Shedding some light on the violent stock market moves

Have you ever heard of the saying Be careful what you wished for? It turns out that traders wished to see some growth in average hourly wages, some inflation over deflation and yields on long duration bonds to go up. They got their wish which started a violent market correction.

Market watchers remain at odds over what tripped the sell switch. Primarily, the conversation comes down to fundamental vs. technical. In the days since the correction began the markets have recouped more than half the downside since the low point.

Plenty of theories, I call mine “The Domino Effect”

Inflation fears was the first domino to fall hitting the fear of raising interest rates. The next domino to fall was money managers and institutional investors were caught with a lot of leveraged positions. The sharp fall triggered margin calls causing massive sell orders. This initiated sell orders from funds that use technical analysis better known as quantitative funds. The last domino to fall was retail investors (who haven’t seen a correction in over two years) did some panic selling.

The Dow suffered two drops of 1,000 points. The fall seems big but the actual percentage was not extraordinary. There have been larger percentage drops in the past. In my 35 years of investing, I have experienced some worse percentage downward moves.

Rank Date Close Net change % change
1 October 19,1987 1,738.74 −508.00 −22.61
8 October 26, 1987 1,793.93 −156.83 −8.04
9 October 15, 2008 8,577.91 −733.08 −7.87

 

Is the correction over?

The market fundamentals haven’t really changed. U.S. corporate earnings are getting better and the Trump tax cuts should boost economic growth. Plus there is systematic economic growth happening in both developed and emerging markets.

I am not an expert on technical analysis and I don’t believe in buying or selling based on lines on chart. However, pension funds, hedge funds and quantitative funds use technical indicators to manage a large amount of investors’ money. 

Analysis from Kensho, a quantitative analytics tool used by hedge funds, looked at seven occasions of similarly sharp drops in the S&P 500 beginning in 1987. The study found that following such a drop, stocks tended to fall further, with a median decline of 2.29 percent one week later and a drop of 1.68 percent two weeks later.

 

This is the ABCD bullish chart:

This is the year to date chart of the S&P 500:

In my humble opinion, corrections tend to last more than nine days. I put some money to work last week and plan on dollar cost averaging on some more positions. If you are new to my blog, consider reading:  Dollar-cost averaging using an option strategy

What do you think? Are you buying the dips or selling into the rallies?

Advertisements

Home bias adds sector risks for investors

 

 

 

 

 

 

 

Legendary investor Warren Buffett, among others, is notorious for telling investors to buy what they know. Basically, Buffett and his enthusiastic followers suggest investing in companies that you really understand or at least know enough about them to be able to explain how they make money.

That is fairly good advice if you are an American since the S&P 500 generates nearly half of its revenue from outside of the United States. However, there is still a lot of risk in the form of sector concentration. For example, the tech sector accounts for nearly 21% within the S&P 500.  Do you remember the bursting of the dot com bubble?

Home bias for Canadian investors is really risky. Seventy–five percent of the Toronto stock market is dominated by three sectors, energy, materials and financials. There are only a handful of companies in other sectors that are available to further diversify your portfolio. Year to date, the Toronto stock exchange is only up 5% compared to the S&P 500 which is up 18.5%, see chart below:

The Canadian market has under-performed when compared to the U.S. markets for the past five years. The main reason is the decline in oil prices which has effected many non-energy sector companies which still rely energy prices in determining their revenue growth. For instance, Canadian banks may rely on loans to energy companies to drive their growth rates. See the 5 year performance chart below:

Why home bias exists

Vanguard’s Investment Strategy Group identified a range of reasons why investors might not embrace global diversification, including concerns about currency risk and an expectation that their home country will deliver out sized returns.

One factor we identified—preference for the familiar—seems particularly relevant. With so much global uncertainty about geopolitics, monetary policy, and the economic outlook, it’s understandable why investors may not want to stray too far from home.

Why Canadian markets may continue to under perform the U.S.

  • Oil and gas exports are land locked and selling at a huge discount!
  • The housing market is slowing down due to a 15% foreign buyers tax, tightening mortgage rules and higher mortgage rates.
  • Tariffs on softwood lumber and airplanes from our largest trading partner (U.S.) has put the success of re-negotiating NAFTA questionable.
  • Passing of the U.S. tax reform legislation will make investing in Canada less attractive (plus we have a carbon tax and high electricity rates).
  • Canadian consumers are carrying high levels of debt which will slow down spending.

Exchange traded funds are a low cost way to diversify your portfolio outside of North America. Many providers offer the ability to hedge fluctuations in foreign currencies. 

The markets are due for a correction, I would recommend slowly increasing your exposure to the U.S. stock market.

A fun exercise: Stock picking verses indexing

The average person is afraid of investing in individual stocks and 61 percent of millennials say they’re afraid of even getting started. Despite the fact that investing in the stock market has been shown to be the most efficient and effective way of turning money into more money.

Financial website How Much took a look at some popular stocks in 2007 to find out how much a $1,000 investment in each would be worth now, as of October 31.

