Between Two Bloodthirsty Monsters

Dear SlingShot Trader Subscriber,

The equivalent to the expression “between a rock and a hard place” in Greek mythology is to be “between Scylla and Charybdis” – two monsters on either side of the strait between Italy and Sicily. Applying the expression to stocks is particularly apt right now, as investors focus on the struggling negotiations over Greek debt that threatens to spill over into Italy and the rest of the Eurozone.

Serious disagreements exist between the parties to the talks. How much are institutional investors (representing the six-headed Scylla) willing to give up in value, versus how much the Greeks (the deadly Charybdis whirlpool) are willing to pay in interest. Germany and the IMF are trying to push interest rates down, but that may not be a realistic option for bond holders. The potential for a “credit event” or default is still very high. Often credit-events can set off a cascade of financial repercussions which, through credit default swaps and obligations, can have far-reaching effects.

Negotiations in Greece are ongoing today after picking up where they were abandoned on Friday. The real issue is the impact that the deal, or lack thereof, will have on the debt market. Whether both sides agree to terms or not, downgrades could occur, and the margin at the institutional level could shift again. This is problematic for the new rally in financial stocks, which has pushed prices to mid-term resistance.

The stocks are up at the moment on a series of news that has been “less bad” rather than good. For example, today’s release from Goldman Sachs (GS) showed declining revenues across the board, but profits popped on salary cuts. We should all shed a tear for the poor GS employees, who now have an average salary in the mid $300,000′s. While that may not lead to any real belt-tightening, it represents the primary issue facing the market right now: How much further can banks and other stocks continue to grow, when so many profits are coming from cost cutting rather than top line growth?

In the chart below you can see how the financial sector has been performing on average. Resistance is in play, and a break or bounce could be triggered by the conclusion of the Greek debt talks. The news is clearly not all bad, though. A rally is in play, and although it is occurring on light volume, other cyclical stocks have been doing well enough to push the broad market indicies through resistance.

 
chart1
SPDR Financial Sector ETF (XLF) – Chart courtesy of MetaStock
 

If a positive deal is reached for Greece, and Bank of America (BAC) meets or beats expectations tomorrow morning, resistance could break and traders will start expecting to see last summer’s highs again. Fortunately, we don’t have to wait long to get the information we need. A change like that would shift our outlook, and motivate us to start looking for a few more positive surprises in the higher-risk sectors of the market.

Bank of America – The Earnings Report to Watch this Season

BAC is carrying a hefty burden of expectations this earnings season. More than 10% of the earnings growth for the entire S&P 500 for 2012 is expected to come from the firm (some estimates are even higher.) But BAC’s peers have not done much to back up that optimism. We have already seen reports from Citigroup (C), Wells Fargo (WFC), JPMorgan (JPM), and a few regionals like U.S. Bancorp (USB), but with the one-day exception of Goldman Sachs (GS) the reaction in stock prices has been muted.

The rally in financials over the last month seems to have been building up to fourth quarter reports, and any “good news” is already included in the price. This would help explain the lack of volume in the stock market and why bonds have continued to be in demand. We are in a situation now where only a positive surprise could move prices higher, rather than merely meeting expectations. And there are still more reasons to be cautious as we work our way through the week.

How the Market’s Precarious Balance Affects Our Trading

As news-traders, we are somewhat unbiased about market direction. We intend to continue taking positions that can profit on negative or positive surprises; however, as long as the broad market indicies remain above resistance, we plan to mix more bullish trades into our portfolio. Our calls on McDonalds (MCD) are a recent example of how we plan to execute that strategy. One difference is that we are more likely to close bullish news-based trades before the announcement than to hold through the report.

The reason behind that strategy is that a very positive announcement will often be priced into the stock before the report, and then implied volatility crashes following the release. That means that even on a positive report, calls can sometimes lose more value, due to a drop in implied volatility, than they gain because the stock moved up. Avoiding that drop by exiting early is a strategy we have frequently turned to during strong bull-runs. This is because the risk of opportunity cost (a big surprise) is lower than the known risk of a decline in implied volatility.

The Bottom Line for the Next Seven Days

Global events are in flux, and the potential for a decline in stocks is still very real. Earnings have been soft on average, but a few buyers have been willing to take some early bets that growth will resume in 2012. We are still playing this market on a day to day basis as new information is priced. There is the potential for volume to rise if traders are able to get past the latest round of Greek-debt talks and the BAC report is uneventful or positive.

As earnings season heats up this week and next, implied volatility levels can spike, which means we may have to buy a little extra time and pay more attention to the trend. This is not necessarily a bad thing, if stocks remain relatively positive. If the trend does continue, the biggest change for us will be the potential for more early-exits. Closing trades before the announcements becomes much more attractive in a bull market, and can shift the win/loss ratio further in our favor.

This Week’s Events

Earnings for Q4 are flowing, and the news has been soft but not alarming yet. Changes in the global debt market are probably the biggest source of risk currently, and we will continue to integrate our forecast for a resolution in our trade alerts. We will be discussing these upcoming events in more detail during today’s weekly webinar.

Jan. 18 – F5 Networks (FFIV) Quarterly Earnings – After Market Close

Jan. 19 – Bank of America (BAC) Quarterly Earnings – Before Market Open

Jan. 19 – Microsoft (MSFT) Quarterly Earnings – After Market Close

Jan. 24 – McDonalds (MCD) Quarterly Earnings – Before Market Open

Jan. 25 – Fed Open Market Committee Statement – 2:15 p.m. ET

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via email. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolio here.

Positions Opened

These are the SlingShot Trader positions we opened during the past week of trading and haven’t closed yet.

On Jan. 18 we recommended to ‘Buy to open’ the MSFT Feb 27 Puts for a maximum price of 37 cents.

On Jan. 17 we recommended to ‘Buy to open’ the MCD Feb 105 Calls for a maximum price of 55 cents.

On Jan. 12 we recommended to ‘Buy to open’ the FFIV Feb 100 Puts for a maximum price of $4.05.

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

On Jan. 17 we recommended to ‘Sell to close’ the AMTD Feb 17 Calls at market. The position was originally opened on Jan. 10 for 50 cents per share.

On Jan. 13 we recommended to ‘Sell to close’ the JPM Feb 35 Puts at market. The position was originally opened on Jan. 9 for $1.59 per share.

Top Trades Now

These are the current SlingShot Trader positions that we still recommend getting into now, assuming you can get in for the advised price or better and haven’t already bought a full position.

On Jan. 18 we recommended to ‘Buy to open’ the MSFT Feb 27 Puts for a maximum price of 37 cents. This position still looks good at our entry price or less.

On Jan. 17 we recommended to ‘Buy to open’ the MCD Feb 105 Calls for a maximum price of 55 cents. This position still looks good at our entry price or less.

On Jan. 12 we recommended to ‘Buy to open’ the FFIV Feb 100 Puts for a maximum price of $4.05. We still like this trade, but the earnings report we are trading takes place after the market close today. New entries are not recommended for Thursday.

Webinar Preview: Join Us Tonight at 6 p.m. ET

Every Wednesday at 6 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you have live access to us for an hour every week.

And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at johnandwade@slingshot-trader.com. (Please send any questions about the status of your subscription directly to Customer Service at service@slingshot-trader.com.)

If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.

Sincerely,

 

John Jagerson and Wade Hansen
Editors
SlingShot Trader