Setting a Gold Stock ‘Volatility Time Bomb’

Let’s start with a simple question: Do you have $110 bucks you are willing to use to speculate in gold stocks for the next 13 months?

If you answered “No”, thanks for checking in and please come back soon.  If you answered “Yes” (or at least “well, maybe”) then a brief lesson is the first order of business.

(Disclaimer: What follows is not intended to be a specific trade recommendation but rather an example of “one way to play a particular situation)

The Implications of Volatility

Figure 1 displays 1000 days of price data for ticker GDX with the “implied volatility” for 90+ day GDX options overlaid.1Figure 1 – GDX price with 90-day option implied volatility (Courtesy www.OptionsAnalysis.com)

If we asked 100 traders to state where they though GDX price was headed in the year ahead chances are we would get a lot of different answers. On the other hand if we asked 100 traders whether IV on GDX options is “high” or “low” my guess is that at least 99 of them would say “low”. And therein lies a potential opportunity.

Here is another rhetorical question: “Do you think there is a possibility that GDX IV will rise sometime in the next 13 months?”  If you think “Yes”, or at least “well, maybe”, that’s where the $110 bucks comes into play.

But first, let’s finish the lesson:

*The price for an out-of-the-money option is comprised of “intrinsic value” and “extrinsic value” (heretofore referred to as “time premium”.

*Out-of-the-money options are comprised solely of “time premium”.

*Time premium is the amount of money an option writer demands from the option buyer in order to induce the writer to assume the risk of writing the option in the first place.  Think of it as the premium an insurance company charges to induce them to write a policy.

*IMPORTANT: Low implied volatility = low time premium (i.e., options are “cheap” and strategies that buy premium and/or benefit from a subsequent rise in IV are favored).

*Longer-term options have more time premium built into their price than shorter-term options, thus changes in IV will move longer-term option prices much more than changes in IV will move shorter-term options.

*A calendar spread involves buying a longer-term option and selling a shorter-term option.  It benefits from, a) the passage of time and/or, b) a subsequent increase in implied volatility

A “Far Out” Strategy

Consider the following trade:

*Buy 1 Jan2020 GDX 34 call @ $1.07

*Sell 1 Jan2019 GDX 36 call @ $0.24

*Buy 1 Jan2020 GDX 12 put @ $0.27

Figure 2 displays the particulars and Figure 3 the initial risk curves

2Figure 2 – GDX trade particulars (Courtesy www.OptionsAnalysis.com)

3Figure 3 – GDX risk curves (Courtesy www.OptionsAnalysis.com)

At first blush it appears that this trade is simply a speculative bet that GDX will make a large price move in one direction or the other sometime between now and January 2019 (400 days from now). But what we are really betting on here is volatility. Look at Figure 4.

4aFigure 4 – GDX IV tends to”spike” (Courtesy www.OptionsAnalysis.com)

There were 2 big ”spikes” in IV in recent years – one saw IV rise 64% and the other IV rise 123%.  Also, not shown in Figure 4 are two other spikes in 2012 and 2013 of 52% and 73%, respectively.  So what we’re really betting on here is another spike of that variety sometime in the next 13 months. The average of these four previous “spikes” was 78%.  In other words, IV on GDX options bottomed out and then increased on average by 78%.

So what would happen to our example trade if GDX IV rose 78% from current levels?  In Figure 5 we are going to change the “IV Multiplier” in order to increase the IV for all GDX options by 78%.

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Figure 5 – Changing the IV Multiplier to see effect of higher IV (Courtesy www.OptionsAnalysis.com)

The results?  See Figures 6 and 76Figure 6 – GDX trade particulars if IV rises 78% (Courtesy www.OptionsAnalysis.com)

7Figure 7 – GDX risk curves if IV rises 78% (Courtesy www.OptionsAnalysis.com)

As you can see, a big spike in GDX IV anytime in the next 400 days would have a very positive impact on this hypothetical trade.

Summary

Option prices can fluctuate from “cheap” to “expensive”.  And vice versa. With IV on GDX currently at an all-time low, these options are “cheap.”  I am in no way suggesting that the trade highlighted herein represents “a good idea.”  The example trade detailed herein is simply an example of one way to set a “Volatility Time Bomb” for a very low dollar risk.

If GDX continues to meander and/or IV never picks up over the course of the next 13 months then this trade may lose $110.  However, if GDX moves significantly, and/or if IV “spikes” from current levels, this trade trade can make a great deal more.

I am not suggesting that either of these things will happen,I am simply illustrating “one way to play.”

In terms of real world trading realistic expectations are in order.  There is every chance that nothing much of anything will happen soon. GDX price may continue to drift sideways and IV may continue to drift lower.  And this trade will lose a little due to time decay every single day.  Also, if and when IV does spike it may all happen very quickly and the time window to take profit may be short.

Bottom line: This type of “oddball” trade  may be little psychological gratification along the way.  Prepare accordingly.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

 

A Useful Inflation Indicator (and a Decent Bond Market Model)

There are plenty of things available for people to worry about these days. I won’t even begin to list them out as they are too numerous to really mention. Interestingly though, one thing that I hear very few people being concerned about these days is inflation.  Anyone who still bears the emotional scars of the high inflation of the late 70’s and early 80’s (“Hi, my name is Jay”) may be somewhat wary still. But for just about everyone else, inflation concerns are nowhere on the radar.

