Which Is Better? Bear Put Spreads vs. Bear Call Spreads

The stock market spends a majority of its time in a bull market. We already know this much as fact. But that doesn’t mean that short-sellers don’t play an important role in the market’s dynamics and that bears can’t benefit from a decline in the market. Taking it a step further, individual stocks and ETFs can make wide-ranging moves, even when the overall market doesn’t exhibit that type of volatility on the surface. That allows bearish option plays to profit for short-sellers who trade options, whether that’s bear put spreads vs. bear call spreads or otherwise. 

When it comes to options strategies — for both bulls and bears — there’s no shortage of choices. Without sounding too wishy-washy, that can be both an advantage and disadvantage at times. The disadvantages can be in play when it comes to making a quick decision. Should we do something mellow, like a covered call, or step it up a notch with a bear put spread?

Of course, using OptionParty can help in this regard, as the platform breaks down all the probabilities in the blink of an eye. But for traders in general, we can suffer from decision paralysis when trying to make real-time decisions. (That’s why we do so much of our homework when the market is closed!)

In other cases, these choices can work in our advantage. They allow us to leverage various strategies to use what works best for the situation rather than something that will “just get the job done.” In this case, we’re looking at bear put spreads vs. bear call spreads. Both are bearish options strategies and both will theoretically benefit from a decline in the underlying asset.

Covered Calls vs. Cash-Secured Puts

Bear Put Spreads vs. Bear Call Spreads

Both strategies are similar in the fact that they are bearish setups, but they differ in their requirements. Bear put spreads are looking to benefit from a notable move lower and involve taking on a net debit, meaning the trader pays to take on the position. In most cases, the bear put spread needs to have the underlying price move lower in order to generate a profit.

The bear call spread differs as it is a net credit trade rather than a net debit. More so though, the strategy differs most in what is required by the underlying stock. Unlike the bear put spread, the bear call spread doesn’t need the underlying security to decline in order to show a profit. In fact, the underlying security can oftentimes trade flat and still leave the bear call spread profitable. Further, the underlying asset can actually rally at times and still leave the the bear call spread profitable. I would say this is one of the biggest difference in the bear put spreads vs. bear call spreads debate.

Another key difference? When we enter a bear put spread we know the maximum profit potential. If we enter a $5 spread with a cost basis of $1, we know our maximum profit is $4. While we know the potential, we do not know what the profit will be until we exit the position. With the bear call spread though, we collect our maximum profit right from the get go. The credit is ours to manage from that point on, but we won’t make more than what we collect once we open the trade.

So which one should you choose? Well, that depends.

Bear Put Spreads

Bear put spreads involve buying one put option and selling a lower strike put option of the same expiration. This creates the spread and in order to be profitable, we need the underlying stock price to decline. To find our break-even points, we first need to determine the cost of the spread. Then, add that to the long put option’s strike price.

For instance, say we are bearish on shares of ABC, which is trading at $77. We buy the $75 put option for $2.00 and sell the $70 put option of the same expiration for $0.80. The trade can be put on for a net debit of $1.20. However, we need more than $1.20 decline in ABC. Specifically, we need ABC to fall below the long strike price $75 plus the net debit. So just to break-even, we need ABC to close below $73.80 on expiration.

Below this mark is when ABC will start to show a profit, up to $3.80. If it falls below $70, our gains are capped at this figure, as we are short the $70 put option. While this requires a large decline in ABC, the nice part is that we have a defined risk; we can’t lose more than the net debit we paid. In this case, that’s $1.20.

Bear Call Spreads

Let’s look at how we could take on a short bias in ABC in the bear put spreads vs. bear call spreads debate. With shares at $77, perhaps we consider the $80-$85 bear call spread. Meaning we short the $80 call and buy the $85 call of the same expiration to limit our potential losses.

In this case, we sell the $80 for $1 and buy the $85 for $0.15, receiving a net credit of $0.85.

Those who do not like credit spreads will quickly point out that this leaves investors exposed to $4.15 in potential risk. That realized if ABC closes at or above $85 at expiration. For this risk, the trader is only receiving $0.85 in compensation. That doesn’t sit well with many investors, as they do not like the potential risk that could bite them on an unexpected move.

