Monday, October 29, 2012

Morning Update

With hurricane Sandy bearing down on the east coast traders are trying to figure out how energy markets will be affected. One trader was positioning himself to take advantage of volatility in crude oil on Friday by buying the USO Nov. 32 straddle for 1.85. A straddle involves buying both a put and a call in the same expiration and strike. Traders buy straddles when they expect an explosive price move but are unsure of the direction. Straddles are also very sensitive to changes in implied volatility and profit when volatility increases. This spread will profit if USO is above 33.85 or below 30.15 at expiration. As of now the NYMEX will be closed to today and could be closed again tomorrow. Ahead of the storm in electronic trading crude oil is lower while gasoline and heating oil are higher. This is a result of east coast refiners in Sandy’s path shutting down, which means less demand for crude oil and less supply of gasoline and heating oil. Crude oil has fallen considerably from its highs in September, mainly on fears of a global slowdown and excess supply. USO looks like it could be headed to the 30.00 level, which is near its 2011 and 2012 lows and is likely to provide support. The bullish case for oil is that it is oversold and buying it at these levels over the past few years has been a winning strategy. For traders wanting a fixed risk way to profit from the potential for large directional swings in crude oil over the next few weeks, this is the trade for you.

Friday, October 26, 2012

Morning Update

After selling off on Apple’s earnings miss in the overnight session, the S&P 500 futures are back to unchanged on a better than expected Q3 GDP report. The top line number in the report was a 2.02% annualized Y/Y increase in GDP, which beat expectations of a 1.80% increase. However, digging into the report shows that this was driven by a much larger than expected increase in government spending which offset lower than expected personal consumption. Below is a graphic detailing the components of GDP growth over the past few years, and as you can see today’s report has the largest increase in government spending of all of them. For a government running a $1 trillion budget deficit every year we would like to see personal consumption driving the economy, not government spending.

The SPDR Gold Trust (GLD) looks poised to post a fourth down week in a row, which has prompted some option traders to begin picking a bottom. Yesterday the largest GLD trade was the sale of 20,500 Nov. 162 puts for $0.77. Selling a put allows you to pick a level you are willing to buy the stock at and collect premium while you wait for the stock to come to your entry. This option trade allows you to effectively buy GLD at 161.23, which coincides with the 200-day moving average at 161.44.

The recent sell off in gold can be attributed to moderate strength in the dollar and risk asset selling. Since the beginning of October Gold, Crude Oil, the S&P 500, and the 10-year bond are all lower while the US dollar index is higher. In the short term I would not be surprised to see gold continue to trade a bit lower. However, once the Fed’s QE-infinity has run for a few months the monetary base will be much higher and increasing inflation expectations are likely to take GLD higher. Picking a bottom in a market is always tough but for a long-term investor buying GLD around the 200-day moving average is likely to look like a brilliant trade a few years. Worldwide central bank liquidity programs mean that the fundamentals driving gold’s rally over the past few years are still very much in place; it is only a matter of time before the effects of quantitative easing are seen in the economic data and send gold higher.

Thursday, October 25, 2012

Apple Earnings Option Trade

After the close today Apple will release its much anticipated earnings. We are playing the announcement via the weekly options expiring tomorrow. Our trade it to buy the 635/645/655 call butterfly for $1.00 and also buy the 585/575/565 put butterfly for $0.75. Our net cost and maximum risk in this trade is $1.75, and we can make up to $8.25 if Apple expires at 575 or 645. On average Apple moves 6.3% after earnings, so we designed this trade to profit from another move of that magnitude and chose strikes near levels we believe Apple is likely to end up near. Our experience tells us that even if Apple only gaps up or down about 4% tomorrow morning we are likely to be able to unwind this trade for a small profit. We like the risk/reward profile of this trade see a good chance it is profitable come tomorrow morning.

Morning Update

This morning US equity futures are higher in pre-market trading after getting a boost from better than expected durable goods orders and jobless claims. Yesterday’s Fed meeting was, as expected, a non-event that produced no new headlines. The Fed reiterated that it would continue Operation Twist through year end, buy $40B of mortgage-backed securities each month, and keep rates “exceptionally low” through mid-2015. They also said they see significant downside risks to the economy but that the housing sector is showing signs of improvement and that household spending is advancing a “a bit more quickly” than thought. Equities ended down on the day, but so did treasuries, which is making us wonder if the rally in credit nearing a top? A chart of US credit risk appetite suggests not, but option traders are thinking otherwise. 

