Options Trading Insights from the Ruble Crisis, and More from the Last 24 Years

Our Senior VP of Research on options pricing pitfalls, common-sense chart analysis, and the sector he still hates

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Our senior vice president of research, Todd Salamone, reported for his first day of work at Schaeffer's Investment Research back in August 1993 -- nearly a quarter of a century ago. And as many of you may already know, Todd has been the lead author of our popular Monday Morning Outlook column, a weekly stock market forecast, for over a decade. It's a task that has changed shape over the years, thanks to the advent of tools like Twitter and StockTwits, as well as the ever-evolving landscape of technical and sentiment indicators.

As the primary editor of Monday Morning Outlook (and one of Todd's favorite coworkers for over a decade now), I've had a unique perspective on the evolution of his weekly stock market analyses. This week, we've teamed up for an exclusive Q&A to pull back the curtain on the production of this widely cited investing column. For Todd's most memorable trading lessons, his current favorite indicators, and his latest sector picks, just keep reading.

Elizabeth Harrow: You've been at Schaeffer's for some major market shocks -- the dot-com collapse, 9/11, the financial crisis, Brexit, the recent U.S. election, and many more. Is there one single trading day that stands out to you the most? Which one, and why?

Todd Salamone: It isn't a particular day, but more a particular period... 1998, during the height of the Russian ruble crisis and failure of Long-Term Capital Management (LTCM). I had been trading options for just about five years, and had never seen nor experienced anything like it. I really got a lesson, as an option buyer, on paying close attention to how much I pay for an option, because both index and equity implied volatilities were jacked up due to the uncertainty related to this crisis.

I remember buying an at-the-money option on a stock with about 30 or 60 days until expiration. The stock made an unusually large move in my favor, but I think the option experienced a gain of only 20% -- whereas such moves would normally generate a triple-digit profit. During the height of this crisis, it certainly was not an environment to buy options. The risk/reward was terrible; it was nearly impossible to make money.  Nearly 20 years has gone by since that period, but it is something that I will never forget. And that likely made me a better trader as a result, as I'm really in tune with option pricing on every trade.

I had to call you late one Friday night back in 2011 because the S&P downgrade of U.S. credit hit after you'd already submitted the Monday Morning Outlook draft for that weekend. The current geopolitical environment seems to produce new surprises at least once a week -- to what extent does this impact your weekly forecasts, if at all? (And were you disappointed that I wasn't calling just to gossip?)  

Heck yes, I was disappointed when you only called to talk shop on a Friday night! You are correct, there is a litany of "unknowns" that tend to impact the market, at least in the short term -- whether that be North Korea misbehaving, terrorist attacks, Brexit, Fed uncertainty, Putin, etc., etc. The biggest certainty I have seen in a while was the solar eclipse.

That said, we don't live in a certain world -- we never have, and hopefully we never will (how boring would that be!).  We are constantly navigating both a world of "unknown unknowns," in which unexpected and unforeseen events occur, and "known unknowns," in which a particular event is on the horizon, but the outcome is uncertain. "Unknown unknowns" (such as when, if, or where Kim Jong-Un fires another ballistic missile, or what's lurking that could unravel our economy) are risks that investors and traders always assume to take on in exchange for the possibility of higher returns. This is true now and has been since the advent of stock trading -- but in today's environment, thankfully, there are ways to manage risks (otherwise known as hedging).  

Therefore, the best I can do is deal with the "known unknowns" by assessing the sentiment and technical backdrop of the market to give readers a roadmap they can follow to make better-informed decisions. I don't pretend to have all the answers, but I think I do a pretty good job of highlighting what is important to consider in one's decision-making process. I try to do this in an objective manner that is easy to understand for those market participants who are engaged and/or eager to learn.

You frequently nail the action in the stock market each week, sometimes to a degree that's eerily accurate -- I'm thinking here of how you predicted exactly how the stock market would react to Trump's unexpected election win. But can you recall a time where stocks caught you completely off-guard?

Wow, you are being nice -- thank you for the compliment! But I have missed some things and, being human, will be on the wrong side of some moves in the future. So, to answer your question, unknowns such as the May 2010 flash crash and 9/11 really stand out. And, I've got to admit, the exact timing of the "tech wreck" that began in 2000 and the exact trough in March 2009 caught me off-guard.

For example, I remember put open interest on the PowerShares QQQ Trust (QQQ) being huge relative to call open interest as tech stocks were peaking in 2000, with the QQQ put/call open interest ratio rolling over from an extreme high around the time of the ultimate top. My rationale for staying bullish was that while the ratio was not at its high, it was still relatively high and indicative of caution. But what was really happening was that hedge funds, who were up to their eyeballs in technology stocks and using QQQ puts to hedge, were in the early stages of liquidation mode, and therefore demanding fewer puts as insurance. So, the "rollover" in the QQQ's put/call ratio was evidence that deep-pocketed players were in the early stages of unwinding a huge long position in tech. And then the March 2009 bottom caught me by surprise when the CBOE Volatility Index (VIX) failed to carve out a new high, even as stocks made multi-year lows in early March.

Fortunately, in both cases -- despite not making money off the initial peak and bottom -- I was open-minded and recovered early enough to make money during both bear and bull phases.

What's one (or what are a couple) of your current favorite sentiment indicators that the average investor might not be watching closely enough?
 
There are a few. I've used the weekly Commitments of Traders (CoT) report to observe the positioning of large speculators, particularly on VIX futures -- and, in the past few months, large speculators in the oil market, who have been extremely long (on the wrong side) of a decline in oil futures.  

