Don’t look now, but trouble be brewin’ in the transport space.  With distribution on the rise and a test of the 50-day moving average imminent, things look a bit precarious.  Pundits looking for a palatable causation story will likely cite the recent rise in oil as the culprit for the transports’ demise.  No doubt many with a short-term memory would concur.  Since the beginning of the month crude oil is up 9% while transports are down 3%.   Unfortunately, such a conclusion is not only oversimplified but grossly overused every time high oil prices come to the forefront.

Though the correlation between oil and transports has turned notably negative over the past month, it spent the majority of 2011 in positive territory.  That is to say, both assets exhibited a strong tendency of moving in the same direction.  This evidence certainly casts a dubious light on the assertion that rising oil prices kill transports.

Some would go a step further and contend it’s not so much rising oil prices that hurt transports, but rather the elevation of oil to a high enough level (such as $100 or $110) that finally takes its toll.  Such an argument certainly appeals to ones intuition.  Yet, I’m not so sure recent evidence corroborates the theory.  In early 2008 when crude rose from $100 to $145, transports actually rallied for the majority of the surge.  An eventual bout of selling seized the sector in June but it wasn’t until crude had cleared the $130 level.  It’s worth pointing out that crude also became a victim of the selling a short one month later as it began its epic $100 drop.

We could also consider last year’s Feb to April rise of crude from $85 to $115.  Though the initial pop coincided with a drop in transports, they came back and rallied strong during March and April.  So, yet again we have transports rising in the face of strong oil.

The common argument that high oil threatens the performance of the transport sector is shaky at best.  With such a  fuzzy correlation it’s also difficult to time.  One day transports outright ignore the price of crude, the next day they care immensely.  Bottom line – don’t get caught up in the oil-transport correlation argument.  The actual chart of the transport industry will tell you when to be cautious, not the price of crude.

Source:  MachTrader

Apologies for the sparse posting of late. My attention has been otherwise occupied elsewhere.  I hope to be back to my normal blogging self in short order.

The equities market seems to have ripped a page out of the early 2011 playbook and is following it with unquestioning loyalty.  Bulls eager to draw support to their cause are parroting the classic tenet “a trend in motion stays in motion.”  The late 2010/early 2011 run provided the ultimate example of how low-volatility uptrends can enter Energizer Bunny mode for many many moons.

Bears growing weary of the relentless run maybe hoping one of the inevitable market corrections will come to the rescue.  Not a question of if, they say, but when.  Of course, when the current low volatility regime is overthrown and replaced by a more volatile leader remains to be seen.  Evidence for such a shift is scarce.

Speaking of volatility, the VIX futures term structure remains firmly in contango territory.  While February futures are swiftly approaching their deathbed (next Wednesday), they will still inflict damage to the beleaguered IPath S&P VIX 500 Short-Term Futures ETN (VXX) on their way out.  February futures currently sit at a $2 discount to March.  But, hey, cheer up VXX.  March is only trading at a $1.60 discount to April.  Still bearish for you, of course, but in a mildly less sucky kinda way.

One of the principle advantages of technical analysis is its universal application across all asset classes.  The obvious allure of this precept is the ease at which any investor can switch from trading one security to another without having to modify their thought process.  Fortunately, no intellectual leaps need to be made when one jumps from assessing a price chart of Google to a price chart of Crude Oil.

Certain dangers do arise, however, when one takes this technical analysis tenet to extremes such as assuming all you need to know is reflected in the price chart.  In some circumstances, price charts fail to reveal the complete story which can in-turn lead the well-meaning trader to draw a number of erroneous conclusions.    Consider the case of the iPath S&P 500 VIX Short-Term Futures ETN (VXX).  Unlike most assets whose price is driven solely by supply and demand, the price movement of VXX, particularly in the long run, is a driven by the term structure of VIX futures.

It’s behavior, therefore, deviates from what most traders come to expect from your everyday stock.  One particular quirk I’ve had to personally come to terms with is the VXX’s tendency to trend lower for extended periods of time without any type of counter-trend bounce.  It possesses the rare ability to enter oversold territory, setup camp, and abide there for as long as it darn well pleases.  Trading it successfully requires the ability to see past its oversold status and realize it will NOT bounce merely because it’s been beaten senseless.

