Dear SlingShot Trader Subscriber,
Welcome to the first edition of the SlingShot Trader Weekly Update newsletter! Each Wednesday afternoon, you’ll receive our thoughts on the market, a preview of coming news events and a review of our existing trades. Then, Wednesday evenings at 6 p.m. ET, we’ll host a live webinar in which we’ll go into further detail and also answer your questions live.
Now, let’s dig right in!
Traders are driving prices up to resistance around the 1,200 level on the S&P 500, and they’ve seemed willing to give this week’s jobs reports the benefit of the doubt. Or have they? Yes, prices have risen, but there has been very limited participation.
Volume has been falling since the initial crash this month, and that’s normal during a consolidation. However, to be statistically predictive, the “breakout” we saw Monday should have been accompanied by a volume spike. Unfortunately, volume didn’t confirm a breakout, which means the current trading range between S&P 1,100 and about 1,200 is still intact — and prices most likely are headed back down toward the bottom of this range.
Below is a chart of exactly the kind of volume pattern we don’t want to see when the market reaches resistance in the chart of the SPDR S&P 500 Index ETF (SPY).
Chart courtesy of Metastock
As you can see, Monday’s volume was particularly low — just barely higher than the levels we saw right before the crash in late July. Extremely low volume is important because it represents a lack of commitment from traders to the current price movement.
If no one is trading now, then they’re probably waiting for something to happen. Right now, there’s only one thing anyone has been waiting for: the August unemployment reports — one released this morning and the other due Friday.
Because of the lack of commitment in the market, we’ve been looking for bearish news-based opportunities. Earlier today, we opened some puts on Manpower Inc. (MAN), a staffing and outsourcing firm headquartered in North America. The firm was up a bit this morning — following the ADP jobs report — on speculation that the labor market is improving.
This move up gives us an opportunity to buy puts right before the official labor news hits Friday morning. This is sometimes referred to as “selling the news” — when speculation is running prices higher just before the scheduled report. We think MAN is getting overextended and likely will decline quickly when the bubble pops after the Friday’s jobs report. Because of the recent rally, prices are low and volatility is mild, which improves our risk/reward profile considerably.
Is a Jobless Recovery Really a Recovery?
This week, we’re hearing from two different sources about how many jobs were added to or subtracted from the economy and whether the unemployment rate changed in August. Economist expectations for this month’s numbers actually aren’t that bad considering the panic we’ve seen in the financial markets recently. However, there’s a strong bias toward a negative surprise once you look past the headline numbers.
Chart courtesy of St. Louis Federal Reserve Bank
The chart above tells a strange employment story. It measures the percentage of adults in the United States who are working in the labor market compared with the total available working population. The United States took a hit during the 2001 recession (that’s the first shaded area), then flattened out after the recovery started in 2003. However, the latest “recovery” has been accompanied by a more severe decline in the participation rate.
This measure is a long-term indicator, and although the trend is alarming, it might seem irrelevant for short-term option investors. But it’s really quite useful when we’re trying to make trading decisions. If the labor market is shrinking (that’s different from the official unemployment rate), then consumers have less money, there’s less momentum behind growth, and stocks will tend to move faster to the downside following negative news surprises.
It isn’t a coincidence that about 80% of our biggest winning trades (those with more than 100% gains) in our last four months of beta-testing have been bearish.
– Youku.com (YOKU) Sept 33 Puts, closed on Aug. 8 for a 102% profit in 5 days.
– Glu Mobile (GLUU) Sept 5 Puts, closed on Aug. 2 for a 112% profit in 11 days.
– Clorox (CLX) Aug 70 Calls, closed on July 15 for a 224% profit in 2 days.
– Ralph Lauren (RL) Jun 120 Puts, closed on May 25 for a 121% profit in 5 days.
– Advance Auto Parts (AAP) Jun 65 Puts, closed on May 19 for a 135% profit in 3 days.
– Staples (SPLS) Jun 19 Puts, closed on May 18 for a 475% profit in 1 day.
