• This Week's Trade Ideas:
Bullish:
The Mosaic Co. > MOS (Trend Reversal Trade: SPECULATIVE!)
AND/OR:
CF Industries > CF (Trend Reversal Trade: SPECULATIVE!)
AND/OR:
Archer Daniels Midland > ADM (Trend Reversal Trade: SPECULATIVE!)

Bonus Idea:
SPDR Energy ETF. > XLE (Trend Reversal Trade: SPECULATIVE!)

Bearish:
Square Inc. > SQ (Trend Reversal Trade: SPECULATIVE!)

(Editor's note: These trade ideas may be updated periodically, in keeping with market conditions. They are intended solely for educational purposes.)

• Market Overview:
Once again, the FED is set to deliver the biggest news of the week. The FOMC minutes will be released at 2 PM Wednesday. Will they provide details as to the “whens” of balance sheet reduction? Will they show that rates are going to rise in the face of weaker than expected GDP, supposedly lower levels of inflation and stagnating wage gains?

• Below the Radar:
While Bubblevision dutifully cheers things on, some folks out there in the research and commentary arena are striving to explain the market in which “nothing matters” as long as that nothing is negative. The word “euphoria” is starting to pop up more as is “late cycle”…

• Options Academy:
A few earnings reports will trickle out here and there for the next few trading days but we’re about 10 days away from earnings season kicking in for real. With that in mind, we thought it might be a good idea to briefly review the “poor man’s straddle” concept.!

More interesting times came.  Will they stick around?

The Trade(s):

We strongly suggest attending tomorrow morning's Advantage Point Morning Call for full details with respect to these idea(s), last week’s and options education.  The resurgence in volatility we began to sense finally kicked in a little last week.  Will that continue through this short post-holiday week?

As usual, we’re still maintaining the “singles” oriented / risk-averse mindset and approach as we’ve been for some time and it’s with that in mind that we’ve generated the following ideas.  We may or may not be quick to take profits, should they develop.  It will depend upon the action in the stocks and markets as we observe them.  We’re presenting several ideas this week for specific educational purposes that we’ll cover in-depth in our webinar.  However, it’s worth noting here that agriculture may be finding a bid.

Bullish:

The Mosaic Co. > MOS – Buy the July 21st 23 Calls for $1.15 or less with a close or anticipated close above $23.85 in an up market with expectations for continued strength.
(Trend Reversal Trade: SPECULATIVE!)

AND/OR:

CF Industries > CF – Buy the July 21st 28.5 Calls for $1.55 or less with a close or anticipated close above $29.40 in an up market with expectations for continued strength.
(Trend Reversal Trade: SPECULATIVE!)

AND/OR:

Archer Daniels Midland > ADM – Buy the July 21st 41 Calls for $1.10 or less with a close or anticipated close above $41.70 in an up market with expectations for continued strength.
(Trend Reversal Trade: SPECULATIVE!)

Bonus Idea:

SPDR Energy ETF. > XLE – Buy the July 21st 66 Calls for $1.20 or less with a close or anticipated close above $66.50 in an up market with expectations for continued strength.
(Trend Reversal Trade: SPECULATIVE!)

Bearish:

Square Inc. > SQ – Buy the July 21st 23 Puts for $1.00 or less with a close or anticipated close below $22.65 in a down market with expectations for continued weakness.
(Trend Reversal Trade: SPECULATIVE!)

Outlook:

The DOW continues to melt up fueled by overnight futures jam sessions while the SPYs lag a little behind and the NDX even more so.  Things are mixed up a bit and sector rotations are grabbing the headlines.  Thus, tech remains heavy, the SPYs subdued and the DOW frothy.  The agricultural sector seems to be in the early stages of increased money flow.  Is this a defensive, value or “both” rotation???

Technicals:

Will be discussed in-depth in the Advantage Point Morning Call webinar.

Fundamentals:

These trade idea(s) are technically-driven.

(Editor's note: This trade idea may be updated periodically, in keeping with market conditions. It is intended solely for educational purposes.)