In the end, those willing to try their hand at gaming VXX should consider removing the term “oversold” from their financial lexicon when analyzing this particular ETN.

When it comes to volatility trading, opportunity is spelled E-X-T-R-E-M-E-S.  While the eye of an option trader is trained to identify opportunity in all circumstances, it’s easiest to spot when volatility has deviated significantly from it’s mean.   Volatility traders are like obsessive stalkers.  They stealthily monitor volatility waiting for the ideal time to pounce.  Most of the time volatility is careful and sticks close to home (its mean).  But, on occasion it gets careless and travels a bit too far from the safety of its mean.  And before you know it, those seedy volatility stalkers swoop in and exploit the situation.

Such a circumstance seems to be cropping up in the implied volatility of AAPL options.  Following this week’s earnings announcement, 30 day IV has dropped to territory otherwise uncharted in recent years.  Unless AAPL is entering a new regime of depressed volatility, this deviation to the downside might become an opportunity to scoop up options on the cheap.  In this environment strategies like the stock replacement strategy become increasingly appealing to those looking to ring the register on profitable long stock positions while maintaining additional upside exposure through long call options.

One the other hand, with the compensation provided to option sellers quickly diminishing, short volatility strategies are losing their appeal.

Source:  Livevol Pro

To the naive spectator earnings announcements may seem like manna from heaven – a godsend providing instant outsized profits.  It’s not uncommon to see stocks explode higher capturing huge gains in a single day following their quarterly release. Take Google Inc. (GOOG) for instance.  In response to its last two earnings releases it was up a quick 13% and 7%, respectively.

Unbeknownst to these shortsighted investors is the fact that a large portion of the so-called manna is laced with arsenic.  Many earnings announcements are downright toxic and can result in instant losses of epic proportions.  Just ask any Netflix junkie that held into the October 2011 announcement which resulted in a 37% gap down.

Over time as earnings seasons come and go, one overriding truth becomes apparent – earnings announcements are the playground for degenerate gamblers.

Fortunately, shareholders can sidestep the earnings drama by utilizing the risk-reducing nature of the options market.  The iron-clad collar strategy affords the ability to protect stock positions into earnings. To initiate a collar, stock owners sell an out-of-the-money call option while simultaneously buying an out-of-the-money put option in the same expiration month.  With the collar in place, traders enter earnings with defined risk to the downside and limited reward to the upside.

Since Goldman Sachs is slated to report earnings next Wed January 18th, we’ll use it as an example.  Though, admittedly, it doesn’t tend to be a huge mover on earnings.

Suppose you own 100 shares of Goldman Sachs (GS) which is currently trading for $98.50.  To enter a collar you could sell the February 100 call for $4.15  and buy the Feb 95 put for $3.35.  At current prices you would receive a credit of $.80 to initiate the collar (the risk graph below displays the collar position).

By purchasing the Feb 95 put you acquire the right to sell your shares at $95.  That limits your downside risk to $3.50 (98.50 – 95) minus the $.80 received from entering the collar, or $2.70.

By selling the Feb 100 call you obligate yourself to sell the stock at $100.  That limits your profit potential to $1.50 (100 – 98.50) plus the $.80 received from entering the collar, for a total of $2.30.

Next time your waffling with whether or not to hold a stock position into earnings, consider appealing to the protection afforded by the collar.

Source:  MachTrader

Suppose we dipped a large bucket into a pool of traders, of which you and I are a part, to obtain a statistically significant sample.  From such a sample we might conduct all sorts of analysis to determine any number of data points.  Average account size, annual returns, percentage of profitable trades, survival rate, and strategies employed would all be of interest.

Despite the wide variety of trading strategies used by the masses, I suspect we could narrow them down to two broad categories:  trending and mean reversion.

The trending crowd seeks to exploit the continuation of price movement.  They live on momentum and the propensity of prices to trend in one direction or the other.  The mean reversion crowd often stands at odds with trend seekers as they pray to the market gods for non-trending conditions.

Some may wonder whether it is wise to implement trending and mean reversion strategies simultaneously.  The idea behind such a two-pronged approach is that at least one strategy should be thriving regardless of conditions.  And, in the event your management is top notch, you may have some months where both strategies produce a profit.

