You have just made a respectable 10.40% profit in only two trading days. What’s more, you have captured 90.32% of the maximum potential profit in this position. So it’s time to take a welcome profit. The risk/reward of running this position into the May 20 expiration is no longer favorable. As I argued vociferously at the February 11 bottom, yield support is underpinning stocks in a huge way, frustrating the hell out of short sellers, market timers, and hedge funds everywhere. With the volatility Index (VIX) plunging to the $13 handle today we have a nice opportunity to sell the S&P 500 SPDR’s (NYSEARCA: SPY ) May , 2016 $195-$198 in-the-money vertical bull call spread for a few extra pennies than we could yesterday. This all lends further credibility to my “Dreaded Flat Line of Death Scenario” whereby markets move sideways in a narrow range and nobody makes any money, except us. To see how to enter this trade in your online platform, please look at the order ticket below, which I pulled off of optionshouse . The best execution can be had by placing your bid for the entire spread in the middle market and waiting for the market to come to you. The difference between the bid and the offer on these deep in-the-money spread trades can be enormous. Don’t execute the legs individually or you will end up losing much of your profit. Spread pricing can be very volatile on expiration months farther out. Here are the specific trades you need to execute this position: Sell 37 May, 2016 $195 calls at………….….……$12.40 Buy to cover short 37 May, 2016 $198 calls at…..$9.43 Net Cost:…………………………………………………..$2.97 Profit: $2.97 – $2.69 = $0.28 (37 X 100 X $0.28) = $1,036 or 10.40% profit in 2 trading days. Is That a Profit I See? Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
If guests have the nerve to die, they wait, like unwanted calories, until they’ve crossed the line and can do so safely off the property. – The Project On Disney, via Snopes Disney: Estimize Versus Value Investor’s Edge With Disney (NYSE: DIS ) reporting earnings after the close, the nearly 1,200 Disney analysts reporting to Estimize collectively predict the company will beat Wall Street’s consensus earnings estimate, as the graph below shows. Click to enlarge The Estimize consensus earnings estimate shown above, $1.46, is 6 cents ahead of the Wall Street consensus of $1.40. Since its analysts include private investors as well as those from independent research shops, buy-side firms, and sell-side firms, Estimize says its estimates tend to be more accurate than those from Wall Street analysts alone. On the bearish side is Seeking Alpha premium author J Mintzmyer, who runs the Seeking Alpha Marketplace service Value Investor’s Edge . In a Pro Research column ( Time To Short Disney ), Mintzmyer argued the stock was “horribly expensive” (in the comments, Mintzmyer clarifies that, while he still finds the stock overvalued, he is no longer short Disney and feels there are better short opportunities available now). Limiting Downside Risk For Disney Longs For Disney longs boosted by the bullish Estimize earnings prediction, but looking to hedge their downside risk over the next several months, we’ll look at a couple of ways of doing so below the refresher on hedging terms. Refresher On Hedging Terms Recall that puts (short for put options) are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). And calls (short for call options) are contracts that give an investor the right to buy a security for a specified price before a specified date. Optimal puts are the ones that will give you the level of protection you want at the lowest cost. A collar is a type of hedge in which you buy a put option for protection, and at the same time, sell a call option, which gives another investor the right to buy the security from you at a higher strike price by the same expiration date. The proceeds from selling the call option can offset at least part of the cost of buying the put option. An optimal collar is a collar that will give you the level of protection you want at the lowest cost while not capping your possible upside by the expiration date of the hedge by more than you specify. In a nutshell, with a collar, you may be able to reduce the cost of hedging in return for giving up some possible upside. Hedging Disney With Optimal Puts We’re going to use Portfolio Armor’s iOS app to find an optimal put and an optimal collar to hedge Disney, but you don’t need the app to do this. You can find optimal puts and collars yourself by using the process we outlined in this article if you’re willing to take the time and do the work. Whether you run the calculations yourself using the process we outlined or use the app, an additional piece of information you’ll need to supply (along with the number of shares you’re looking to hedge) when scanning for an optimal put is your “threshold”, which refers to the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purpose of the examples below, we’ve used a threshold of 15%. If you are more risk-averse, you could use a smaller threshold. And if you are less risk-averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge. Here are the optimal puts as of Monday’s close to hedge 200 shares of DIS against a greater-than-15% drop by late October. As you can see at the bottom of the screen capture above, the cost of this protection was $424, or 2.01% of position value. A few points about this hedge: To be conservative, the cost was based on the ask price of the put. In practice, you can often buy puts for less (at some price between the bid and ask). The 15% threshold includes