Recap of Last Week:

We finally got a trigger last week in the form of MSFT.  The indices moved “to and fro” and that allowed MSFT some operating space.  A new low was hit on Monday and the charts of MSFT still have an ominous look to them.  We put out an update last week that spoke to rolling or profit taking should MSFT drop to the $67.00 - $67.50 range and that is still valid.  Much as with other parts of the market, a “save” attempt was launched on Thursday but Friday’s wild action left MSFT at a new closing low and below the 50 SMA.  The 100 SMA lies below near $67.25 which is one form of support that help cushion MSFT’s fall, should it continue, and thus our profit taking/rolling approach makes sense there.  CSX was a non-trigger.

Once again, the FED is set to deliver the biggest news of the week.  The FOMC minutes will be released at 2 PM Wednesday.  Will they provide details as to the “whens” of balance sheet reduction?  Will they show that rates are going to rise in the face of weaker than expected GDP, supposedly lower levels of inflation and stagnating wage gains?  As we’ve noted many times, the market players read in and take out whatever they prefer from FED minutes, speeches, and for that matter earnings guidance etc.  The fact remains however, that whatever dominant spin that’s assigned to the FED minutes release will likely dictate the next big move in the indices if there’s a big move coming at all in this shortened week.  We’re approaching earnings season in the very near future and that’s typically bullish fodder.  Maybe the “levitation game” we’ve seen need only last a couple more weeks before predictable “earnings beats” can take center stage again…We have to remember that this is how the game is played.  We can’t harp on the fact that earnings peaked nearly 2 ½ years ago and the indices have rallied much higher in the absence of better earnings!  That’s just the way it is and is likely to remain until it doesn’t work anymore.  When will important factors such as that matter again?  It could be in a few weeks and it could be years from now.  We should remain focused on how the markets behave and the charts are our best source of information with respect to market behavior.  Moreover…

We intentionally left the SPYs chart above absent of annotations as the patterns in place may be most important right now.  The SPYs have been relatively “heavy” for a while as can be seen via the Parabolic (PSAR) in yellow dots.  The SPYs have been able to hold on the bottom of the rectangle we’ve drawn but also on the key support line of the large channel we’ve drawn.  The SPYs seem to be getting close to a crucial point in time wherein they could break in a big way or could yet again rally up to the top line of the rectangle which has proven to be stout resistance.  The clock has been ticking on the sellers.  They likely need to break the critical support of the big up-trending channel soon or they’ll risk the buyers regaining control and moving things higher.  Should the SPYs make a new all-time high that would likely trigger some short covering and then if earnings are good enough to juice the markets even more (we’d expect them to at least be spun that way, if at all possible), we could see the SPYs challenge the upper most resistance of the large channel later this summer.  Knowing that they need only hold things up a little longer to make it to earnings season might explain why the futures have been curiously pushed up nearly every night (without news backing) though most days of late have seen sellers dominate the session.  In short, the gang would seem to need to hold on only a little longer and then the time will be right for another leg of melt-up.  If, rather shockingly, the long-term support line is breached, that’s another matter entirely…

This Week’s Economic Reports

Yet again this week, we could write virtually the same paragraphs with respect to what’s been happening in the markets.  Instead, we’ll simply summarize:

1. The Wall St. operators push futures up overnight without a news driver.
2. Most of the trading day that follows consists of selling.
3. Sector rotations are dominating intraday action as well. Many money managers are refocusing for the second half of the year.
4. It seems that only a little more time is required to see if we’re on the verge of a breakdown or the next leg of melt-up.
5. The NY FED still forecasts Q2 GDP will come in below 2.0%. This doesn’t seem to matter.
6. The VIX is still relatively low but is attempting to lift off multi-decades lows of the recent past.

That just about does it.  Oh…except for North Korea launching ICBMs towards Japan.  That doesn’t seem to matter either.  There will plenty of items that do not seem to matter in Below the Radar just in case you were wondering…

While Bubblevision dutifully cheers things on, some folks out there in the research and commentary arena are striving to explain the market in which “nothing matters” as long as that nothing is negative.

