Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Using Option Credit Spreads To Create Wealth: Update Aug 8-12, New Trades Aug. 15-19, 2016

|Includes: IWM, SPDR S&P 500 Trust ETF (SPY)

It's been 6 months since my last post, and I decided I finally needed to get back to documenting my trading efforts with credit spreads. This past few months have been hectic: my wife was in the hospital for 5 months, and we now have a new baby boy as a result. After a good dose of domestic chaos, our lives are finally calming down, and so it's now or never to get back on the blogging wagon.

I have continued to trade over these intervening months, but I've simplified my approach because my spare time is just not as plentiful as it was last year. I now trade only e-mini S&P500 futures options (NYSE:ES) and Russell 2000 (RUT) index options. I have also been experimenting with VIX calls to capture volatility spikes: I have not been been able to generate consistently positive results with the calls because I have not been sufficiently proactive to roll out the calls during periods of low volatility (like we have now). In all likelihood I'll drop the VIX calls and focus exclusively on ES and RUT credit spreads.

One other change to mention: after the market drops last year and early this year, I decided it would be a good idea to develop a hedging technique for credit spreads. Previously, I have taken the approach to roll spreads up/down and out in time to recover losses, and if done well, this approach works. However, to make the roll outs less taxing on capital I decided I needed to incorporate a hedge to capture capital in down markets. The key to successfully incorporating a hedge into my strategy is to reduce the cost of the hedge to as close to zero as possible, and to have it always available; and it can't require me to get into something as time intensive as day trading. Almost all hedging techniques I have come across have been developed for equities and compensate losses without the need to sell positions. It is not straightforward to apply these methods to credit spreads, particularly with relatively short term option expirations, and a 100% loss overnight a very real possibility. What I'm proposing to do is definitely not a perfect hedge, but it should provide a respectable amount of capital in most circumstances. The technique I decided to research was one I had seen discussed on Seeking Alpha by a contributor with the nom-de-plume of Reel Ken. The idea is to buy LEAP long puts, or put debit spreads in my case, for downside protection, and to use weekly short puts to pay for the debit spread. This is only feasible if the debit spread expiration is pushed out over a year as this reduces the weekly premium required to be earned. With no experience with this hedging technique, I decided I would paper trade for the remainder of this year and then make a decision whether to incorporate it. I'll document the results weekly here.

Getting back to details, I'll follow the approach I took previously, and look at the economy, followed by US markets, and then get into details of trades.

Summary of major economic / market events: Ritholtz

Market Action: Urban Carmel

Economy / Market Analysis: Fear and Greed Trader

The US economy appears to have escaped the growth fears that were prevalent earlier this year. Although growth is mediocre at best, a reasonable read of the economic indicators suggests a recession is nowhere in sight. Non-farm employment gains are, however, slowing suggesting the economy is past the mid-point of expansion and entering into the later and final stage of expansion. As such, I don't expect a major market disruption this year, barring a geo-political black swan. This does not preclude a 10-15% panic attack similar to the the August 2015 and Jan 2016 episodes, particularly if the Fed sees fit to increase interest rates this year. Despite the fears of a global meltdown, with China in particular coming off the rails, the global economy is still bumping along. The UK economy is going to take some time to recover from the own-goal that was Brexit, while the EU economy continues to expand, albeit geographically uneven. Markit's latest global PMI shows an increasing rate of expansion.

Recent market action has been overwhelmingly positive for equities. This past week SPX, COMPQ and INDU all made new all time highs simultaneously, a rare feat; the last time this happened was 1999. SPX is showing continued strength despite being mildly overbought. Market internals are supportive of further gains. New highs are trending higher, up-down volume is moving higher, while breadth is showing broad participation in the rally. However, with VIX < 12, the potential is there for a short - term correction, although any such dip is likely to be bought into and so, short-lived given the robust market internals. Earnings are a concern, with Factset reporting Q3 projections are negative. However, Urban Carmel pointed out recently, ex-energy SPX earnings are growing YoY, although the growth rate leaves much to desire. However, 12 month forward earnings, which correlate strongly with market performance, are increasing, and this may be the trend the markets have latched onto. All appears relatively good for the US markets, but as always the markets are climbing a wall of worry: interest rates, oil, global growth, earnings, US presidential election. As Jeff miller pointed out recently on Seeking Alpha, the time to be concerned about the markets is when there is nothing to worry about.