Now typically this is where the author pivots to the “Aha, you fools” argument and begins to list all of the reasons that inflation is “just around the corner” and all of the “inevitable” impending devastating effects. Alas, I don’t really have enough ammunition to make any kind of argument along those lines. At the moment inflation is pretty tame and my crystal ball that I would normally use to peer into the future broke a long time ago (unfortunately I continued to stare into the damn thing long before I realized it didn’t actually work, but I digress).

Still, it never hurts to “be prepared”. So here goes.  “TIPS” stands for “Treasury Inflation Protected Securities” (some marketing guy or gal somewhere must have gotten a decent bonus for coming up with that one).  If you want to know all about them I suggest Google. For our purposes just know that the interest rate paid on a TIPS bond can fluctuate higher if inflation rises – i.e., they offer some protection from higher interest rates that regular bonds do not.  TIP is an ETF that tracks an index of TIPS securities.

Ticker TLT tracks the standard 20+ year treasury bond. This bond has the most direct exposure to interest rate, i.e., if long-term rates go down a lot these bonds can go up a lot in price and if long-term rate go up  a lot these bonds can down a lot in price.

Figure 1 displays ticker TIP on the top and ticker TLT on the bottom. Note that sometimes they move together, sometimes they move apart and note also that TLT is almost always more volatile that ticker TIP.1Figure 1 – Ticker TIP divided by ticker TLT (daily, 12/5/2003-12/13/2017)

Figure 2 tracks the ratio of TIP divided by TLT from 12/5/2003 through 12/13/2017 along with the 2500-day exponential moving average.2Figure 2 – TIP/TLT Ratio with 2500-day exponential moving average (daily, 12/5/2003-12/13/2017)

The bottom line: If the ratio is trending lower and is below the 2500-day EMA then inflation fears are low and vice versa.  As you can see the ratio and the trend line are generally trending lower.  This suggests that perhaps people are right not to be too concerned about inflation at the moment.

A couple things to keep in mind:

*This by itself is not a “trading” indicator, only a “perspective” indicator. As long as the ratio is below the moving average there is probably not a big need to worry about “hedging your investments” against inflation.

*Once that changes though, the dangers of potential inflation should at least be considered.

As a Bond Market Indicator

As it turns out this indicator can be used to trade in the bond market – although the method is somewhat counter intuitive. Still, because I am only pointing out the possibilities and NOT recommending that you actually use it to trade bonds, here goes:

*Figure 3 displays the TIP/TLT ratio with 3 exponential moving averages (using daily data). They are the 10-day EMA, the 1200–day EMA and the 2500-day EMA (daily, 12/5/2003-12/13/2017).3aFigure 3 – TIP/TLT Ratio with 10-day, 1200-day and 2500-day exponential moving averages (daily, 12/5/2003-12/13/2017)

Our Test Bond Model works like this:

*If the 10-day EMA is below the 1200-day EMA then we add +1 point

*If the 1200-day EMA is below the 2500-day EMA then we add +1 point

*So for any given day our Test Bond Model can read 0, +1 or +2.

Figure 4 displays the growth of $1,000 since 2003 generated by holding ticker TLT depending on whether our Test Bond Model reads +2 (blue line) OR less than +2 (red line).  As you can see, the long-term bonds did pretty well when the Model was less than +2 and have been pretty choppy when the Model is at +2.

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Figure 4 – Growth if $1,000 invested in ticker TLT when Test Bond Model < +2 (red line) versus growth of $1,000 invested in ticker TLT when Test Bond Model = +2 (daily, 12/5/2003-12/13/2017)

For the record:

*$1,000 invested in TLT ONLY when our Test Bond Model is less than +2 grew to $1,764, or a gain of +76%

*$1,000 invested in TLT ONLY when our Test Bond Model is equal to +2 declined to $841, or a loss of (-16%)

Despite these apparently useful results, no one should start trading long-term bonds using this simple method without doing so serious research on their own.

Summary

At the moment, scant fear of inflation seems reasonable based on the continued lower to sideways trend of the TIP/TLT ratio.  Likewise, the Test Bond Model is firmly planted at +2 so no position in TLT would be held based on this experimental model.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

Bitcoin May Rise Another 20-fold, But First….

First off, for the record I am an “Old Dog” and Bitcoin is a “New Trick”. That creates a problem right there.  The truth is also that can’t honestly say that I fully understand what Bitcoin actually is or how it actually works (which technically means I am in pretty good company with a lot of people who are actually trading it, but I digress).  And as a “grizzled veteran” (of the markets) there is a part of me that instinctively wants to dismissively shout “bubble” and sneeringly walk away.  It’s not like it hasn’t been seen before – tulip bulbs, the Nifty 50, silver, technology/dot.com stocks, interest only mortgages and so on.

Most of you know the drill:

*Some form of “investment” catches lightning in a bottle

*The investment world (for lack of a more professional phrase) “wet’s itself”

*Price soars beyond all rational levels

You know, sort of like what you see in Figure 1…

BitcoinFigure 1 – Bitcoin price (Bitcoin.com)

…And then it all ultimately plummets painfully to earth.

Well, at least temporarily. I mean sure tulip bubbles never ascended the heights again, but a lot of the Nifty 50 went on to still be major companies even after their stock cratered.  The same for a lot of the major dot.com era companies.  Silver is still trading as a serious commodity and real estate seems to have rebounded.

In sum: Is Bitcoin forming a price “bubble”? It’s hard to look at Figure 1 and not think so.  Of course, even if it is the questions no one can answer for sure are “When” and “from what level”?

The other question is “if it is a bubble and the bubble bursts, will crypto currencies go the way of tulip bulbs (as an investment) or is there a future for them in the long run?”

