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The Stealth Correction

Here's where we stand on the markets:

spx

If we were to see this in a "textbook," then sellers should show up shortly.

The levels tested on Friday coincide with prior support which leads to potential resistance... and we have a declining 200 day moving average that should bring in sellers.

On top of that, the market saw an incredibly strong move last week and we should expect reversion.

In other words, a correction is due.

But what exactly should we expect?

The Bearish Prediction

If you think this market will fall, odds are you're not just expecting a pullback but a crash through 1800 and then follow through below that.

Traders are pointing to a "head and shoulders" top on the weekly chart and projections take us to 1500. That would be quite a bear market.

What kind of assumptions are being made here?

The first is that we are going to see the same kind of fear as we did back in August as well as January. For this to be true, you'd need to see a reintroduction of new macro catalysts... something stupid out of China, or maybe the Fed raising rates in March. You'd also need to see the same kind of stockholders sell with the same amount of velocity.

The next assumption is that we will see movement with the same kind of volatility like the other big selloffs. That means the S&P selling off 3% per day and then some.

The third assumption that I see in bearish predictions here is that all of this will happen at once. I'm starting to see 2008 analogies pop up on social media.

The Other Possibility

I think the "straight up bearish" positioning lacks nuance.

Here's where I think the assumptions fail.

  1. We don't have the same kind of stock holders as we did at the beginning of the year. If you were scared, you sold. And you probably sold at much lower prices... and if you hedged with options, you probably still have disaster protection put in. The "fear" dynamic right now is more related to the fear of missing out (FOMO) on further upside.
  2. Volatility moves in cycles. We see periods of high volatility followed by periods of low-ish volatility. Odds are we haven't had enough time go by for another volatility event to manifest.
  3. We've got a "shelf" in the markets now. The breakout above 1930 happened and it did so with volume and breadth. If we do manage to pull back, we could find those FOMO buyers come into play.

Allow me to step through another scenario, and I do think this one has higher odds than the disaster scenario that keeps popping up.

First, the correction will be rotational in nature. Right now the hot sectors are in the commodity space, and they are stupid overbought. Once the hot money comes out of that instead of going to cash it will chase into another space. Maybe high beta tech, maybe biotech.

Because the correction is rotational, we will see intermarket correlations break down and the market will churn sideways. This will frustrate short-biased traders and those in cash looking for a pullback.

Maybe we get one shakeout to the downside to embolden the shorts, but there isn't any followthrough because the downside breadth is lacking. You'll find stealth bids in pockets of the market that help to hold up the indexes. This will be especially true if it is in larger market cap stocks.

At some point we will see "upside" capitulation where investors on the sidelines will feel forced to chase. I think we saw a small example of that last week, but we could see a second push higher with that kind of dynamic.

It's very possible distribution starts to occur but a lot of sideways action can happen while volatility compresses. Those traders who were expecting an outright collapse within the next month will be left with puts that expire worthless.

Once that happens we'll start to see proper sellers come in, simply because all those that needed to buy... bought. Only then is when the pain is felt to the downside again.

Trading is Not Brute Force

I think way too many traders take an "all or nothing" approach to trading.

Either the market is fully bearish or fully bullish.

There's no room to accept the fact that volatility could just be non-trending and we see sideways action... and the correction you're looking for will actually be a stealth one.

Can the market crash here? Sure it's possible. But a more nuanced approach to the market, with a little understanding of investor psychology, will get you a better edge in your trading compared to focusing on betting it all on black.

The One Stock That Was Unfazed By The Market Selloff

One of my favorite trade setups is to look for relative strength in individual stocks.

Because if a stock is trading near its recent highs and is outperforming the market, odds are that trend will continue.

2016 has not been a good year for this setup, because nearly every single stock in the market was hit.

When we see global macro risks, correlations run to 1 and everything moves on the great macro conveyor belt.

There is one standout among all the other stocks I follow:

fslr

The stock is First Solar (FSLR). And it has been on an absolute tear over the past few months.

The original catalyst for the stock was back in December when the solar subsidies were extended in the US budget. Since then the stock has been sideways but it did not rollover with the rest of the market.

