Welcome to the January 9th 2017 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
At Profit effect we know that the only “secret” to successful investing is well-informed investors applying sound market strategies. That’s why the Profit effect mission is to teach you how to understand the market, the modern tools available for successful investing, and how to apply both for investment success.
Last week we covered Exchange traded funds and went through an overview of the sectors of the US economy. You learned that an exchange traded fund or ETF is a marketable security that trades like a stock but can be made up of a basket of stocks or other assets. The assets include shares of stock such as an index, or bonds, commodity futures, precious metals and currencies. I also, showed you a great website for screening ETFs.
This edition of Profit Talk I’m going to share another great website to use for charting and scanning the market for opportunities. I’ll show you a scanning method to use with ETFs which reveals the strongest and weakest sectors of the economy. We can use this information to find bullish and bearish opportunities. Also, we’ll cover another option strategy designed to create cash flow using sector ETFs.
Relative Strength or Weakness
When it comes to finding prospective directional trades, outside of supply and demand zones, there is arguably no single measure more important to consider than relative strength or weakness. If you’ve heard me before on the subject of prospective trade analysis, I say trend is the first thing to consider. It’s true, trend should be the first consideration outside of supply and demand, and relative strength or weakness is the reason why. The strength or weakness of a market reveals a general sense of the enthusiasm held for the particular market. When the performance of one market is compared to another market, such as its peers or other segments and/or industries, the analysis is able to paint a picture showing the money flow across the various markets.
Our focus here will be on on using relative strength and weakness to measure the “big money” or institutional money flow occurring in the market. In many cases, the “big money” mutual funds and institutional investment managers are bound by the rules of the fund to stay invested. Different phases of the business cycle favor investment in particular market sectors
The movement of funds among the various sectors is displayed by the sector performance
This information can be used to see what the big, market moving funds are currently doing. We can use the information to filter out the market noise.
The fact is the media is not looking out for your best interest when reporting. The media is looking out for their best interest which is ratings and keeping advertisers happy. People react (tune in) to a much higher degree when driven by fear so the media over dramatizes everything.
The problem is poor investment decisions are often made when emotions are involved. That’s why it’s very important to always pull back and take a bird’s eye view of things. Get away from the everyday fear and noise associated with the markets by getting an objective view of what is actually happening. I’m going to go over the steps involved for a technique that you can use to help you ignore the financial media and stay focused on opportunities provided by the short term market noise.
We’ve all heard the term follow the money. This goes under the rule ignore what people say, watch what they do. One great method of doing that is to measure relative strength and weakness among the main sectors of the economy. The money flowing from certain sectors of the economy into other sectors is often referred to as sector rotation. Paying attention to sector rotation and the relative strength or weakness among the sectors allows you to see what the big money is doing and ride along on their “collective coat tails”. You can do this by aligning your directional assumptions for a particular market with the evidence displayed by the money flow. Let’s go through the details of how to analyze the money flow. One way to do this is by using a great charting website called stockcharts.com
Go to the free charts page and find the performance charts or Perfcharts as they call it. (Figure 1) This type of chart compares the relative strength and performance of different markets by measuring them all starting from zero. Type in the symbols you want to compare.
Let’s use the 10 sectors of the broad market.
The main sectors are:
XLY - Consumer discretionary https://www.spdrs.com/product/fund.seam?ticker=XLY
XLP - Consumer staples https://www.spdrs.com/product/fund.seam?ticker=XLP
XLE - Energy sector https://www.spdrs.com/product/fund.seam?ticker=XLE
XLF - Financial sector https://www.spdrs.com/product/fund.seam?ticker=XLF
XLV - Healthcare sector https://www.spdrs.com/product/fund.seam?ticker=XLV
XLI - Industrials sector https://www.spdrs.com/product/fund.seam?ticker=XLI
XLB - Materials sector https://www.spdrs.com/product/fund.seam?ticker=XLB
XLK - Technology sector https://www.spdrs.com/product/fund.seam?ticker=XLK
XLU - Utilities sector https://us.spdrs.com/en/product/fund.seam?ticker=XLU
IYR - Real Estate sector https://www.ishares.com/us/products/239520/ishares-us-real-estate-etf
This chart will show relative strength among these 10 sectors. Here they are zeroed out and start at the exact same point. (Figure 2)The default duration setting is for 200 days back. That is the point all prices are equalized. From that point the performance relative to one another is tracked. The zero line is important longer term. Especially when set at year to date. It’s the breakeven point for the funds invested in those sectors.
The point of this style of chart is momentum or relative strength and weakness analysis.
The money flow will determine the rising or falling relative strength of the various sectors.