Along the lines of the VIX, I've paid attention to the term structure of VIX futures, as extremes across the term structure have given decent signals. Also, I pay close attention to the open interest configuration on exchange-traded funds, such as the SPDR S&P 500 ETF Trust (SPY), specifically to gauge levels of interest in conjunction with other technical indicators and the odds of a sharp sell-off as options expiration approaches.  

Finally, historical trends in short interest are important to me. It isn't only about how much short interest, but the direction of short interest in the context of price action.  

With the major equity indexes recently hitting record highs, have you discovered any new (or newly relevant) technical indicators to inform your analysis of possible resistance/support levels?  

Great question! I think to do this, especially when trying to figure out resistance levels, you should think like a trader or investor that is looking to take profits (or at least some profits). And really, I do this in a simple, common-sense manner. I think many market participants try to make it more complex than it needs to be, and thus are constantly try to catch the proverbial tail that won't be caught.  

For example, round numbers. If multiple equity benchmarks are trading around round levels for the first time simultaneously, you are more likely at or near resistance. Investors like to take profits, and will often pick levels that are round -- such as a millennium mark on the Dow, or a century mark on the S&P 500 Index (SPX). In fact, as long-time Monday Morning Outlook readers are aware, even half-century marks on the SPX have had an uncanny way of acting as hesitation points and/or support and resistance levels. I cautioned readers about this back in June, and here we are three months later with the SPX still toying with 2,450.

I also determine resistance and support relative to closing levels after key events, such as the election or a Fed meeting, because there are traders and investors who take a "wait and see" approach around "known unknowns." So, for example, if they buy after a Fed meeting in which the Fed didn't raise rates, there could be a plan to take profits when the market is higher by 5% or 10% in the coming weeks or months. Or if they are short-term oriented, and the market sells off after a Fed meeting, these traders may be targeting breakeven, and will sell when the market approaches the Fed-day close. In fact, this occurred in the weeks following the late-July 2017 Fed meeting, as the SPX immediately sold off the day after the meeting and constantly got turned back at the late-July Fed-day close on several rally attempts in August.

Additionally, where an index is trading relative to an obvious low can be helpful in identifying resistance -- such as 10% above a recent low, or 20% above a 52-week low that occurred months ago.

Finally, some people might be happy taking profits when an index is up a certain percent above the previous year's close. In other words, sellers may be more apt to emerge when an index is up 10% for the year than 7%. 

Basically, it's human nature to work with round numbers, whether it be a round percentage gain or a round number on an index. If you can think like a majority of traders and investors, you can likely pinpoint areas of potential resistance. And I emphasize "area," as sometimes these levels are not precise.

Are there any old-favorite technical or sentiment indicators that you don't cite anymore because you've found they've lost some usefulness over the years?  

In the options market, I've found the put/call volume ratio can be deceiving, whether you're looking at an individual equity, basket of equities, ETF, or index. One reason it can be deceiving is that volume alone does not tell you if it resulted in liquidations or new open interest. In other words, you might have a high put/call volume ratio, but if put buyers were selling previously opened positions, what looks like pessimism in the ratio might be the equivalent of covering a bearish position.  Moreover, and especially as more hedge funds and institutions use options, there are more spreads and complex strategies.

But we have found that a few exchanges break the volume down by type: buy to open, sell to open, buy to close, and sell to close. Therefore, I use this data to dig into what's really going on in the options market.

We used to include bullish and bearish sector picks in Monday Morning Outlook each week. For old times' sake, what are a couple of your current faves and hates?  

Autos and auto-related (supplier) stocks have really caught my attention on the bullish side. I don't hear a lot of chatter about these stocks, but they have really been impressive in terms of price action.  And when you take a look at the components of this group, there is still some caution. For example, there are only 47% "buys" when we add up all the analyst ratings, versus 49% one year ago. The average equity has a Schaeffer's put/call open interest ratio (SOIR) that exceeds 1.0, and the average short interest ratio is 5.0.  

On the bear side, I've long been an energy bear, especially when this sector was viewed as a "slam dunk" easy-money long by experts following the OPEC production cut in November 2016. The price action in crude never validated this optimism, and there may still be too much optimism among those that haven't yet admitted that they are wrong.

What's your best options trading advice for any market environment?  

Realize that options have many uses -- speculating, hedging, or generating additional income via premium selling. Along with the multiple uses are multiple strategies -- some simple, and some more complex. Educate yourself on the strategies so you are equipped to implement them based on the environment, meaning (a) whether or not the underlying instruments you are playing options on are trending or range-bound, and (b) how options are priced.  

Remember, options can be traded successfully in ALL environments -- whether the market goes up, down, or sideways, and whether options are relatively cheap or expensive. If the environment is ripe for option buying -- cheap options with directional trends -- do more of it! If you are a buyer of options, but notice option prices are unusually high and there is not a lot of directional movement, do less option buying and/or consider other strategies, such as credit spreads.   

If you think the market or a particular stock is on the brink of a major move, but you think the odds of a move higher or lower are roughly even, seriously consider strategies such as straddles or options pairs trading. The more flexible and educated you are, the more likely you can successfully navigate any market environment and, in many instances, with less risk relative to traditional and newer trading products.

To get all of Todd's weekly dispatches on the state of the stock market -- and, most importantly, the best ways to trade it -- sign up now for a free subscription to Schaeffer's Monday Morning Outlook e-newsletter.

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