Just recently they had earnings, and there was a strong reaction to the upside. Odds are we will see post earnings announcement drift come into play.

The weekly chart is very encouraging if you're looking for momentum to come into play.

fslr

 

Over the past few years the stock has found sellers into that $75 level. If those sellers can clear there really isn't much in terms of resistance until $100 per share.

If you're looking for stocks to play if the market manages to keep some upside momentum, this should be at the top of your list.

 

4 Reasons The VIX Isn't Moving

Since the beginning of the year I've been getting questions about the market through email and social media.

... and to be honest I've had the same question too.

We've had the worst start to the year ever, and things are still looking really sketchy.

Earnings reports are obliterating stocks, Chinese currency risk is still out there, and the Fed is being stubborn about how fast it wants to raise rates.

But during all this time and all this volatility, it feels like the VIX hasn't budged:

vix

After all, we've broken below the August crash lows but the VIX hasn't managed to hold above 30 for any amount of time.

Is this the options market full of "smart money" traders looking for a bounce, or is it extreme complacency in front of the coming abyss?

I've got 4 reasons that explains how the VIX isn't moving as much as we thought.

Investors Are Already Hedged

Once possibility here is that anyone who needed to hedge already did back in August of last year.

After all, we did see massive movement that indicates a bunch of investors were buying puts to protect themselves. If they still have that protection on, they don't need to re-buy their protection, which helps to keep a lid on further upside VIX movement.

The same kind of dynamic occurs with investors who have already sold their stocks. If you're in cash, then you don't really have to worry about buying protection, do you?

We see this often in market pullbacks... where the S&P 500 will make a lower low but the VIX won't because those that needed to hedge... hedged.

This reason is a little weak because of how much time has passed between the August crash and today. If you bought 3 month hedges, then 3 months has already passed and you already need to hedge.

Let's see what else could help explain this....

Volatility Futures Are Already Elevated

Let's take a look at a chart of the near term VIX futures:

vx-futures

We're still lower than what we saw back in August 2015, but not that far away. In fact, there has been plenty of demand in VIX futures compared to the actual VIX itself.

This represents a pretty big shift in how investors buy protection. A few years ago, your best bet would be to buy puts, but in doing so you have other risks involved... time decay the most obvious.

Many institutional players have moved onto the VIX futures market, which doesn't exactly track the spot VIX. So it's possible that the fear is there, but is being shown in other trading instruments... more on that in a second.

Volatility Futures Have Been Backward All Year

One interesting shift in the market has been the volatility futures market when we look at different durations.

I don't want to bog you down in the complexities, but basically a "normal" market is when the VIX futures contract that's closer to expiration has a lower value than longer dated VIX futures.

But since the crash in August, this has been flipped upside down:

contango

This chart from VIXCentral.com shows the relationship between the near term VIX future and the next term VIX future. Above the red line is contango, and below is backwardation.

Most of the time we are above the red line. When we see the volatility markets shift below the red line, it's usually during a very turbulent time in the markets and often indicates a bounce is near.

But something has shifted, and the fear of near term downside has persisted all year. It truly is an extraordinary occurrence.

This is one of those where looking only at the VIX doesn't give you the whole picture. The fear has been there, just not in ways that you think.

The Risk Off Trade Is Hitting Other Places

I have a pet theory on this one, and I'm not sure I can fully prove it but it feels about right.

My guess: investors are burned out on trading volatility.

Think about it, there have been a few times of panic in the markets over the past few years. And if you used VIX options or VIX futures in reaction to that panic, you've looked stupid.

I also think the other side of the trade got burned... that going into August there were way too many people stuck short VIX options and futures. We can see the squeeze by looking at the VVIX, which is the "fear index" for VIX options:

vvix

That move we saw in August was even higher than what we saw back in 2008.

In response to this, I believe that investors moved back to more traditional "risk off" instruments. At the time of this writing, the Yen/Gold/Treasuries risk off trade has seen a massive rally.

Here's Your Edge

If you've been leveraged long FANG stocks, you've probably been smoked and aren't looking forward to the rest of the year.

Same goes to players that have a longer term horizon.