One trade that caught our eye in the options market was the sale of 9,075 TLT Nov. 125 calls for $0.70. Implied volatility in these options was smashed from 17% to 15% as traders like this rushed to sell calls on the belief that TLT will not rally higher than 125.70 in the next 22 days. Typically when bonds fall stocks rally, though yesterday was an aberration and indicative of a confused market.

The case for bonds to head lower is simple: as inflation expectations rise, so will expectations of higher interest rates. These expectations will first manifest themselves in long term treasury bonds. Although at the moment inflation is low and the Fed is doing everything it can to keep long term rates low, inevitably Treasury bonds will sell off. The big question is when this will occur. This trade is a bearish bet on treasuries, but will profit if TLT goes down, stays the same, or goes up less than 3.5%. This is a trade for people cautiously bearish on bonds who do not want to get outright short yet but think the top is very near.

Like this trader I prefer to trade bonds via the options market where I can use calls and puts to lock in better than market interest rates without an outright directional bet. However I do not sell naked calls, not matter how much conviction I have in the trade. Though there is a strong long term case for bonds to head lower, in the short term anything could happen, and a continued sell off in equities will likely send TLT through the 125 strike. I would prefer to see this trade hedged by a further out of the money call option and a break through TLT’s 200-day moving average, where is currently sits, could be a signal to begin getting cautiously short bonds.

Wednesday, October 24, 2012

Morning Update

This morning US equity futures are modestly higher after a sharp sell off yesterday on better than expected earnings from Visa and Facebook and a good PMI in China. Later today new home sales will be released and there will be a Fed announcement. Typically the market is quiet leading into a Fed announcement with sharp moves coming after. No policy changes are expected to be announced today.

Yesterday’s sell off in equities sent many scrambling to buy downside portfolio protection. There was one big trade however, that was doing the opposite. With the VIX at 18.95 one trader sold 32,000 VIX Nov. 19 calls for $1.95. This is a bet that the VIX stays below 20.90 and implies that the S&P 500 has at most only a few more percent to fall before bouncing. Historically the VIX has moved up 4% for every 1% move down in the S&P 500. By that logic, this trade will be profitable if SPY remains above 135.70 through November expiration.

Although the call sold in this trade is 16% out of the money, it is still a very risky sale. A short call has unlimited upside risk, and it is not uncommon for the VIX to make sharp moves upward. Therefore I prefer to keep my risk fixed and defined by buying a further out of the money call when making these types of trades.

Tuesday, October 23, 2012

Morning Update

This morning US equity futures are lower by over 1%, following Europe down. The risk off sentiment is being driven by a downgrade of several regions of Spain by Moody’s, which cited deteriorating liquidity positions. This has sent Spanish 2yr bond yields up over 20bps. On top of this, a French business conditions index fell to a three year low, which sent the Euro decisively through the 1.30 level to its 20-day moving average.

Yesterday news was released that Monster Beverage Corp.’s energy drinks have been cited in five deaths in incident reports submitted to the Food and Drug Administration. Monster is also being sued by the family of a 14 year old teenager who died after drinking two cans of the energy drink. This sent shares of the company crashing down 14% lower on the day. However, one option trader was selling puts into the sell-off, suggesting they believe this is a one day knee-jerk reaction and that the selling will not continue. The trade that caught our eye was the sale of 2,092 Nov. 42.5 puts for $3.00. This is a bullish bet that will turn a profit if Monster does not drop more than 13% in the next 24 days. If Monster does the trader will effectively own the stock at 39.50. Selling puts at a level you are willing to own the stock at is a great way to get paid to wait for a great entry and keep yourself from chasing a stock. When stocks have huge intraday moves like Monster did, selling puts becomes even more attractive because implied volatility explodes, making options very expensive. However, despite how tempting it is to sell Monster options, it is important to remember that they are expensive for a reason and could be fairly priced for all we know. Lawsuits like these generate lots of bad press and their outcome may not be easily predictable so I will be on the sidelines for this trade.

Monday, October 22, 2012

Unusual Options Activity

On Friday we noticed unusual option activity in Johnson & Johnson. The biggest trade of the day was the sale of 22,500 Jan. 67.5 puts for $0.46 and simultaneous purchase of the same number of Jan. 60 puts for $0.07. This is a bullish trade done for a net credit of $0.39 that bets JNJ will be above 67.5 at expiration. On Oct. 16th JNJ reported better than expected earnings and raised forward guidance, which has sent the stock up over 4% since then. This has created a bullish chart pattern with strong support at 67. By selling the 67.5 puts this trader is choosing that as a level they are willing to buy the stock at. They hedged this sale by buying the 60 put, which reduces the risk and margin required for the trade by getting them out of a long stock position there.