A Recent Bubble History Lesson

In the late 90’s into 2000 a bubble formed in tech stocks. And the bubble burst and it was ugly. And many “hot” companies folded and vanished. But not all of them and certainly not the major players.  And certainly not the industry as a whole.  Like I said before I don’t truly understand Bitcoin and crypto currencies. So I can’t say for sure if they are a “craze” – like tulip bulbs in the 1600’s during “Tulipmania” or something more viable and sustainable – like technology stocks.  To understand why this distinction matters, consider the stocks listed in Figure 2.aFigure 2 – Dot.com bubble stocks that survived and thrived

As you can see in Figure 2 through 7 each of these stocks experienced a “bubble” and a “crash”.  Interestingly, the companies themselves ultimately rebounded and thrived.

The average “crash” was -87% and the average post-crash advance (so far) is about 16,000%.aaplFigure 3 – Apple (Courtesy AIQ TradingExpert)

amznFigure 4 – Amazon (Courtesy AIQ TradingExpert)

msftFigure 5 – Microsoft (Courtesy AIQ TradingExpert)

nvdaFigure 6 – Nvidia (Courtesy AIQ TradingExpert)

pclnFigure 7 – Priceline (Courtesy AIQ TradingExpert)

Summary

The only thing we can say for sure is that some people will make a great deal of money from Bitcoin/crypto currencies and others will likely get wiped out.  The danger is obvious: whenever you have a lot of investors “chasing” something – especially something that many of them don’t even understand – it is a recipe for trouble.

That being said, in my (market addled) mind the real “long-term” question is, will crypto currencies still be “a thing” after the bottom falls out?  If Bitcoin is a bubble, then if history is a guide we can look or a decline in price somewhere in the 80% to 99% range after the top is ultimately made.

From there, if history is also a guide then depending on whether or not crypto currencies prove to be a viable thing, we can expect them to either:

a) Vanish altogether

OR

b) Rise 15-20 fold from the bottom

So here is my Bitcoin/crypto currency investing guide:

*It is OK to pile in and buy Bitcoin in hopes of getting rich (as long as you do not “bet the ranch”, invest only a small portion of your capital and acknowledge that a 100% loss is absolutely a possibility and that you are willing and able to accept that risk).

*It is also OK to sneer and shout “bubble” and not invest.  But if and when the bottom drops out and prices crater remember to peruse the wreckage.  There just might be an opportunity there (remember, Priceline lost -99% when the dot.com bubble burst, then gained 32,000%).

In any event, hold on tight people, this is NOT going to be a smooth ride.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

No, Value Investing is NOT Dead

Since I started in this business (back during the “Hair Era” in my life) certain debates are ongoing.  Large-cap versus small-cap, growth versus value, stocks versus bonds and so on.  And one of my pet peeves is when people starting pronouncing that “we have a winner” in one of the comparisons.

The latest incarnation is a spate of “Value Investing is Dead” themed articles and reports that I seem to be seeing a lot these days.  Rubbish.

Don’t get me wrong, I am not a died-on-the-wool “value guy”.  It makes no difference to me whether growth is outperforming value at the moment or vice-versa. But what is most important is to recognize that there is an ongoing ebb and flow between the two disciplines.

The Ebb and Flow of Growth versus Value

For our purposes we will use total monthly return data for the MSCI US Prime Market Growth Index versus the MSCI US Prime Market Value Index.  The relative performance of growth versus value since 1992 appears in Figure 1.

When the line in Figure 1 is rising it means that growth is outperforming value and vice versa.1Figure 1 – Relative Strength: Growth Index vs. Value Index; 1992-2017

What do we notice about this chart? Two things come to mind:

1. The line fluctuates.  Sometime is goes up (i.e., growth leads) and sometimes it goes down (i.e., value leads)

2. The line has been trending higher of late (i.e., growth has been outperforming value)

When you see an article purporting that “value investing is dead” what it means is that you are supposed to believe that the line in Figure 1 will trend higher from now on in perpetuity and will never turn down again (i.e., growth investing has vanquished value investing once and for all).

Maybe you believe that, but I don’t.  Like ying follows yang, some day momentum will shift and value will perform relatively better than growth. Of course, the one thing I can’t say is when this shift will happen.  But to think that such a shift will never happen is folly.

Figure 2 displays the same ratio (Growth vs. Value) shown in Figure 1 with a 16-month exponential moving average and a 60-month exponential moving average overlaid.2Figure 2 – Growth/Value Ratio with 16-month and 60-month exponential moving averages

For argument’s sake we will posit that when the 16-month EMA is above the 60-month EMA then growth is leading value and vice versa.

Figure 3 displays:

*The growth of $1,000 split between Growth and Index (red line)

*The growth of $1,000 invested in Growth when the 16-mo EMA in Figure 2 is above the 60-mo EMA, and invested in Value when the 16-mo EMA is below the 60-mo EMA (blue line).3Figure 3 – Growth of $1,000 invested using 16-month/60-month EMA crossovers (blue) versus buying and holding both indexes (red); 1992-2017

Figure 4 displays some comparative results using the simple switching method described above versus splitting money between the two indexes.4

Figure 4 – Comparative Results

Summary

This 16/60 method is not presented as a recommended strategy.  It is presented simply to illustrate that the there is an ongoing “struggle” between growth and value and that no permanent “winner” will likely ever be declared.

