Seeking Alpha
Long/short equity, medium-term horizon, hedge fund manager
Profile| Send Message|
( followers)  

by Mike McDermott

In last week’s View From the Turret we talked about the potential for an initial rally based on the debt ceiling “resolution” followed by a selloff as traders’ focus reverted to the broad economic risks.

This “gap and crap” scenario turned out to be spot-on, as the initial market pop lasted less than an hour and equities spent the majority of the week in true liquidation mode.

To cap off a volatile week, Standard & Poor’s issued a downgrade of US Treasuries after the close on Friday. A rating of AA+ shouldn’t be a total surprise (market’s were reacting to rumors of a downgrade throughout the day Friday) but issuing this downgrade after markets were closed left traders in limbo for a very uneasy weekend.

Heading into another week of trading, there is plenty of uncertainty and speculation as to how the downgrade will effect markets on both a short-term and a long-term scale.

There is certainly an argument that can be made for a gap reversal similar to what we saw last week (only inverted this time around). In this case, any gap lower today could be seen as a buying opportunity as prices become washed out and then recover. But trading this scenario in any size creates a significant amount of risk as further selling could be fast and furious – with liquidity levels making it difficult to unwind long positions.

Last week as the market was plummeting, a number of traders began talking about capitulation and climax selling. My argument to this perspective is that capitulation selling usually occurs after months of negative action – not after just a few negative trading sessions. Just a couple of weeks ago, the major market indices were within striking distance of 52-week highs.

So while there could certainly be rallies and volatility along the way, a true climactic selloff with a sustainable recovery is much more likely to occur after a longer period of weakness – which means that we are still operating in an environment with significant risk.

It’s very difficult to make a definitive call on the market direction this week. As nimble swing traders, we prefer to develop a number of different potential possible scenarios, and then let the price action determine our best course of action.

So with our focus much more geared toward making money rather than “being right,” here are some of the trades we are tracking this week…

~~~~~~~~

S&P 500 Breaking Support

Last week’s price action represents a significant breakdown for broad equity indices. Taking a 40,000 foot perspective on the S&P 500, you can see that the action from this past week challenges the positive trendline that has been in place since the March 2009 low. Click to enlarge:

Several months ago, we became concerned with the mounting economic risks despite the relatively bullish price action. In early May, we entered a long-dated volatility trade that allowed us to profit from a major dislocation in the market, while still capping our risk at an absolute level.

The capped risk was an important part of the setup because it allowed us to “set and forget” the trade and avoid getting stopped out if the market continued to rally for some time before selling off.

From the Mercenary Live FeedMay 4th before the open:

After looking at various options (no pun intended), we have elected to use SPY as the vehicle for this trade. The following options are meant to act as one structure for one “set and forget” limited risk position.

While prices (and potentially strikes) may differ, here is the basic structure:

  • Buy 2 SPY Sept $120 puts @ $2.10 ($420 debit)
  • Sell 1 SPY Sept $132 call @ 7.38 ($738 credit)
  • Buy 1 SPY Sept $140 call @ 3.04 ($304 debit)

The above can be recognized as an outright put position (long puts) financed by a bear call spread. The premium collected by the call spread covers the cost of the put position. The risk in the position is represented by the maximum possible loss on the bear call spread (if SPY finishes in September at 140 or above, i.e. S&P 1400).

This past week, we took two actions to lock in profits on this trade. On Wednesday, we covered the SPY 132 calls at a price of $0.85 which allowed us to take the liability (risk) component off the table.

Shortly before the close on Thursday (when the Dow was down 400+ points), we sold half of our Sept 120 puts at $4.10 – realizing a hefty profit on the opportunity component of the trade.

Heading into this week, we still have half of the put contracts remaining – which allows us to continue to profit if the market plunges. If the S&P stages a rebound after the US downgrade, we may look for opportunities to add exposure back to this position – or look for correlated short opportunities.

Momentum Leaders Feel the Pressure

There are a number of momentum names that we have been skeptically watching for a number of months. Stock prices have continued to drift higher as investor confidence improved. But fundamental risks and high price multiples have make these positions simply too risky for us to participate in.

Last week, a number of these names took on water as investment managers paired back exposure. Chart patterns broke down and investor sentiment began to shift.

This week, we will be watching a number of these breakdown names for opportunities to set up short exposure and profit from further declines. An anemic rally would give us a more attractive inflection point so that we could short names once the negative pattern continues. This type of action would also give us a clear risk point, setting up an exit if the stock clears the swing high from an short-term rebound.

VMWare Inc. (VMW) began last week trading at about 50 times expected earnings for this week. By the end of the week, VMW had broken both the 50 EMA as well as the longer-term 200 EMA support line. However, the stock still holds a premium price and is vulnerable to more selling.

If growth expectations are revised lower and businesses reduce spending on technology, VMW could decline sharply (and still be priced for growth). Considering the number of growth investors that are committed to this name, a shift in sentiment could spark massive liquidation – giving us a great short opportunity. Click to enlarge:

On the retail side, Lululemon Athletica (LULU) is a breakdown candidate we have been tracking for a number of months.

The stock is currently trading at nearly 50 times expected earnings (even after the selloff this past week) and the company’s growth rate is expected to decline sharply in the coming quarters. Up to this point, the company’s affluent customer base has been relatively immune to poor growth in the overall economy.

But if the market continues to drop, it could affect affluent consumer sentiment and lead to lower spending on the high-priced discretionary apparel that LULU is famous for.

Over just a handful of weeks in June and July, LULU added 50% to its market cap in what appears to be a climactic rally. If that positive action is reversed, it will leave a number of new stockholders in a loss position which could accelerate a second leg lower as investors hit the exits.

We’re not involved at this point, but a brief rally in the stock could give us an attractive entry point for a bearish continuation trade. Click to enlarge:

Safety / Dividend Stocks May Catch a Bid

Fund managers with a mandate to remain fully invested may not be able to cut back their allocation to equities, but they may still be looking to cut risk as much as possible.

In this scenario, stable blue chip stocks with an attractive dividend yield immediately become buy candidates. We have been screening for large-cap stocks that have held up relatively well over the past few weeks, have a stable business, and are trading at a reasonable multiple.

Coca Cola Co. (KO) looks attractive with a near 3% dividend yield and a relatively stable stock price. The company has a very diversified international customer base and is expected to grow earnings by 11% both this year and next. A PE ratio of 18 is not cheap, but with the dividend yield and stable business, it could move higher as managers allocate capital to safe harbors. Click to enlarge:

Entering yet another volatile week, it’s important to remember that this is a time to execute on your trading plan – not a time to make it up as you go along. Making decisions based out of fear or panic almost guarantees failure. If you have a robust trading plan that provides contingencies for this type of market action, then stick to your risk management process and use the volatility to your advantage.

If, on the other hand, you’re not sure how to handle the gyrations, the best thing to do is to take a step back and trade much smaller (or in some cases not at all). There will always be opportunity for traders who protect capital. But without the “inventory” of a capital base, a trader has no means to generate profits.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.

Source: Trading the Downgrade Aftermath