This trade is a good example of how to use options to get long exposure to a stock. This trade will require the trader to put up $7.11 in margin versus 71.86 to buy the stock now. As long as JNJ does not drop over 6% between now and January expiration this spread will realize its full value and return an annualized 22%. However, unlike a stock position it is possible to lose the entire amount invest in this spread if JNJ drops below 60m, or 16% from Friday’s close.

For traders looking to get long JNJ but who do not want to chase the stock, this is a good alternative that can make money in an up, sideways, or modestly down market. As long as the position is sized appropriately and you are willing to buy JNJ at 67.5, consider this spread as an alternative to buying the stock.

Friday, October 19, 2012

Low Volatility Portfolios

With today’s sell off in US equities accelerating we have been getting questions from about how we are managing downside risk. Our primary risk management tool is our proprietary SVIX (“synthetic VIX”), which allows us to replicate the performance of the VIX without the decay found in other long volatility vehicles like VXX. One strategy clients have been very pleased with is our Low Volatility Large Cap strategy, in which we aim to meet or exceed the S&P 500’s returns with a fraction of the downside volatility. We recommend this strategy to clients who would traditionally own large cap stocks but want to remove the tail risk of black swan market crashes.

We achieve our target performance via an actively managed portfolio of stock options and an allocation to SVIX. Below is the performance of this strategy month to date, which as you can see has matched the S&P 500’s return with a fraction of the volatility.

Morning Update

Today is the 25th anniversary of the 1987 market crash, a day when the S&P 500 fell over 20% and traders learned the importance of covering their tail risk. Today it is as imperative as ever to cover your tail risk, and yesterday we saw one trader doing just that. With the January VIX future trading at 19.20, one trader bought 11,000 Jan. 45 VIX calls for $0.30. These calls are 136% out of the money and to many it may seem like wasted money. However, should a black swan event occur between now and January these calls will explode in value as traders scramble to buy portfolio protection and implied volatility skyrockets. There is no shortage of headlines that could come out of Europe, the Middle East, or America that could cause a massive sell off, and that is why we are seeing so many traders hedging right now. At the same time it only takes a glimpse at a chart of the S&P 500 the past year to see that it is a bull market. We want to be invested in the market right now, but also have tight hedges on should the uptrend abruptly reverse. Buying deep out of the money VIX calls is one way to accomplish this, though it can be costly due to options decay and need to be rolled forward at expiration. However, it only takes one extremely volatile day to make this insurance pay for itself. As traders in 1987 will tell you, it was the people with long volatility positions that has the last laugh who were able to stay in the business to trade another day.

Thursday, October 18, 2012

Morning Update

This morning the major data point released was jobless claims, which came in at 388K versus 365K consensus and 339K last week. US stock futures have since sold off, erasing modest overnight gains. Though this report is a disappointing 39K increase over last week, it is important to remember that last week’s number was unusually good and could have been the result of incomplete data from a state.

Five days ago the iShares FTSE China 25 ETF, FXI, gapped up over two percent through its 200-day moving average and has rallied ever since. Yesterday we noticed unusual options activity in the ETF. With the underlying at 37.23, one trader sold 20,000 Jan. 34/38 strangles and bought 30,000 Jan. 25 puts, for a net credit of $3.63 million. The core of this position is the 34/38 short strangle, which is a spread that benefits when implied volatility declines and the underlying market moves sideways. However, short strangles have unlimited risk, so this trader hedged themselves by buying deep out of the money puts to limit risk on the downside in the event of a black swan event. This spread will be profitable if FXI is between 32.18 and 39.82 at Jan. expiration in 92 days. These breakeven points are close to the ETF’s 52-week high and low, which could act as support and resistance and help to keep FXI in its range.

Because this spread is unhedged on the upside and could produce potentially unlimited losses should FXI rally hard into expiration, I will be on the sidelines for this one. At better trade in mp opinion would be to turn this into an iron condor by buying calls at a higher strike than was sold. This will reduce potential absolute returns but also reduce margin and therefore can actually increase return on investment.