Don’t believe for a minute that value investing is “Dead”.  At the same time, don’t ever believe that growth investing is dead.  The stock market is like the tide – sometimes the waves come in and sometimes the waves go out.  Sometimes waves get so large – or the sea gets so calm – that one can’t imagine it being any different than it is right at the moment.

Those thoughts are always wrong.  Prepare instead for the next wave, whenever that may come.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

 

The Four Stages of Santa

Much has been written about the Santa Claus Rally (for instance here).  But even this period often has its own “personality”.  So let’s take a closer look.

The Periods

There are four “Periods” to the Santa Claus Rally.  Specifically:

Period 1: The last 6 trading days of November

Period 2: The 1st 6 trading days of December

Period 3: December trading days #7 through #11

Period 4: December trading day #12 through the end of the month

For our test we will use daily price data for the Dow Jones Industrials Average starting on 12/31/1933 and look at each period separately and together.

Figure 1 displays the growth of $1,000 invested in the Dow only during each of the four Periods listed above.1Figure 1 – Growth of $1,000 invested in the Dow during each pas o the Santa Claus Rally Periods 1, 2, 3 and 4;1934-2016

*Period 1 (Blue) was choppy into 1950 and has been mostly trending higher ever since.

*Period 2 (Red) had a down swing from 1974 through 1985 but mostly higher the rest of the time.

*Period 3 (Green) has some upswings here and there but has been underwater since the very beginning.  This is the weakest of the four periods.

*Period 4 (Purple) has been the strongest of the four periods and has tripled in value since 1933.

The “Bullish” Periods

Since Period 3 has been consistently underwater since the beginning let’s designate Periods 1, 2 and 4 as “Bullish”.

Figure 2 displays the growth of $1,000 invested only during Periods 1, 2 and 4 each year since 1934 – including so far in 2017 (in other words, we are in the market for the last 7 days of November, the first 6 days of December and during December trading day 12 through the end of the year, and out of the Dow during December trading days #7 through 11).3Figure 2 – Growth of $1,000 invested in Dow Jones Industrials Average ONLY during Favorable Periods 1, 2 and 4 of the Santa Claus Rally; 12/31/1933-12/6/2017

Figure 3 displays some comparative numbers for each of the individual periods and the combined bullish periods.2

Figure 3 – Facts and Figures; 1934-2016

Summary

In 2017, Period 1 ended on 11/30/17 with a gain of +2.9% for the Dow.  As this is written there are two days left in Period 2. At this point Period 2 is showing the Dow down -0.38%. So combined these two are showing a net gain of +2.5%.

Will the Dow rebound during Period 2? Will Period 3 show a loss? Will Period 4 show a gain thus locking in another Favorable Periods 1, 2 and 4 Santa Claus gain?

Stay tuned.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

December Sectors

Some days are better than others.  Some months are better than others. And some sectors are better in certain months than other sectors – typically.  But not always, of course.  And there’s the rub. There are never any sure things when it comes the financial markets.  Still, in the end, a lot of investment success revolves around playing the tendencies.

Five Sectors for December

For our purposes we will use Fidelity Select sector funds for our analysis. There are alternatives however, including Rydex, Profunds, Direxion and myriad ETFs.

The list below highlights 5 Fidelity sector funds for December (and a highly correlated ETF as an alternative):

FSCGX – Industrial Equipment (VIS – Vanguard Industrial VIPER)

FSHOX – Housing and Construction (XHB – SPDR Hone Builders)

FSLEX – Leisure (IYJ – iShares Dow Jones US Industrial)

FSMEX – Medical Equipment (IHI – iShares Dow Jones US Medical Dev.)

FRESX – Real Estate (VNQ – Vanguard REIT)

For our test we will hold 20% in each of the 5 funds listed above only during the month of December starting in 1998.  We will also compare the results to buying and holding the S&P 500 Index only during the month of December.

Figure 1 display the growth of $1,000 invested in our 5 Sectors versus SPX during the month of December.1Figure 1 – Growth of $1,000 invested during December in Sector 5 funds versus; 1998-2016

Figure 2 displays some comparative results.

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Figure 2 – Comparative Figures: Sector 5 versus SPX in December; 1998-2016

Figure 3 displays the year-by-year results during the month of December.

Year Sector5 SPX Difference
1998 5.3 5.8 (0.5)
1999 6.9 5.9 1.0
2000 9.0 0.5 8.5
2001 4.8 0.9 3.9
2002 (2.2) (5.9) 3.6
2003 3.5 5.2 (1.7)
2004 5.5 3.4 2.1
2005 0.4 0.0 0.4
2006 0.4 1.4 (1.0)
2007 (0.9) (0.7) (0.2)
2008 8.0 1.1 6.9
2009 4.9 1.9 3.0
2010 8.5 6.7 1.8
2011 0.8 1.0 (0.3)
2012 2.6 0.9 1.6
2013 2.9 2.5 0.3
2014 0.8 (0.3) 1.1
2015 (1.2) (1.6) 0.4
2016 2.1 2.0 0.1

Figure 3 – Year-by-Year; December Only

Summary

Are the 5 sectors highlighted above guaranteed to make money and/or outperform the S&P 500 Index in December of 2017?  Nope.  But history suggests that they are not a bad place to look for opportunities to outperform.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

 

The Critical Impact of Volatility

Many option traders spend a lot of time focusing on volatility.  And rightly so. There is the volatility of the underlying security itself and there is the “implied volatility” of the options on that security. It can make a big difference to know when volatility “goes to extremes”.  Let’s illustrate this with an example.