That’s what we’re watching for …relative strength or relative weakness. The chance for success is higher when buying strength and shorting weakness. In a general sense, for me, this means the sectors trending above the zero line provide the hunting ground for bullish candidates and sectors trending below provide prospects for bearish candidates. I like to break it down into smaller time frames to see smaller, counter trend moves. These can be used to hop aboard the prevailing bigger picture trend of money flow during a short term period of weakness.
The idea is to start with the bigger picture and work your way up to the near term picture to see any changes occurring in the money flow. And if interested in shorter term trades, use the information to find candidates.
Shorten the duration by adjusting the time frame or starting point from which to measure the price performance. Right click on this tab and choose the time frame. (Figure 3)
Start with 1 year out and make note of the strongest and weakest few sectors over the past year
You see here you have the Energy and financials as the top relative performers. (Figure 4) Healthcare and consumer staples are the worst performing over the past year. Then work forward and look at a 6 mos. and make note of the strongest and weakest few sectors over that time period.(Figure 5) We’ve go the financial and technology sectors on top and the utility and consumer staples lagging the pack.
Then go to 3 mos. And so on. Look for a any signs of an overall shift in the money flow. Sectors with longer term strength showing nearer term weakness may offer opportunities to buy the weakness.
I want to make an important point about this type of chart analysis. I would never use this chart to determine entries or exits in a particular market. NEVER. But, it can be used as a support tool or confirmation tool. Or as a source for trade ideas. Also, it can used for spotting the resumption of a current trend after a short term pull back.
The crucial point is, if looking for bullish trades, always look in the sectors with the most strength and on the other hand, when searching for shorting candidates, look in the weakest sectors.
You’ll find more success when going with the big picture flow.
The idea is to act as a short term contrarian. Use the strongest sectors as your hunting ground for bullish prospects and wait for a pullback in price to enter. Or, if looking for bearish trades hunt in the weakest sector and look to short counter trend rallies. Put simply, you focus on buying pullbacks to demand in the top performing sectors and selling rallies at supply in the worst performing sectors when directional trading.
If looking for a non-directional trade prospect, look for sectors with “middle of the road” performance, near the zero line on the relative strength chart. Or, use the method I’ll show you when we pick the example trade. That method consists of finding the highest current IVP markets with the smallest range of price movement over the last year.
You can find the individual candidates within the sector you’re interested in by using a tool covered in last week’s edition of profit talk. The Finviz.com heatmap for the sector ETFs can by used. Go to Finviz.com. Choose the maps page then Exchange Traded Funds. The main sectors shown and the sub sectors and specific industries within the sectors are here. (Figure 6) Look here for prospective trades. Again, if interested in directional bullish trades look for pullbacks in the top performer and bearish trades look for rallies in the worst performing sector.
Remember, this analysis is designed to narrow the focus to a particular area of the market. The decision if an entry will be made and at what price is determined by the trend condition and direction and supply and demand areas on the bar chart or candlestick chart. Use supply and demand zones or whatever chart analysis you use to determine the entry and exit points.
When it comes to choosing trades and the strategy to use it’s important to select the correct strategy for the market condition. But, in addition the strategy must be aligned with your personal risk tolerance and expectations. Decide beforehand what your assumptions are and whether you plan to take possession of the shares or not and the degree of directional bias desired for the trade. Choose the strategy that offers the best fit based on those questions.
Previously we covered the “Bull Round Trip” cash flow strategy. That is a good choice if taking a directional stand. The bullish version can be used for trades in the strongest sector and the bearish version used for markets in the weakest sector. On the other hand if your prefer a neutral bias, directionally speaking, then the option strategy we’re covering this week may be a great choice for you. We’re going to go through the details of creating and a “Range Bound Round Trip”.
The “Range Bound” Round Trip strategy employs the use of a Short Straddle trade for entering the strategy. The Short Straddle is another great cash flow strategy to use with ETFs. It is best used in higher volatility situations. But, if using the short Straddle as entry into a “round trip” cash flow strategy in a way similar to the Bull Round Trip strategy, the high volatility requirement is not necessary. Simply put, if you’re okay with taking assignment of the shares, you don’t have to worry about the IV Percentile as much. If you are not familiar with the terms IV Percentile, short option “credit” style strategies and Bull Round Trip, then please review the previous issues of Profit Talk covering those topics.
If the short Straddle is not being used as part of a round trip strategy, but instead as a stand alone options trade, then it should only be used when the IV Percentile is at the high end of its range.Typically, 80% or higher is ideal for this strategy if it’s not being used for entry into a “round trip” strategy. In addition, the credit strategy risk analysis rules including the 1:1 reward to risk ratio requirement should be followed.
If the short Straddle is being used for entry into a round trip strategy, which means exercise of the option and assignment of the shares is welcomed, those rules don’t apply and you’ll find the Short Straddle can provide an excellent way to create cash flow and profits from your stock investing when used in this way.
