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Using Option Credit Spreads To Build Wealth: Trades For Nov. 21-25, 2016

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

New ATHs for the major US indices. The risk-on mindset adjustment continues, with expectations running high for major changes in economic policy from the US government. Sector rotation is driving the rally thus far, with industrials and financials leading the charge. Despite the blowup in the bond market as yields on the 10Y reach 2.3%, which is resistance from the long term downtrend since the 1980s, large outflows of funds from domestic bond funds have yet to occur. A lot of money is waiting out the recent market moves.

Indicators:

Outlook: Rally breadth is improved, large caps participating; equity fund flows are weakening. Indices continue overbought, with resistance in sight. Expect a pause while macro events unfold; seasonality will push markets higher into year end.

Economy: GDP estimates robust > 3% YoY, recession > 1 year away; long leading, short leading and coincident economic indicators positive.

Credit Markets: No stress.

Earnings and Valuation: Q3 growth across all sectors. Q4 and 2017 estimates improving. Policy shifts implying significant 2017 earnings impact. Equity risk premium remains high despite bond market rout. Profit margins improving (Factset)

Breadth: all metrics, all indices improved. Broad markets (SPX, NYSE) improving but still relatively weaker. SML breadth close to previous extremes.

Sentiment: Individuals, asset managers are bullish. Positive sentiment improved, no extremes.

Event Risks: Nov. 30 OPEC meeting, Dec. 4 Italy referendum, Dec. 14 FOMC interest rate decision.

Summary of Weekly Events: Ritholtz

Market and Economy Review: Fear and Greed Trader

Credit Spread Positions:

ESZ16: Last week ES finished right at 2180 resistance. On Monday it blew through 2180 and carried on higher for the whole week, finishing above 2211. Finally, the large caps are starting to participate in the rally. Looking at the chart, ES appears to be moving within a broad rising channel; support will now most likely be at 2180, which is previous resistance, and stepping down to relatively weak support 2160, 2140 and 2125, with stronger support at channel resistance coinciding with the 200MA at 2090. ES is about as strongly overbought on the daily chart as it has ever been. On the weekly chart, RSI(5) is overbought, but STO(10,3) still has room to climb, while MACD has just issued a buy signal. In the short-term we can expect a pause in the price action, but the technicals are signaling the potential for further increases over the next few weeks. The seasonal strength of the markets into year end argues for more aggressive credit spread positions, but I'm taking time opening new spreads given the potential for event-driven volatility over the next couple of weeks. The major event being the FOMC interest rate decision. US markets and economy are in a much stronger position than the end of 2015, and an interest rate increase is baked into prices now. Volatility is likely to be relatively mild compared to the last rate increase episode. Next week is the OPEC meeting with expectations for oil production limits, and the weekend will see the referendum in Italy on constitutional reform. I may consider opening put spreads for Dec. 9 expiration if premiums are reasonable at 2140 or below. I really don't want to expose too much capital to risk until these events are over, and any new positions will have to have clearly defined recovery strategies to mitigate risk.

RUT: Really an amazing run for RUT since the results of the US elections. An unbroken run of 13 days of price increases. This hasn't happened for 30 years, and is an indication of the strength of the new-found positive sentiment toward domestic equities. Last week I could see that upper channel resistance was in the vicinity of 1350, but I didn't expect RUT to come even close to it within a few days, and yet here we are. The daily chart is topped out in terms of overbought: doesn't mean a significant price dip is imminent though. The weekly chart is also overbought, but it has room to run further. However, now price is at a "natural" resistance point, and so I'd expect RUT to pause for breath. No obvious support levels are in the vicinity of the current price; the breakout price is way behind at 1263, while the 38.2% Fibonacci retracement from the election rally low is at 1275. These don't really seem realistic levels in the current environment, so my planning revolves around the 1300 level for short strikes, which is still almost 4% below Friday's close. Risk management is still the order of the day, and a recovery strategy should be in place before new positions are opened.

Trades for the Week

I managed to accomplish less last week than I hoped. I had open orders for both RUT and ES for 11/30 expiration, but I didn't get any fills. I had priced put spreads too high thinking it was likely there would be a respectable pullback to drive prices higher. I plumped instead for 12/02 spreads where premiums were reasonable. The only surprise last week was the strength of ES, which I had expected to show some weakness since large cap breadth was clearly lagging. I closed the 2210 short strike call spread in time to avoid going ITM and recovered for a small profit with a put spread for Jan. 2017 expiration all the way down at 2025 short strike. Not taking any chances. Now we're into December, a seasonally strong month. I've already discussed caveats to near - term trading, but I anticipate a strong end to the month. The challenge is to take full advantage of that strength. I'm only looking 1 week out until it's clear how the markets play out through the middle of the month.

Hedge Stategy (Paper Trade)

Another successful trade this week. Total profit is now up to ~US$38K with a total of US$62K required to provide (best case) US$80K of downside protection for free. I decided to move these trades to their own page rather than list them out here since there really is not much to say about them. Next trade is for 12/02 expiration with SPX short put strike at 2190.