Credit Spread Positions

ESU16: The September ES future, ESU16, has been steadily climbing higher for the past month. It appears to be in a "good" overbought conditions, where dips are shallow and are quickly bought. RSI(5) and stochastic suggests there is more upside before the future is so overbought a pullback can be expected. MACD has a weak sell signal in place, but it is trending sideways and it would not take much of a positive move to generate a buy signal. The weekly chart has a strong uptrend in MACD, consistent with continued market strength. Volume is lackluster, which is not unusual for the summer months. In the absence of a reasonably substantial increase in volume its unlikely price is going to make a strong move either way. Most recent support is at 2170, with stronger support at 2150 and then at the 200MA at 2125. August and September are historically volatile months, so my preference here is to stay well below support to write credit spreads. For put short strikes at the 200MA, biweekly premiums are still respectable. If the market does pullback to 2150, this would be a very good trade for a couple of weeks. I would not touch call credit spreads with a barge pole in the current market. Put credit spreads are the only way to go for me.

RUT: This chart is remarkably similar to ESU16, with the index approaching overbought on RSI(5) and stochastic. MACD is quite strongly positive, flat and on the verge of issuing a buy signal. RUT has also been crawling higher over the past month. Support is at 1220, and more substantially at 1200 and at the 200MA at 1180. I'm sticking with the 200MA for short strikes for biweekly trades. Be prepared to roll down to 1140 should we see more than a short -lived dip.

The small caps have been leading SPX over this rally; the broad participation is consistent with the breadth internals, and the small cap push also jives with the risk-on mentality of traders at the moment. A switch to underperformance compared with SPX would be an early signal that the rally has really run out of steam. So far, we don't seem to be there. Good news for writing credit spreads.

Trade Summary for the Week

Credit Spreads: The chart below summarizes the trades done so far this month. All-in-all a nice set of trades this month. The 8/19 ES iron condor was getting a touch sensitive as ES move up above 2100 so I closed this out for a 3.5% gain, below what I would have preferred (~6%), but still acceptable. All trades have finished OTM so far this month. I have 2 trades open for 08/26 expiration, EW4 and RUT. Given recent market action I would expect little difficulty with these trades, but they should also be easy to defend by moving down and increasing capital, or worst case, rolling-out by month. I am sweating over an iron condor I opened in July for the 9/16 expiration. I simply did not anticipate ES would spring up toward 2200 so fast; I had anticipated a slow climb which would allow me time to close out for a profit. My strategy to salvage this trade is to open long futures positions to match the number of short calls. I've been doing this since ES hit 2145 with the aim of having a full set when ES hits 2200. In this way I'll turn the call spread into a covered call since the number of futures will match the number of short calls, with the long calls then providing additional profit.

Hedge Strategy (Paper Trade)

This strategy aims to provide up to $80K in a reasonably severe market down turn (15%). The debit spread covers 200 points between 1900 and 2100 for SPX. When I opened this spread in April SPX was close to 2100. The cost of the debit spread is reasonably substantial, and so I am using weekly short puts to pay off this cost over the life of the spread, which is out to 06/17. However, these weekly short puts also require protection since they would be completely exposed during a sharp sell-off, such as we have experienced twice over the past year. Therefore, I have bought 2 long puts with the same expiration as the debit spread, and I write the weekly puts against these long puts. So far, the strategy is working OK; the goal is completely pay off the debit spreads / long puts well before expiration. Given the rather benign market action over the past 3 months, the profit from the weekly puts has been impressive, and I'm about 1/3 of the way through the premium needed to pay off the spreads / long-puts.

Reading list

This is what I've been reading this week.

Markit comparison of employment PMI with NFP, and composite PMI with GDP. Good correlation since the great recession. PMI data implies that GDP growth will be only ~1% in Q3. No interest rate hike anticipated in September.