That said, those who opt for the bear call spread instead of the bear put spread do not need to see a big decline in the stock in order to collect a profit. In fact, ABC wouldn’t even need to decline in this scenario. As long as ABC closes below $80 on expiration, the trader would collect their full profit.

Up until $80.85, the trade is profitable. At this level, the trade breaks even and above $80.85, the trade turns into a loss. This is a key difference in the two strategies. 

How Much Money Is Involved in March Madness?

We’re in the thick of March Madness, the 64-team tournament that will leave just one team standing at the end of several single-elimination rounds. Okay fine, 68 teams if you count the play-in round. Still though, the March Madness tournament is one of the most exciting stretches in college sports.

But that brings up an interesting question: Just how much money does such a tournament stir up? There’s the famous bracket challenge pools and countless gambling across 63 games. An estimated 100 million people tune in to watch the games, driving countless dollars across network television and resulting in big-time advertising budgets. There’s hotels in tournament cities, venue sales and expensive tickets. If you really dig into it, there’s all the extra business local pizza joints, bars and Buffalo Wild Wings rack up in sales during game night too.

Let’s get a look at where some of this money is going!

Advertising During March Madness

Many may not realize just how much ad money March Madness attracts. In 2018, total ad spend hit $1.32 billion, up slightly from $1.28 billion in 2017. In fact, it’s just under the total ad spend that pro football attracts each year for its playoffs (inevitably boosted by the Super Bowl), and easily tops ad spending during the pro basketball postseason.

Digging through the totals, the $1.32 billion March Madness generated trailed NFL ad spending of $1.67 billion. However, it easily outpaced the $970 million in pro basketball ad spending during the playoffs — in fact, that’s a whopping 36% more! That said, NFL and NBA ad spending growth is outpacing March Madness ad spending.

And you thought college football bowl season was impressive? That total came in at just $399 million, more than four times smaller than March Madness ad spending.

Breaking it down by company, General Motors was the largest spender, followed by AT&T and Coca-Cola. Surprisingly, their immediate competitors — Ford, Verizon and Pepsi — weren’t even in the top 10. Go figure.

How Much Do People Bet on March Madness?

When you think of long-term, deep-value investors, who’s the first to come to mind? It has to be Warren Buffett. Given how against trading and “timing the market” Buffett has been both publicly and professionally, it’s surprising to see his open-mindedness toward March Madness. A couple years ago, Buffett and Dan Gilbert were involved in offering $1 billion for anyone who could complete a perfect bracket.

That’s right. A billion bucks.

Of course, no one ever won as it’s virtually an impossible task. While that offer was only around for a short period of time, Buffett has other offers on the table. For instance, this year he offered anyone in his company who has a perfect “Sweet 16” — meaning they got every pick in the first two rounds correct — $1 million a year for life.

With Buffett in the news for March Madness, it has us wondering, just how much money is wagered during the tournament?

It’s impossible to get a full look at this aspect. Who knows how many office or family pools have $10 to $50 a person on the line. But we can get an idea of how much is gambled during March Madness. The American Gaming Association estimates that $10.4 billion will be wagered this year during the tournament. Incredibly though, just 3% is expected to be legal.

Some may question this estimate, but the $10 billion figure is commonly cited as the betting sum. One estimate pegs $3 billion being wagered on brackets alone.

Productivity and Player Pay

There’s big money in advertising and plenty of money in gambling, but what about the lost money thanks to productivity? Many estimates have suggested that companies lose about $1.7 billion in productivity during the Big Dance.

One estimate read, “Studies have estimated the lost production around tournament time contributes to $134 million in lost wages and about $1.9 billion in lost productivity for businesses.” However, many say that the tournament leads to positive outcomes, whether that’s in office morale or in the sales department

At this point, it’s no secret that there’s billions of dollars on the line. But none of the players are involved at this point. At least when it comes to getting a piece of the pie. There’s a number of people that feel these players deserve some sort of compensation. After all, if it weren’t for them, there would no money to go around. As we’ve seen, that would shift billions of dollars in the grand scheme of things. They are risking their health and their bodies and putting plenty of other of people to work as a result.

That said, many others feel they should be grateful for the opportunity to play in front of millions of fans. Further, they can attend college and get a degree, most often on a scholarship. A case can clearly be made to justify either scenario.

What Is Portfolio Management and Should You Use It?

Portfolio management is a very broad term and it may be easy to overlook what exactly it means. In fact, it opens up a very wide range of nearly endless decisions. So what exactly is portfolio management? 

