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Using Option Credit Spreads To Build Wealth: Update Sept. 26 - 30, New Trades Oct. 3 - 7, 2016

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

US stock markets continued to be volatile this week, with traders concerns about oil prices and Deutsche Bank's financial stability, or the lack thereof, getting most attention. Last Friday was the end of Q3 and produced a nice rally to end the week on a positive note. We will now see if this was just a window dressing rally for the professionals or something of more substance for the markets.

While economic data continues to point to a low growth rate for 2016, forward earnings estimates for the SPX are improving. In fact, estimates for 2017, if they come to pass, will provide the first year of earnings growth since 2014. Factset's analysis of earnings is also positive for Q3 with lower downward pressure than is normal. The more optimistic earnings outlook supports the 6 (!) technical analyses I have counted this year suggesting markets are heading higher. We are also now moving into the more seasonally favorable time of the year, where a year end rally will be a much anticipated event.

Credit Spread Positions

ESZ16: The SPX price action this week was driven by macro events. The end of the week saw a rally back up to the 50 MA, which now is acting as resistance. Despite that past couple of week's action having some similarity to a bear flag pattern, price is still moving within a rising channel. Technically all the indicators, as well as volume, are pointing to continued upward movement, although momentum is weak. Both RSI and stochastics are neutral leaving room for price to increase before getting to overbought. Upper channel resistance is in the vicinity of 2220, but the future needs to break above 2175 as a first step to a new breakout. There is likely to be strong resistance at 2200 following that. My thoughts are that price will stay below 2200 until earnings for Q3 and projections for Q4 start to show definite improvement. Support is now at 2125 at the channel bottom and then at 2100 from the longer term uptrend. I have been reluctant to use short strikes above 2100 with the likelihood of continued volatility. A rally to 2200 will open the way to increasing the short strike to 2125.

RUT: The small cap index experienced similar volatility to SPX last week, but displayed more positive price action as it continues to lead the larger caps. The rising channel still contains the price, unlike SPX where the channel that had formed since May was violated on the downside. RUT technical indicators are neutral and more bearish than we see for SPX, but by and large are now neutral. Support is at 1200 from the intermediate term rising channel, 1225 from the shorter term channel, and at 1240 from the most recent price action. Meanwhile resistance is at 1263, and 1285 from the channel and then ~1300. Any move upward by the large caps should be mirrored by RUT. Short strikes at 1200, the most conservative option, have reasonable premium due to RVX increasing this week. I would consider 1225 for short strikes if the market moves up earlier in the upcoming week.

Trades for This Week

I finished up September with ES and RUT spreads that expired OTM. Profitability was better than I projected last week once I got my mathematics straight, and is quite pleasing given my relatively low activity for the month.

I opened several new spreads for October expirations, committing more capital than in recent months in expectation of a decrease in volatility. In addition to RUT and ES spreads for 10/14 expiration, I opened 2 shorter term SPX put spreads, for mid-week and week-end at 2100 short strike. I expect to the able to let these expire, or close out for a small cost if the market increases at the start of the week.

Hedge Strategy (Paper Trade)

Continuing to make progress. Put debit spread is paid off.

Reading List

Some reasons to expect earnings to improve for Q3 and Q4 2016. https://seekingalpha.com/article/4008300-s-and-p-500-weekly-earnings-update-bullish-next-2-quarters-election-notwithstanding

More earnings considerations for 2017. Analysts are expecting 2017 to be the first year in the past 3 where overall earnings will improve. https://seekingalpha.com/article/4009618-s-and-p-500-weekly-earnings-update-expect-fwd-4-qtr-estimate-near-129-next-week

The increase in TED may have more to it than looming USA regulation changes. Spreads between AA financial and non-financial bonds are also increasing, suggesting higher levels of stress in the financial world. This is probably linked to EU bank problems at DB. moreover, the close correlation of TED with VIX has broken down, implying a high level of complacency amongst investors. Seems like the author is trying to torture a dubious message from these observations. http://www.investing.com/analysis/reports-of-the-ted-spread%E2%80%99s-death-are-greatly-exaggerated-200155651

Wall Street Analysts are negative about market prospects for the remainder of 2016. Good News according to Barry Ritholtz. https://www.bloomberg.com/view/articles/2016-09-30/bullish-news-from-wall-street-s-bearish-seers

CRB metals index (scrap copper and lead, tin zinc I.e. The non-sexy stuff) continues to rise. Suggests industrial activity is picking up globally. Counter signal to the latest WTO downer. http://scottgrannis.blogspot.tw/2016/09/global-activity-reviving.html?m=1

Asset class correlations are rising, particularly bonds/stocks. This may be a premonition of bad things for stocks? http://www.investing.com/analysis/analysts-fret-over-rising-asset-class-correlations-200156217

Combined debt levels (consumer, corporate, government) keep rising. The author is of the opinion that high debt levels were responsible for the last 2 recessions, and will be the cause of the next recession. But since the last recession was a global affair, and debt levels certainly varied widely between countries it seems this argument may be more nuanced than presented here. Nevertheless, the point is that deteriorating credit quality or growth induced inflation may be enough to push up interest rates and tip the economy into recession once again. The credit markets may provide an early warning of a deteriorating economy. https://seekingalpha.com/article/4009425-devil-debt

An interesting take on AAII sentiment survey data compared to the Consensus-Inc survey of brokers / advisors. Individuals are consistently less bullish than brokers. This suggests individuals have given up on the stock market, and moreover, are unlikely to come back. Authors suggests this points to the top will be followed by a gradual roll-over instead of a blow off since the latter requires a high level of exuberance from the general public. https://seekingalpha.com/article/4009617-strange-sentiment-conflict

Additional disclosure: Don’t mistake what you see here for investment advice.