Financials now appears to be breaking above recent downtrend resistance. This will help the markets retain some positive momentum.

Analysis of USA vehicle turnover rates. Back to "normal" at 14 years. Interesting data that I had not followed before. No sign of an increase typically associated with recessions. Light vehicle sales have reached previous highs; likely to move sideways.

Lance Roberts makes the point that the markets never experience the average growth rate. The real killer to long-term returns is draw-down because it takes a long time to recover lost capital. This cycle will, of course, end in another sizeable draw-down, the timing of which is now unknown. The key is to be prepared for the eventuality.

The average stock, as represented by the value line arithmetic average index has exceeded its 2015 ATH. This is a confirmation of the breadth of the market advance that is underway. Author suggests the markets may be in the process of a long topping process. several indices have not yet made new ATHs I.e. NYSE, RUT, VLG, so it is possible this is a bear market rally focused on selective areas such as large cap, defensives, dividends. Time will tell.

Urban Carmel suggests being on the lookout for a pop in volatility. Previous instances of SPX approaching a round number have seen pullbacks. The key to understanding the market direction will be to look for consistent closes below the 5MA, which will flatten and then dip.

Inventory to sales ratio continues to decrease, consistent with recent trends in new orders and business sales. The economy continues on solid footing but with tepid growth.

Lance Roberts holds forth on oil prices, suggesting that prices have room to drop to 30-35/bbl. Supply is still much larger than demand, and given the tepid economic situation and its likely longevity, it is not realistic the demand side will increase to soak up supply. He suggests oil may be in for an extended period of range bound prices, which will affect energy companies ability to grow. Since the SPX tends to correlate with oil, the potential exists also for a drop in prices to take the SPX with it. Another section of the wall of worry is in place!

Are consumers really behaving like we are in a recession, or is this an artifact of the choice of M to represent the high end of retailing? Given that AMZN has been eating into retailing the story may not be so simple

Cam Hui chimes in on the VIX situation, and combines Urban Carmel and Dana Lyons points. VIX dropping below the BB and a BB squeeze tends to produce flat to negative returns in the short term. Speculators ("smart money") have a record number of VIX long futures i.e. anticipating a volatility spike and a market drop. Speculators are not always correct, but they tend to be correctly positioned at turning points. Caution advised for the next couple of weeks.

What are the causes of weak productivity growth in USA? Part of the answer may be difficulty in estimating productivity growth for service industries. Other issues are: overcapacity; productivity cycles - we are at a low. A big question is why are profit margins so high given the low rate of productivity increase. No answer yet, but the author promises to get back to us soon.

Data from China continues to show a slowing economy. Fixed asset investment (SOEs) is now at a 16 year low as the government tackles overcapacity. Factory output rose less than expected as industrial production slipped substantially compared to last month. Retail sales also slipped this month. Keep an eye on China since the markets are sensitive to signs of a hard landing for the economy.'s-fixed-asset-investment-growth-slips-to-lowest-in-more-than-16-years-419933

If history is a a good guide, then expect the SPX to be up by several percentage points from here by the end of the year.

Some of the US most famous and experienced investors are cautioning over the prices of the stock markets (Icahn, Drukenmiller, Gundlach, Gross etc.) The arguments appear to be: low bond yields do not justify high equity prices (true, but prices tend to rise in response anyway); recovery of corporate profits is illusory, although ex-energy profits are at least growing QoQ; stock valuations are high, and some would argue excessive; corporations have not invested for the future, focusing instead on allocating capital to buybacks; and finally, the FED has introduced moral hazard into the markets i.e. the belief that risk taking is justified since the central banks will continue to support prices. The latter is perhaps the most dangerous aspect of the current situation.

The latest inventories data shows inventories increased at a much slower pace than sales, so the ratio is coming down, as the NDD predicted for the completion of a mid-cycle slow down. Retail sales leads employment and has been decreasing from the 2012 to 2014 level. Confirms the slowdown in hiring that is underway.