted to place client funds in the sort of inverse or leveraged ETF?s that most benefit from these kinds of moves (like the (YCS), (EUO), and (DUG)).

That left them reading about the success of others in the newspapers, even when they knew these trends were unfolding (through reading this letter).

How frustrating is that?

What was one of my best investments of 2015?

My San Francisco home, which has the additional benefit in that I get to live in it, have a place to stash all my junk, and claim big tax deductions (depreciated home office space, business use of phone, blah, blah, blah).

Of course, I do have the advantage of living in the middle of one of the greatest technology and IPO booms of all time. Every time one of these ?sharing? companies goes public, the value of my home rises by a few hundred grand.

The real problem here is that investing since the end of the Federal Reserve?s quantitative easing program ended a year ago has become a real uphill battle.

While the government was adding $3.9 trillion in funds to the economy we traders enjoyed one of the greatest free lunches of all time. It made us all look like freakin? geniuses!

Just maintaining their present $3.9 trillion balance sheet, not adding to it, has left almost every asset class dead in the water.

Heaven help us if they ever try to unwind some of that debt!

Janet has promised me that she isn?t going to engage in such monetary suicide.

The Fed is continuing with Ben Bernanke?s plan to run all of their Treasury bond holdings into expiration, even if it takes a decade to achieve this. And with deflation accelerating (see charts below), the need for such a desperate action is remote.

Still, one has to ponder the potential implications.

It all kind of makes my own 43% Trade Alert gain in 2015 look pretty good. But I don?t want to boast too much. That tends to invite bad luck and losses, which I would much rather avoid.

What! No QE?

11 Surprises that Could Destroy This Market?

Diary, Newsletter

The Teflon market is back.

Good news is good news. Bad news is good news. What could be better than that?

However, there are a few issues out there lurking on the horizon that could pee on everyone?s parade. Let me call out the roster for you.

1) Economic Data Continues to Weaken - After a nice data run into September, the numbers have suddenly turned ugly, taking Q3, 2015 GDP forecasts from 3.9% down to 1.5%.

Sluggish corporate earnings in 2015 should rebound in 2016, as the European and Chinese drag dissipates. They should improve going into Q4 and Q1, 2016. But if they don?t, watch out below.

2) The Fed Raises Interest Rates in December - This has been the world?s greatest guessing game for the past two years. With China stabilizing, and the US stock market on the mend, the path is open for our central bank to raise interest rates for the first time in nine years. Janet Yellen lives in fear of the American economy going into the next recession with interest rates at zero! That would leave them powerless to do anything.

We could get a 4% mini correction in stocks off the back of a December surprise, especially if the stock indexes go into the announcement from a high level. But, I doubt we?ll see more than that.

3) Another Geopolitical Crisis - You could always get a surprise on the international front. But the lesson of this bull market is that traders and investors could care less about ISIS, Al Qaida, Afghanistan, Iraq, Russia, the Ukraine, or the Chinese expansion in the South China Sea.

Everyone of these has been a buying opportunity, and they will continue to be so. At the end of the day, terrorists don?t impact American corporate earnings.

4) A Recovery in Oil - Texas Tea (USO) is clearly trying to bottom here, now that we are at the nadir of the supply/demand balance. If it recovers too fast, and rockets back to the $70 level, we lose some of our energy tax windfall.

5) The End of US QE - The Fed?s $3.5 billion quantitative easing policy ended a year ago, and since then the return on US stocks has been absolutely zero, save for the odd special situation (Amazon, Netflix, etc.). Anyone who said QE didn?t work obviously doesn?t own stocks. Still to be established is whether stocks can rise without QE.

6) A New War - If the US gets dragged into a new ground war, in Syria or elsewhere, you can kiss this bull market goodbye. Budget deficits would explode, the dollar would collapse, and there would be a massive exodus out of all risk assets, especially stocks.

However, it is unlikely that a pacifist President Obama would let things run out of control in the Middle East, nor would a future President Hillary. Better to leave it to the Russians. After all, their move into Afghanistan in 1979 worked out so well for them. It caused the demise of the old Soviet Union.

