What’s Goin on Everybody?
The Bill Comes Before the News
Good afternoon:
Most traders pick an option expiration by feel. They want a month, so they buy the monthly, and they never read what's on the bill.
That's where I started I'd Trade That yesterday morning. I also walked through why your call can lose money when the company beats, and I pointed to one group where I can't name a single thing that's improved. I'm interested anyway.
You can check out the replay below or read the wrap up:
The bond market was shut for Columbus Day and Japan was closed, so stocks traded with no rate signal.
Light volume makes moves look bigger than the conviction behind them, and it makes your fills worse.
A breakout on a holiday tape is a lack of sellers.
Read the Bill Before You Pay It
Implied volatility on the index (the market's price tag for how much it expects to move) sits at five-year lows for options expiring October 30. At the same time, 65% of the S&P's market value reports earnings between now and then.
So you've got some of the cheapest options in five years sitting in front of one of the densest stretches of news in the quarter.
An option price is mostly a bill for the events that happen before it expires. You're not buying time, you're buying the news that falls inside that time. The market charges you for every event in the window whether you want it or not.
October 30 buys you the Fed meeting, the CPI print and most of earnings season. Go out to November and you get all of that plus the midterm elections. Nobody knows that outcome, everybody wants protection around it, and that makes it expensive.
If you've got a view on the midterms, pay for them. If your view is just that earnings season goes well and options are cheap, paying for the election is a tax on a trade you don't want to make. Ask what you actually want to trade, then buy the shortest date that covers it.
I pulled up the SPDR S&P 500 ETF Trust (SPY), one of the most liquid options chains on the planet, and ran the October 30 math live. An at-the-money call costs about $8.20, and SPY has to clear roughly 788 before you make a dime.
A call spread (buy one call, sell a higher one against it) defines your risk. Buy the 770 and sell the 775, and you put up $3.71 to make $1.29. That's a 34% return with a 63% probability of profit, and your breakeven sits near where the 20-day moving average should be by then.
Want the lottery ticket? The 800 call gives you an 11% probability of profit, and SPY has to reach 801.
Are we going to get there? I don't know.
The Rite of Passage
I'd rather trade what's already been beaten up, and right now that's the banks. Banks are the most oversold against this market since 1993.
Not since the financial crisis. Since 1993.
Large caps only: the Financial Select Sector SPDR Fund (XLF) and JPMorgan Chase (JPM). The regionals carry commercial property exposure I don't want while the weakest borrowers pay over 1,000 basis points (10 percentage points) to borrow.
JPMorgan just tapped its 200-day moving average, and every time it does, it's funny how the shorts start to cover. But I'm not a huge fan of trading into earnings, and here's why.
Everybody in the room has done this at least once. I've done it. You buy a call into an earnings report, the company beats, the stock goes up, and you lose money.
Before a company reports, nobody knows the answer, and option sellers charge for that uncertainty. Taiwan Semiconductor (TSM) reports Thursday, and its options price a move of 6% to 7% in either direction.
Then the number hits, and the thing you paid a premium for no longer exists. Traders call it volatility crush. If the stock goes up 2% but the premium deflates more than that, you were right and you still lost money.
So sell some of that inflated premium back with a spread, or wait. By the time you read this, JPMorgan has reported, and that matters less than you'd think, because the repricing doesn't happen all at once.
The hedges unwind, the options get cheaper, and over a period of days you get post-earnings drift (the market slowly working out what the number means). Anchor your VWAP (the average price everybody paid, weighted by size) right to the report. The people who ran the banks into the ground may suddenly have to buy them back.
Who's Left in the Room
Utilities ripped about 4% last week, and they're still off their highs. Two weeks ago, hedge fund exposure to the sector hit its lowest level in four or five years.
Dealers now sit at maximum short gamma there. When you buy a call, a dealer sells it to you and hedges by buying some stock. As the stock climbs, that call costs them more, so they buy more stock, which pushes it higher and forces them to buy again.
Short gamma doesn't start a move. It needs a catalyst, and then it amplifies. That's why you want options here, not shares.
On the Utilities Select Sector SPDR Fund (XLU), I like buying the 41 call and selling the 42 or 43, two to three weeks out. When Mark Sebastian jumped on, he asked for a name. Dominion Energy (D) sits on its 20-day, and above 62.21 I'd buy the 62 call and sell the 64.
Then there's biotech. It's not my sector, but I saw the number and said, "Ooh."
The group just went through an eight-week unwind, and it didn't drift. It got liquidated.
Repriced means the news got worse. Liquidated means holders got forced out because a fund took losses somewhere else and cut leverage. The selling ends when the sellers are gone.
Repricing grinds. Liquidation turns violent, and when 40 names fall together, including the ones with no news, that's positioning unwinding.
I can't tell you a single thing that's improved about the fundamentals. Buying a liquidation is about who left. Basket only, through the SPDR S&P Biotech ETF (XBI), which bounced off the 145 area on October 8.
I'll be back tomorrow at 9:20 a.m. to walk you through the markets and the opportunities…
See you there,
Garrett