this cost, i.e., in the worst-case scenario, your DIS position would be down 12.99%, not including the hedging cost. The threshold is based on the intrinsic value of the puts, so they may provide more protection than promised if the investor exits after the underlying security declines in the near term, when the puts may still have significant time value . Hedging Disney With An Optimal Collar When searching for an optimal collar, you’ll need one more number in addition to your threshold, your “cap,” which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A logical starting point for the cap is your estimate of how the security will perform over the time period of the hedge. For example, if you’re hedging over a five-month period, and you think a security won’t appreciate more than 6% over that time frame, then it might make sense to use 6% as a cap. You don’t think the security is going to do better than that anyway, so you’re willing to sell someone else the right to call it away if it does better than that. We checked Portfolio Armor’s website to get an estimate of Disney’s potential return over the time frame of the hedge. Every trading day, the site runs two screens to avoid riskier investments on every hedgeable security in the U.S., and then ranks the ones that pass by their potential return. Disney didn’t pass the two screens, do the site didn’t calculate a potential return for it. So we looked at Wall Street’s price targets for the stock via Yahoo Finance (pictured below). We usually work with the median target, but in this case, it’s pretty low relative to the price of the stock. The $110.50 12-month price target represents about a 2% potential return between now and late October. On the other hand, the high target of $130 implies a return of about 9.6% over that time frame. By using a cap of 9%, we were able to eliminate the cost of the hedge in this case, so we used that. As of Monday’s close, this was the optimal collar to hedge 200 shares of DIS against a greater-than-15% drop by late October while not capping an investor’s upside at less than 9% by the end of that time period. As you can see in the first part of the optimal collar above, the cost of the put leg was $328, or 1.56% of position value. But if you look at the second part of the collar below, you’ll see the income generated by selling the call leg was a bit higher: $364, or 1.73% of position value. So, the net cost was negative, meaning an investor opening this collar would have collected an amount equal to $36, or -0.17% of position value. Two notes on this hedge: Similar to the situation with the optimal puts, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, an investor would likely have collected more than $36 when opening this collar. As with the optimal puts above, this hedge may provide more protection than promised if the investor exits after the underlying security declines in the near future, due to time value (for an example of this, see this recent article on hedging Apple (NASDAQ: AAPL ), Hedging Apple ). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook (NASDAQ: FB ), Facebook Rewards Cautious Investors Less ). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
If we have an atom that is in an excited state and so is going to emit a photon, we cannot say when it will emit the photon. It has a certain amplitude to emit the photon at any time, and we can predict only a probability for emission; we cannot predict the future exactly. —Richard Feynman This week, the S&P 500 finally broke through its 2,100 level, despite a huge influx of negative earnings reports . Though it failed to hold, the resistance has been tested. We ask whether the fundamentals of the stocks in this index could justify a true breakthrough of this resistance level. Much of this 7-year rally has been bolstered by central bank stimuli and stock buybacks. Both of these catalysts are coming to their ends. Most notably, as pointed out by Seeking Alpha contributor Gary Gordon, corporations are abandoning their buyback programs as a result of debt concerns. The next market crash will inevitably be labeled a “debt” or “balance sheet” market crash – allow me to explain: The Japanese market crash of the 1990s was caused by companies selling their assets to pay off debt. Individually, each company was doing the logical thing: Cleaning its balance sheets. However, when the majority of corporations engage in this action at once, you have a situation in which no companies are borrowing – despite ZIRP. The quiet liquidation of assets to pay off debt leads to a market crash that is stealthy at first but quickly turns into a landslide. The problem in the current market is investors’ ignorance of such an activity in favor of the go-to data, such as strong nonfarm payroll reports and interest rates. When we see such positive data, we feel the equity prices are justified. The problem is that if the economy really does look good, the Federal Reserve (the Fed) will have no choice but to “slow things down” by raising interest rates; and we all know what happened last time the Fed raised rates. That is, we are in trouble either way. On the one hand, if the fundamentals as per company activities and earnings look bad, the market should react negatively. On the other hand, if economy data supports a strong economy, the “data-driven” Fed must raise rates, which will cause a market correction. It seems that in either case, the 2,100 level of the S&P 500 should not hold for long. From a technical standpoint, the S&P 500 is stuck between 1,810 and 2,134. If this condition holds, we have much more