The jobs numbers from ADP this morning were just below expectations, but so far traders seem to be undisturbed. This initial reaction may be a little misleading: The official government report on Friday usually has a more lasting effect on stocks and can vary significantly from the Wednesday report. In either case, the news was not great, so our bias remains the same.
So How Do We Turn News Into Profitable Trades?
Many people try to trade the news — and more often than not, the stock doesn’t act the way they thought it would. We’ve been trading the news successfully for a long time, and our mission here at SlingShot Trader is to help you trade news the right way.
The problem that most news traders deal with is that too often an option’s price doesn’t follow the stock. In general, a call or put will rise or fall with the stock, but the pace of that price change will differ depending on demand for the option and the expectations of traders or market makers on both sides of the trade.
Expectations for volatility obviously grow before a pending news event, having a very large impact on an option’s price in the short term. Greater expectations for a big move will inflate an option’s price. Prices also can fall very quickly following a news event, creating losses even if the stock moves in the direction of your forecast.
At SlingShot Trader, we solve this price inflation/deflation problem for you, dramatically increasing your chances of being profitable. We do this by looking at historical examples of the same news event to determine whether those expectations (embedded in an option’s price and reflected in implied volatility) are in line with the extreme reactions of the last several announcements (earnings, labor, sales data, etc.) before making a purchase. If the option’s current price shows that expectations for volatility are lower than they should be — based on the potential reaction — then we consider it undervalued and ripe for a trade.
We’re always looking for those rare conditions when the market has underpriced the unknowns. We look for an option with a price that is too low compared with historical reactions to the announcement. When this happens, we stand to make massive gains if our trade is successful, and we’ll lose less if we’re wrong.
In order to find trades like this, you have to know what expectations are now, what they’ve been in the past and whether there is a significant mismatch between them. If there is a mismatch, then we have a potential trade entry opportunity. We’ve been writing about and using this kind of analysis for several years: We first published a version of this strategy in Stocks and Commodities Magazine in March 2005.
Because this kind of analysis is specialized and requires access to data that typically isn’t available to individual traders, you may be unaware of when expectations are too high compared with the past and not realize how much more risk you’re taking on. But via your SlingShot Trader subscription, you — the individual trader — can access that research and make the same trades we are without having to spend hours every day doing the research by yourself.
This Week’s Events
Here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.
– 8/31 ADP employment report (out this morning; see comments above)
– 9/1 U.S. manufacturing sentiment report (also known as the ISM, PMI report)
– 9/2 non-farms payroll and U.S. unemployment reports
– 9/9 Kroger Co. (KR) quarterly earnings report
– 9/9 Federal Reserve interest rate statement
Our Bottom Line
Bad news doesn’t have to equal bad profits. Because stocks move further and faster to the downside than they do to the upside, we news traders can be better off in a bear market. There’s always the potential of a positive surprise, but at this point, our strategy of taking short-term positions that will profit from disruptive announcements looks solid. It’s always more emotionally satisfying to be a bull, and we have no doubt the market will get back to that eventually. But in the meantime, let’s make some big slingshot trades to offset those dismal headlines in The Wall Street Journal.
When it’s time to open or close a trade, we’ll send you alerts via e-mail. 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 portfolios here.
Manpower Inc. (MAN) – Earlier today, we recommended you to “buy to open” the MAN Oct 35 Puts for $1.05 or less.
Jos. A Bank (JOSB) – On Aug. 29, we recommended you to “buy to open” the Oct 40 Puts for $1.70 or less. By the time the alert landed in your inbox, the pricing was even better — $1.55 on the ask. This morning, the stock surprised to the upside on good earnings, but volatility is high enough to close it out and preserve some of our capital. Earlier today, we advised you to “sell to close” the puts for 45 cents or more.
Top Trades Now
Manpower Inc. (MAN) – See Positions Opened above.
Webinar Preview: Join Us Tonight at 6 p.m. ET
Every Wednesday evening at 6 p.m. ET, we’ll host our 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’ll have live access to us for an hour every week.
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If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It should be posted within about two hours of the end of the live session.
John Jagerson and Wade Hansen