7) The European Refugee Crisis Worsens - If the numbers get too big, there are supposed to be 4 million refugees en route, it would demolish Europe?s (FXE) economic recovery.

Unfortunately, the enormous influx of Islamic migrants into Europe has already led to the resurgence of Nazi parties in Sweden, Denmark, and the Netherlands. Some are showing up with their 13 year old brides.

Good for Germany for doing the heavy lifting here. After all, they did happen to have a spare empty country at hand, the old East Germany. With a collapsing birthrate, it was the smartest thing they could have done to boost their long-term economic growth.

8) Another Emerging Market Crash - If the greenback resumes its long-term rise, as I expect, then another emerging market debt crisis is in the cards. With US rates rising and European rates falling, how could it go any other way? This is because too many emerging corporations have borrowed in dollars, some $2 trillion worth.

When their local currencies collapse, it has the effect of doubling the principal balance of their loans, and doubling the monthly payments, immediately. This is the problem that is currently taking apart the Brazilian economy right now. It happened in 1998, and it looks like we are seeing a replay.

9) China Goes Into Recession - So far, the Middle Kingdom has resorted to cutting interest rates, easing bank reserve requirements, and selling big chunks of its US Treasury and Eurobond holdings to reinvigorate its economy. What if it doesn?t work? Look for a new China scare to hit US stocks, and don your hard hat.

10) Interest Rates Start to Rise - I have already chronicled the sudden shortages in truck drivers, airline pilots, and minimum wage workers at Amazon fulfillment centers. What if wages really start to take off, and the trend towards 40 years of falling real wages reverses? That would bring substantial interest rate hikes, a rocketing dollar, true inflation, and eventually, a recession. 2017 anyone?

11) Donald Trump is Elected President - I doubt the Donald has seriously thought out his economic policies, and most of what he has proposed is unenforceable under current US law. But he has established that he has the money and the media strategy to win the Republican nomination.

What if Hillary then develops a major health problem and has to drop out of the race? The implications of a Trump presidency are hard to fathom, but it certainly would NOT be good for the stock market. This is an outlier, but is not impossible.

I know you already have trouble sleeping at night. The above should make your insomnia problem much worse.

Down the Ambien, and full speed ahead!

A Threat to Your Portfolio?

Keep Gilead Sciences on Your Radar

Diary, Newsletter, Research

I am going to continue to use this correction in the stock market as an opportunity to put new names in front of you for inclusion in your investment portfolio.

That way, when the markets turn, you can strike with the speed of a rattlesnake in returning to a ?RISK ON? posture.

Major turnarounds are not the time to engage in deep, fundamental research. It is when you should be pulling the trigger on Trade Alerts, which you have wisely spent time lining up.

This brings me back to my three core sectors for long-term investment, technology, health care, and energy. For a four cyclical play, you can add the financials as an interest rate play.

Which brings me to one of my perennial favorites, Gilead Sciences (GILD). Long-term readers will recall this big momentum name, which I first recommended last December at $75 a share. It hit $125 in June, last week, and could fly as high as $200 in 2016.

Obamacare is proving to by one of the greatest windfalls in the history of the health care industry. More than 45 million new individuals now enjoy government guaranteed payments for health care services for the first time. In addition, millions more are signing up for private insurance.

One of the cleanest shots at this new profit stream is Gilead Sciences. The ticker symbol seems so appropriate for this new Golden Age for the health care industry.

(GILD) is an American biotechnology company that discovers, develops and commercializes treatments for a range of different diseases. The California based firm initially concentrated on antiviral drugs to treat patients infected with HIV, hepatitis B, or influenza.

In 2006, Gilead acquired two companies that were developing drugs to treat patients with pulmonary diseases.

These are all expected to be huge growth areas in the future, and the company has become a favorite of hedge fund traders. Both the shares and the sector have been on fire all year.