Investopedia describes it as, “The art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance.”

In other words, investors have to first determine their objectives and then find suitable investments as a result. While there will be plenty of overlap among investors, the answers can vary quite a bit.

As a young employee at the start of their career, the objective would be to maximize long-term growth in their portfolio. They will already have to work 30 to 40 years and need their investments to do the heavy lifting with the added benefit of time. Investors with less than five years left before retirement have a different objective. While they still need growth to get them through retired life, they also need to strongly consider capital preservation. How many soon-to-be-retired investors had to stick it out another 5+ years at work because their portfolios were decimated during the Great Recession? Finally, for our last example, look at the short-term trader. Their objective is to preserve all of their capital and take advantage of high-quality risk/reward situations that quickly generate cash flow.

Again, there are a ton of different answers here, but they all boil down to one thing: investment objectives. When we know our objectives — long-term growth, dividend income, capital preservation, short-term cash flow trades, etc. — we can begin to build our portfolios around those objectives.

Then they can start to hone in on the other two aspects mentioned at the top: asset allocation and “balancing risk against performance.”  

These two topics could be discussions on their own (and they will be), but for now, let’s keep it concise. Asset allocation refers to what percentage of the portfolio will be allocated to specific assets. Generally speaking, it refers to three categories, that being cash, stocks and bonds (and more commonly, just the last two). However, there are many more asset classes to consider, such as gold, futures, options, commodities, real estate and partnerships, among other options.

When it comes to “balancing risk against performance,” it simply means investors need to consider the risk of their chosen assets vs. the performance they are seeking. One wouldn’t need to load up on tech stocks if they were looking to achieve consist income on low-volatility positions.

What Else in Portfolio Management?

The cited description for portfolio management also reads, “Portfolio management is all about determining strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other trade-offs encountered in the attempt to maximize return at a given appetite for risk.”

This perfectly ties into what we were just talking about with asset allocation and risk vs. performance. Essentially, investors need to determine which pieces of the investment world best fit their puzzle. At the end of the day, they are managing for their and their family’s future, no one else’s.

But it goes beyond simply choosing the types of assets an investor wants in their portfolio. They have to decide things like actively or passively managed funds, or whether to use an investment advisor to help make financial decisions.

Portfolio Management in Trading

Investors who use their portfolios to trade need strict parameters in order to survive the harsh world of trading. Be it equities, futures, bonds, forex or options, there are periods of boom and moments of bust. Knowing when to sit on one’s hands and when to pounce are very important. But without a rules-based approach, many investors will do just the opposite; pouncing at the wrong times and doubling down at a time where they should be sitting on the sidelines.

Even when times are good, following the rules are key. While we can “get away” with breaking these rules at times, it only reinforces bad habits. Using backtests and simulators can certainly help, as it never hurts to have the odds on your side.

When it comes to options, using Option Party’s Portfolio Manager solution can provide a big boost. By being able to completely customize our trading strategy, users can tweak every essential part of the trade. This ranges from entry, exit, risk, cash reserve and position sizing, (along with the strategy of course).

These types of tools may not seem like portfolio management, but they can go a long way in making sure investors have the proper exposure. Too much risk can doom a portfolio. Not enough risk when the opportunity is right can cost investors performance as well. Balancing it is key, whether the outlook is 30 minutes or 30 years. These strategies can also help with execution, confidence and perfecting the strategy at hand.

How to Trade Options on Gold

Gold prices have been on fire lately, with the yellow metal now hitting multi-month highs. The debate around gold is an interesting one. There’s a lot of investors who swear by gold as a de facto inflation hedge and gold bugs who consider you crazy if you don’t have at least a few ingot nuggets in the safe. But there’s plenty of investors with no exposure to gold and no interest in altering their portfolio to obtain that exposure.

Then of course, there’s plenty of people in the middle. These investors’ exposure to gold usually fluctuates over time. Perhaps they allocate more money to gold when it seems like the metal is going on a prolonged rally. Maybe they pile into gold when the economy is entering more turbulent times. Through one form or another, these investors usually have some form of exposure to gold prices.

That’s the thing with gold: there’s a ton of different ways to gain exposure. With stocks, we usually talk about them in the form of a percentage. As in, 65% of our portfolio is in equities. In other cases, such as  single-company ownership, we gain long exposure by buying the equity, bonds or a fund that has a large allocation to the name, (think something like Apple).

