Greetings, BigDeaL traders! I hope everyone had a relaxing Memorial Day weekend, filled with family and friends. Now it’s time to dive back into the markets!
Last week, in the Big Deal Newsletter #1, I said the U.S. dollar would resume its bullish trajectory against the euro, and this would send oil prices lower. Over the course of the previous week, the euro and oil had been gaining strength. Below are two-week charts for the euro and oil:
The euro and oil were both trading lower early on Tuesday, as well. I expect these trends to continue given the European Central Bank’s ongoing monetary stimulus, the trouble in Greece, and the U.S. Federal Reserve’s move towards higher interest rates. These monetary issues put pressure on oil, which is also under pressure from foreign producers that don’t want to scale back, more efficient shale operations in the U.S. ready to come online if prices remain high, and weak global demand.
Last week, I recommend bearish positions in Phillip Morris International (ticker: PM) and McDonald’s (MCD), due to both companies’ high-degree of international exposure, combined with short-term technical analysis. Each of these plays are reviewed in the follow-up section of this report, but suffice it to say I’ve had more success in calling the direction of the euro, oil, and these stocks than has been reflected in the options. This is due to the persistently low VIX, which is finally seeing an uptick in early trading today. Below, a two-week chart of the VIX:
The VIX is a measure of implied volatility, gauged by the premiums commanded by S&P 500 call and put options. When investors are complacent, they buy fewer options, and the VIX is low. This is theoretically indicative of low-volatility going forward, but UBS equities-derivatives strategist Rebecca Cheong says the ultra-low VIX, in this case, is indicative of an overly complacent market. With the situation in Greece, the weakness in oil, “capitulation” in Europe, and weak U.S. growth, she says the VIX should be much higher now, and the fact that it’s not is troubling.
Stocks are long overdue for a correction, even a modest one, and a sharp sell-off could be healthy for the market. With the euro and oil expected to continue their bearish trends, the U.S. stocks least-likely to succeed remain those with broad international exposure, as the stronger dollar makes their non-dollar-based sales less valuable, while simultaneously increasing their dollar-denominated input costs.
One such stock is Boeing (BA), the U.S.-based aerospace and defense contractor that operates in a commercial airline duopoly with France’s Airbus. The U.S. federal government has cut its defense budget, causing its share of Boeing’s business to decline to 26%, while foreign business has soared to more than 40% of Boeing’s total. With a cheaper euro and the promise of ongoing stimulus from the ECB, Airbus will continue to take share away from Boeing, as it already has in the next-generation single-aisle aircraft market.
Even lower oil prices won’t be especially beneficial for Boeing, since Airbus will enjoy them too, and Boeing’s latest major project – the Dreamliner 787 – was designed to minimize weight and maximize fuel-efficiency. And further out, there’s political risk for Boeing in the potential closure of the Bank of International Settlements (BIS), which many Republican lawmakers have identified as an engine of crony capitalism – even Jeb Bush told the Club for Growth that government should consider whether the BIS should be phased out. In 2014, the BIS financed 10% of Boeing’s sales, down from 37% in 2010.
Shares of Boeing opened Tuesday at $144.34, down 0.32% from their closing price on Friday, and they’ve since fallen to as low as $142.50 – down 1.6% for the day. I identified the trade prior to the opening bell, based on Friday’s close below its Bollinger midpoint, and the stock has gapped down since and appears headed for a new three-month low:
However, given the VIX’s 17% surge in early trading, the fact that BA is already down significantly in intraday trading, and our current positioning with two debit put spreads, I think selling BA’s calls is more prudent than buying its puts. Of course, selling naked calls is rarely (if ever) a good idea, so instead we’ll enter a credit call spread on BA, and we’ll limit our loses to an absolute maximum of $2,000.
We’ll sell (sell-to-open) BA’s $145-strike July calls. This is the dominant leg of our spread. We’ll receive a credit on this leg.