Wednesday, October 17, 2012

Morning Update

Overnight the biggest news story was that there was no Spanish downgrade; Moody’s reiterated their rating of Spain’s debt at Bbb3 with a negative outlook. This sent Spanish stocks higher and 10-yr yields to 6-month lows. The other European indices are little changed, and US futures are modestly higher. This is mostly due to stronger than expected housing starts, which came in at 0.872 million versus 0.765 consensus.

The big news story yesterday was the abrupt resignation of Citibank’s CEO Vikram Pandit. Since becoming CEO in December 2007 Citi’s stock has fallen 88% versus a 6% gain for Wells Fargo and 2% gain for JPMorgan over the same period. The market seemed to welcome the change and Citi’s shares closed up 1.6% on the day, well ahead of the broad market. Option trading was also bullish yesterday with a put/call ratio of 0.71. The biggest trade of the day was the purchase of 10,000 January 2014 45 calls for $2.75 with the stock at 37.00. This is a bullish trade that is betting Citi’s stock will be above 47.75, or 23% higher, at Jan. ’14 expiration, 457 days from now. Yesterday implied volatility in Citi options plummeted to a 52-week low as the stock rallied, meaning option premiums are relatively low in the stock right now. When implied volatility falls to extremely low levels it is a good time to consider buying out of the money options: calls to bet on a rally, and puts to insure a stock position. This trader is betting on a rally, and Citi’s chart looks poised to deliver. If the stock can close above 38.50 the next major area of resistance is around 45.00, the July 2011 highs. Should Citi breakout, these Jan. 2014 calls could prove an excellent buy.

Tuesday, October 16, 2012

Unusual Options Activity

This afternoon we noticed unusual options activity in LyondellBasell Industries, an independent chemical company that coverts liquid and gaseous hydrocarbon feedstock into plastic resins and other chemicals. At 12:14 EST one trader bought 34,500 Nov. 57.5/60 call spreads for $0.60, and at 12:50 another 19,500 Nov. 57.5/60 call spreads were bought for $0.65. The stock was up over 5% on the day on expectations of increasing profit margins, as discussed in a Bloomberg Businessweek article this afternoon.

From Bloomberg:

Profit margins for ethylene, a colorless gas used to ripen fruit, open flowers and make products from plastic bags to paint removers, are surging to near record levels and may climb further, reviving fortunes of U.S. producers.

Two of the commodity’s largest makers, LyondellBasell Industries NV (LYB) and Westlake Chemical Co. (WLK), have posted their highest-ever profits and their shares have gained 66 percent and 91 percent respectively this year. Their margins will continue to improve as constrained production capacity pushes up prices, say Brian Maguire and Bob Koort, analysts at Goldman Sachs Group Inc. in Houston.

The driver is cheap shale gas, which is rejuvenating the country’s chemical industry after a decade of decline. Hydraulic fracturing of shale rock formations, known as fracking, cut U.S. gas prices to a 10-year low in April. It has also produced an oversupply of ethane, a natural gas component that is converted to ethylene with heat and pressure in a process known as cracking. Gas liquids, mostly ethane, supply about 85 percent of the feedstock for U.S. ethylene makers.

The full article can be found here:

Curiously, the stock opened up $0.50 and was up over 4% before the article was published, suggesting that the article was not the main driver behind the move. Westlake Chemical Co, another stock mentioned in the Bloomberg article, was up nearly 8% today. We couldn’t find any reason traders suddenly jumped into these stocks, but are wondering if it means if fracking, natural gas, and America’s competitive advantage in ethylene production will come up tonight in the debate…

Morning Update

Overnight sentiment in Europe was risk-on as a Financial Times article said Spain will imminently ask for a bailout. This has the Euro above $1.30 and the STOXX 50 up nearly 2%. In the US the September CPI was released this morning, coming in at a month/month increase of 0.6%, ahead of expectations of a 0.5% increase. The core CPI (ex. Food and energy) increase 0.1%, below expectations of a 0.2% increase. The only other economic data to be released today are industrial production figures at 9:15 EST.

Yesterday we noticed unusual options activity in Groupon. One trader sold 5,900 April 4 puts for $0.60 and bought 5,900 April 5 puts for $1.15 with the stock trading at 5.25. The net cost to put this spread on was $0.55, and its maximum value at expiration in 185 days is $1.00. To realize its full value, GRPN must be at or below 4.00 at April expiration, and to break even it must be at or below 4.45. Since this breakeven is 18% lower than yesterday’s close, this trader is very bearish and sees much more downside for this stock that has already tumbled 81% since its IPO.