With gold though, there are various means to gain long exposure to the metal. The most obvious form of exposure to gold prices comes by owning physical gold. For instance, items like gold bullion, bars or coins. Broadly speaking, investors can’t trade options on these types of gold investments. That is, with the exception of trading options on gold futures, which is delivered in bar form.

However, these types of investors have different considerations than traditional stock, bond and option investors. They have to consider things like premium markup, delivery and logistics, and storage of the metal.

gold prices

A four-year weekly chart of the GLD ETF.

More Exposure to Gold Prices

For those that want to invest in gold but don’t want the hassle of physical of gold, they can consider the SPDR Gold ETF, which trades under the ticker symbol “GLD.” This is the largest gold ETF, which holds physical gold that’s represented in stock form. Many investors like the GLD for its easy access and simplicity, while many dislike this form of “paper gold” for their lack of having the tangible asset to themselves.

This ETF is optionable, meaning we can trade puts and calls on it. That allows investors to take advantage of all sorts of bullish, bearish and neutral strategies. Covered calls, cash-secured puts, bull call spreads, bear put spreads — you name it, and you can trade it on this one.

The miners are another option. Miners tend to be more volatile than gold prices, at least when viewed as the overall sector. For those that do their homework, they can pick an individual firm to invest in, like Barrick Gold (GOLD), Newmont Mining (NEM) or Kirkland Lake Gold (KL). Most gold-mining stocks will have options available, although some may be too thinly traded to be worth the risk.

If individual miners involve too much research, risk, or investors simply want broad-industry exposure, two ETFs come to mind: The VanEck Vectors Gold Miners ETF trading under the symbol “GDX” and the VanEck Vectors Junior Gold Miners ETF trading under the symbol “GDXJ.”

The GDX has more extreme price moves than gold — in both directions. The GDXJ is similar, with even more extreme price swings. That is to say, when gold prices are on the rise, GDX and GDXJ generally outperform. When gold prices are under pressure, the two ETFs generally underperform the yellow metal.

How to Use Options With Gold

As we touched on before, investors can use options in place of these publicly-traded ETFs and stocks. As it relates to gold, these are as close as it gets without buying actual gold.

Investors could always consider buying and selling gold futures, which operate in a somewhat similar fashion to options. But know that this involves plenty of knowledge of the futures market, a different brokerage account and different risks. For that reason, we are only referring to two ownership options: physical gold and equity forms of gold such as those laid out above.

Because we can’t trade options on physical gold, that only leaves the latter when it comes to the discussion of options. Put simply, investors can use options to trade gold prices just as they would to trade regular stocks. If investors are bullish, they can consider using bullish options strategies, including stock-replacement and stock-enhancement strategies. If they are bearish, they can use a combination of puts and calls to create either synthetic short positions or positions that enhance an existing short position.

Gold isn’t for every investor and therefore using options on them may not apply. But for those that do want exposure and are knowledgeable in options, this is certainly a consideration to think about.

What Oil Prices Mean for the Stock Market

Oil prices have been highly volatile over the past few months, wreaking havoc not just on energy stocks, but on equities in general. Why does oil have this seemingly all-important focus and what does it mean for the stock market? In truth there are multiple implications that oil prices have on the market and economy. Likewise, there are an equally large number of inputs that effect the commodity’s price.

Generally speaking, stock investors follow just a few commodities, mainly oil and gold. Others investors may follow natural gas, silver, copper and a few other commodities, but without question, gold and oil are the two most popular. The latter is arguably the most important though, because of its implications on the economy.

With the energy sector making up less than 10% of the S&P 500, oil prices have a limited but evident impact on the market’s most notable index. When oil prices are on the rise, energy stocks generally are as well. All things equal, that’s good for stocks. Obviously the flip side of that is bad news for the S&P 500.

But what dynamics are we really working with?

Oil’s Impact on the Economy

Are rising oil prices a net negative or net positive for the economy? On the surface, the answer is easy: Of course rising oil prices are bad for the economy. It leads to higher gas prices for consumers, higher fuel costs for airlines and cruise operators, and higher transportation costs for logistics operators.

Despite all that, many view rising oil prices as a good thing for the economy. 

Here’s why.

