Financials: The Delicate Balance of Rates and Yield Curve

The financial cohort is in a difficult space as the broader economic backdrop continues to dictate whether these stocks can appreciate higher. A delicate balance between interest rates, Federal Reserve commentary, yield curve inversion, trade war, and concerns over a potential recession in late 2019 or early 2020 must be attained. A disruption in this complex web can lead to the financials breaking down as witnessed in Q4 2018 and in May of 2019. In Q4 2018 rates were increased by the Federal Reserve and sent the financials in a downward tailspin. In May 2019, a trifecta of a yield curve inversion, trade war concerns, and increased chatter about a potential recession on the horizon again sent the cohort lower. The broader market appreciated markedly in June, and the bank stocks participated in the rally. Coupled with renewed record share buybacks and increased dividend payouts stemming from successful stress tests, banks elevated higher on the news. Now, the market is anticipating that the Federal Reserve will cut rates at its next meeting, which may serve as another catalyst to propel some bank stocks to new 52-week highs.

The Q4 2018 Federal Reserve and Jerome Powell

The market-wide sell-off in the fourth quarter of 2018 was largely induced by the Federal Reserve and its alleged commitment to sequential interest rate increases into 2019. This was largely viewed as reckless and misguided while turning a blind eye to broader economic data-driven decision making about further interest rate hikes. The stock indices responded to the sequential interest rate hike stance with overwhelming negative sentiment, logging double-digit declines across the broader markets. Many market observers were questioning the Federal Reserve’s aggressive stance as companies issued weakness in ancillary economic metrics (slowing global growth, strong U.S. dollar, trade war, government shutdown, weak housing numbers, retail weakness, auto sluggishness, and oil decline) as an indication that cracks in the economic cycle were materializing. The strong labor market and record low unemployment served as a basis to rationalize increasing rates to tame inflation; however, these aforementioned economic headwinds appeared to cause the Federal Reserve to pivot in its aggressive stance. As Chairman Jerome Powell began to issue a softer stance on future interest rate hikes, January saw very healthy stock market gains after being decimated for months prior. On January 30th, Jerome Powell issued language that the markets were craving to levitate higher as he left interest rates unchanged and exercised caution and patience as a path forward. Using data-driven decision making as a path forward was cheered by market participants as the broader indices popped for healthy gains on top of the already robust gains throughout January. Continue reading "Financials: The Delicate Balance of Rates and Yield Curve"

Options: Long-Term Game of Discipline and Outperformance

Options trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. To this end, an options-based portfolio requires discipline and time to materialize in order to reach its full benefits when benchmarked to a broader index. An options-based approach provides a margin of safety with a decreased risk profile while providing high-probability win rates. An options centric portfolio ebbs and flows just like any portfolio as various types of trades are executed, management of trades are carried out and the inevitability of assignment of occurs. Over the long-term, this approach provides smooth portfolio appreciation while generating consistent income. Since options are a bet on where stocks won’t go, not where they will go, this is accomplished without predicting which way the market will move. When adhering to options trading fundamentals, this approach can provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. Following these option trading fundamentals, I’ve demonstrated an 85% (175/205) options win rate over the previous 9 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 4.51% return against a 0.95% for the S&P 500.

Results

The broader market has been tumultuous over the past 9 months, to say the least. In Q4 2018, the S&P 500 posted one of its worst quarters and since the Great Depression with the index selling off 14% and erasing all of its gains for the year. 2019 started off on a high note for the S&P 500 with January posting a 7.9% gain, logging its best January in over 30 years. This was followed by continued strength in February, putting the index on its best footing since 1991 with a cumulative return of 11% through the first two months and rounding out Q1 2019 up just over a 13% return. May witnessed a market sell-off which saw a decline of -5.8%. June 2019 was the best June for the Dow since 1938 whereas the S&P 500 posted its best first half of a year since 1997, notching a 17.3% gain. Sticking to a set of disciplined fundamentals through this volatile market over the previous 9 months generated superior returns relative to the historic run by the S&P 500 (Figures 1-4).

Options Trading
Figure 1 – Options based portfolio return (4.51%) in comparison to the S&P 500 return (0.95%)

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Figure 2 – Comprehensive options metrics over the previous 9 months

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Figure 3 – Dot plot summarizing ~225 trades over the previous 9 month period

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Figure 4 – Additional, comprehensive options metrics over the previous 9 months

Difficult Market Conditions Resulted In Mixed Results For Q2 2019

The options based portfolio did not perform as well as the broader index during Q2 2019 due to specific sector exposure weighing on performance.