In the above picture, the blue dots are equivalent to the $1,000 initial investment, so they are the same size for each company. The pink ones represent the current total value of the investment, so each of those varies.

The larger the pink circle, the more your investment is worth,” according to How Much. “If the pink fits inside the blue, then you lost money. The graphic assumes that you took any dividend paid out in cash and did not reinvest into the company by buying more stock.”

Warren Buffett, Mark Cuban and Tony Robbins all agree index funds are a safe bet, especially for new investors, since they fluctuate with the market, stay pretty constant and eliminate the risk of picking individual stocks. However, if you were lucky enough to pick these 15 American stocks, your $15,000 would have been worth $99,291 compared to $26,741 for the S&P 500 (SPY).

What if you missed owning the two top performing stocks Netflix & Amazon? Your total return would have been $34,927 assuming that you didn’t panic during the great recession. There are other household names like Facebook or Visa that could have help you beat index returns.

Keep in mind, it is easy looking backwards! I do remember getting phone calls and emails from formal clients and co-workers looking for advice during the market meltdown of 2008-09. It is hard to do nothing and hold on to your investments when markets are down 35% to 45%!

My point is simple, even with the worse meltdown (2008-09) since the great depression of the 1930’s, you would have still made money investing during the past ten years. Investing in the stock market is still the most efficient and effective way of turning money into more money.

 

 

 

Opportunities for option traders on the takeover of Time Warner

Back in late October, I wrote that AT & T had reached an agreement in principle to buy Time Warner for about $85.4 billion, Time Warner shareholders would get a combination of cash and AT & T stock. The total purchase price would be around $107.50 and the whole process could take around a year to complete.

Click here to read “Looking for option trades on the Time Warner takeover by AT&T”

The stock price of Time Warner was trading at around $86.75 at that time which was way below the takeover price. I suggested two option trades with April expiry dates and one that didn’t expiry until Jan 2018. All three trades turned out profitable.

  1. Buy 300 shares of Time Warner at $86.75 and sell 3 April $90 call options for $3.00 each. This reduces the adjusted cost base to $83.75 and I am hoping that these call options will expire worthless.

Results: Time Warner stock was called away at $90.00 in April for a $6.25 profit or 7.46% in 6 months.

  1. Buy 100 shares of Time Warner at $86.75, sell 1 April $90.00 call option for $3.00 and 1 April $85.00 put option for $3.80 reducing the purchase price to $79.95 a share. ($86.73-$3.00-$3.80 = $79.95)

Results: Time Warner stock was called away at $90.00 in April and the put option expired worthless. Profit of $90.00 – $79.95 = $10.05 or 12.5%

  1. Buy 10 Jan $97.50 call options for $3.50 that expire in 2018. If the deal goes through, these options could be sold for $10 each.

Results: Time Warner stock closed at $99.18 on Friday, I still have 8 more months to take profits. I could sell the Jan $97.50 call options for $6.05 on Monday for a profit of $6.05 – $3.50 =$2.55 or 73%

Being a senior, I totally forgot about this post, I have to apologize for not providing an update sooner. However, I repeated option strategy number 2 by buying 500 shares of Time Warner at $97.50, selling 5 May 97.50 call options for $1.95 and 5 May 97.50 puts for $1.45 (which reduced my purchased price to $94.10) and made $3.40 or 3.6% in one month.

Unfortunately, the VIX which is the ticker symbol for the Chicago Board Option Exchange volatility index has been falling. It measures the market’s expectations of 30 day implied volatility. (Referred to as the fear index) A falling VIX means a reduced amount of fear and cheap option premiums.

Despise the lower possibility of profit, I repeated option strategy number 2 and bought 500 shares of Time Warner at $98.96, sold 5 June 30 100 call options for $1.00 and 5 June 98 put options for $1.00 reducing my overall cost to $96.96 per share. I could potentially make $3.04 if TWX is above $100 by June 30th or 3.14.%

A falling VIX tends to widen the bid / ask price spread on most options. It makes it harder to get your order filled. I had to change my limit order a couple of times during the day to get this Time Warner trade completed.

There is always a risk that this deal will not be approved by regulators. However the takeover price gap has narrow from $86.75 / $107.50 in October to $99.18 / 107.50 in June. A good sign that investors believe that this deal will go through.

Disclaimer: This post is for educational purposes only.

Three key tips for option traders

Most new option traders start by selling covered calls. It is an income producing strategy where you sell a call option on a stock that you own to collect the option premium. However, the premium comes with an obligation, if the call option you sold is exercised by the buyer, you may be obligated to sell your shares of the underlying stock.

1.  Consider the ex-dividend date

A common mistake to avoid is selling a covered call near the ex-dividend date of a stock that you own. Sometimes investors will come in to buy a stock a few days before the dividend date causing the stock value to briefly go up. This could make it very profitable for the buyer of the call option to force you to sell and collect the dividend payment. Not only do you lose the dividend but your broker’s fee to sell your shares will be much higher than normal.

For example; Royal Dutch Shell (RDS.b) has an ex–dividend of May 17th and pays $0.94 per share every quarter. So if you sold a May 19th call option, your shares could be called away early if the call option is in the money.