Groupon is scheduled to report earnings on Nov. 8th and another disappointing quarter has the potential to accllerate the stock’s drop. However, the company has made efforts to fix its struggling businesses. Groupon’s senior management in Europe has been reshuffled and the head of international business is leaving the company. Groupon has also recently acquired Breadcrumb, a point of sale iPad app targeted at local businesses. This could be a stepping stone for Groupon to begin taking restaurant reservations and allow it to compete directly with OpenTable, but that will be a ways down the road.

The high levels of uncertainty surrounding this stock have driven up option premiums, which make spreads like this one expensive. Risking $0.55 to make $1.00 over 185 days on a 20% down move in the stock is not a risk profile that impresses me, so I will on the sidelines for the time being.

Monday, October 15, 2012

Morning Update

This morning US stock futures are moderately higher ahead of the open, driven by an overnight rally in Greek bonds and positive US retails sales. Month over month retails sales came in at 1.1% versus 0.7% consensus. The rest of the week will be packed with data, such as the CPI and industrial production tomorrow, housing starts Wednesday, and existing home sales Friday.

On Friday we noticed unusual options volume in Yahoo. The biggest trade of the day was the sale of 27,000 Oct. 16 calls for $0.09 with the stock trading at 15.88. Next Monday Yahoo will report quarterly earnings for the first time since CEO Melissa Myers took the helm. However Oct. expiration is this Friday so these options will expire ahead of the announcement. This trade is very likely a hedge to a long stock position in a trade known as a covered call or buy-write. This is a conservative strategy traders use when they expect sideways to mildly bullish price action. In this case the trader is being paid $0.09 to forgo any upside gains on his long stock position above $16.00 per share. Since the trader collects $0.09, this trade will outperform a naked long stock position if the stock remains below 16.09 this week. If Yahoo is above 16 the trader will make the $0.09 collected from selling the call plus $0.12 from buying stock at 15.88 and selling it at 16.00, which is a 1.3% return in a week. If Yahoo sells off this week the trader will have the $0.09 collected as a cushion to downside losses in the stock.

Yahoo’s stock has had a strong run-up since September 4th when it traded 14.59 and is nearing a major area of congestion and resistance in the 16 – 16.5 range. For investors who are long the stock but want to reduce some of the stocks day to day volatility, a buy-write strategy like this makes sense. However, since the options in this trade will expire ahead of Yahoo’s earnings it will not dampen the potentially sharp swings the stock could have next week. For investors looking for a little protection from the earnings announcement they should look to sell Nov. call options. These have elevated implied volatilities due to the pending news and will therefore offer sellers large premiums.

Friday, October 12, 2012

Unusual Options Activity

Yesterday we saw unusual call option activity in Anadarko Petroleum, an independent oil and gas company. The biggest trade of the day was the purchase of 2750 Nov. 80 calls for $0.37 with the stock trading at 69.10. This is a bullish bet that APC will be above 80.37 at Nov. expiration, which will require a 16% move in the next 35 days. Approximately 50% of Anadarko's revenue is derived from their natural gas business, which means the stock is likely to rally along with natural gas. Currently the stock is consolidating at support in the 68-69 area, and this trader believes a breakout will take it above 80. We see Anadarko as a hedged play on natural gas; since its business is split 50-50 between oil and gas, its stock will have less volatility than the price of natural gas but will certainly benefit from a rally. If Anadarko breaks out above 80, the next major resistance level is its 52-week high of 88, which means this call option could potentially return a lot but at just $0.37 it does not require taking much risk.

Thursday, October 11, 2012

Morning Update

This morning US stock futures are pointing towards a higher open after better than expected jobless claims and import/export data. Europe sold off early in the overnight session on news that S&P downgraded Spanish debt to BBB-. However, since then markets have retraced a good portion of that move down and the Euro is now in positive territory.