Reading List

Chart storm for the week. https://seekingalpha.com/article/4026451-weekly-s-and-p-500-chartstorm-27-november-2016

Goldman has a positive view of 2017. No meaningful chance of recession. Some caution around expectations for fiscal stimulus: issues are already large debt load (rinsing interest rates) and close to, to full employment. Large scale stimulus may produce inflation. http://www.calculatedriskblog.com/2016/11/goldman-2017-outlook-under-new.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+CalculatedRisk+%28Calculated+Risk%29

Put options may not be cost effective even in calm markets. There are other cross asset hedges that may be cheaper to implement. http://blog.alphaarchitect.com/2016/11/18/in-calm-markets-should-we-buy-cheap-put-protection/?utm_source=Alpha+Architect+Website+Users&utm_campaign=3314ae93dd-RSS_EMAIL_CAMPAIGN&utm_medium=email&utm_term=0_2f87b7924e-3314ae93dd-188295577#gs.pxACVDI

An opinion on the economic impact of Trump's main proposals from a respected blogger. Bottom line, expect a modest short-term boost from spending and rising wealth inequality. Parts of the program to boost growth will be enacted quickly while the other parts that will detract from growth will take time to implemented. http://www.calculatedriskblog.com/2016/11/some-earlythoughts-on-impact-of-trump.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+CalculatedRisk+%28Calculated+Risk%29

Funds are now flowing out of bonds and into equities. It is retail investors who have been pumping money into bonds. http://fat-pitch.blogspot.tw/2016/11/fund-flows-investor-positioning-and.html

Fund managers are still overweight cash and underweight equities. Expectations for economic growth are improving up from the low if February 2016. Inflation expectations are at a 12 year high. At these levels yield have typically turned around, http://fat-pitch.blogspot.tw/2016/11/fund-managers-current-asset-allocation.html?m=1

Lance suggests markets will likely drift higher until early December and may then sell off as mutual funds and hedge funds make year end distributions. With fed interest rates hike occurring in December the markets may once again sell as the dollar strength, bond sell off combine with distributions. He also takes Dana Lyons analysis of VXST extremes as another piece of evidence pointing to potential short term market weakness. https://realinvestmentadvice.com/dont-be-the-turkey-11-19-16/?utm_medium=email&utm_campaign=Real%20Investment%20Report%20-%20Dont%20Be%20The%20Turkey&utm_content=Real%20Investment%20Report%20-%20Dont%20Be%20The%20Turkey+CID_ebfe0ce3185fbeb3c861d906c9cc688f&utm_source=RIA%20Email%20Marketing%20Software&utm_term=READ%20MORE

Recession concerns increasing for late 2017. If fed starts to shrink its balance sheet impact could be large in 2018. Trump policies are stimulative for the USA but recessionary globally. Pay attention to China since debt has been rising rapidly. https://humblestudentofthemarkets.com/2016/11/20/going-on-recession-watch-but-dont-panic/

Market composite PMI remains at 54.9, the same as October. "Business activity across both manufacturing and services is growing at a rate unchanged on October, which was in turn the fastest for a year. Together, the two PMI surveys indicate that the economy is expanding at a respectable annualized rate of 2.5% in the fourth quarter."
https://www.markiteconomics.com/Survey/PressRelease.mvc/21666382963f437e9d5232550c13a48d

Five reasons to be thankful:
1. Low Unemployment claims
2. Near record job openings
3. Near record low household debt
4. Low gasoline prices
5. Accelerating wage growth
http://www.calculatedriskblog.com/2016/11/five-economic-reasons-to-be-thankful.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+CalculatedRisk+%28Calculated+Risk%29

Employment data suggests first half of 2017 will see continued growth. Retail sales and initial claims tend to lead unemployment rate and both are improving. Underemployment rate has dropped below 10% which has also tended to produce wage growth. Again positive for the economy. http://bonddad.blogspot.tw/2016/11/will-early-2017-be-indian-summer-for.html?m=1

Melt up to 2400? https://seekingalpha.com/article/4025584-technically-speaking-welcome-melt-up?app=1&uprof=45&isDirectRoadblock=false

Retail sales are improving. This portends a stronger economy in the short term. Longer term signals (retail hiring vs retail sales) suggest a downturn is possible in the next year. Consistent with other long term signals. https://seekingalpha.com/article/4025602-retail-sales-forecast-near-term-improvement

Chemical activity continues to improve. Suggests industrial production will soon move up. http://www.calculatedriskblog.com/2016/11/chemical-activity-barometer-continues.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+CalculatedRisk+%28Calculated+Risk%29

401k plans are typically not sufficiently well funded to provide retirement income at the level most expect e.g. 40-50% of pre-retirement income. http://www.economist.com/news/finance-and-economics/21710255-workers-are-being-deceived-past-high-returns-save-yourself?frsc=dg%7Ce

It pays to look behind the headlines. No big rush into USA equities from the cash that has been removed over the past couple years. Bonds are being dumped outside the USA. Domestic funds are not showing a panic for the door. https://seekingalpha.com/article/4026167-hustle-flow

High frequency long, short, coincident indicators are now positive. First time this year! http://bonddad.blogspot.tw/2016/11/weekly-indicators-for-november-21-25.html

This how bad a bond market selloff could get. Obviously long durations and high yields will take the biggest hit, but otherwise past experience is that losses are contained. http://awealthofcommonsense.com/2016/11/how-bad-could-bond-market-losses-get