  • Oil and oil-related stocks sold-off (i.e., USO and SLB)
  • Retail stocks tumbled double digits (i.e., GPS, URBN, LOW, KSS, and CPRI)
  • Pharmaceutical supply chain stocks continued to be pressured (CVS and WBA)
  • Financials couldn’t seem to get much traction (i.e., BAC and C)
  • Steel stocks plummeted (i.e., X)
  • Airlines were pushed lower (i.e., AAL)

A series of buy-to-close trades at a loss and a few assignments (KSS and X) largely negated premium income gains throughout the second quarter. Previously assigned positions from past quarters continued to weigh on performance (GE, SLB and USO) as well. Overall portfolio performance for Q2 2019 was anemic and slightly positive at 0.32%. Despite these mixed results, continuing to trade through all market conditions is essential to long-term options success.

Portfolio Approach

For the past 9 months, I’ve managed an options-based portfolio where I predominately leverage cash to sell options and collect premium income. The goal in options trading is to leverage cash and/or stock and sell options using the underlying cash and/or stock to collect premium income. This can be performed in a high-probability manner where a statistical edge goes to the option seller’s advantage.

The vast majority of my trades are cash covered puts. Thus I am not buying the underlying stock. However, I’m leveraging/earmarking cash and agreeing to buy shares at an agreed upon price by an agreed upon date. For example, if a stock sells for $50 per share now, I may elect to sell an option for $0.75 per share and agree to buy the shares for $45 one month into the future in exchange for $75 (since options trade in blocks of 100). When selling an option, one collects premium income ($75) in exchange for taking on the obligation/risk to buy the shares at the agreed upon price. I contractually agree to buy shares with a high probability that the shares will not trade lower than $45 before expiration. Thus, I’ll capture the premium income of $75 and re-purpose the cash that was earmarked upon expiration of the contract.

I like this type of trade when coupled with a high implied volatility rank (IV Rank) value because there’s a high probability that the shares will not be as volatile as the market is predicting as measured by IV Rank. Historically, predicted volatility is nearly always overestimated; hence, the stock will be less volatile than predicted. Meanwhile, a healthy margin of safety to the downside is built into the trade, and in this case, it’s a 10% cushion to the downside. Taken together, these types of trades are placed 1 standard deviation out-of-the-money to yield ~85% probability of winning the trade at expiration. These probabilities of success are based on past volatility moves over a given timeframe of the underlying security. Using past volatility moves, the market can use this to predict future stock volatility and probability of success. When IV Rank values are high, rich premiums are paid out at any given strike price since market participants are predicting a high level of volatility. If the shares break below the strike of $45, then your effective purchase price would be $44.25 per share since $0.75 per share was received upfront in the form of premium income. Best case scenario, premium is collected, and cash is re-purposed for future trades while worst case scenario is an assignment at $44.25 (which is 10% lower than the stock traded at the time of the initial trade).

The 7 Essentials for Effective Options Trading

Let’s review these 7 essentials that provide long-term options trading success for durable portfolio appreciation.

  • 1. Be an overall options seller
  • 2. Sell options in high IV Rank scenarios
  • 3. Sell options that possess liquidity in the options market
  • 4. Set an appropriate probability of success using Delta as a proxy
  • 5. Manage winning trades
  • 6. Maximize the number of trades
  • 7. Limit position sizing/allocation

Mitigating Risk

This outperformance is due in part by proactively addressing losing trades to manage the overall risk profile. When engaging in options trading, losing trades are inevitable however managing these trades via risk-defined trades, position sizing, diverse sector allocation, buying-to-close for a gain or loss, allowing assignment to occur at expiration, selling covered calls on the assigned stock and rolling the trade out to a different strike level can mitigate risk and enhance long-term successful options trading. In the end, following a set of options, trading fundamentals will enable your portfolio to appreciate steadily month after month for consistent portfolio appreciation.