2.  Open interest or liquidity

Sometimes there is a wide spread between the bid and ask price of an option based on trading volume or the amount of open interest. The open interest will tell you the total number of option contracts that haven’t been exercised or assigned. Many options on Canadian stocks are illiquid and the bid-ask spread can be really extensive.

For example; Shopify (shop) trades on the Canadian exchange at $128. 14 and $93.58 on the U.S. stock exchange. If you wanted to sell a cash secured put option June 125 strike price the bid is $4.50 and ask is $5.75 but the open interest is zero contracts. However, the June 90 put option on the U.S. exchange has an open interest of 873 contracts and the bid is $3.10 and ask is 3.30 making it much easier to trade.

3. Implied volatility can increase when earnings are released

Implied volatility represents the expected price action of the stock over the life of the option. As expectations change, or as the demand for the option increases, implied volatility will also rise. Earnings expectations can influence the option premiums that expire when companies release their earnings.

For example; Ulta Beauty (ulta) is currently trading around $297.55 and is reporting their earnings on May 25th. See the weekly at the money call and put options below:

Calls Bid Ask Open Interest
May 19 $297.50 $2.45 $2.85 141
May 26 $297.50 $8.90 $10.60 87
June 2  $297.50 $10.30 $11.80 0
June 9  $297.50 $10.80 $12.30 2

 

Puts Bid Ask Open Interest
May 19 $297.50 $2.45 $2.80 99
May 26 $297.50 $8.90 $10.50 13
June 2  $297.50 $10.40 $11.90 1
June 9  $297.50 $10.70 $12.00 0

Without the change in implied volatility  the May 26 calls and puts options bid-ask price would have been in the $4.90 to $5.60 range but earnings expectations have increased the value of these options. Take note of the wider bid-ask spread on the June 9 and 16 call and put options which have little or no open interest contracts.

Before you buy or sell options you should always check for the ex-dividend date and earnings release date. Keep a close eye on the number of open interest contracts, a large bid-ask spread could turn a profitable trade into a loser.

 

Disclaimer: The stocks mentioned in this post are for educational proposes only and not recommendations.

Baby Buffett loses 4 Billion on Valeant shares

Hedge fund manager Bill Ackman first came to my attention when he invested in Canadian Pacific railroad. As an activist investor, Ackman started a lengthy proxy battle with the board of directors to remove Fred Green as CEO and appoint Hunter Harrison in his place. Not only was Ackman successful but it was very profitable for his hedge fund since the value of CP shares more than doubled under Harrison’s leadership.

In early 2015, Bill Ackman invested in Valeant, another Canadian company. His hedge fund purchase shares around $196 and recently sold all of them at $11 a share. He accelerated his losses by buying call options and selling put options.

Hindsight is of course 20-20, are there any investment lessons that we can use?

 Lesson: Intelligent people are capable of doing very dumb things.

Bill Ackman is clearly a smart man otherwise his Pershing Square hedge fund wouldn’t manage pension fund money. But if you asked the average investment professional /your grandmother whether it is a good idea to stick over a quarter of your assets into a highly levered pharma roll up the answer would tend to be a firm “no”.

Lesson: Position sizing is very, very important.

Always be aware of your risk of ruin, no matter how much you are convinced the odds are in your favor. Regardless of how amazingly smart and brilliant you are and how many hundreds of hours of research you have done, it is perfectly possible that you will lose money on any given investment. Pershing Square had too large a position to simply sell its stake and walk away when things started to go wrong.

Lesson: Highly incentivized management teams can still blow themselves up, and take you down with them.

Part of the original appeal of Valeant to the hedge funds that backed it was how the CEO’s stock options had been structured to make him highly incentivized to get the share price as high as possible. Having management teams with “skin in the game” is clearly important but this does not mean they will not do something very stupid.

Lesson: Auctions are not usually very good places to find bargains.

Ackman admits that he now believes Valeant “substantially overpaid” for Salix, its last big acquisition before things fell apart. A big problem with a role up strategy is paying high prices for third rate assets that no one else in the world is willing to buy.

Lesson: Beware of political risk.

Valeant used aggressive drug pricing to help pay for their acquisitions which got the attention of American lawmakers. Bill Ackman had to testify at a hearing held by the U.S. Senate aging committee which was reviewing escalating drug prices. It also became a big issue during the U.S. 2016 presidential election.

Lesson: Take a loss, don’t let your Ego get in your way.

There is no doubt that billionaires tend to have large egos. Being labeled “Baby Buffett” on the cover of Forbes is quite the ego booster. But there is an old saying, “the bigger they are, the harder they fall”. Ackman’s buying call options and selling put options on a losing position is a clear sign that his ego wouldn’t accept taking a loss on Valeant shares.

Postscript: The share price of CSX railroad jumped up 35% on rumors that Hunter Harrison would be the new CEO. Harrison got the job but can he deliver another turnaround? It may be too early to tell. However, I bought some shares of CSX for my investment club.