Consider the condor enthusiast for instance.  Their Achilles Heel comes in the form of rapidly rising or declining markets.  To combat these adverse conditions they may experiment with running a strategy designed to profit in strong trending markets concurrent with their monthly condors.  The successful implementation of this dual approach could serve to smooth returns by lessening the volatility of your equity curve. Of course, as a prerequisite for such an approach one would want to make sure they have a knack for both identifying and exploiting directional moves.  Those lacking such a skill would probably be best off sticking to their non-directional niche and avoiding the whole directional game.

It also might be worth mentioning that each strategy should do well when implemented on its own.  The combination of two crappy strategies won’t magically produce a winning approach.

Traders insisting on a stock-centric approach can sometimes miss clues residing outside the realm of equities. While any major momentum shifts will undoubtedly reveal themselves in the price of stocks, sometimes significant moves in other asset classes serve as early warning signs of an impending change in stock land.  By keeping tabs on these inter-market relationships, traders gain access to information that will either corroborate their current bias on equities, or perhaps give them sufficient reason to modify their outlook.

Take the strong inverse relationship between stocks and bonds for instance.  While stocks are part and parcel of the “risk on” trade and head higher anytime risk appetite is on the rise, bonds sit firmly in the “risk off” camp and are sought after when safety is deemed paramount.

The volatile behavior of stocks in 2011 did little to soothe the jittery investor, leading many into the welcoming arms of bonds.  In fact,  the 20-Year+ Treasury ETF (TLT) ended up over 28% on the year providing all sorts of goodies to those clairvoyant enough to jump aboard the long bond trade.  Interestingly, the bulk of the gains occurred in the August – September time frame concurrent with the failure of the US to reach the debt ceiling deadline and the subsequent S&P downgrade of the US debt rating from AAA to AA+.

The bond bull seems to have entered sleep mode since the beginning of Q4 2011.  Whether or not the last three months of consolidation end up serving as a launching pad for yet another surge higher remains to be seen.  A much better scenario for those rooting for higher stock prices would be a breakdown in bonds and subsequent trend reversal.  As evident in the chart below, the 50 day moving average along with the highlighted trendline has provided support for bonds over the last three months.  If the TLT can finally breach this key support level, lower bond prices may provide a much needed boost to stocks.

Picture the financial markets as one giant puzzle with different assets acting as the individual pieces.  The size of each piece varies depending on its importance in revealing the final picture.  Sometimes the individual pieces align to reveal a docile bull market, other times they combine to expose a ferocious bear market.  Let’s just say if the intermediate uptrend in bonds can turn south, the picture begins to take on more of a bullish tone for stock prices.

Source:  MachTrader

For related posts, readers can check out:
Bonds. Short Bonds.
Bond Yield Beatdown

It’s been a long time since I’ve addressed any viewer mail, so let’s kick off the new year by tackling a question from Trevor on everyone’s favorite volatility ETN – the VXX.

I was thinking of buying VXX outright, and selling a $40 Jan/2013 call against it. My breakeven after collecting the premium is 24% below current price. However, I’m concerned about time decay over the long term. What is the best way to take advantage of collecting some of the richest premiums out there with VXX?

A great starting point for this discussion is assessing whether or not VXX is an appropriate underlying for the covered call strategy.  To review, covered calls perform best in neutral to mildly bullish environments, while losing money hand over fist in bear markets.  In order to sell covered calls  on the VXX you would want to be able to make a compelling case that it will have a neutral to bullish year.  Given the death grip the bears have had on VXX since inception, you’ve certainly got your work cut out for you.  In fact, I bet it would be difficult to find many stocks that are worse buy and hold candidates than VXX.

If you’re heart is set on covered calls, then there are probably hundreds of alternatives that are altogether more likely to be neutral to bullish this year.

Now, suppose you did in fact come up with an intriguing argument that VXX will finally conquer the contango beast and throw together a nice mildly bullish move this year.  I would not encourage jumping right to one year options when selling covered calls. Why not sell 6 two-month call options, or 12 one-month call options over the year?  It affords more flexibility plus will rack up a lot more premium over time.

