From the Top

When It's OK to Break the Trading Rules

Considering a paired precious-metals play on GLD and SLV

by 10/6/2014 10:22 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the October 2014 edition of The Option Advisor, published on September 25. For more information or to subscribe to The Option Advisor, click here.

Not many people are excited (in a positive way) by the prospect of "catching a falling knife." But many who would be repelled by that scenario engage in similarly dangerous activity from a financial perspective when they attempt to "pick a bottom" by taking a bullish position in an asset that has been mired in a bear market and is regularly recording 52-week lows. And, in fact, trying to catch a falling knife is how many veteran traders would disdainfully describe such attempts at taking a bullish stance in a bear market and, implicitly expecting the decline to terminate and then reverse and then for the backdrop to turn bullish -- all within the holding period for their position. And even more challenging still is to make such a situation work for you when using options as your trading vehicle, which by their very nature will deteriorate in value if this process takes too long, and will disintegrate all the way to "worthless" should this not occur (arguably the most likely scenario).

And though I had all these concerns at top of mind when I recently recommended a January 2015 call option on the SPDR Gold Trust (GLD) exchange-traded fund (ETF) in our Weekend Player service, for a number of other reasons this call trade passed muster with me.

So, I'd like to excerpt here from my discussion of this call trade in Weekend Player -- which essentially amounts to "calling a tradable bottom" in gold -- because I feel it is a good illustration of the fact that while basic trading rules (such as the one that admonishes against taking a bullish position in a bear market, but instead waiting for some evidence of a change in direction before acting) have been developed for the simple reason that they help you avoid making the same serial mistakes most non-professional traders make with regularity, there is also an accompanying element of "Good trading rules are made to be broken by those who thoroughly understand those rules, but who feel they recognize a major opportunity in leaning against them." Plus, since this trade has not yet resolved itself one way or the other, it gives you an opportunity to view the results as they unfold in the weeks and months ahead.

The following is an excerpt from Weekend Player, Sunday, Sept. 21, 2014:

While it is undeniable the SPDR Gold Trust (GLD) remains in a bear market, it is equally true that by June 2013 the bear's damages had been fully inflicted. And since then, GLD has basically range-traded between $120 and $130. There's not much money to be made by options traders in "hurry up and wait," range-bound markets that are very choppy and exhibit high volatility, as the price you pay to play (in terms of the option premium level) is too high relative to the magnitude of the potential directional move (even if you catch a top or a bottom with some precision). But this is far from the case for GLD, which has traversed this $120-$130 range no less than six times since June 2013, in "steady as you go" intervals of roughly three months' duration.

In addition, the options on GLD are very reasonably priced relative to this ongoing directional movement. In fact, our recommended GLD January 2015 120-strike call sports a super-charged "Leverage Ratio" of 18.6. While we'll discuss the Leverage Ratio concept in a future "Chart of the Week" commentary, for now suffice it to say that a Leverage Ratio in excess of 10 for options that are near-the-money is very high, and this all accrues to the good for option buyers.

To put a more concrete face on what high Leverage Ratio options can accomplish for buyers, consider the fact that on a rally of 10% by GLD from its closing price of $117.78 on Thursday, Sept. 18 (which would place GLD at $129.56 -- near the top of its range), the January 120 call would gain about 250% from its closing "mark" of $2.75 on that same day. A 250% call option gain on a 10% rally in the underlying security can be an extremely attractive proposition for the call buyer.

Of course, the leverage becomes moot if we don't get the direction right (and the move does not occur over the life of our option). But there are other reasons -- aside from the roughly three-month cyclicality for GLD in traversing the range -- to expect the next major GLD move to be to the upside. As indicated on the accompanying chart, there are several levels of "auxiliary support" below the $120 mark, and in the vicinity of GLD's Friday close at $117.09.

Another theme from this chart relates to the tendency of many assets to develop "significant levels of interest" for multiples of two or three times (and sometimes more) a "base level." In the case of GLD, this base level is $60, with multiples of two and three at $120 and $180, respectively. The fact that $120 is a level of interest within this framework, and is also the level at which declines in GLD have terminated over the past 15 months, serves to reinforce the expectation of yet another GLD rally to the top of the range.
Weekly Chart of GLD since May 2012
Also encouraging is the 3-point increase in 30-day implied volatility (IV) for GLD options on this most recent pullback -- a very similar IV pattern to that which occurred on the five-week GLD rally from $120 in early June 2014 to a peak at $129.21 in early July. While IV for the precious metals does not tend to spike on pullbacks and peak at bottoms in the same manner as that for equities, over the past 18 months or so this has been the case for gold.

Along these same lines, the extent to which GLD is "oversold" (as measured by its 14-day Relative Strength Index, currently at 25.49) is very similar to the oversold condition that existed at the lows of early June.