Don?t rush out and buy (GILD) today. Rather, I?d wait until the last of the sellers get flushed out in this correction, which will probably not be until well into October.

Take a look at the charts below, and they suggest that the S&P 500 could reach as low as 1,976, or down another 160 handles from here.

That will give us another top to bottom pullback of 12.52%, which certainly qualifies as a healthy correction. This will be the time to load the boat with (GILD).

Keep close tabs on your text message service and email, and I?ll let you know when it is time to lay your cajones on the line once more.

Yes, It?s $1,000 a Pill

The Bull Market is Alive and Well

Diary, Newsletter, Research

It?s fall again, when my most loyal readers are to be found taking transcontinental railroad journeys, crossing the Atlantic in an a first class suite on the Queen Mary 2, or getting the early jump on the Caribbean beaches.

What better time to spend your trading profits than after all the kids have gone back to school, and the summer vacation destination crush has subsided.

It?s an empty nester?s paradise.

Trading in the stock market is reflecting as much, with increasingly narrowing its range since the August 24 flash crash, and trading volumes are subsiding.

Is it really September already?

It?s as if through some weird, Rod Serling type time flip, August became September, and September morphed into August. That?s why we got a rip roaring August followed by a sleepy, boring September.

Welcome to the misplaced summer market.

I say all this, because the longer the market moves sideways, the more investors get nervous and start bailing on their best performing stocks.

The perma bears are always out there in force (it sells more newsletters), and with the memories of the 2008 crash still fresh and painful, the fears of a sudden market meltdown are constant and ever present.

In fact, nothing could be further from the truth.

What we are seeing unfold here is not the PRICE correction that people are used to, but a TIME correction, where the averages move sideways for a while, in this case, some five months.

Eventually, the the moving averages catch up, and it is off to the races once again.

The reality is that there is a far greater risk of an impending market melt up than a melt down. But to understand why, we must delve further into history, and then the fundamentals.

For a start, most investors have not believed in this bull market for a nanosecond from the very beginning. They have been pouring their new cash into the bond market instead.

Now that bonds have given up a third of 2015?s gains in just a few weeks, the fear of God is in them, and dreams of reallocation are dancing in their minds.

Some 95% of active managers are underperforming their benchmark indexes this year, the lowest level since 1997, compared to only 76% in a normal year.

Therefore, this stock market has ?CHASE? written all over it.

Too many managers have only three months left to make their years, lest they spend 2016 driving a taxi for Uber and handing out free bottles of water. The rest of 2015 will be one giant ?beta? (outperformance) chase.

You can?t blame these guys for being scared. My late mentor, Morgan Stanley?s Barton Biggs, taught me that bull markets climb a never-ending wall of worry. And what a wall it has been.

Worry has certainly been in abundance this year, what with China collapsing, ISIL on the loose, Syria exploding, Iraq falling to pieces, the contentious presidential elections looming, oil in free fall, , the worst summer drought in decades, flaccid economic growth, and even a rampaging Donald Trump.

We also have to be concerned that my friend, Fed governor Janet Yellen, is going to unsheathe a giant sword and start hacking away at bond prices, as she has already done with quantitative easing (I?ve been watching Game of Thrones too much).

This will raise interest rates sooner, and by more.

Let me give you a little personal insight here into the thinking of Janet Yellen. It?s all about the jobs. Any hints about rate rises have been head fakes, especially when they come from a small, anti QE Fed minority.

When in doubt, Janet is all about easy money, until proven otherwise. Until then, think lower rates for longer, especially on the heels of a disappointing 173,000 August nonfarm payroll.

So I think we have a nice set up here going into Q4. It could be a Q4 2013 lite--a gain of 5%-10% in a cloud of dust.

The sector leaders will be the usual suspects, big technology names, health care, biotech (IBB), and energy (COP), (OXY). Banks (BAC), (JPM), (KBE) will get a steroid shot from rising interest rates, no matter how gradual.

To add some spice to your portfolio (perhaps at the cost of some sleepless nights), you can dally in some big momentum names, like Tesla (TSLA), Netflix (NFLX), Lennar Husing (LEN), and Facebook (FB).