Yesterday the options order flow in Boeing caught our eye as call buyers pushed the put/call ratio on the ISE down to 0.0625. Across all exchanges Boeing’s put/call ratio was 0.43. The biggest trade of the day was the purchase of 4,500 May 77.5 calls for $2.05. These options are 10% out of the money as of yesterday’s close and expire in 218 days. There are a few different reasons traders are getting bullish on Boeing. One is that yesterday Alaska Air announced that they will be buying 50 aircraft from Boeing to be delivered between 2015 and 2022. This is the largest order in Alaska airline’s history and the contract is worth $5B in revenue to Boeing. Also, yesterday Citigroup said that it expects Boeing’s December board meeting to result in a 20% dividend hike and a $2B share repurchase program. Citigroup reaffirmed their buy rating on the stock with a price target of $89. Finally the most recent edition of Barron’s said that Boeing is one of the companies that would benefit most from a Romney victory, which could be increasing bullish sentiment on the stock as Obama’s lead in the polls narrows. Boeing shares have underperformed the Dow and S&P so far this year, but the winds may be changing for the stock. The 77.5 strike corresponds with the stock’s 52-week high, so buying these calls is a way to profit from an upside market breakout with only $2.05 of risk should the market stagnate or decline.

Wednesday, October 10, 2012

Morning Update

Yesterday Alcoa kicked off earnings season with a mediocre report that showed declining cash flow and a bottom line loss despite better than expected EPS and revenue. The shares are modestly lower ahead of the market open. In Europe sentiment has been negative after the IMF said that by 2013 European banks will have to dispose of up to $4.5 trillion in assets. However, there was some good news out of Italy and France, whose industrial production numbers were bother better than expected. Later today in the US wholesale inventories and the Fed’s Beige Book are set to be released, and Bundsbank president Jens Weidman is scheduled to speak, which could generate anti-ESM headlines.

Yesterday call options were unusually active in Ford, with the top trades occurring in the January calls. We saw one trader buy the Jan. 11/12.5 call spread 1,853 times for a net debit of $0.18. This was done with Ford stock trading at 10.10 and is a bullish trade betting Ford will be above 11.18 at January expiration. This means that the trade will require the stock to appreciate by 10.7% in the next 100 days to break even. The maximum profit this spread can return is $1.32, which will occur if Ford is at or above 12.5 at expiration. Since this spread only risks $0.18, it has a very favorable risk/reward ratio. The reason for yesterday’s call activity is likely the news the Ford’s sales in China have increased 1.7% year over year and 10.5% since August 2012. To capitalize on China’s growth, Ford is planning to launch 15 new vehicles in the country and double its production capacity by 2015. Ford’s strong growth in China may have caught investors by surprise due to news out of the region focusing on the slowing economy. Additionally, yesterday Ford was named a top pick by Morgan Stanley, who said the company is leveraged to the US housing recovery and a European restructuring. It appears that this trader is willing to risk a little to gain a lot in the event the global economy does better than forecasted over the next 100 days.

Tuesday, October 9, 2012

Morning Update

This morning protests rocked the streets of Athens again as a result of Angela Merkel’s visit to Greece. This, along with growth forcast downgrades by the IMF yesterday, has overnight sentiment negative. The Euro is lower heading into the North American crossover, which has S&P 500 futures modestly higher before the open. Today, much like yesterday, is devoid of any major economic news so many trader’s focus will be on Alcoa’s earnings after the bell.

Analysts are looking for earnings of $0.01 on revenue of $5.57B, and at least one options trader believes Alcoa will beat these expectations. Yesterday with Alcoa stock trading at 9.12 we saw one trader buy 10,078 Nov. 10 calls for $0.12 and sell 5,978 April 8 puts for $0.41. This is a bullish trade that gains long exposure to the stock by buying near-term call options and financing it by selling long dated out of the money puts. This trader avoided buying Oct. calls because they are trading with a high implied volatility premium to Nov. options due to earnings. This trade will make money if Alcoa is above 9.91 at Nov. expiration, which is 8.7% above yesterday’s close. Historically Alcoa has moved 3.2% after reporting earnings and currently the options market is pricing in a move of 4.9%. 

One reason this trader may be bullish on Alcoa is because everyone else has become so bearish. Since reporting mixed results in Q2 Alcoa has been downgraded by three analysts, aluminum prices have fallen, and the company announced it will take an $85M after tax charge as a result of the EPA’s Proposed Remedial Action Plan for the Grasse River. However CEO Klaus Kleinfeld has continued to say that the fundamentals of the aluminum market are strong and expects global demand to increase 7% this year. With sentiment generally pessimistic on Alcoa the stock could have quite a bit of room to run should earnings beat, which is exactly what this options trade is looking to profit from.