Going a step beyond the above excerpt, I'd also caution you to avoid long positions in silver, even as I am feeling quite friendly toward gold at this juncture.

Using the iShares Silver Trust ETF (SLV) as a good proxy for the silver market, I see SLV traders as having exhibited huge complacency compared to GLD traders, based on SLV option activity over the period since each of these metals peaked in April 2011, even as SLV's price performance continued to lag that of GLD.

Most striking of all is the fact that call option speculators in SLV are back in "hot and heavy" mode (as illustrated on the chart below of SLV open interest since January 2011). Meanwhile, interest in GLD call options is significantly more muted these days than at the 2011 GLD price peak.

SLV Open Interest since June 2014
Chart courtesy of Trade-Alert

Finally, for those a bit reluctant to make a bullish stand on gold (through GLD call options), I think a pretty decent hedged trade right here would be long GLD calls/long SLV puts. I see this as one of those combination trades in which one has the ability to profit based on a huge directional move in the precious metals one way or the other, even if I am completely wrong about gold outperforming silver. But I would not take such a trade for options that expire sooner than January 2015, as such situations almost always need at least a month or two to sort themselves out before significant profits can be realized.


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Whatever Happened to the Earnings Catalyst?

These six stocks barely budged in response to their latest earnings reports

by 8/5/2014 10:51 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the August 2014 edition of The Option Advisor, published on July 25. For more information or to subscribe to The Option Advisor, click here.

Remember a time when earnings reporting day was truly a day of reckoning for a stock, especially on the tech front? A time during which the market's enthusiastically positive response or its palpable disgust with that all-important "number" could catapult stocks to price levels never before seen, or wipe out five years' worth of price appreciation?

I think I still might remember, but my vision has become clouded after quarter upon quarter of the kind of post-earnings action as illustrated on the accompanying charts.

Visa (V): Down by about 5% at its lows today -- but has been grinding higher ever since, and if you wipe out the action of the previous 10 days this could be just another dull trading day from early July. No trajectories changed here.



20-Day Chart of Visa (V) with 2-Hour Bars

E*Trade Financial (ETFC): Can you guess the date this (allegedly) highly volatile brokerage name reported on this 3-month chart? Hint: It was after yesterday's close. But don't say it too loud, or you might wake the stock up.



3-Month Daily Chart of E*Trade Financial (ETFC)

General Motors (GM): At point A, the headlines were that GM was a dead man walking after Congress finishes with them; at point B, the GM perma-bulls were crowing about how well sales have held up despite all the bad publicity; at point C (two days after earnings), the bears are back. The only problem (assuming you are a trader who likes to profit from strong directional movement) is point C is disturbingly close, price level-wise, to point A. Only airline passengers like to buy round trips.



3-Month Daily Chart of General Motors (GM)

Google (GOOGL): So Google finally took out with authority that pesky $600 level on its post-earnings surge? Well, for at least a week or so. And if you don't count intraday. And if you don't count today (so far).



20-Day Chart of Google (GOOGL) with 2-Hour Bars

Apple (AAPL): What's not to like? They sold the "(insert your word here)" out of their gadgets and gizmos, and once again "proved" they were not even approaching irrelevant (just check out their TV commercials), and the Street liked it, and the people liked it, and the first bar was big and (what could be more perfect?) it was green, and there was dead aim on that September 2012 high just north of $100. And then many little tiny baby steps.



3-Month Daily Chart of Apple (AAPL)

Amazon.com (AMZN): Okay, that Bezos guy is finally gonna taste it, right here and now! Down north of 10% in the pre-market? That's nothing -- here comes the 2-handle! But wait -- what's with that niggling little smarty-pants of a rally since the opening? And isn't the stock trading at just about the same level as a couple of weeks ago? So, nothing has changed. Except perhaps for some gratuitous Fire phone buzz?



20-Day Chart of Amazon.com (AMZN) with 2-Hour Bars


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How Much Upside Is Really Left for Adobe Systems (ADBE)?

Predicted gains for ADBE may already be baked into the share price

by 6/30/2014 2:10 PM
Stocks quoted in this article:

I think a critical question with regard to what I am sure is the fundamental-based view on Adobe Systems Incorporated (NASDAQ:ADBE) -- as expressed in this Barron's piece -- is to be able to discern whether this "20% upside" is applicable to:

  • The current share price
  • The share price before all this subscription-based success was revealed

Unfortunately, analysts will regularly confuse these two concepts, so you have to make your own independent judgment as to how much of this stuff is already priced in.

For example, ADBE is currently trading just about 20% above its 40-week moving average, represented by the orange line on the first chart below. If you consider the 40-week to represent "all known information" about ADBE and its prospects before the most recent earnings (and the success of the subscription model), one could argue this 20% upside has now been fully priced in. Similarly, the +20% year-to-date (YTD) level is at $71.84 -- not far below ADBE's last sale -- and once again, we can play this hypothesis against the information priced into ADBE's price at year-end and conclude this upside is now "in there."