Managing Trades and Optimizing Outcomes

A variety of actions can be deployed in a losing trade situation to mitigate risk and optimize portfolio performance. A rule of thumb that I generally stand by is limiting myself to selling options on underlying dividend-paying stocks in the large-cap space thus an event I’m assigned, I’ll own shares of the underlying company at a significant discount (since I always sell options out-of-the-money in high IV Rank situations) and a dividend to reinforce the position. There are four actions that I usually employ to manage trades:

  • 1. Take the assignment and sell covered calls against your long position
  • 2. Buy-to-close at a loss to avoid assignment altogether prior to expiration
  • 3. Buy-to-close at a loss and sell a new further out-of-the-money option to reset your positioning
  • 4. Sell option spreads to define your risk (sell a put and buy a further out-of-the-money put)

Upon assignment, selling covered calls is a great way to extract additional value while waiting for the underlying assigned position to recover or appreciate beyond your assigned price. If an option is near expiration and has already broken through my strike price, then I often buy-to-close at a loss, especially if earnings are due prior to expiration. If this situation presents itself, buying-to-close and taking the loss may be the superior route since the odds are not in your favor moving into earnings/expiration. If the underlying stock has already broken through the strike, then upon earnings, the stock may sink lower and result in a huge loss upon assignment. After buying-to-close at a loss (if that was the best action to take) then selling a further out-of-the-money option will offset the loss and reset the odds of being in your favor.

In order to define your risk, you can sell an option spread, which is when an option is sold, and another option is purchased further out-of-the-money. In this situation, you receive premium income for selling the option, and you use part of that income to buy protection via buying a further out-of-the-money option. If you sell a put at a strike of $65 and receive $100 in premium income, you can buy a further out-of-the-money put strike at $60 for $40 in debt. The net premium income would be $60 ($100 - $40), and the max loss would be $500 ($65 strike - $60 strike) if the stock broke through the $60 level. If the stock breaks through $60, you have the right to sell shares at $60 since you bought the put option as well for protection. So, the ideal scenario is the income of $60 at expiration, and the worst case scenario is a max loss of $500. This can be modulated to define risk and optimize net premium income.

Lessons Learned

Everything that could’ve gone wrong in May 2019 went wrong. Airlines, banks, retail, oil, pharmaceutical supply chain, and trade war sensitive stocks all disproportionally impacted my portfolio. Despite the diversity of tickers across sectors, occasionally trades go horribly bad even in large-cap, dividend-paying stocks that are ostensibly lower risk equities. CVS Health (CVS), American Airlines (AAL), Bank of America (BAC), General Electric (GE), Kohl’s (KSS), Schlumberger (SLB), US Oil ETF (USO) and US Steel (X) were all assigned and have weighed heavily on my overall portfolio throughout the past 8 months. All of these assignments were down double digits (~-20%) from the assigned purchase price at one point. These stocks have been dead weight, especially the stocks in the oil space and the middle of the trade war crossfire such as US Steel, General Electric, and Kohl’s. Case in point, CVS fell from $70 to $53 per share, dropping 24% in one week and Kohl’s dropped from $72 to $51, dropping 29% in a single week. These drastic market moves are unpredictable; thus, managing risk is essential. These unrealized losses could have easily been avoided had I executed a buy-to-close at a loss prior to earnings being announced for both Kohl’s and CVS and/or sold an option spread to define my risk.

Conclusion

This comprehensive options strategy provides key fundamentals for long-term successful options trading. These fundamentals allow your portfolio to appreciate steadily since options are a bet on where stocks won’t go, not where they will go, without predicting which way the market will move. These fundamentals provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. I’ve demonstrated an 85% options win rate over the previous 9 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a 4.51% return against a 0.95% for the S&P 500 with a lower risk profile. However, unrealized losses can pile up and negate these performance metrics if proactive management isn’t utilized. This includes a variety of techniques that can be deployed to mitigate unrealized losses and/or assignment altogether. Taken together, options trading is a long game that requires discipline, patience, time, maximizing the number of trade occurrences and continuing to trade through all market conditions. When adhering to options trading fundamentals, this approach can provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves.