(See also The Critical Importance of Understanding Risk (and Risk Control))

Ticker JNUG

Ticker JNUG is the Direxion Junior Gold Miners Bull 3x ETF. It tracks the MVIS Global Junior Gold Miners Index of gold mining stocks using leverage of 3-to-1.  In other words, if the index rises 1% today then JNUG should rise 3%. Our starting point is a double calendar spread involving the following positions:

*Buy 1 Jun 2018 JNUG 15 call @ 3.65

*Buy 1 Jun 2018 JNUG 20 call @ 2.41

*Sell 1 Jan 2018 JNUG 15 call @ 1.43

*Sell 1 Jan 2018 JNUG 20 call @ 0.36

IMPORTANT: As always, this position is an “example” and NOT a “recommendation.”

The initial particulars and risk curves are displayed in Figures 1 and 2.1Figure 1 – JNUG Double Calendar Spread (Courtesy www.OptionsAnalysis.com)2Figure 2 – JNUG Double Calendar Spread risk curves (Courtesy www.OptionsAnalysis.com)

Note that as initially configured the trade will show a profit if JNUG is anywhere between $13.80 and $25.08 at January option expiration on 1/19/2018.  In Figure 2 this range looks pretty wide.  However, when you look at it on wider price chart as in Figure 3, suddenly the profit range does not look quite so wide. But the real driving force behind this trade is implied volatility.3Figure 3 – JNUG (Courtesy ProfitSource by HUBB)

Implied Volatility on JNUG Options

Figure 4 displays 500 trading days of data for ticker JNUG along with the average implied volatility for 90+ day options on JNUG.4Figure 4 – JNUG price and Implied Volatility for 90+ day options (black line) (Courtesy www.OptionsAnalysis.com)

Note that IV is at the extreme low end of the range. The big question is “where to from here”. We already saw in Figure 2 what will happen if IV remains unchanged.  But what if IV continues to collapse?  And what if it spikes higher instead?

The Impact of a Decrease in Implied Volatility

Let’s assume that between now and January option expiration, IV falls another 30% from current levels.  This is probably unlikely but is useful in illustrating the effect of changes in implied volatility. Because longer term options are much more sensitive to changes in volatility (because longer term options have more time premium built into them) the June options will lose more value than the January options resulting in the risk curves you see in Figure 5.5Figure 5 – If IV collapses 30% from current level profit potential disintegrates (Courtesy www.OptionsAnalysis.com)

MAKE THIS IMPORTANT MENTAL NOTE: If you enter a calendar spread and volatility subsequently declines, your potential to make money will be severely – and negatively – impacted.

The Impact of an Increase in Implied Volatility

Now let’s look at what would happen if IV reverses course and “spikes” 30% higher from current levels.  The risk curves for this scenario appear in Figure 6.6Figure 6 – If IV spikes 30% from current levels profit potential rises and profit range expands significantly (Courtesy www.OptionsAnalysis.com)

Note that if JNUG IV increased by 30%, the “profit range” for this trade would expand greatly – to $12.12 a share on the downside and $31.69 a share to the upside.

Summary

As always, it is important to emphasize that I am not “recommending” this trade.  It is presented solely as an example to highlight the potentially large implications of changes in implied volatility when utilizing certain strategies.

What we have seen here is that a calendar spread:

*Is best entered when IV is already low

*Will suffer if IV subsequently declines

*Will benefit if IV subsequently rises

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

 

The Critical Importance of Understanding Risk (and Risk Control)

Well Good News and Bad News.  The Good News is that in this article I suggested that things were “too quiet” in the silver market and that a sharp move in price was likely forthcoming – and I nailed it to the day!  The Bad News is that in the example trade I included I got direction EXACTLY WRONG!

Since I offer only “examples” here and not “recommendations” I don’t feel too bad (although I still do marvel at times at the ability of Murphy’s Law to make me look like an idiot).  On the brighter side, this turn of events does offer the opportunity to highlight the importance of risk control and the potential benefits of trading options.

To wit:

Had one bought a March 2018 Silver futures contract, he or she would be sitting with an open loss of -$2,725 per contract as displayed in Figure 1.

7Figure 1 – Buying Mar2018 Silver futures show a big loss in just 2 days (Courtesy ProfitSource by HUBB)

On the other hand, had a trader instead entered into the call backspread position using options on ticker SLV (as highlighted in the original article), he or she would be sitting on an open loss of only -$100 as displayed in Figure 2.8Figure 2 – SLV call backspread; a lousy start but hardly catastrophic (Courtesy www.OptionsAnalysis.com)

In addition, the holder of the option position would still have unlimited profit potential on the upside and limited risk on the downside.

Which brings us to…

Jay’s Trading Maxim #22: Sometimes it’s not how much you make when things go right as it is how much you don’t lose when things go wrong.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

 

All (Too) Quiet on the Silver Front

The setup is as old as the markets themselves.  The price for a given security – be it a stock, an index, a commodity, whatever – moves sideways, first in a fairly wide range and then narrowing more and more into a tighter range. If options are traded on that security, typically implied volatility for those options declines to a very low level.  Then, just when it seems that that security will never stop drifting sideways the breakout comes.

In many cases – though most certainly not in all – the price move following the breakout can be surprisingly large.  These situations offer traders some potentially spectacular profit potential.

How to play these situations is a whole other topic.

Anticipation versus Reaction

Some traders will wait for a breakout and then “react” by trading in the direction of the breakout – long for an upside breakout or short for a downside breakout.  The disadvantage here is that:

1) In many cases you may miss a significant price move before getting in, and/or;

2) Occasional false breakouts are a fact of trading life and can lead to quick whipsaws and a need to act cut your loss quickly (and in all candor, painfully).