On one hand, rising oil prices will draw in more production from the energy sector. That’s more jobs in the fields extracting crude oil from the earth, more jobs on the pipelines and railroads to transport it and more jobs at the refineries.

Far more important though, many investors use rising oil prices to indicate one thing: rising demand.

At the end of the day, oil prices come down to the simple economic principle of supply and demand. Simply put, when the economy is strong, demand is too and the higher oil prices go. As the economy flounders, demand for oil falls and the lower prices go. That’s precisely the reason why so many investors view rising oil prices as a good thing for the economy. To them, it means that the global economy is gaining steam and therefore more oil is needed. As a result, when oil prices rise, so too do stock prices. Never mind the fact that it’s an overall negative for consumers, airlines, cruise operators, truckers and others.

Oil’s Own Factors Are Growing

If the only consideration came from the demand side, this game would be easy. As laid out above, rising demand means economic activity is increasing. Therefore oil prices — and thus stock prices — rise in unison. The opposite is also true. Lately, that seems to be a tight correlation. But it can change at any time and one reason why is supply.

Put simply, the United States has become a huge player in the oil market. When prices collapsed a few years ago, it forced many of these companies — whether in the Permian basin or otherwise — to become lean and mean. This meant reducing production costs as low as they could, driving break-even costs down to levels many thought were impossible. 

Because a company like Exxon or BP can turn on the spigot — literally — when prices start to creep higher, they essentially have a cash cow just waiting to produce. Too much supply and energy companies will sink oil prices to unprofitable levels. But the point is all the same: By keeping the supply side flush, it keeps a lid on oil prices, making the economic theory harder to interpret.

The complexity only grows when we take foreign production into consideration.

Oil prices

One-year daily chart of oil prices

The Bottom Line on Oil Prices

So where the heck does that leave us — is oil really an indicator of economic health or not? Is rising oil prices good or bad for the economy?

The answer is, unfortunately, a mixed bag. Oil prices are an economic indicator when demand is driving it and supply is being kept in check. Meaning that, supply isn’t gushing into the market nor is it so short that the market is having a price squeeze. Ultimately though, supply does play a role in oil prices and with the additional output in the United States, it’s playing an even larger role.

That may leave some scratching their heads as to how oil prices are a helpful indicator then. Well, know this. If oil prices — which just enjoyed one of their largest monthly gains ever in January, up 18% — press higher, demand isn’t lacking. In which case, we can take away a positive interpretation for the global economy. While rising oil prices will hurt retail and consumers, there’s flexibility to a point. Even as gas prices trend higher, it won’t break the consumer overnight.

All that said, it doesn’t take a rocket scientist to connect the dots. Look at the chart above. Oil prices topped out right at the start of the fourth quarter — just like the S&P 500. And surprise, surprise, when did it bottom? Right near Christmas Eve, just as the market did as well. If anything, keep oil prices on your radar.

How to Trade Bull Call Spreads

So you’re hearing all about investors using options to crush it in the stock market, huh? Many investors know the basics of options — 1 contract represents 100 shares of stock — but many don’t understand how to turn these trades into spreads. For instance, there are bull call spreads that investors use to build a long position in an underlying security.

Let’s look at the basics of bull call spreads to get a better idea of what we’re dealing with.

When an investor buys one call contract, they have the right (but not the obligation) to buy 100 shares of a specific stock at a specific price (the strike price) on a specific date (the expiration date). The other end of that trade comes from the trader who sells the call contract. The seller has the obligation, not the right, to sell 100 shares at a particular price on a specific date to the option buyer.

When we combine this trade — the buying and selling of call contracts — we can form a bull call spread. First, the trader who takes on the bull call spread is a buyer, not a seller, of the spread because it results in a net debit, meaning the trader has to pay the premium vs. getting to collect it. Second, in order to enter a bull call spread it has to be on the same security with the same expiration date. Finally, the long call needs to have a lower strike price than the call contract that is sold.

In all, bull call spreads involve one long call option and one short call option on the same underlying security with the same expiration date.

Breaking Down the Bull Call Spread

Let’s look at bull call spreads by using an example. Say we’re bullish on shares of ABC but decide that buying a call option is too risky. We want to lower our risk (by reducing our net debit) but still want to participate in potential upside. As a result, we enter the bull call spread.