Monday, October 8, 2012

Morning Update

Last night’s Asian trading session was dominated by risk-off sentiment as traders focused on China’s slowing economy and talks in Europe about the ESM, Greece, and Spain. The Chinese HSBC PMI was reported at 54.2, up from 52.0 last month. A story in the China Securities Journal says the government is likely to introduce more interest rate cuts to help ease the economy. The Euro is lower heading into the North American crossover, which could be supportive of US equities which are lower pre-market.

While the broad market gave up its pre-market gains on Friday, Phillips 66 closed up 1.4% on the day and had bullish options activity. We saw one trader buy 10,000 Jan. 2014 60 calls for $2.15 and another trader buy 5,000 Feb. 55 calls for $1.05. Phillips 66 stock closed at 46.02, so the first trader is expecting a 35% move higher and the second is expecting a 22% move higher. This bullishness could be attributed to a rising crack spread, which is the difference between crude oil and gasoline. Since a refiner buys crude oil and sells gasoline, a wide crack spread means strong margins and high profits. In the last month WTI crude has plunged over 15% while gasoline has fallen only 2.5%. Gasoline’s relative strength has been due to refinery outages in Southern California which have caused fuel shortages and caused spot prices to jump. PSX has also recently raised its dividend 25% and now yields 2.15%, and is a favorite at Berkshire Hathaway, which bought 27.2 million shares in August.

Friday, October 5, 2012

Morning Update

This morning the Non-farms payroll report showed the unemployment rate was 7.8% in September, which was well below expectations of 8.2%. This has the S&P 500 futures up pre-market but gold futures are down. The past few days the market has opened higher only to drift lower throughout the day, so holding today’s gains will be an important sign that the bulls are back.

Yesterday it appeared as though the market got a “Romeny bump” and at least one options trader believes the market’s rally will follow through into the election. We saw someone buy 56,650 QQQ Nov. 71 calls for $0.68 and 45,000 QQQ Nov. 72 calls for $0.39. The breakeven at expiration of this bullish bet is 71.99, which is 3.8% higher than yesterday’s close. The underlying thesis for this trade could be that a tighter election race where Romney has a good chance of winning will be good for markets as they try to price in the chance of a Republican victory. When the broad market rallies tech has typically outperformed, which makes the NASDAQ 100 ETF a logical choice for traders expecting a rally. Buying out of the money calls is a great way to participate in a rally without a huge outlay of cash, but in the event the market does not move high enough all of the premium paid for the options can be lost.

Thursday, October 4, 2012

Morning Update

This morning jobless claims data came in at 367K slightly beating consensus estimates and last week’s numbers were revised up again by 4,000. The S&P 500 futures did not have much of a reaction to the data and continue to hold gains made last night during the presidential debate. In Europe Mario Draghi held a press conference after the ECB meeting where he left rates unchanged and gave little new information about the debt crisis.

The Wall Street Journal is reporting this morning that “Turkey's parliament approved a measure proposed by Prime Minister Recep Tayyip Erdogan, giving the government broad powers to send soldiers into "foreign countries" after Turkish armed forces and Syria traded fire on Wednesday and Thursday.” Though not literally a declaration of war, this is likely to escalate the conflict in Syria and could be the beginning of the end for the Assad regime.

During yesterday’s trading we saw large options trades on VIX futures betting that the "fear" index would remain in its current range through November expiration. One trader sold the Nov. 16-17 strangle and bought the Nov. 20 call 35,000 times for a net credit of $1.90. This trade is a bet that the VIX will be between 14.10 and 18.90 at Nov. expiration. Since a short strangle has unlimited risk this trader bought the Nov. 20 call as a hedge. By doing this the spread's risk is limited to $1.10 on the upside no matter how high the VIX goes.

The VIX index is a measure of implied volatility in S&P 500 options and is negatively correlated with the market. Historically, for every 1% down move in the S&P 500, the VIX has increased by 4% on average. Therefore, by betting the VIX moves no higher than 18.90 this trader thinks a sharp decline in the S&P 500 is unlikely. Since September the VIX has been range bound between 13.51 and 18.96 and is currently in the middle of this range at 15.43. This trade is betting that this range will hold for the next 47 days until November expiration.

I like the way this spread was constructed because it has many of the attributes I like to see in my trades: a hedge to limit risk where the trade is most vulnerable, a favorable risk-reward ratio, and breakeven points that coincide with major support and resistance levels. The VIX is a mean-reverting index, and with its 50-day average at 15.79 there a very reasonable chance the VIX will still be near current levels at November expiration.

