$QQQ Tip

by Dan February 23, 2016 2:35 pm • Commentary• Trade Ideas

The Nasdaq 100 (QQQ) had been a pretty boring trading vehicle for a while, as some of its large components had been in a fairly complacent upward trajectory for what felt like years. But then in the Summer things changed as some of those same stocks became a bit unhinged.  The top five holdings, Apple, Alphabet, Amazon Microsoft and Facebook, make up nearly 40% of the weight of the index of 100 stocks (equaling about $2 trillion in market cap). If you ad those to the next five, Comcast, Intel, Cisco, Gilead & Amgen and the combination is greater than the value of the remaining 90 stocks.

There’s still a good bit of positive investor sentiment tied to some of these NASDAQ leaders but if the broad market re-tests the early Feb lows, few stocks or sectors will be spared and stocks that have already broken like AMZN and AAPL and stocks that have had sharp breaks followed by snap backs like FB and GOOGL could all be equally vulnerable.

Earlier today in my MorningWord (The New Style) I highlighted what I felt was likely the source of risk asset volatility in 2016:

So far in 2016, some of the most volatile period for equities have been around ECB, BOJ, PBOC and FOMC action and/or meetings.  I think this reinforces  El-Erian’s point above, and his conclusion:

The world is experiencing policy and economic realignments that undermine two notions that have served “buy and hold” investors well in the last few years: that global growth, while low, remains relatively stable; and that systemically important central banks continue to be both willing and able to repress financial volatility and boost financial asset prices.

This paradigm is coming to an end. Moreover, what may follow is far from predestined, depending in large part on whether politicians are able to bring about the much needed hand-off from excessive reliance on central banks to a broader policy response. In the meantime, we all better get ready for the return of greater financial market volatility.

No matter how constructive you think the recent bounce is, I’ll just say this, if the SPX fails l at 1950 (or gets above for a bit and can’t hold), right at the 50 day moving average, than the technical set up for stocks in the first half of 2016 just went from bad to worse.  The series of lower highs and lows since late spring, with a few bouts of severe volatility, not just in stocks, leads me to believe that the causes of prior volatility are very likely to return.  Largely for one main reason, The ECB meets again on March 10th, the BOJ meets again on March 15th, the FOMC meets again on March 16th, and who the hell knows that the PBOC is going to do.

As we head into March, and further away from corporate earnings, Central Bank policy will once again be at the forefront and if recent history is any guide, things could get real once again as the fear of negative interest rates spreading to other developed economies could spook the crap out of investors.

The Nasdaq 100 looks like a decent target on the short side for two reasons, some of its leaders have already broken (AAPL, AMZN, NFLX, INTC, AMGN & GILD) and others have shown the potential for sharp declines despite fundamentals that have held up (FB, GOOGL & MSFT).

Short dated options prices are clearly elevated but well off of the recent highs, with 30 day at the money implied volatility at 23%, vs 2016 highs just above 30% and 52 week highs made in August at 37.5%:

from Bloomberg
from Bloomberg

From a technical standpoint the Nasdaq 100 is one of the only large cap equity indices in the world above its August 2015 lows. Aside from the flash-crash on August 24th it’s never meaningfully tested its October 2014 Ebola low:

QQQ 2yr chart from Bloomberg
QQQ 2yr chart from Bloomberg

Taking a look from its 2009 lows, the index has held its uptrend with two recent tests coming since late August:

QQQ 7 year chart from Bloomberg
QQQ 7 year chart from Bloomberg

Given what lies ahead in March with 3 major central bank meetings and China, who seem determined to provide surprise devaluations of their currency, I expect the recent rally in global equities to fail, and a possible re-test of the early February lows.

So what’s the trade?  

With the QQQ at $102, the March 18th 102 straddle (the call premium plus the put premium) is offered at about $5, if you bought that, you would be buying the implied movement in the etf between now and March 18th, or about 5% in either direction, a move above $107, or below $97 to make money. If the etf moves far less than implied the two options will continue to decay as options prices will settle and time value bleeds out.  But here is the thing, because the 3 three CB events are in the week prior to expiration, options prices should stay bid, and short dated options seem fairly priced for those with a directional view.  I think you can guess which direction I chose;

*Trade: QQQ ($102) Bought March 102 Put for $2.60

-Bought to open 1 March 102 put for $2.60

Break-Even on March Expiration:

Profits: below $99.40

Losses: up to 2.60 between 99.40 and 102 with max loss of 2.60 above 102.

Rationale: Options prices look fair given the expected events. I will look to spread by selling a lower strike put if the etf goes our way soon.  We will look to cut losses quickly if the market holds, using a our typical 50% premium stop for long premium directional trades towards the upside.  The risk/reward with defined risk looks favorable.