You Mean it?s September Already?

The Coming Market Reaction to the Fed Decision

Diary, Newsletter

Up, then down, then up again.

How about that?

Will the Federal Reserve reverse their nine-year interest rate-cutting trend, or does it have another three months of life?

Is global economic weakness, or the approach of US full employment first and foremost in the mind of my friend, Federal Reserve governor Janet Yellen?

I?m sure that two days before the meeting, even the Fed itself doesn?t know the answer to these burning questions.

That has been the wellspring of the tremendous volatility we have grievously suffered for the past month that had the Volatility Index (VIX) at one point tickle a twice a decade high 53% level.

But could we be focusing on the wrong thing?

Is the Fed decision a simple matter of smoke and mirrors distracting us from the real market driver?

That would be the calendar.

After all the pundits predicted that the ?Sell in May, and go away? effect was utterly useless, backward looking, and little more than popular folklore, it then performed like a star.

I was certain this would be the case, and warned readers in the spring we would see a ?Sell in May, and go away? with a turbocharger, racing tires, and fuel injection.

This is why almost every S&P 500 Trade Alert I shot out since April was from the short side. My strategy thankfully delivered windfall profits for believing followers.

The problem is we may be trying to overthink the markets.

The May peak, and the 15% swoon that followed could be simply no more than further proof of the 60 year seasonal preference to sell stocks in the Spring and buy them back in the Fall.

Global growth fears, the China slowdown, stock market crash, and currency devaluation, the European refugee crisis, ISIS, the commodity collapse, saber rattling from Russia, and even share price valuations all could be nothing more than simple noise.

If I am right, then the Thursday Fed decision will be absolutely of no consequence. Whether they raise ?% and follow it up with ultra dovish talk will have no impact of the profitability of US companies whatsoever, except financials.

As we mathematicians like to say, ?it is close enough to zero to still be zero.?

The mere fact that the Fed decision is out of the way is the really important thing.

I have always believed that making money in the stock market is all about anticipating what is going to happen next.

What happens after a China crash? A China recovery.

European chaos? European stability.

An ISIS victory? An ISIS defeat.

A commodity collapse? A commodity bull market.

Russian saber rattling? Russian peace overtures.

Concern about share valuations? A return to momentum investing.

It all adds up to a global synchronized economic recovery sometime in 2016.

When do stocks start discounting this? How about right now!

You better pay attention to me, because I have been dead on right about how the stock market would play out after the August 24 flash crash.

That was my expectation of a narrowing triangle of higher lows and lower highs that reaches an apex exactly on Thursday, September 27 at 2:00 PM EDT.

After a false breakdown, the risk is we may get a stock melt up once the Fed announcement is out. It could kick off the six months a year we usually get seasonal strength for equities.

And this time, the follow up discussion will be far more important than the initial, algorithm driving headline.

Don?t get me wrong. We haven?t suddenly gotten a free pass on market turmoil.

Volatility is not about to plummet back to 10% and then sit there for four more years. We still have October to get through, which has a notorious reputation for ruining people?s lives and wealth.

However, my prediction for new all time high in American stock markets by the end of 2015 still stands.

Make your bets, and place your chips on the table please.

It?s Really All About the Calendar

Stress Testing the Mad Hedge Fund Trader Strategy

Diary, Newsletter

It is always a great idea to know how bomb proof your portfolio is.

Big hedge funds have teams of MIT educated mathematicians that constantly build models that stress test their holdings for every conceivable outcome.

WWIII? A Global pandemic? A 1,000 point flash crash? No problem. Analysts will tell you to the decimal point exactly how trading books will perform in every possible scenario.

The problem is that these are just predictions, which is code for ?educated guesses.?

The most notorious example of this was the Long Term Capital Management melt down where the best minds in the world constructed a portfolio that essentially vaporized in two weeks with a total loss.

S&P 500 volatility (VIX) exceeding $40? Never happen!