But this increase in volatility is very profitable for option traders.

It means there are higher option premiums, not only on an absolute basis but also with further out of the money options.

Given the right strategies and setups, you can see fast profits in the market... both to the short side and long side.

If you'd like to get my views on the market on a daily basis, as well as receive option trading alerts, then I encourage you to join my trading service. You can get a two week trial for only $14.

Click Here to Join.

The Great Holiday Volatility Crush

crushWelcome to the shakeout.

The investor zeitgeist is currently obsessed with two things:

  1. High yield debt
  2. Fed raising rates

The outcome of the Fed is what we would call a "known unknown."

If you have some magical crystal ball that will tell you exactly what the fed will do and how the market will react to it...

... you probably paid too much for it.

We don't know how the market is going to react to the Fed. The consensus is that Rate Hike = Bad and No Hike = Good-- but how many times have we seen the reaction to the Fed meeting be one giant stop-run, fade and reversal?

Instead of trying to predict where stocks are headed, how about we focus on the volatility markets.

The Current Readings

Equity volatility is being pumped up as the Fed outcome is being treated as an earnings-like outcome for the markets.

At the time of this writing, VXST (short term volatility) is at 28% and the VIX is at 24%.

Contrast that with the actual volatility in the market which is sitting at 15%.

That's a pretty hefty premium.

My End of Year Volatility Predictions

Volatility will spike but only for a day or so. After that, the actual volatility in the market will head back to 10% or so.

Remember, after the fed meeting we've got a week then Christmas. Overall trade and liquidity will wind down as trade books close and fund managers wrap up their

As the main risk event investors are concerned about is the Fed, the need for post-Fed protection will be less. The holiday trading season will get priced in and we'll see the VIX head lower. January SPX options and VIX futures will also see their premium levels drop.

If anyone buys protection it's going to be out in February. That will coincide with the start of earnings season for stocks. On top of that, the next Fed meeting will be at the end of January, which is after options expiration.

Looking at the VIX futures curve, here's what I expect:

vix-futures

Technically, December VIX futures expire before the Fed meeting but the overall idea here is that:

  1. Near term vol goes down
  2. Jan vol goes down
  3. Feb vol probably heads lower but stays bid relative to jan
  4. VIX futures curve will head back into contango

What If I'm Wrong

My opinion is that the current premiums being traded in stock options is very rich and will not be justified.

And remember...

the only way for it to be justified is if we actually see a larger volatility move than what the market is pricing in.

As an example, the SPX Dec options chain is pricing in about 50 handles worth of movement.

spx-pricing

If you think we can move bigger, then you should be buying the straddles right now.

It's possible that this trade thesis doesn't pan out.

I believe that the only way I'm wrong is if we see a non-fed catalyst come out.

It would have to do something with the high yield debt risk spilling over, or potentially a large oil firm that surprises with ugly guidance.

Maybe something out of a BRIC nation. But none of those catalysts are really expected until the beginning of the new year.

How to Position Into It

I've already structured trades into this trade thesis, let's have a look at a few:

Sell Put Spreads In Relative Strength Names. It's easier to hunt for a bottom in stocks like FB and AMZN than it is in the S&P 500. Good stock selection has worked great in 2015 and I expect it to continue into the end of the year.

Shorting VXX. I'm not going crazy short here, but I do have some smart limited risk plays that profit if VXX starts to trade lower.

Income Trades in Jan and Feb. Take advantage of the high option premiums and the holiday trading season by deploying iron condors, butterflies, and calendars. Don't overstay your welcome and look to scale in if we do end up seeing a big move.

 

Why is the Market So Wide On Options?

Some days, it feels like you're just getting screwed.

You get bullish on a stock, so you put an order in to buy a call. The bid/ask spread is .50 wide, which means if you use a market order you're already down $25 against the mid.

Instead, you opt for bidding at the mid... but no fills. Instead, a rush of orders come in exactly at the price you wanted. And they end up getting filled before you!

While you're sitting there for a fill, the stock ends up taking off without you. And a missed opportunity can feel just as bad as a losing trade.

The Stock Is Wide So The Options Are Wide

Many times, the option market is very wide because the stock market is very wide.

