MorningWord 1/25/17: QQQ-ing Up For Earnings

by Dan January 25, 2017 9:26 am • FREE ACCESS

I understand the current investor mindset as to why most equities are where they are, and for the most part I agree. I think we are in a cautiously optimistic phase opposed to all out euphoria. But with less than 15% of the S&P 500 (SPX) reporting Q4 earnings so far, things could still turn on a dime. The biggest thing investors are looking for is guidance expectations vs earnings visibility offered by managements. I would also add that the Fed’s Feb 1 meeting might be reason enough for traders to rethink how long they want to see the CBOE Volatility Index (VIX) below 11 (last night’s close 10.77). That’s very near historic lows as equity markets and complacency push into uncharted territory.

On Thursday, Alphabet (GOOGL) and Microsoft (MSFT) will report earnings and offer guidance for the current period. These two companies have a combined market capitalization of nearly $1.1 trillion, or about 19% of the Nasdaq 100 Index (QQQ).  The options market is implying about a 4.5% move in either direction for both stocks. If the stocks were to realize that move (in the same direction), that’s a near $90 billion market cap move. That would move cap weighted markets, especially the QQQ. Obviously there is the possibility that they cancel each other out and move in opposite directions, and befitting a sub 11 VIX, there’s the chance they don;t move at all.

It’s all guess work. But low levels of volatility are not. That will change, we know that. And for those considering replacing long exposure with defined risk strategies, it has rarely been this cheap to do so. For instance, looking at the QQQ, the February 17th expiration 124 straddle (the call premium + the put premium) as of last night’s close of $124.18 was offered at $2.75. That is saying that between now and Feb 17th, (three weeks from now) the implied movement in the QQQ, an etf that will have more than 70% of its weight report earnings, will move only 2.2% in either direction (between $121.25 and $126.75). Which means that for those who have a directional bias, or seeking protection can wager 1.1% for an at the money put or call in the QQQ to have very near the money participation. That seems more than fair.

For those like me, who thought that with a new administration (with an unconventional President), and a change in the calendar would mean heightened volatility in the early months of 2017, we have been sorely mistaken as stocks have gone nowhere. That’s making it very hard to hold options positions with a long premium bias. And it’s possible that doesn’t even change in the near future. But buying options tactically, and infrequently, with vol so low in front of events like earnings season and Fed meetings might be the sort of action it makes sense to protect gains, preserve capital and/or leverage existing holdings. This is not a great strategy in the long run, premium sales for yield should always be as big or a bigger part of your options portfolio to hedges. But right now there is a lot of opportunity to define risk while not spending much in premium.

To my eye a pull back to just below $120, the prior breakout level could happen in a day or two of hectic action, with $115 a likely downside target on a sustained sell off… oh and the upside, uncharted territory, you tell me whether we go from cautious optimism to out of control animal spirits (it’s possible):

QQQ 1yr chart from Bloomberg

With markets at or near new highs for the past few months, we’ve continued to detail stock alternatives for those already long, or those with their eye on a breakout. That has been a really good strategy. But with the VIX now near historic lows, and plenty of news on tap, it’s probably time to start thinking about some low cost portfolio (and individual equity) hedges. We’ll detail some of those in the near future.