The Wrong Day...

Yesterday, with the Dow down 500(!) points, I had to send an alert to my Real Income Trader subscribers about a trade we just entered on Monday: 

With apologies to Airplane’s Lloyd Bridges, it looks like I picked the wrong day for Bank of America call options…

Sorry for the levity. But sometimes you just gotta laugh. I mean, what else can you do? Well, other than not buy them in the first place…

So, a couple things. One, I don’t really think losing money is funny. I remind myself every time I put out a trade or investment recommendation that you work hard for your money. I do not take that lightly. 

At the same time, there’s simply no way to avoid losses when trading or investing. You assess the opportunities, take your shots, and let the chips fall where they may. I’ve been doing this a while — the chips usually fall in my favor. I’m not gonna flip out when they don’t.

The second thing has to do with just how we go about making money in the current market environment. Where’s the opportunity? Upside or downside? 

The S&P 500 came within a point of a new all-time high on October 3rd. So we’re looking at an 8% loss for the month. 

The reason is pretty well known at this point. Trade issues are hurting, and the Fed is tightening just as the economy is getting more uncertain. (And I gotta say I find it funny that everybody thought an “outsider” at the Fed was such a great idea… until things get dicey and now it’s, “What is that guy doing?”)

Premature Allocation

Now for a candid observation: Downtrends rarely get broken by opening gaps to the upside. Take Monday, for example. Futures were launching before the open, after China’s government said it would pump the liquidity to help its economy and stock market. (China is uniquely positioned in the world to do this because there aren’t many checks and balances from the global financial machinery. There’s only $146 billion in Chinese bonds out there, you can’t convert to yuan easily, etc.)

The S&P 500 did manage a higher open yesterday. And traders sold right into it, pushing stocks lower all day and breaking below the 200-day moving average. 

Now, there’s an old saying that stocks tend to overshoot. For example, they don’t tend to stop right on a major support/resistance line like the 200-day MA. So when the S&P 500 blew through it, that was an extreme move, and it said to me that a reversal to the upside was now a likely event. Hence the Bank of America call options, which will make money on an upside move…

I’ve told you this before, but I tend to be a little early with both trades and investment. That is, I suffer from premature allocation.

So these Bank of America calls may be early, but I still think they’re going to make us some loot. Here’s why…

Reading the Market’s Tea Leaves

Exhibit A is the CBOE Volatility Index, or VIX. 

Now, when you hear someone say the market will be “volatile,” it usually means that person thinks stocks will sell off. A rallying market is never called volatile. 

It might sound like the VIX measures how much stocks are selling off. And it sort of does, but not directly. You see, when stock prices start falling, big fund managers can’t just start dumping millions of shares on the market, or things would get totally out of hand.

Yes, they will sell some stock. But they will also buy put options on the S&P 500. Put options gain value as the underlying asset (in this case the S&P 500) loses value. When you buy one thing to offset losses in other things, it’s called a “hedge.” So when stocks start selling off and fund managers are scrambling to buy S&P 500 put options to hedge their portfolios, the price of those put options starts to rise.

That price rise for the put options is what the VIX measures. When fund managers are paying more for put options (and the VIX is rising), it’s a pretty good bet that stock prices are falling.

Now, a careful reader might say, “Wait a minute. The fund manager knows he or she is going to sell stock and that will push the market lower. So buying the put options is almost a guaranteed profit, right?” Ding, ding, ding! Get that reader a cookie! 

So, now what does it mean when the VIX starts falling? Could it be that fund managers aren’t buying as many put options because they know they aren’t selling any more stock?

Yes! More cookies!

Back to that chart. You can see it started ramping in early October. But it’s that last glyph I’m really interested in. That was yesterday, when the market opened up with huge losses. As you might expect, the VIX jumped higher, anticipating a flood of put option buying.

But did it keep going higher? No, it did not. In fact, it went lower pretty much all day. 

I’m all out of cookies, but it’s a pretty good bet that the VIX fell all day because those fund managers have been taking the profits on their hedges (selling the puts). It’s also a pretty good bet that they will hold off selling more stock for at least a couple of days. 

Confession: I Ate All the Cookies

One more chart and I’ll let you go. Exhibit B, the S&P 500…

Again, it’s the last glyph that’s important. That’s Tuesday. And you can see that the S&P 500 sold off a lot and then the buyers stepped in. The red line is the 200-day moving average, sitting at 2,786. Recent highs for the S&P 500 from October 15–18 are up around 2,810. 

So yeah, I think there’s some upside coming. If you don’t like Bank of America for a quickie, try Twitter (NYSE: TWTR). It’s been virtually unfazed by the selling. Could be good for 10% over the next few days.

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.