Look Out for the 900-Pound Gorillas

Dear SlingShot Trader Subscriber,

The Fed’s minutes from the last Federal Open Market Committee (FOMC) meeting were released yesterday, and the notes helped stocks come up off their lows. The minutes are hinting at an additional round of quantitative easing (QE3) and how that should be used in a communication strategy to market participants. We also learned that the International Monetary Fund (IMF) will be opening two new credit facilities to help bail out troubled economies, such as in Europe. The combined efforts could lead to significant short-term changes in the market.

The really big money in the market isn’t hedge funds or commercial banks. Nor is it Warren Buffett, Steven Cohen or Bill Gross. The biggest market participants often are referred to as the “official sector,” which includes semi-government entities such as central banks and the IMF. Normally, the activity in this sector is relatively slow and mild. However, the stock and bond markets are anything but normal these days, and as a result, the 900-pound gorillas in the official sector are incredibly active.

The gorillas get restless when prices are moving “too fast,” but their increased activity can cause even more volatility when they overwhelm normal market fundamentals. This leads to a feedback cycle in which more uncertainty creates a greater incentive to intervene in the markets, which then leads to more volatility — and so forth.

Opinions vary among investors about the proper amount of intervention that should be used by the official sector. There are even many who believe that there shouldn’t be any intervention at all. The question probably will be resolved only in theory given that fully managed or non-managed markets never have existed and likely never will.

The argument is moot anyway for option traders: Intervention is happening now and will be increasing in the short term.

 

What Is Quantitative Easing? 

Quantitative easing is actually a misnomer that describes a broad spectrum of activities (including bailout credit lines) that are used to drive down the cost of capital or interest rates. The Fed, the IMF or the European Central Bank (ECB) can do this by pushing cash into the market and purchasing other assets such as government bonds. This increases the supply of money and reduces the yield on bonds. Theoretically, this could create an incentive for investment by banks and businesses. It also can (very theoretically) reduce the borrowing costs of governments, which is the problem faced by countries in the eurozone.

When it comes to making estimates about the potential impact on stock, bond and commodity prices in the long term, investors have very limited experience with prior rounds of quantitative easing. There’s a lot of guessing going on, and the stakes are high. That’s why we see such a large trading range in the stock market on a day-to-day basis. This also is one of the main reasons the market has been channel-bound for so long.

We’ll leave it to others to argue whether quantitative easing is a good thing or a bad thing in the long term. But it will have an impact on our short-term trading decisions. The last few rounds of this kind of government activity have had a remarkable correlation with stock rallies and declines. This may not be the worst thing for traders who are looking for big wins in the options market in the next few months.

 

How the Market Responded Last Time

As you can see in the chart below, the last few announcements were strongly correlated with stock rallies at the beginning of QE campaigns as well as declines when they ended. We don’t see any reason why this pattern wouldn’t repeat itself this time around.

Chart courtesy of Metastock


As you can see, the anticipation of a round of QE has had just as strong an impact on stocks as the QE itself. Despite the news this week, it’s a little early to expect immediate changes to the market. And with the holiday this week, we don’t expect major changes to occur. However, the potential for a rally in stocks is close enough to justify maintaining a balanced outlook for the market. Continuing to look for undervalued calls AND puts in this market is likely to produce the best results until (or if) a trend emerges while traders get a handle on the planned intervention by the 900-pound gorillas.

The good news is that this uncertainty can be a benefit for long option buyers. We have the opportunity for unlimited gains if a trade goes our way — but losses are capped. This is an important side benefit of trading in an aimless market like this one.

 

This Week’s Events

Earnings are quieter this week, and with the holiday in the United States, we’re expecting volume to drop a little and price ranges to calm down. As usual, however, there are a few very key reports that should be followed. We’ll be discussing them in today’s webinar at 6 p.m. ET.

  • 11/28 — U.S. new home sales — 10 a.m. ET
  • 11/29 — Tiffany & Co. (TIF) quarterly earnings — before market open
  • 11/29 — H&R Block (HRB) quarterly earnings — before market open
  • 11/29 — U.S. consumer confidence — 10 a.m. ET
  • 11/30 — ADP non-farm employment change — 8:15 a.m. ET

 

The Bottom Line for Next Week

The effect on the market from the actions of the big central banks could be dramatic. There’s a good chance that speculation for QE3 could start to lift prices, and we need to be flexible in the kind of trades we’re seeking. We’re already evaluating a few positions that could take advantage of another announcement by the IMF, the ECB or the Fed.

On a more practical note, we aren’t entering any further trades this shortened week so that we won’t take a big hit in time value. This is normal before the Thanksgiving weekend each year. Volume usually is low, which can increase our costs, which reduces our edge in the market. We would expect to send one or two new entry trades alerts on Monday.

 

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. You also can see more trade-specific details by clicking on the trade links below.

 

Positions Opened

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

No positions are still open.

 

Positions Closed

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

Pandora (P) We bought to open the P Dec 11 Puts (P111217P00011000) on Nov. 21 for $1.30. Earlier today, we recommended to “sell to close” the puts at market near breakeven. We closed the trade at $1.25, for a slight loss.

Tiffany & Co. (TIF) We bought to open the TIF Dec 65 Puts (TIF111217P00065000) on Nov. 22 for $1.39. Earlier today, we recommended to “sell to close” the puts at market. We closed the trade at $1.95, for a 40% gain.

Chico’s (CHS) We bought to open the CHS Dec 11 Puts (CHS111217P00011000) on Nov. 17 for 50 cents. On Nov. 22, we recommended to “sell to close” the puts at market. We closed the trade at $1, for a 100% profit.

Tyson (TSN) On Nov. 21, we recommended to “sell to close” the TSN Dec 19 Puts (TSN111217P00019000) at market. We closed the trade at 65 cents, for an 8% profit.

Lowes (LOW) On Nov. 17, we recommended to “sell to close” the LOW Dec 23 Puts (LOW111217P00023000) at market. We closed the trade at 58 cents, for an 18% loss.

Buckle (BKE) On Nov. 17, we recommended to “sell to close” the BKE Dec 40.25 Puts (BKE111217P00040250) at market. We closed the trade at $2.20, for a 59% gain.

 

Top Trades Now

These are the current SlingShot Trader positions that we still recommend getting into now, assuming you haven’t already bought a full position.

No positions are open. Look for new trades on Monday.

 

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