The word “euphoria” is starting to pop up more as is “late cycle”.  Here’s a little bit from BofA courtesy of CNBC with respect to euphoria:

The BofA folks are making the case that this is the most euphoric reading that’s been registered since 2011.  That appears to be true with respect to this indicator but it stills appears well below other historical high points.  The full read is here:  http://www.cnbc.com/2017/07/03/euphoria-bull-markets-sell-side-indicator.html

Others aren’t pointing to indicators as much as they are raw data.  JP Morgan’s research team is pointing to the massive influx of passively invested capital year to date to explain the potentially precarious state of the market.  Why would capital inflows amount to a warning sign?  Well…the idea behind the graphic below is that the public, after hearing the financial media drone on endlessly about it, has finally decided to go big, very big, into passive investing.  In other words, the small-time amateur investor is jumping in with both feet which has historically been a reliable contrarian indicator.  In fact, it appears that many small-timers are panic buying as to not miss more of the rally.  They can’t take missing it any longer!:

Not to be outdone by JPM, the BofA team is back today with even more with respect to concerns that arise from the passive investing bubble.  In fact, they have 4 major warnings that they highlight here:

http://www.zerohedge.com/news/2017-07-05/four-major-warnings-bofa-sp-500-becomes-one-giant-etf

This piece is well worth the time to read it if you want better understand at least one component of the failure to correct/market euphoria stage we now seem to be entrenched in.

Here’s a few snippets that really caught our eye with emphasis added:

"when the world decides that there is no need for fundamental research and investors can just blindly purchase index funds and ETFs without any regard to valuation, we say the time to be fearful is now."  They also noted a previously voiced warning that that "the flood of money into passive products is making stock prices move in lockstep and creating markets increasingly divorced from underlying fundamentals" and that "as the market moves ever higher, there’s the potential for a sharp decline."

“This new market structure hasn’t been tested,” Bryan said, noting that the stock market has never gone through a major downturn when passive investors were as important as they are now. “We could get an onslaught of selling.”

The piece is chock full of informative tables and graphics but this particular one stood out to us.  It shows how Vanguard ALONE has become even more of a monster in a short period of time.  Of course, they’re big proponents of passive investing so naturally they’re benefitting greatly from the passive investing mania:

Assuming the graphic is accurate, we can see that Vanguard owns >5% of the outstanding float of 98% of all stocks!  Market breadth and internals may not be well in terms of broad-based buying but the investing public is long virtually EVERYTHING! Except protective puts!

Historically, the public acting very foolishly near tops in many ways, has been fairly-bankable in our view.  What follows may only add fuel to that fire.  Do recall that folks are behaving this way as auto inventories build!: http://money.cnn.com/2017/07/03/autos/long-auto-loans/index.html

“Car buyers are going deeper into debt and for longer periods of time as they reach to buy more expensive new cars.

The average car loan last month stretched out for 69.3 months, or nearly six years, according to Edmunds.com.

That's the longest average loan term ever recorded since Edmunds.com began tracking the statistic in 2002. Based on industry trends, it's very unlikely that it has ever been higher.”

The “no ask” loans are back big as well and the automakers are getting in even deeper when it comes to “fake till you can make it”.  http://www.zerohedge.com/news/2017-07-03/gm-reports-record-channel-stuffing-dealer-auto-inventory-highest-june-2007  As noted above, the auto inventory glut has become epic:

We don’t want to focus too heavily on Autoland.  We need to maintain balance and thus we’ll check out manufacturing as a whole.  Here are 2 very hot graphics straight from the presses.  First we’ll check on manufacturing in general:

It’s not just automobiles that are flashing red.  Manufacturing levels have retreated back to pre-Trump readings.  Let’s dig a little deeper into this area.  To do so, we’ll update our tried and true durable goods/new orders graphic vs. the performance of the DOW historically.

Week after week here in this newsletter we’ve noted divergences like the one above.  But, as we’ve noted before, there’s a strong correlation there that’s fallen apart.  Something is likely to give and soon.  The economy is about to pick up or the passive investing bubble will further inflate!