Anticipating a breakout can lead to large profits. The catch is that one typically needs to pick the right direction in order to profit. This disadvantage may at times be mitigated via the use of options.  Let’s consider a current example – the silver market.

Silver Futures and ETF Ticker SLV

As you can see in Figure 1 – which displays the front month in silver futures going back to the 1970’s – silver has a long history of “contracting” and then “expanding”.1Figure 1 – Monthly Silver Futures – a History of Contraction and Expansion (Courtesy ProfitSource by HUBB)

Ticker SLV is an ETF that tracks the price of silver futures. Figure 2 displays a weekly chart for ticker SLV.  You see the same type of “contraction” and “expansion” – including a significant contraction unfolding in the latest fortnight.2Figure 2 – Ticker SLV Weekly Chart (Courtesy AIQ TradingExpert)

So where to from here?  Will SLV ultimately break lower or higher?  I have to go with my usual answer of – “it beats me.”  Still, for what it is worth, in Figure 3 we see that the weekly and daily Elliott Wave counts (generated using an objective algorithm built into  ProfitSource by HUBB software) for ticker SLV are both suggesting that a move to the upside may be in the offing.  The weekly chart in the top clip of Figure 3 suggests that a weekly 5 wave down pattern may have been completed (which in “Elliott Speak” suggests that a 5 wave up pattern should follow next).  The daily chart in the bottom clip suggests that we may already be in a daily Wave 4 buy for SLV.4Figure 3 – Weekly and Daily Elliott Wave counts for ticker SLV (Courtesy ProfitSource by HUBB)

So for now we will lean towards playing the upside – with an eye on mitigating downside risk as much as possible.

Implied Option Volatility is Low

In Figure 4 we see 1000 days of SLV price and implied volatility data.  Clearly implied volatility is presently trading at the low end of its historical range.3Figure 4 – Implied volatility for SLV options at the low end of the historical range (Courtesy www.OptionsAnalysis.com)

Why does this matter?  Two reasons:

1) It tells us that the amount of time premium built into the price of SLV options is presently very low on a historical basis – i.e., SLV options are “cheap”, so “buying premium” offers a possible “edge”.

2) We might be able to enter a position whose reward/risk ratio can actually improve after the position is entered – if implied volatility rises after we enter the trade.

An Example Trade

Given everything we have seen so far:

*The propensity for silver to contract over a period of weeks or months and then move sharply in price over a subsequent period of weeks or months

*The current “contracting” status of ticker SLV

*The fact that weekly and daily Elliott Wave counts appear to be pointing to the upside

*The current low level of implied volatility for SLV options

Let’s consider a position that might allow us to take advantage if things play out properly – without assuming tons of risk.

Our example trade involves:

*Selling 1 SLV June 2018 11 call @ 5.25

*Buying 5 SLV June 2018 16 calls @ 1.11

This strategy is referred to as a “Call Backspread”.  In essence we are selling 1 in-the-money call option and using the proceeds ($525) to pay for (most of) our 16 strike price calls (cost = 1.11 x 100 x 5 = $555).

5Figure 5 – SLV backspread particulars (Courtesy www.OptionsAnalysis.com)

6Figure 6 – SLV backspread risk curves (Courtesy www.OptionsAnalysis.com)

Why this trade?  With the caveat that no implication is being made that this is the “best” trade firmly in mind, this trade is highlighted because:

*There are 200 days left until expiration – so there is plenty of time for “something to happen” with the price of SLV.

*The maximum risk (and the cost to enter the position) is $530.  However, this maximum loss would only occur if we were still holding this position on 6/29/2018 AND SLV closed at on that day at exactly $16 a share.

*Also, longer term options are more sensitive to changes in implied volatility.  So if implied volatility for SLV options does move higher in the months ahead that will serve to inflate the return on this trade (NOTE: in the upper right hand of Figure 4 we see that this position has a “Vega” of $22.84.  What this means is that if implied volatility rises 1 percentage point then this trade will gain $22.84 based solely on a change in volatility.  Our hope is to get higher SLV prices AND higher implied option volatility).

As you can see in Figure 6:

*This position has unlimited profit potential if in fact SLV does break out to the upside.

*If we are exactly wrong and SLV breaks to the downside our loss actually shrinks the further SLV falls.

*Our worst case scenario is if SLV remains unchanged between now and June 2018 option expiration.  This is OK because the impetus for the trade in the first place is the belief that SLV is setting up for a breakout somewhere in the months ahead – so we are in essence deeming “remaining unchanged” as our least likely scenario.

Summary

Is the SLV trade highlighted herein “guaranteed” to generate a profit.  Absolutely not!  In fact, we can’t even say that a profit is likely.  In the end, this particular position is nothing more than a speculative bet on higher prices (and possibly higher volatility) for SLV.

The bottom line: If SLV fails to move to the upside this trade will lose money.

But please remember that I am NOT “recommending” this trade.  It is simply an example. of one way to play a given set of circumstances.  What is important is to consider the thought process behind choosing this particular position.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.

 

The 40-Week Cycle (Begin Again)

There are some things that can logically be explained.  And there are some things that cannot.  Welcome to the latter.

I first stumbled upon something known as the “40-Week Cycle” in the stock market sometime in the 1990’s. In all candor, I don’t even remember where I first read about it. And it is by known means “magical” or a panacea of the “you can’t lose in trading” variety.  But it is interesting.  And the latest “Bullish Phase” began at the close on 11/24/2017.