Two important distinctions exist between using a Short Straddle to enter a round trip strategy as in the case of the “Range Bound Round Trip” and using a short Call or Put to enter a bull or bear round trip strategy. First, unlike selling a Call or Put which has a good chance of not leading to assignment of the shares, the Short Straddle is almost guaranteed to lead to assignment. The only way it won’t happen is if the share price at expiration is the exact same as the strike price of the options sold. Outside of that very unlikely event, holding a Short Straddle past expiration will result in assignment of the shares.
The second important distinction is, unlike the bull or bear roundtrip strategies, which allow the trader to choose whether the resulting assignment consists of short or long shares, the Short Straddle assignment gives no such control. The shares will almost certainly be assigned to you but whether these shares are long or short won’t be determined until expiration. This is due to the nature of the Short Straddle construction.
The Short Straddle is a credit type option strategy and derives its profit from selling options. As you’ve learned, short option profit can come through the passage of time via theta decay and/or through a fall in implied volatility. The implied volatility is what the market expects in terms of price movement in the future. Collectively, the amount of time left until expiration and the expected price move or implied volatility, make up what’s often referred to as “Time Value”. When you sell options you are selling or shorting the time value in the option.
The short Straddle is constructed by selling two different at the money options. Sell 1 ATM Put and 1 ATM Call option with the same expiration. This creates 1 spread. The expiration should be in 60 days or less. 45 days is the sweetspot. The short Straddle used on it’s own as a stand alone trade, profits when price stays within a range. The range is determined by the premium received from selling the options used in the strategy construction. The more premium received the larger the range price can move while the position still remains profitable if trading the Short Straddle on its own.
All the premium received from the Straddle sold is kept no matter what happens. This makes the Short Straddle a very nice cash generating strategy when used for entry on a round trip. The premium amount received is twice that of selling a Call or Put on it’s own. Yet the risk is really the same as selling just the one or the other. This is because assignment can’t happen from both the Puts and the Calls.
If the share price is below the ATM strike prices on expiration, the Calls will expire worthless and the Puts will create assignment of 100 long shares per spread sold. In this case, go to step #2 of a “bull” round trip, because you are now long shares. Step #2 after assignment of long shares is to sell 1 OTM Call for each 100 shares you are long. If possible, sell Calls equal to or higher than the assignment price. (straddle strike price used for entry)
If the share price is above the ATM strike prices on expiration, the Puts will expire worthless and the Calls will create assignment of 100 short shares per spread sold. In this case, go to step #2 of a “bear” round trip, because you are now short shares. Step #2 after assignment of short shares is to sell 1 OTM Put for each 100 shares you are short. If possible, sell Puts equal to or lower than the assignment price. (straddle strike price used for entry)
Whichever scenario plays out, the total payments received from the strategy so far includes the premium from the Short Straddle, plus the premium from the OTM Put or Call options sold in step #2. Just like any round trip strategy, when the shares are called away from the Step #2 option, any positive difference between the assignment price and the “called away” price is added to the profit.
For example, if the Short Straddle results in assignment of short shares and therefore step #2 was to sell OTM Puts. Selling Puts lower than the assignment price of the short shares will increase profit in the trade by that difference multiplied by the number of shares. On the other hand, if the Short Straddle results in the assignment of long shares, selling OTM Calls higher than the assignment price of the long shares will increase the profit by that difference multiplied by the number of shares.
To demonstrate using the strategy in action we’ll select an example trade and go through the process of constructing and analyzing the possible outcomes . As I mentioned, this is one of my favorite cash flow strategies and I especially like using them with ETFs. ETFs can help you avoid the extra risk that comes with buying or shorting individual company stocks by spreading the risk across numerous companies.
This strategy works very well in markets that are on the lower end of the scale when it comes to their historical price range. I don’t really care if they don’t go anywhere. In fact, that’s what I want. Sideways price action is the best possible and most profitable scenario for this strategy.
The biggest challenge we face at the moment is the extremely low relative implied volatility conditions or IVP. In the previous Profit Talk I said I was hoping for an increase in IVP in the new year. This “hope” was the reason I wanted to share this particular strategy. But, unfortunately the opposite condition has occurred. Implied volatility has gotten crushed. However, as mentioned earlier the IVP level is not nearly as important when using the Short Straddle as entry for a round trip strategy. In this case, choosing a sector that fits your current portfolio and/or your personal appetite for exposure should be the number one factor for deciding which market to use the strategy on.
With these considerations in mind, let’s take a look at our choices among the main sectors of the economy. Among the main 10 sectors of the US economy, we can see that the top four in terms of current Implied Volatility Percentile (IVP) are the real estate sector, symbol IYR coming in on top with a 25.98 IVP, next is the utilities sector, symbol XLU at 21.44 IVP, then we have the healthcare sector, XLV at 19.21 Implied volatility percentile and in fourth place is the industrials sector XLI with and IVP of 17.67.(Figure 7)
Remember, we want higher IVP if possible because the premium payment received for selling the options will be higher relatively speaking. But, at the same time, we’d prefer less overall movement in the stock price. Yes, that is a bit of a contradiction but let’s go through these top 4 and see what we’ve got. Over the previous year, you can see that IYR has a price range of about $20 per share. XLU’s range is about $11 over the previous year. XLV, the healthcare sector had a range last year of about $14 per share and XLI, the industrials, had a range last year of $18 per share.