And just for further perspective (above), we can see that CB balance sheets are still working wonders for US equities but not so much for the USD, commodities, the economy at large or the yield curve!  Nothing to worry about!

As we begin to bring things to a conclusion, we need to focus on the manipulators behind the curtain, the FED.  They may be feeling like Dr. Frankenstein right about now.  Last week, many FED speakers tried to jawbone the equities markets down a little.  It was a very clear theme that emerge last week.  Naturally, the DOW was then goosed to a new all-time high!  The bubble they’ve fomented is now untamable.  Not even THEM trying to talk it down seems to matter.  Here are some of the headlines that hit the news ticker after the FED minutes were released:

FED OFFICIALS DIVIDED OVER WHEN TO START BALANCE-SHEET RUNOFF

FED OFFICIALS REPEATED SUPPORT FOR GRADUAL INTEREST-RATE HIKES

A FEW FED OFFICIALS SAW EQUITY PRICES HIGH ON STANDARD METRICS

FED OFFICIALS NOTED FINANCIAL CONDITIONS EASED DESPITE HIKES

A FEW OFFICIALS SAW LOW VOLATILITY STOKING RISKS TO STABILITY

Bloomberg Intelligence noted, financial stability concerns appear to be very high on policy makers’ radar and seem to be pushing the Fed’s hand to continue to gradually tighten policy.

Some participants suggested that increased risk tolerance among investors might be contributing to elevated asset prices more broadly; a few participants expressed concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability.

Even the central planning asset inflators at the FED are concerned about equity valuations but we have to remember one thing:  This remains the market in which nothing negative matters!

Finally, we have to briefly touch on another bit of dystopia creep, therefore…

Another week, another installment of March of the Robots.  The signature of the current “jobs recovery” has been one of lower wage/temporary jobs not those of the career oriented type.  This week we encountered a few stories on the Internet that covered the increase in adoption of robots that will not only threaten cashiers, order takers, bartenders and waiters but also short order cooks and masonry workers:

Here’s hoping that the robots next target political jobs and seats on the board of the FED.

A few earnings reports will trickle out here and there for the next few trading days but we’re about 10 days away from earnings season kicking in for real.  With that in mind, we thought it might be a good idea to briefly review the “poor man’s straddle” concept.

Folks are always looking for ways to capitalize on earnings releases.  Quite often earnings news and guidance can trigger explosive movement which can be lucrative for those on the right side of it.  Naturally, this draws great interest and options markets reflect these facts and thus “earnings” contracts that have expirations just after earnings releases often see their prices (implied volatility levels) rise significantly.  Many players, knowing that earnings can drive great movement will seek to acquire the at-the-money straddle as it will allow them to profit regardless of which way the stock moves AS LONG AS THE STOCK PRICE MOVES A LOT! (more than the straddle buyers paid for the straddle).  In fact, the ATM straddle price is often referred to as the “implied price move” that’s expected by options market participants.  The problem with buying the straddle is that it is normally very expensive relative to normal times and if the earnings produce a “dud” reaction, the owner of the straddle is typically crushed mercilessly shortly after the stock and options markets open post-earnings.  Thus, earnings straddle buying is often high-risk/ high-reward.  It’s this dilemma that can make the “poor man’s straddle” attractive but there can be a catch...

As the name implies the “poor man’s” acts like a straddle in some ways but it is a less expensive option that doesn’t deliver unlimited profit potential.  As always in economics, there’s a trade-off.   And it stays consistent in finance; the reward is commensurate with the risk.  Let’s look at examples of both to compare the main pros and cons…