Noah Kiedrowski
INO.com Contributor

Disclosure:The author holds shares in AAL, BAC, C, CVS, GPS, GE, KSS, SLB, USO, and X. However, he may engage in options trading in any of the underlying securities. The author has no business relationship with any companies mentioned in this article. He is not a professional financial advisor or tax professional. This article reflects his own opinions. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned. Kiedrowski is an individual investor who analyzes investment strategies and disseminates analyses. Kiedrowski encourages all investors to conduct their own research and due diligence prior to investing. Please feel free to comment and provide feedback, the author values all responses. The author is the founder of www.stockoptionsdad.com where options are a bet on where stocks won’t go, not where they will. Where high probability options trading for consistent income and risk mitigation thrives in both bull and bear markets. For more engaging, short duration options based content, visit stockoptionsdad’s YouTube channel.

Will CVS Health and Walgreens Survive?

Is it the single payer narrative being pushed by Democratic Presidential frontrunners? Is it the Amazon threat via its acquisitions of PillPack and Whole Foods that may displace traditional pharmacies? Is it the drug pricing pressures that are eroding margins and limiting margin expansion over time? Is it the secular decline in the physical footprint storefront retail space that’s hindering foot traffic and off-the-shelf purchases? Regardless of whether or not it’s singularly attributable to one of these factors or the culmination of all the aforementioned factors, CVS Health (CVS) and Walgreens Boots Alliance (WBA) are being pressured in many different directions. CVS and Walgreens have plummeted by 53% ($113 to $53) and 46% ($97 to $52), respectively from their multi-year highs. Over $110 billion in combined market capitalization has been erased from these two companies. With threats coming from all angles, will these two pharmaceutical supply chain heavyweights be able to not only survive but compete and revive their dominance in the marketplace?

Backdrop and Market Dynamics

The pharmaceutical supply chain cohort, specifically CVS and Walgreens, are simply unable to obtain firm footing in the backdrop of consolidation within the sector, negative legislative undertones, drug pricing pressures, rising insurance costs and a market that has lost patience with these stocks. All of these factors culminate into sub-par growth with a level of uncertainty as this sector continues to face headwinds from multiple directions. Many of the stocks that comprised this cohort presented compelling valuations in a very frothy market. This allure has been a value trap as these stocks continue to be a falling knife. It’s no secret that these companies have been faced with several headwinds that have negatively impacted the growth and the changing marketplace conditions have plagued these stocks. Continue reading "Will CVS Health and Walgreens Survive?"

Options: How About Those Losing Trades and Managing Risk Profile?

Let’s discuss losers and managing options trades that move against you despite the high probability of winning the trade at the onset. When engaging in options trading, losing trades are inevitable however managing these trades via risk-defined trades, position sizing, diverse sector allocation, buying-to-close for a gain or loss, allowing assignment to occur at expiration, selling covered calls on the assigned stock and rolling the trade out to a different strike level can mitigate risk and allow long-term successful options trading. In the end, following a set of options, trading fundamentals will enable your portfolio to appreciate steadily month after month for consistent portfolio appreciation. Since options are a bet on where stocks won’t go, not where they will go, this is accomplished without predicting which way the market will move. These fundamentals provide long-term durable high-probability win rates to generate consistent income while mitigating drastic market moves. Following these option trading fundamentals, I’ve demonstrated an 86% options win rate over the previous 8 months through both bull and bear markets while outperforming the S&P 500 over the same period by a wide margin producing a -0.1% return against a -5.6% for the S&P 500. This outperformance is due in part by proactively addressing losing trades to manage the overall risk profile.

Losers Negate Winners

The goal in options trading is to leverage cash and/or stock and sell options using the underlying cash and/or stock to collect premium income. This can be performed in a high-probability manner where a statistical edge is to the options trader’s advantage. Despite the odds being in your favor, occasionally trades can move against you in a major way and negate a large swath of winning trades. Let’s say 12 trades were placed and closed with an average income per trade of $65, translating into $780 in income. If one trade goes south and assignment occurs at $8 below the strike, then this would more than wipe out the $780 in profit and result in an overall loss on the portfolio, translating into a net $20 loss over these 13 trades since options trade in blocks of 100 shares. The onus is on the trader to circumvent this situation and manage these trades before this huge loss in relation to all the option-income received. The example used above is the primary rebuttal from cynics when it comes to an exclusive portfolio driven by options trading. Even if this assignment occurs, the stock was purchased at a substantial discount relative to where the stock traded when the option was placed. Additionally, the assignment can be held until the underlying stock recovers beyond the assigned strike price. Continue reading "Options: How About Those Losing Trades and Managing Risk Profile?"