I think this puts even more emphasis on this +20% YTD level holding as a post-gap low, and so a move back below could be even more negative than I had been thinking. It's also not the biggest positive that the Barron's piece has had such a minor post-weekend effect (so far, anyway) -- seems like the stock was again looking to pull back to test +20% YTD before the weekend buyers kicked in.

The second chart below is a 30-minute bar, and my experience had once been that I wanted to look to enter from the long side after these low-volatility sideways moves following a big gap rally, and by so doing I have most often gotten burned. I would see this as especially of concern here if $71.84 is taken out.

Weekly Chart of ADBE since February 2012
30-Minute Chart of ADBE since June 10, 2014

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Gold and Silver Grapple with Round-Number Returns

GLD and SLV have struggled at the +10% year-to-date level

by 6/30/2014 10:20 AM
Stocks quoted in this article:

Both the SPDR Gold Trust (GLD) and iShares Silver Trust (SLV) have had trouble at different times this year with closing above the +10% year-to-date (YTD) level. Last Wednesday, these exchange-traded funds (ETFs) each experienced an intraday failure shy of +10% YTD, with gold coming the closest.

This might be of particular interest with recent talk of gold futures clearing resistance at $1,300 an ounce.

Year-to-Date Chart of GLD and SLV

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One Victim of the Market's Stagnation

Are VIX call buyers at risk of a knockout punch?

by 6/2/2014 9:49 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the June 2014 edition of The Option Advisor, published on May 22. For more information or to subscribe to The Option Advisor, click here.

The blue, green and orange lines on the accompanying chart might as well have been produced by a 6th grader asked to draw 3 lines of any shape (one in each color) across the page, with the only "rule" being that none should rise above the horizontal line labeled "+4%" nor fall below the horizontal line labeled "-6%." And then it turns out the student "made a mistake" in drawing the orange line by allowing it to wander too far downward early on.

Year-to-Date Daily Chart of DJI, SPY, and IWM

This explanation for what appears on this chart would actually have made a lot more sense to me at year-end 2013 than if you had instead told me it represented the year-to-date 2014 changes (as calculated daily on a closing basis, through May 22, 2014) relative to their 2013 closing prices for the two "headline" market benchmarks (the Dow Jones Industrial Average and the S&P 500 Index -- as represented by the SPDR S&P 500 Trust [SPY], its actively traded ETF) and the most widely followed measure of the price action of the smaller caps (the Russell 2000 Index -- as represented by the iShares Russell 2000 Index [IWM], its actively traded ETF). Because to have guessed that not a single one of these 3 instruments would have moved at any time over this period by more than 6% in either direction (except for one very brief period for one of the three) from its 2013 closing price, and that in late May all 3 would be trading within 3% of their 2013 closing price, would have defied credulity.

In fact, the only "credulity" to the way the 2014 stock market has played out so far is in itself highly ironic. Because when viewed in the proper context, this "lack of volatility" (actually more akin to "lack of a pulse") in the 2014 stock market appears to me to be the final nail in the coffin for those who had followed a strategy that had -- despite its innocent-sounding purpose -- attracted mania-like levels of participation from even the most sophisticated money managers and hedge funds. I think you've seen me refer to this as "the protection trade," for which call options on the CBOE Volatility Index (VIX) were the "weapon of choice" and whose objective was to protect against a crash in the stock market by betting on the sharp increases in volatility that so often accompany market plunges.

Not only did those who stick to this "hedging strategy" experience no market crashes, but market volatility -- with a few interruptions here and there -- proceeded to decline inexorably, thus causing the expiration of their various VIX call options to become a monthly rendezvous with death. And while open interest on the VIX call options is still huge (and some open interest records were set this year), VIX call volume appears to be drying up, as has the new money for this trade best described as "a solution looking for a problem."

Presumably, those managers who have now been deprived of their "VIX toys" and who were truly "bears disguised as fully invested bulls" have been expressing this view the "old fashioned way" -- by cutting back on their market exposure. And this activity has, I am sure, contributed to the supply every decent rally in the making has encountered in 2014.

But I believe the real knockout punch has yet to be delivered to those hedge fund-type bears who had decided to become "pretend bulls" by taking positions in "VIX hedges" until too much cash had been incinerated for almost anyone's constitution. The first blow came from volatility that refused to "pop." The final blow to those who can barely tolerate long positions in the market will come from a stock market that refuses to suffer a decent pullback -- until their opportunity cost for being under-invested will top even the money that was incinerated on VIX calls. And, yes, it will be at that point of maximum pain that it will, in fact, truly become time to consider "hedging volatility."


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  • Founder and CEO of Schaeffer’s Investment Research, Inc. and Senior Editor of the Option Advisor newsletter since 1981
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