When I tell you that we are doing our best to fight some urges here, I really mean it. The price action this week was fairly irrational in our opinion, from the nearly down 2% day to start the week that was coupled with a 35% spike in the VIX, to the SPX with less than an hour left to trade making back all lost ground. One thing is for certain, Mr. Bernanke knows how to both walk the walk and talk the talk as evidenced by his calming and definitive tone on Capital Hill this week. Congratulations Mr. Chairman, you have successfully re-inflated some burst bubbles. The reflation was evident in the housing data we got on Tuesday, and the fact that the Dow Jones Industrial Average sits just a hair away from the all time highs made in late 2007.
We are obviously cautious here and think it is ill advised to commit new money to equties until we see a meaningful correction of at least 5% that we think could come in the next month and a half.
We see headwinds to earnings growth as a primary reason for what could cause equities to stall in the near term, and here are a few data points that help make our case:
1) Earnings have actually been flat in the S&P 500 for the past 18 months (see this post🙂
2) Earnings growth going forward is hindered by the already historic profit margins, From Pimco:
(chart courtesy of Pimco)
3) Cross market indicators are flashing red. Industrial commodities are breaking important support (copper and oil today), the dollar is rallying, and Treasury bonds have been bid for the past week
Our Positioning:
As many readers know, we have been probing many single stock stories from the short side from a trading perspective, and I have been trading around index etf shorts, I am now starting to consider longer term “set it and forget it” sort of options plays that offer a good risk reward in the event of a 5% sell off btwn now and April Expiration. With portfolio protection starting to become a bit more en vogue this week, out right premium has gotten expensive on a relative basis, which is why I am going to use an in the money Butterfly to make this bearish play.
TRADE: SPY ($152.15) Bought Apr 153/148/143 Put Butterfly for .90
-Bought 1 Apr 153 Put for 3.60
-Sold 2 Apr 148 Puts at 1.85 for a total 3.70
-Bought 1 Apr 143 Put for 1.00
Break-Even on Apr Expiration:
Profits: of up to 4.10 btwn 152.10 and 143.90 Max profit of 4.10 at 148
Losses: losses up to 0.90 btwn 152.10 and 153, and btwn 143.90 and 143 with mac loss of .90 above 153 and below 143
Trade Rationale: This trade gives me short exposure in the market without the risk of premium decay as intrinsically this trade is worth 85c with the stock at 152.15. It also gives me a very wide range of profitability (between 143.90 and 152.10) below where the ETF is currently trading. I centered the trade at 148 as that is the 50 day moving average and would likely look to take off the trade if we saw that level before expiration.