downside at the 2,100 level than upside; i.e., a downward movement can bring us down 300 points but an upward movement is unlikely to bring us up more than 30 points. One problem with earnings being so poor is that the drop in earnings necessarily raises the P/E of stocks in the S&P 500. We are looking at an average P/E of 25. Falling earnings should be seen as a warning sign that the P/E is on the rise – that stocks are becoming increasingly expensive. The natural – logical – reaction would be to sell stocks and instead short stocks or buy bonds and other non-correlated investments, such as gold . Still, the market could continue to rise, as a result of short squeezes and algorithmic trading, which makes up 50% of the market’s trades. A new all-time high could be on the horizon, but it would be historical: The first all-time high created by a short squeeze, not by fundamentals. The question we must ask now is whether a reversal is also on the horizon. Thesis Corporate debt will be the catalyst for the next market crash. This market crash will be the result of balance sheet recession, which was the same type of recession that caused the Japanese market crash. This type of crash is fueled by debt: Corporate debt reaches all-time highs Companies begin to default Other companies begin paying off their debt out of fear To pay off this debt, assets are sold (this is where the crash begins) Borrowing slows The government lowers interest rates to attract borrowers Monetary policy fails because it relies on the assumption that borrowers always exist The economy grinds to a halt Investors move their capital into savings and precious metals, as bonds and equities no longer pay off Food for Thought Balance sheet recessions are basically invisible because only two groups of people look at balance sheets: fundamental investors and creditors (banks). The latter group only wants to know the probability that a company will default. The former group only sees the trees – not the forest. To put it more clearly, think of it this way. If you’re an investor looking at company ABC and you notice ABC paying off debt, you’ll think of this as a bullish indicator. After all, paying off debt is the responsible thing, especially when the company’s debt is at record-high levels. However, the point of a company is to invest your money better than you can. If that company is not investing but paying off debt, it is ignoring its main duty. In addition, paying off debt is not part of the growth cycle of a business, and a company spending its money to reduce debt is therefore not a worthwhile investment. As for how this relates to a market crash, investors look at companies individually. Rarely would an investor note that the result of a massive number of companies engaging in debt reduction equates to a lack of borrowing, which equates to the government engaging in new fiscal and monetary policies – the latter of which fails during the beginning stages of a balance sheet recession, and the former only softens the blow, delaying the inevitable. When we step back and look at company behavior as a whole, we begin to see the forest: Paying debt when interest rates are near-zero is the sign of a recession. What spurs debt reduction? Defaults, exposure to debtors at risk of default, and heightened overall default risk. Food for thought: Click to enlarge The Contrarian Strategy We should always be hedged against a Japan-like market crash. But going short on the S&P 500, such as via the SPDR ETF (NYSEARCA: SPY ) could be dangerous during a phase in which government intervention and short squeezes could bring us to new highs. Instead, I recommend a ratio back spread: Click to enlarge Here, we short an out of the money (OTM) put option with a near strike price and buy two OTM put options with a far strike price and long expiration date. This position is taken when we think a large downward movement will happen in the future for SPY but simply cannot pinpoint when. Here, we are delta neutral and theta positive, which means that the small, daily fluctuations of the SPY will only help us profit via time decay. However, once a large downward move takes place, we will see the profit of the above option strategy skyrocket, as the delta for the bought put will increase much more quickly than that of the sold put (note how gamma is negative). Vega is high, implying that any volatility change in the SPY will lead to an increase in the above spread. With market volatility at a relative low, now is a good time to open such a spread. We only need to do one thing to manage the spread: Roll over the front-end put every month. That is, every month, sell a monthly put option that is roughly $10 out of the money. In this way, we keep the strategy delta-neutral and theta positive. Happy trading. Learn More about Earnings My Exploiting Earnings premium subscription is now live, here on Seeking Alpha. In this newsletter, we will be employing both fundamental and pattern analyses to predict price movements of specific companies after specific earnings. I will also be offering specific strategies for playing those earnings reports. In our last four newsletters, have accurately predicted earnings beats 100% of the time. In the most recent newsletter, we predicting how Microsoft (NASDAQ: MSFT ) will react after its upcoming earnings report. Request an Article Because my articles occasionally get 500+ comments, if you have a request for an analysis on a specific stock, ETF, or commodity, please use @damon in the comments section below to leave your request. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.