Based on that information, the top two picks for relatively high implied volatility coupled with lower overall historical price movement are XLU and XLV. Again, the markets you choose, if any, to use this strategy on should be based on the “Delta Match” considerations in your portfolio and personal preferences. This concept was covered in the 12/12/16 edition of Profit Talk called “Balanced Portfolio Techniques”. Personally, I’m fine with using the strategy on any of the main sector ETFs. I will choose which one to go with based on the current holdings in my portfolio and the “Delta Match” considerations.
For our example trade, let’s go with XLU. Based on the analysis we just performed it’s the best pick, with highest relative volatility and lowest historical price movement. To create the Short Straddle choose an expiration less than 60 days that is closest to 45 days. The February 24th expiration is 46 days away, let’s go with that. (Figure 8)
Creating the strategy consists of selling 1 ATM Call and 1 ATM Put for each spread or each 100 shares you wish to use for the trade. The shares are currently selling for around $48.60 per each. The $48.50 strike is the closest. Simply right click on the ATM Put or Call bid column and select “analyze sell trade” and choose straddle. (Figure 9) Then adjust the lot size for each 100 shares you are okay with buying or shorting in this particular market. (Figure 10)
Remember, if price is above the strike price on expiration you’ll be assigned short shares and if price is below the strike on expiration you’ll be assigned long shares. 100 for each Straddle sold.
You will receive $2.16 per share for this Short Straddle. (Figure 11) Each spread represents 100 shares, so that comes to $216 per spread in premium payment. This money you keep no matter what happens. Once you place the trade, just sit back and wait for assignment.
Or, if the stock price happens to remain within the $2.16 price range over then next 46 days, as the expiration comes closer, you can buy back the spread for a profit and sell another for a further expiration. I like to buy back the spread if it reaches 50% of total profit. In other words, when I can buy back the spread for ½ of what I sold it for, in this case, when I can buy it back for $1.08, I will do so and then sell another Straddles around 45 days out. Keep doing this until you are assigned the shares.
Then go to Step #2 in the “round trip” strategy and sell either Calls or Puts. Once the assigned shares are called away from the step #2 option the round trip cycle has ended and you can repeat the whole process again.
First, when placing directional trades, use relative strength or weakness in a sector to define trade direction and enter on contrarian price move. So, if you do want to take a directional stand, go with strength for bullish trades and weakness for bearish trades. But, enter when near term price action is contrary to longer term strength or weakness.
Second, non-directional “round trip” trades can be entered using a short Straddle. This strategy brings in an enormous amount of premium.
The third main takeaway is, as always, consider Delta Match and your personal tolerances for final trade entry decision.
Do you remember the movie with Bill Murray called “Groundhog Day”? The character Bill Murray plays keeps living the same day over and over again. I feel a bit like that when covering the market outlook each week. We’ve been stuck in this very tight range for nearly a month now.
The Dow Jones Industrial Average is flirting with the 20,000 mark but can’t seem to get it done. Looking at the charts for the major indexes, the Dow and the S&P, you can see the outer bollinger bands have collapsed inward. (Figure 12)This is like the tightening of a spring. It usually leads to a breakout of some kind. Either to the upside or downside.
The major reports released last week were mixed. Overall signs of expansion are still showing up in some areas of the economy while others have a bit of weakening.
The high impact reports due out this week include:
Wednesday 1/11 - Crude Oil Inventories
Thursday 1/12 - Unemployment claims and Fed chair Janet Yellen speaking.
Friday 1/13 - Core Retail Sales, PPI which is the Producer price index which is an inflation indicator. Also, the retail sales and preliminary consumer sentiment reports are due out on Friday.
As is always the case, any surprises can move the market.
The best practice is to focus on implementing high probability strategies like ones learned here instead of trying to predict when the next market move will occur and what direction it will take. From a trend trading perspective, all the major indexes are still in an uptrend and any bullish trades taken in the buy zone are completely legitimate trades as long as your current holdings allow it. As difficult as buying at these prices can be, often the best trades are the ones that require you to block out everything you think you know, follow the chart and “pull the trigger” according to the facts.
A Look Ahead
Looking ahead to next week. Given this incredibly low implied volatility environment we’ll take a look at an option strategy designed to capitalize on such conditions. We’ll cover the details regarding the horizontal time spread often referred to as a “Calendar Spread”.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at firstname.lastname@example.org.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.