We’ll buy (buy-to-open) BA’s $150-strike July calls as a hedge. This is the recessive leg of our spread. We’ll spend less on this leg than we receive for selling the dominant leg, and thus we’ll have a net credit. Hence, this is a credit call spread, also known as a “bear call spread.”
The logic of this play: We’ll receive a net credit of around $1.45 for entering this play, and our objective is for both legs of the spread to expire “out of the money,” thereby allowing us to keep 100% of our credit. We want shares of BA to fall or remain flat, which will allow us to keep our premium. Although BA’s big losses in early trading today limit the gains that might be made on long puts, short calls will work so long as BA doesn’t appreciably rise. That appears to be the safer wager.
Risk and position size: In the worst case scenario, BA soars above $150, at which point our short $145-strike calls will be worth $5 more than our long $150-strike calls. Five dollars is the maximum gulf between the spreads, and therefore our maximum loss – but of course, this maximum loss is offset by the $1.45 credit we’ll receive, meaning our actual risk is $3.55 per share or $355 per contract
We want to risk a maximum of $2,000, so we’ll enter this trade with just 5 contracts per leg of the spread, which should be efficient on the basis of commissions without engendering too much risk. At the current prices, this would make our max risk $1,775, with our maximum gain our initial credit of about $725 ($145 per contract x 5 contracts). That’s a high-probability 40% return in less than two months – not a bad proposition.
#1) PM $80/$82.50 September debit put spread
Entry price and date: $0.97 on 5/18/15
Position Size: 20 contracts per leg
Current bid/ask: $0.70/ $1.02
Target: $1.15 bid
The craziness of the VIX is on full display in the way our PM debit put spread has performed. I nailed PM’s market direction last Monday and entered this play at $0.97. Despite the stock going nowhere but down, the ask on this spread fell to $0.77 within hours of publication of Big Deal #1, and the bid and ask have drifted far apart at times. Nevertheless, I remain very confident that this play will work on our favor, particularly given the September expiration date. Just look at how PM has performed since we entered its puts:
It’s truly unbelievable that we haven’t been able to cash in 20% gains on this play, considering its bearish nature and PM’s downward trajectory. The stock is even due for a bounce, to be honest, which it should get if the broad market doesn’t sell off. Nevertheless, with PM falling below its 20-day exponential moving average/ Bollinger midpoint, and also experiencing a bearish MACD crossover, and a dip into the “downtrend zone” of Williams %R, this is a good position to have in the portfolio.
#2) MCD $95/$100 June debit put spread
Entry price and date: $2.15 on 5/21/15
Position Size: 9 contracts per leg
Current bid/ask: $2.52/$2.70
Target: $2.60 bid
We entered this short-term play last week at a net debit of $2.15, based on a $2.95 entry on the long $100-strike June puts, and a $0.75 credit on the short $95-strike June puts. With our 20% price target, that puts our exit at $2.58, or $2.60 if you’re rounding. As of early trading today, McDonald’s was down again, and the bid on our spread was $0.06 to $0.08 away from our target:
I’ve circled our holding period in the chart above. Although MCD’s moves haven’t been as dramatic as PM’s, they have been consistently negative since we entered on the bearish side.
I’m a strong believer in trading options in the short term as a means of building value for the long term. Turning options profits into dividend-paying stocks is a wise strategy, and although my forecast for dividend-paying stocks is short-term bearish, it would be imprudent to day-trade long-term holdings on my short-term theses. That’s what options are for!
Jason Seagraves is a 37-year old writer, options trader, entrepreneur, homeschool dad, and evangelist for free-market economics. He launched a successful dot-com business while still in college in the late 90’s, and then went back to school to graduate with a degree in Business, concentration in Finance, from Siena Heights University in 2006. That year, he also earned a Series 7 stockbroker’s license, but opted to pursue a career in freelance writing. From 2008 through 2013, he worked as a “ghostwriter” for a popular stock and options trading newsletter, before joining up with Dividend Lab for a stint in 2014. Now he’s back providing market commentary and actionable options trades for the Big Deal Newsletter, and he’s happy to be here!
This document is also available to our LaunchDL members to provide an example of our work.