Oops. Better get those resumes out!

That?s why events like the Monday, August 24 1,000 flash crash are particularly valuable. While numbers and probabilities are great, they are not certainties. Nothing beats real world experience.

As markets are populated by humans, they will do things that no one can anticipate. Every machine has its programming shortcoming.

Given that standard, I think the Mad Hedge Fund Trader?s strategy did pretty well in the downdraft. I went into Monday with an aggressive ?RISK ON? portfolio that included the following:

The basic assumptions of this book were that the long term bull market has more to run, the housing sector would lead, interest rates would rise going into the September 17 Federal Reserve meeting, the dollar would remain strong, and that stock market volatility would stay within a 12%-20% range.

What we got was the sharpest one-day stock decline in history, a 28 basis point spike up in interest rates, a complete collapse in the dollar, and stock market volatility at an eye popping 53.85%.

Yikes! I couldn?t have been more wrong.

Now here?s the good news.

When we finally got believable options prices 30 minutes after the opening I priced my portfolio, bracing myself. My August performance plunged from +5.12% on Friday to -10%.

Hey, I never promised you a rose garden.

But that only took my performance for the year back to my June 17 figure, when I was up 23% on the year. In other words, I had only given up two months worth of profits, and that was at the low of the day.

I then sat back and watched the Dow rally an incredible 800 points. Now it was time to de risk. So I dumped my entire portfolio. The assumptions for the portfolio were no longer valid, so I unloaded the entire thing.

This was no time to be stubborn, proud, and full of hubris.

By the end of the day, I was down only -0.48% for August, and up +32.65% for the year.

Ask any manager, and they would have given their right arm to be down only -0.28% on August 24.

Of course, it helped that I had spent all month aggressively shorting the market into the crash, building up a nice 5.12% bank of profits to trade against. That is one of the reasons you subscribe to the Diary of a Mad Hedge Fund Trader.

The biggest hit came from my short position in the Japanese yen (FXY), which was just backing off of a decade low and therefore coiled for a sharp reversal. It cost me -4.85%.

My smallest loss was found in the short Treasury bond position (TLT), where I only shed 1.52%. But the (TLT) had already rallied 9 points going into the crash, so I was only able to eke out another 4 points to the upside on a flight to safety bid.

Lennar Homes gave me a 2.59% hickey, while the S&P 500 long I added only on Friday (after all, the market was then already extremely oversold) subtracted another 1.61%.

The big lesson here is that my short option hedges were worth their weight in gold. Without them, the losses on the Monday opening would have been intolerable, some two to three times higher.

You can come back from a 10% loss. I have done so many times in my life. A 30% loss is a completely different kettle of fish, and is life threatening.

For years, readers complained that my strategy was too conservative and cautious, really suited for the old man that I have become.

Readers were able to make a lot more money following my Trade Alerts through just buying the call options and skipping the hedge, or better yet, buying the futures.

I didn?t receive a single one of those complaints on Monday.

I?ll tell you who you didn?t hear from on Monday, and that was friends who pursued the moronic trading strategies you often find touted on the Internet.

That includes approaches like leveraged naked shorting of puts that are always advertising fantastic track records...when they work.

You didn?t hear from them because they were on the phone pleading with their brokers while they were forcibly liquidating portfolio showing 100% losses.

Any idiot can look like a genius shorting puts until it blows up in their face on a day like Monday and they lose everything they have. I know this because many of these people end up buying my service after getting wiped out by others.

I work on the theory that I am too old to go broke and start over. Besides, Morgan Stanley probably wouldn?t have me back anyway. It?s a different firm now.

Would I have made more money just sitting tight and doing nothing?

Absolutely!

But the risks involved would have been unacceptable. I would have failed my own test of not being able to sleep at night. That is not what this service is all about.

In any case, I know I can go back to the market and make money anytime I want. That makes the hits easier to swallow.

You can?t do this without any capital.

With the stress test of stress tests behind us, the rest of the years should be a piece of cake.

Good luck, and good trading.