Dear SlingShot Trader Subscriber,
The credit rating agency Moody’s has downgraded two of the largest banks in France and put another one on review. As usual, the credit rating agency is lagging the market that has already significantly discounted all three stocks during the last few months. Two of the banks, Societe General and BNP Paribas, have announced plans to trim assets on their balance sheets to improve capital structure.
Those of you who have been watching the European debt crisis unfold during the last few months will remember that rumors about Societe General going bankrupt on Aug. 10 led to a 14.7% one-day sell-off in its shares. The CEO denied the rumors and asked for an investigation into the source. Although the bank certainly isn’t bankrupt, it now looks like those rumors had some truth in them.
None of this is a surprise to traders who expected for several weeks that such a downgrade was coming, but the reality of the downgrade is likely to put bearish pressure on the market again. This action certainly will increase volatility, if not an outright break to the downside (more on this later), but it’s not bad news for us at SlingShot Trader. Volatility traders like us do better when the market is moving fast because profitable trades are larger.
There may be some opportunities to trade against European banks in the near term, but right now we’re holding back because options prices are too high. We don’t have to trade banks to profit from uncertainty in the credit market. Individual consumers are very sensitive to these kinds of disruptions, and we’ve already entered two trades this week that can profit from falling margins and lowered future outlooks in consumer and retail stocks.
Why Is Volatility Bearish?
Trading has been a little light in the market while the channel between 1,100 and 1,250 on the S&P 500 (SPX) remains intact. The real issue for investors is not so much that the channel is tight, but rather that the daily trading ranges are so wide. This kind of market action is common when traders are bearish and could be a sign that the decline in stocks isn’t over yet.
You can see an interesting way to visualize this kind of market action with the average-true-range technical indicator, which measures the average distance between the extreme highs and lows from one close to the next. We have applied it to a chart of the S&P 500 index, and you can see how high trading ranges are currently versus the market channel that existed from February through July of this year.
In a bull market, trading ranges or volatility start to drop, as you can see from October 2010 to February 2011 in the chart above. Does this predict that stocks will break out of the current channel to the downside in the short term? The timing might be a little tricky, but we can say that this isn’t a good sign for the next month or two.
Is This Bad News for Us?
Although the chart above might be bad news for buy-and-hold investors, it represents a good situation for us. We are volatility traders – so the more, the better. If traders are anxious, they will have a bias toward downside breakouts, and we will continue to look for the best short-term setups in that direction as well.
We believe that the full impact of further declines in the European consumer markets hasn’t been priced into the market (despite the bank downgrades) because traders continue to account for a small chance that the European debt crisis can be resolved without a spreading default. That seems to be a very long shot.
Remember, It’s All About Expectations
The two trades we opened this week both are primarily earnings plays. That can be a little confusing because we really aren’t trading based on what we think earnings are but what we think expectations for future earnings will be. It’s a subtle, but important, difference.
We opened a new position on Carnival Corp. (CCL) today in anticipation of its earnings report next week. However, the actual results from this quarter are likely to be “good” because this is a big season. We bought puts because we’re anticipating that management will make negative comments about the company’s future outlook. That part of the earnings report typically will have a much bigger impact on a stock’s price than anything else.
For example, CCL released first-quarter 2011 earnings on March 22, with actual earnings above analyst expectations, strong orders, improving margins and an increase in its dividend. And yet, the stock plummeted and has not recovered. The issue traders really cared about was included in the following quote buried two-thirds of the way down the earnings press release.
“The company expects full year net revenue yields, on a constant dollar basis, to increase 2.5 to 3.5 percent compared to 3% to 4% in its December guidance. As previously announced, the change in yield guidance of approximately $44 million, or 5 cents per share, results from the itinerary changes in the Middle East and North Africa necessitated by the political unrest in that region.”
The outlook for growth in future profits was reduced — and that made all the difference. We expect to hear this kind of news again from CCL when it announces earnings next week, as management begins planning for recession-level spending in Europe.
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:
- 9/15 — Pier 1 Imports earnings report before market open
- 9/15 — U.S. Consumer Price Inflation Core
- 9/16 — U.S. Treasury International Capital Flows (TIC Data)
- 9/20 — Carnival Corp. earnings report before market open
- 9/20-9/21 — Federal (Reserve) Open Market Committee Meeting
Our Bottom Line
We’re not finished with volatility in the market, and that’s good for us. But it means we have to be careful about our trade timing. Getting in before premiums ramp up and managing costs as closely as we can will be critical to making the big wins during the next several weeks. We’ll continue to evaluate short-term bullish positions if support on the major indexes holds, 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 email. You also can sign up to receive text messages regarding our trades. For more information about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here.
Carnival Corp. (CCL) – On Sept. 14, we recommended you to “buy to open” the Oct 31 Puts for $1.55 or less. We still like this trade.
Pier 1 Imports (PIR) – On Sept. 12, we recommended you to “buy to open” the Oct 10 Puts for 80 cents or less. We still like this trade.
CurrencyShares Euro Trust (FXE) – On Sept. 7, we recommended you “buy to open” the FXE Oct 138 Puts for $2.25 or less. On Sept. 9, we closed the position for a 77% gain.
Smithfield Foods (SFD) – On Sept. 6, we recommended you “buy to open” the SFD Oct 21 Calls for $1.05 or less. On Sept. 8, we closed the position for a 7% gain.
Top Trades Now
Carnival Corp. (CCL) – See Positions Opened above.
Pier 1 Imports (PIR) – 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