NFLX is reporting on July 17^th and as a result the July 21^st expiration options are priced dramatically higher than non-earnings expirations have been historically.  With the stock price near $148.00, those options are thus the ATMs thus the ATM straddle is trading for about $13.60at present.  This suggests that the options markets participants are willing to pay that much for the straddle because they believe the earnings release will produce a move larger than that and thus they will profit. Of course, that could happen and if it were to happen the owner of the straddle could enjoy virtually unlimited profits as they own both a call and a put and are not short anything against them.  The other side of the coin in this case would be an earnings release dud.  If the earnings produced virtually no movement, it’s possible that in very short order the straddle value could fall all the way to say $5.60!  Remember, there would be very few days left until expiration (7/18 vs. 7/21) of those contracts and the NFLX news is out.  This “all or nothing” type proposition is what makes betting in both directions with earnings options so risky.  Now let’s look at the poor man’s…

The poor man’s straddle consists of shorting a calendar aka time spread.  Normally we seek to be long the calendar spread to profit via differing rates of decay.  We know that the calendar is worth the most when the stock price is at the strike of the calendar spread in focus, in this case, the $148.00 strike.  If we know that, then we also know that the calendar spread will lose value if the stock price moves away from the ATM calendar in either direction.  Thus, we profit much like true straddle owners; we make money if the stock price moves in either direction away from the ATM strike on the earnings news.

We’re going to have to extrapolate values because the perfect options to compare do not currently exist in the marketplace.  Fortunately, our trusty options calculator produced these apples to apples results:

Aug. 4^{th Exp}           148 call value = $7.50

Dec. 15^{th Ep}           148 call value = $13.80

Thus:

(Dec. 15^{th Exp} 148 call value = $13.80)  - (Aug. 4^{th Exp} 148 call value = $7.50) = $6.30 Calendar Sale Value

Let’s assume we sell the calendar spread the same day we’d buy the straddle and let’s also examine how the poor man’s would fare with no post-earnings movement or a big move up or down.  Keep in mind that we used historical real-world post-earnings volatilities as inputs to produce these values.  In other words, we used the volatility tilt (aka the term structure of volatility) across time to approximate the values as fairly as we could.   The day after earnings is July 18^th.  On that day with the stock price unchanged from where we sold the calendar (due earnings reaction) its value would be:

Aug. 4^{th Exp}           148 call value = $4.37

Dec. 15^{th Ep}           148 call value = $13.02

Thus, post-earnings the calendar value would be:

(Dec. 15^{th Exp} 148 call value = $13.02)  - (Aug. 4^{th Exp} 148 call value = $4.37) = $8.65 Calendar Sale Value

Since we sold the calendar originally for $6.30, it’s new value would leave us in the hole by $2.35.  That’s not a surprise since we used the poor man’s straddle and the earnings were a dud!  We lost a lot less than the $8.00 that true straddles owners would have!

HOWEVER, let’s now look at a $15.00 move up and down.  We’re going to jump to the results to save space:

$15 Move Up: @ $163.00 the post earnings calendar with realistic vol. assumptions is worth: $6.45

$15 Move Down: @ $163.00 the post earnings calendar with realistic vol. assumptions is worth: $5.55

Since we sold the poor man’s at $6.30, here are the net results:

$15 Move Up: $0.15 LOSS! (per contract x 100 shares)

$15 Move Down: $0.75 Gain (per contract x 100 shares)

WHAT??? Isn’t the poor man’s straddle supposed to be the smart play?

The answer is YES, it can be BUT… clearly in this example it is not a windfall even if we win.  The main reason for this is the realistic volatility assumptions that we’re using.  What’s happened in NFLX is that the marketplace has evolved to not only anticipate how participants are likely to play the ATM straddle but also how many of them will attempt to capitalize on movement in other ways and thus volatility levels are reflecting that reality.  The poor man’s can work very well but investors need to perform research on the respective volatility levels of the options/expirations that they’re utilizing to initiate the trade.  It’s not just as easy as slapping this crafty strategy on and collecting money!

It’s worth noting that much bigger moves in NFLX would help us potentially but we can’t regularly count on super-outsized moves to make us profits.

This example suggests that the thorough bird may not always get the worm but they may be able to consistently avoid losing their shirt, and time, and commissions, and focus, and so on…

Hopefully this cautionary tale will help you to steer clear of volatility traps.  If you have any questions please bring those to our next Advantage Point Morning Call webinar.

Have a great week!

The Advantage Point Team