Take an example like AMZN. At the time of this writing it's trading in the 500s which is pretty high relative to most of the market. Keep in mind, this doesn't include considerations like market cap, just that a single share will cost you $500.

Here's a look at the order book of AMZN:

amzn-depth-of-book

This was taken at the open and the market was pretty thin to begin with... but let's use these quotes as a jumping off point.

Say you went out and bought an at the money call at market, which guarantees a fill at whatever the asking price is. Because the call is ATM, it's going to have a delta of 50. This leaves the market maker net short 50 shares.

In order to balance that exposure out, the market maker can either use other positions on their book, or they can go buy 50 shares of stock on the open market.

The market's bid/ask is 544.35 x 544.87. That means the spread is 0.52 wide. And that's only on 2 lots to the bid and 1 lot on the ask. If you had to buy 500 shares at what the market is currently showing, that last round is 544.02 on the bid and 545.88 on the ask-- a spread of 1.86.

This calculation assumes that there's no hidden liquidity (which there is) or that more bids won't step up (which they will).

Go back to the market maker with a net exposure of -50. If they were to immediately get flat using a market order, they're already at a $26 disadvantage in the market just due to slippage.

In order to adjust for that slippage, the market maker will only put quotes out at levels that compensate for the slippage in the stock market.

You'll see this more on large priced stocks like AAPL CMG AMZN and NFLX. And it becomes even more pronounced on stocks that don't trade much volume to begin with.

If you're seeing a not-so-liquid options market, it's probably because the stock liquidity isn't that great either.

Markets are More Inbred

With more and more algorithmic trading, you end up with the robots trading against each other in the same markets.

On the stock side, two great examples are SIRI and AMD. They are both large companies, but the stocks trade under $5. And they trade 10s of millions of shares per day.

I have a suspicion that the overall order flow is not due to large institutions getting in and out of the stock, but algorithmic trades using a combination of market microstructure and exchange rebates to milk the market.

We then end up with stocks that generate liquidity inbreeding.

Same thing happens in the options market.

The popularity of certain stocks and etf's mean that 80% of the liquidity is in 20% of the market.

It ebbs and flows, of course. I remember back in 2007 during the big commodities boom ag stocks like POT, MOS, and MON were all the rage and had super liquid markets.

Right now it seems that most of the liquidity for options are in high beta tech stocks.

The liquidity inbreeding becomes even more pronounced when we look at options duration.

Everyone and their mother now trades weekly options. Some people like them for the amount of leverage you can get relative to total capital, others like how fast the theta comes in.

This ends up leaving longer duration options as a ghost town

What You Can Do About It

The first thing you should cut out is whining. If you think you're going to get screwed by the market, you get screwed. It becomes a self-fulfilling prophecy as it affects your psychology and how you approach risk.

Embrace the matra of "it is what it is."

If you don't want to follow the liquidity and trade weekly options, here are some tweaks to your trading to consider.

Trade Like a Market Maker

Instead of forcing trades, you can let the market come to you. Odds are if you're chasing a stock higher, it'll come back to your original price just given the natural volatility of the stock.

If you're trading option spreads, you should figure out the price given certain conditions and float orders out accordingly.

Change Your Execution Strategy

Novice option traders treat the market as an "all in, all out" kind of scenario. I think you can get a better edge through use of scaling in and out, taking advantage of the wide bid/ask spreads and the natural volatility of the market.

Believe it or not, there is liquidity in wide options especially if you are selling risk.

Think about it: if you are an institution with a ton of size in a stock and you want to hedge, you don't really want to use weekly options because they only give you 5 days' worth of hedging. There's demand in longer dated options if you are willing to step up and sell that risk.

Use Liquidity Pings

This is very useful on very wide markets like cash settled indexes (SPX, RUT, NDX).

When the bid/ask is really wide, the only way to find the true price of the market is to probe for it. If you put an order out and it's immediately filled, then try for a better price on your next round.

But if nobody is filling your order, you may want to consider walking the order until you find a fill. If the price isn't what you want then you'll want to consider avoiding the trade or using a different option strategy.