Wednesday, October 3, 2012

Morning Update

The old saying on Wall Street is that you can’t fight the Fed. So see whether this is still true we plotted the changes in gold (GLD), the S&P 500 (SPY), and the monetary base back to 2004 on a logarithmic scale. Here are a few observations we drew from this chart:
1.       The Fed does not always do exactly what it says. Case in point, in Sept. 2008 the monetary base breaks trend and jumps upward, implying Fed intervention. However this was months before the Fed would announce QE1 and a month before TARP. It appears that by Sept. 2008 the Fed knew the financial sector was near collapse and proactively began increasing the monetary base. We closely watch the economic data coming from the Fed to see what they are really doing and when they are doing it.
2.       When a round of QE ends, the S&P 500 declines. This occurred in March 2010 at the end of QE1 and June 2011 at the end of QE2. When a new round of QE starts, the market rallies. We are closing watching Fed data to see when QE3 begins in earnest and would expect the market to tick up.
3.       There is a 73% correlation between monthly changes in the monetary base and monthly changes in the price of gold. We trade gold using a model of economic indicators, of which the monetary base is one of the most important. An increasing monetary base is bullish for gold, and we will be watching closely for the impact of the Fed’s first round of QE3 on the monetary base. 

Tuesday, October 2, 2012

Morning Update

Last night rumors that a Spanish bailout would occur in the near future strengthened, tightening Spanish and Italian bond yields to bunds. Even after the rumors that Spain would seek a bailout this weekend we denied risk-on sentiment remained. The Euro is now trading near the psychologically important 1.30 level and US equities are pointing towards a higher open. Yesterday the market also looked strong early on but gave back nearly all of its gains by the close. A strong close higher today will take some momentum back from the bears, while another reversal will only encourage more near-term selling.
Yesterday we noticed unusual options activity in Best Buy. Someone sold 22,500 BBY Oct. 19 calls for $0.25 and bought 15,000 Nov. 19 calls for $0.90. This trade appears to be someone rolling their long Oct. calls forward into November. The Nov. calls will turn a profit if the stock is above 19.90 at expiration, which would require a 17% move from yesterday’s close. Best Buy has seen declining sales as customers have shifted more of their purchases online to retailers like Amazon. However, founder Richard Schulze still has faith in the company and is attempting to raise money to take Best Buy private. Schultze has voiced interest in paying $24-26 per share, which would put the total buyout price around $8 billion.
If a buyout is announced BBY shares are likely to jump into the mid-twenties. However, short of that happening I don’t see any catalysts for significant share appreciation. This is a speculative trade that has the risk of losing the entire amount invested, but also has the chance of huge returns should Schultze surprise the market. Implied volatility in BBY options is well above realized volatility and looks expensive, so I will be watching the action in Best Buy from the sidelines.

Monday, October 1, 2012

Morning Update

Friday there was unusual options activity in DAL (Delta Airlines). One trader bought 20,000 March 11 calls for $0.50 with the stock at 9.10 at the time. This trade cost $1 million in premium and is a very bullish bet on the stock. If DAL is above 11.50 at March expiration (165 days) this trade will break even. If DAL is below 11 at expiration, the calls will expire worthless and the trader will lose the entire premium paid for them.
One reason to be bullish on DAL is the company’s acquisition of its own oil refinery in May. This deal has since closed and its affects will be seen in Delta’s 4th quarter profits. Delta says that owning its own refinery is less expensive than hedging their fuel costs and will save them $100-300 million annually going forward. Delta has said they do not expect crack spread growth to abate “anytime soon”. The crack spread is price difference refiners earn between gasoline and crude oil. By owning their own refinery Delta can actually profit from a wide crack spread while its competitors are being hurt. Additionally, Delta’s passenger unit revenues are up and the company is on track to meet aggressive debt reduction goals by 2013.
Delta’s management has clearly been working hard to strategically position the company for growth, and now it appears it is time for that to pay off. Buying out of the money calls is a good way to get exposure to the stock while keeping risk limited, which is especially important in the highly volatile airlines sector.
Another stock with heavy options activity on Friday was FEZ, the Euro Stoxx 50 ETF. We saw a trader buy 6,764 Oct. 32 calls for $0.40 with the ETF trading at 31.00. This is a bullish bet that the ETF will rise 4.5% in the coming 18 days. This ETF was down 8% over the past two weeks as protests rocked Spain and fears of the Euro crisis intensified again. This trader is betting that the market will shake those fears and continue its upward trend throughout October, making this an excellent buying opportunity.

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