The covered call profits from time decay so far from hurting your trade, it actually helps.   I’m not really sure what you’re concerned about there.

As for “the best way to take advantage of collecting some of the richest premiums out there with VXX”, it all comes down to your directional outlook.  If you believe option premiums are consistently on the high side, then you would want to be a net seller of options, regardless of what strategy you employ.  In the event you’re bearish, you may consider short call spreads, call ratio spreads, or maybe put calendars.  When bullish, consider selling puts outright, short put spreads, or put ratio spreads.

For related posts, readers can check out:
Reflections on VXX
The Comeuppance for VXX Bulls

Inherent in our DNA is a natural fascination with stories; a need for a narrative offering easy explanations and digestible answers.  No doubt this curiosity acts as an internal impetus driving all of us to seek out answers to intriguing questions.  While it paves the way for new discoveries and intellectual leaps, it can also lead the gullible masses to gobble up whatever is being peddled by the latest guru. In the land of story seekers, the master storyteller is king.  Even if his persuasive tales are riddled with errors.

In the world of trading I wonder if this natural attraction to stories lies at the heart of a mistake which I suspect is quite common – the continuous attempt to explain market movements.  Searching for the “why” behind the “what”, as it were; the perpetual need to determine why some asset rose or fell on any given day.

From an economics standpoint the answer to such a question is actually quite simple.  Prices dropped because supply exceeded demand or prices rose because demand exceeded supply.

Not satisfied? Well, head on over to your favorite financial media site and dollars to donuts you’ll find some pundit opining on a news item or compelling reason that ostensibly caused the price move.  As if said pundit could actually enter the minds of the millions of investors that bought or sold the security in question  and figure out their true motivations.

Those who focus on the underlying theory behind why a particular asset is moving in one direction or the other tend to be much slower to react when adverse conditions arise.  They stubbornly cling to their version of the story, unwilling to face an alternate reality. Consider, for instance, those loyal traders unwilling to disembark from their silver spaceship which they vehemently contend will yet continue its inflation driven rise to the stratosphere. Does it really matter what the bullish story is when you have to sit through a  44% peak to trough drawdown?  Silver bulls who exited when price proved them wrong have no doubt salvaged untold amounts of emotional capital.  What should happen or what should have happened is a weak consolation prize to what IS happening.

Stories are a lousy substitute for a chart.  An overemphasis on building theories to forecast what should be happening leads many to under-emphasize the actual analysis of what is happening in the here and now.

As a trader I find little, if any, utility from the majority of news articles out there.  While sometimes entertaining, they rarely lead to the making of a better trading decision.  And don’t confuse the ability to spin a compelling tale with successful investing prowess.  If connecting the economic dots of  intermarket relationships was a prerequisite to success, the savviest traders would be professors from academia.

In an arena such as ours where timing is everything, the ability to analyze what is happening is altogether superior to crafting a palatable theory on why it is happening.

Given the exclusivity of my top ten list based on page views, it is inevitable that a few of my favorite posts fail to make the cut.  As a blogger it’s always interesting to see which posts gain traction and resonate with the masses and which ones fall flat.  Some are embraced with many a retweet, while others arrive with nary a welcome party.  Over time I think most bloggers develop a sixth sense of sorts where they can identify the posts which will become most popular before even clicking the publish button.  Nonetheless, I am occasionally surprised when a post which I thoroughly enjoyed putting together falls short in the court of public opinion.

So consider today’s list my attempt to give some of my favorite posts of 2011 one more day in the spotlight before they slip quietly away into the archives.

1. Circus of Chaos
2. The Two Handed Economist
3. I’ve Seen This Movie Before
4. The Gap Robber
5. Repetition Repetition Repetition
6. My Idea Factory
7. Strategy Hopping
8. The Adventures of Encyclopedia Brown
9. A True Meritocracy
10. A Monopoly on Trading Wisdom
11. The Power of Slow
12. A Bet is a Bet is a Bet
13. The Charting Popularity Contest
14. The Residual Affects of a Drawdown in Emotional Capital
15. Jack of All Trades
16. The Teeter-Totter of Performance
17. Beware the Backwardness of the Option Learning Curve

For related posts, readers can check out:
My Faves 2010
My Faves 2009