Shares of ABC are trading at $54. We decided to buy the $55 call option expiring in 62 days for $2.00 and sell the $60 call option with the same expiration date for $0.75.

As a result, rather than paying $2.00 for just the $55 call option, our trader is paying just $1.25. Too many investors believe that bull call spreads will limit their profit potential vs. owning the call options outright. In this case, consider the following. Our break-even on just the long call trade is at $57 ($55 strike + $2 debit). The plus side is, we technically have unlimited profit potential. Whether ABC rallies to $58, $108 or $1,008 it doesn’t matter; we participate in all of that upside.

The downside to bull call spreads is that our profit potential is capped by the short call. In the case of ABC, our gains are capped at $60. That said, our break-even price is just $56.25 and our risk is lower by 37.5%. While ABC could rally up to $65 or $70 in just 62 days, it’s an unlikely move short of an event-driven situation (like earnings).

A closer look reveals even more. If shares of ABC do rally, using bull call spreads shows more profit potential than the naked call option in many cases. In fact, not only does the $55/$60 bull call spread result in a lower break-even price, but it actually offers a higher profit from $56.25 until ABC hits $60.75. That’s because of its superior cost while still being long up to $60. 

Anything over $56.25 is a profitable trade for the bull call spread whereas the naked call requires us to get over $57. Because of this lower cost, we get better profit potential until ABC trades through our short call.

The Bottom Line on Bull Call Spreads

Bull call spreads are a great way for investors to reduce their overall costs while still maintaining plenty of long exposure. Aside from factoring in volatility levels, it’s key for investors to remember their break-even cost as well as profit potential. They are benefiting on the former and short of rare and giant moves, are not sacrificing much on the latter. In fact, not only are they sacrificing very little, the trader may actually be gaining an advantage by using bull call spreads.

What the Yield Curve Is and Why It Matters

You may have noticed a lot more talk about the yield curve lately. However, many investors seem unsure of what the yield curve is or what it means. Simply put, the yield curve plots bond yields (generally Treasuries) over the course of varying durations such as the two year, five year, ten year, etc. On a normal yield curve, the yield should increase for longer duration bonds. When the yield curve inverts though, it means that short-duration bonds yield more than long-duration bonds. It suggests the economy may be set to worsen in the not-too-distant future. 

The yield spread measures the difference between two different bond yields. These bonds represent different durations and investors can compare several different bonds to each other.

Many like to compare the 2-year Treasury yield to the 10-year Treasury yield. As the curve expands or grows, the wider the spread is between the two yields. When the spread is under pressure or contracting though, it means that the two yields are closing in on each other. In this scenario, it’s known as a “flattening” yield curve, as the mark approaches zero. Below zero, and it’s known as an “inverted” yield curve.

When the yield curve inverts, it’s often an indicator of a future recession, causing investors to get more defensive moving forward.

Why Yield Curves Invert

The yield curve is flattening right now and it’s not just the 10/2 year spread. In fact, other studies suggest there are more accurate spread-related measurements that investors should be watching. Because the 10-year, 2-year spread is so popular and easy to access though, it remains one of the most watched Treasury spreads in the market.

Some prefer to look at the 2-year vs. the 5-year, while Wells Fargo analysts say the most accurate predictor is the 1-year vs. 10-year. Another study suggests the near-term forward spread is the most accurate. That measures the “difference between the forward rate implied by Treasury bills six quarters from now and the current three-month yield.”

In a perfect word, short-term rates yield less than long-term rates. When times are good, investors aren’t betting that a 10-year Treasury will outperform the S&P 500. That’s why stocks have done so well over the past decade, as the economy continues to expand. When concerns mount though, investors bail on stocks, real estate and other risky assets and go for the safe havens of longer dated Treasuries. That spike in demand causes a decline in yield and allows an asset like the 10-year to yield a similar amount to the 2-year. 

Are We Entering a Recession?

Many investors are wondering if we’re entering a recession, given that the 10-year yields just a few basis points more than the 2-year. Specifically, the 10-year still yields 26 basis points more than the 2-year. Should this figure eventually invert, then the odds of a recession in the next 12 to 24 months increase dramatically. Or rather, the odds increase dramatically in the minds of observant investors.

The situation with the yield curve is a little tricky. Just because the yield curve inverts does not mean a recession is guaranteed to be on the table. In fact, there have been instances in the past — such as 1965 and 1998 — where an inverted 2-year/10-year yield curve did not precede a recession. 