The 40-Week Cycle “System” Rules

*A new 40-week cycle begins every 280 calendar days with an original start date of 4/21/1967 (don’t ask me why that date, ask the guy who I can’t remember who wrote about it first).

*The 1st 140 calendar days of the cycle are considered “Bullish”

*The 2nd 140 calendar days of the cycle are considered “Something Other Than Bullish”

*The Bullish phase of the cycle ends after 140 calendar days OR after the Dow Jones Industrials Average suffers a decline of 12% or more in price from its price on the entry date (this has been triggered twice – in 1974 and in 2008)

*For “System” purposes the “System” holds the Dow Jones Industrials Average during “Bullish” periods and earns annualized rate on interest of 1% when not in the market.

FYI: The latest Bullish phse began at the close on 11.24.2017 and extednds through 4/13/2018 (or until the Dow closes below 20,731.03 if that occurs prior to 4/13/2018).

The Results

*$1,000 invested only during the “Bullish” phase as described above starting on 4/21/1967 grew to $42,301 through 11/24/2017

*$1,000 invested in the Dow Jones Industrials Average on a buy-and-hold basis starting on 4/21/1967 grew to $26,674 through 11/24/2017

$1,000 invested in the Dow Jones Industrials Average only during the “Other Than Bullish” phase starting on 4/21/1967 declined to $817

Figure 1 displays the “System” versus “Buy-and-Hold”.1Figure 1 – Growth of $1,000 invested using the 40-Week Cycle System (blue) versus Buy-and-Hold (red); 4/21/1967-11/24/2017

Figure 2 displays the growth of $1,000 only during the “Other Than Bullish” phase.  There is not a lot of rhyme or reason to the results during this phase – sometimes great, sometimes terrible, sometime in between.  Still, the bottom line is that the results are far worse than that generated during the “Bullish” phase.2Figure 2 –  – Growth of $1,000 invested in the Dow Jones Industrials Average only during the “Other Than Bullish” phase; 4/21/1967-11/24/2017

Figure 3 displays some summary results comparing the “Bullish” phase to the “Other Than Bullish” phase.

Measure Bullish Phase “Other” Phase
Average% +5.8% +0.2%
Median% +4.3% +0.9%
Std. Deviation% 9.3% 10.4%
Average%/Std Dev% 0.63 0.02
Maximum Gain % +42.0% +23.8%
Maximum Loss % (-13.2%) (-27.8%)
# Times UP 50 (76%) 36 (55%)
# Times Down 16 (24%) 30 (45%)

Figure 3 – “Bullish” phase versus “Other” phase

Figure 4 displays the period-by-period results

Start Bull End Bull Start Next Cycle DJIA Start Bull DJIA End Bull DJIA Start Next Cycle Bull% Other%
4/21/1967 9/8/1967 1/26/1968 883.18 907.54 865.06 2.8 (4.7)
1/26/1968 6/14/1998 11/1/1968 865.06 913.62 948.41 5.6 3.8
11/1/1968 3/21/1969 8/8/1969 948.41 920.00 824.46 (3.0) (10.4)
8/8/1969 12/26/1969 5/15/1970 824.46 797.65 702.22 (3.3) (12.0)
5/15/1970 10/2/1970 2/19/1971 702.22 766.16 878.56 9.1 14.7
2/19/1971 7/9/1971 11/26/1971 878.56 901.80 816.59 2.6 (9.4)
11/26/1971 4/14/1972 9/1/1972 816.59 967.72 970.05 18.5 0.2
9/1/1972 1/19/1973 6/8/1973 970.05 1026.19 920.00 5.8 (10.3)
6/8/1973 10/26/1973 3/15/1974 920.00 987.06 887.83 7.3 (10.1)
3/15/1974 7/8/1974 12/20/1974 887.83 770.57 598.48 (13.2) (22.3)
12/20/1974 5/9/1975 9/26/1975 598.48 850.13 818.60 42.0 (3.7)
9/26/1975 2/13/1976 7/2/1976 818.60 958.36 999.84 17.1 4.3
7/2/1976 11/19/1976 4/7/1977 999.84 948.80 918.88 (5.1) (3.2)
4/7/1977 8/26/1977 1/13/1978 918.88 855.42 775.73 (6.9) (9.3)
1/13/1978 6/1/1978 10/20/1978 775.73 840.70 838.01 8.4 (0.3)
10/20/1978 3/9/1978 7/27/1979 838.01 842.86 839.76 0.6 (0.4)
7/27/1979 12/14/1979 5/2/1980 839.76 842.75 810.92 0.4 (3.8)
5/2/1980 9/19/1980 2/6/1981 810.92 963.74 952.30 18.8 (1.2)
2/6/1981 6/26/1981 11/13/1981 952.30 992.87 855.88 4.3 (13.8)
11/13/1981 4/2/1982 8/20/1982 855.88 838.57 869.29 (2.0) 3.7
8/20/1982 1/7/1983 5/27/1983 869.29 1076.07 1216.14 23.8 13.0
5/27/1983 10/14/1983 3/2/1984 1216.14 1263.52 1171.48 3.9 (7.3)
3/2/1984 7/20/1984 12/7/1984 1171.48 1101.37 1163.21 (6.0) 5.6
12/7/1984 4/26/1985 9/13/1985 1163.21 1275.18 1307.68 9.6 2.5
9/13/1985 1/31/1986 6/20/1986 1307.68 1570.99 1879.54 20.1 19.6
6/20/1986 11/7/1986 3/27/1987 1879.54 1886.53 2335.80 0.4 23.8
3/27/1987 8/14/1987 12/31/1987 2335.80 2685.43 1938.83 15.0 (27.8)
12/31/1987 5/20/1988 10/7/1988 1938.83 1952.59 2150.25 0.7 10.1
10/7/1988 2/24/1989 7/14/1989 2150.25 2245.54 2554.82 4.4 13.8
7/14/1989 12/1/1989 4/20/1990 2554.82 2745.65 2695.95 7.5 (1.8)
4/20/1990 9/7/1990 1/25/1991 2695.95 2619.56 2659.42 (2.8) 1.5
1/25/1991 6/14/1991 11/1/1991 2659.42 3000.50 3056.40 12.8 1.9
11/1/1991 3/20/1992 8/7/1992 3056.40 3276.40 3332.18 7.2 1.7
8/7/1992 12/24/1992 5/14/1993 3332.18 3326.20 3443.00 (0.2) 3.5
5/14/1993 10/1/1993 2/18/1994 3443.00 3581.11 3887.46 4.0 8.6
2/18/1994 7/7/1994 11/25/1994 3887.46 3688.42 3708.27 (5.1) 0.5
11/25/1994 4/13/1995 9/1/1995 3708.27 4208.18 4647.54 13.5 10.4
9/1/1995 1/19/1996 6/7/1996 4647.54 5184.68 5697.11 11.6 9.9
6/7/1996 10/26/1996 3/14/1997 5697.11 6007.02 6935.46 5.4 15.5
3/14/1997 8/1/1997 12/19/1997 6935.46 8194.04 7756.29 18.1 (5.3)
12/19/1997 5/8/1998 9/25/1998 7756.29 9055.15 8028.77 16.7 (11.3)
9/25/1998 2/12/1999 7/2/1999 8028.77 9274.89 11139.24 15.5 20.1
7/2/1999 11/22/1999 4/7/2000 11139.24 11089.52 11111.48 (0.4) 0.2
4/7/2000 8/25/2000 1/12/2001 11111.48 11192.63 10525.38 0.7 (6.0)
1/12/2001 6/1/2001 10/19/2001 10525.38 10990.41 9204.11 4.4 (16.3)
10/19/2001 3/8/2002 7/26/2002 9204.11 10572.49 8264.39 14.9 (21.8)
7/26/2002 12/13/2002 5/2/2003 8264.39 8433.71 8582.68 2.0 1.8
5/2/2003 9/19/2003 2/6/2004 8582.68 9644.82 10593.03 12.4 9.8
2/6/2004 6/25/2004 11/12/2004 10593.03 10371.84 10539.01 (2.1) 1.6
11/12/2004 4/1/2005 8/19/2005 10539.01 10404.30 10559.23 (1.3) 1.5
8/19/2005 1/6/2006 5/26/2006 10559.23 10959.31 11278.61 3.8 2.9
5/26/2006 10/13/2006 3/2/2007 11278.61 11960.51 12114.10 6.0 1.3
3/2/2007 7/20/2007 12/7/2007 12114.10 13851.08 13625.58 14.3 (1.6)
12/7/2007 4/25/2008 9/12/2008 13625.58 12891.86 11421.99 (5.4) (11.4)
9/12/2008 10/6/2008 6/19/2009 11421.99 9955.50 8539.73 (12.8) (14.2)
6/19/2009 11/6/2009 3/26/2010 8539.73 10023.43 10850.36 17.4 8.2
3/26/2010 8/13/2010 12/31/2010 10850.36 10303.15 11577.51 (5.0) 12.4
12/31/2010 5/20/2011 10/7/2011 11577.51 12512.04 11103.21 8.1 (11.3)
10/7/2011 2/24/2012 7/13/2012 11103.21 12982.95 12777.09 16.9 (1.6)
7/13/2012 11/30/2012 4/19/2013 12777.09 13025.58 14547.51 1.9 11.7
4/19/2013 9/6/2013 1/24/2014 14547.51 14922.02 15879.11 2.6 6.4
1/24/2014 6/13/2014 10/31/2014 15879.11 16775.68 17390.13 5.6 3.7
10/31/2014 3/20/2015 8/7/2015 17390.13 18127.65 17373.38 4.2 (4.2)
8/7/2015 12/25/2015 5/13/2016 17373.38 17552.17 17535.32 1.0 (0.1)
5/13/2016 9/30/2016 2/17/2017 17535.32 18308.15 20624.05 4.4 12.6
2/17/2017 7/7/2017 11/24/2017 20624.05 21414.34 23557.99 3.8 10.0
11/24/2017 4/13/2018 8/31/2018
8/31/2018 1/18/2019 6/7/2019
6/7/2019 10/25/2019 3/13/2020
3/13/2020 7/31/2020 12/18/2020
12/18/2020 5/7/2021 9/24/2021
9/24/2021 2/11/2022 7/1/2022

Figure 4 – 40-Week Cycle; 1967-2017

Summary

For better or worse, the latest “Bullish” phase began at the close on 11/24/2017 and will last through 4/13/2018. Does this mean the stock market is guaranteed to keep rising?  Not at all.  But it may be one more potentially favorable sign.

Jay Kaeppel

Disclaimer:  The data presented herein were obtained from various third-party sources.  While I believe the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.  The information, opinions and ideas expressed herein are for informational and educational purposes only and do not constitute and should not be construed as investment advice, an advertisement or offering of investment advisory services, or an offer to sell or a solicitation to buy any security.