It’s important to note that an inverted yield curve does not cause a recession. However, it tends to precede them more often than not. While not every inversion precedes a recession, every recession has been preceded by an inverted yield curve. 

Think of it like going to the beach. Just because the sun is out, doesn’t mean we’ll get a sunburn. However, every time we’ve been sunburnt, the sun has been out. In this case, the sun is the yield curve and the sunburn is a recession. Each time the sun’s been out (yield curve inverts), we have often been burnt but sometimes avoid it. However, every time we’ve been burnt (entered a recession), the sun has been out (the yield curve has inverted).

Hopefully that explanation helped more than hurt.

So what are the odds? Studies say nine of the last 10 yield inversions were followed by a recession. Others point out that the inverted yield curve misfired twice in the last 60 years. Either way, it’s fairly accurate. We’re not inverted yet but we’ve been on the way for sometime, with the 2-year/10-year spread slowly but surely flattening for roughly 4 years. So be sure to keep an eye on this mark in 2019 and beyond.

Is the Santa Claus Rally Real?

As of the close on December 18th, the Dow Jones Industrial Average, the S&P 500 and the Nasdaq Composite were all slightly lower for 2018. We came into the fourth quarter with the markets at their highs, consumer spending was expected to be robust (and has been) and all seemed well. However, it’s been anything but rosy since. Stocks have been hammered over the past 10 weeks and with just a few trading days left in the year, investors are hoping for a Santa Claus rally to save the year.

But will it come?

That largely depends on the role that the Federal Reserve wants to play this year. Will Chairman Jerome Powell be handing out candy or coal when the group makes its interest rate decision on December 19th? At this point, the market’s reaction is almost totally dependent on what the Fed does.

We are essentially staring down four main choices, which include:

  1. Raise rates this month, go into wait-and-see mode for 2019 (dovish)
  2. Don’t raise rates this month, go into wait-and-see mode for 2019 (very dovish)
  3. Raise rates this month, remain on same 2019 rate-hiking schedule (very hawkish)
  4. Don’t raise rates this month, remain on same 2019 rate-hiking schedule (hawkish)

Based on recent commentary from the Fed, it seems clear they don’t want to push the economy into a recession. It’s also clear the Fed misjudged its aggressive rate-hiking agenda from earlier this year, putting it in a tough spot now. 

So what does Jerome Powell and the Fed have to do with a possible Santa Claus rally?

The two parties have everything to do with it! A popular saying on Wall Street is to buy into the Santa Claus rally, although depending on who you ask, the timing can be quite different. Some consider it the last week of the year — a gift to investors left after a visit from the big man. Some consider it a gift leading up to Christmas, so generally the stretch from Thanksgiving to Christmas. Some simply think of it as the month of December.

But is it real?

Defining the Santa Claus Rally

Officially, most consider the Santa Claus as the last week of December through the first two trading days of the new year — and yes, it’s real.

Given that Christmas Day and New Year’s Day are exactly a week apart, this leaves many investors, fund managers and traders out of the office and on vacation. This results in light trading volume and let’s the stock market drift in whichever direction it desires. Regarding this period specifically, that direction tends to be higher. Since 1969, this stretch of time has rallied 75% of the time (34 of 45 times) and has gained an average of 1.4%.

Some may wonder if that makes this market a screaming buy. It in fact, does not. For starters, an average return of 1.4% is far from special. Sure, that’s pretty good for one week of work, and if we were in a raging bull market with low volatility, investors would have the green light. But in a market under tremendous pressure and full of volatility, the last thing many want to do is bet the farm on a 140 basis point rally during a low-volume trading week.

Admittedly, this is just an “average” and the market can easily outperform or underperform that figure in any given year. For instance, the S&P 500 could fall 3% that week or rally 3%. We just don’t know for sure.

Widening our scope even more, we found that December is actually the market’s best month. Its average return dating back to 1950 is 1.6%, besting the 1.5% average returns in November and April. That said, look at how the indices have done this month. We can’t always bank on a strong December. 

Santa’s Bottom Line

So all in all, what are we looking at?

The fact of the matter is that the Santa Claus rally is as real as they come. But that doesn’t mean we should expect it every year without fail. Ultimately the market comes down to a number of factors, and seasonality plays just a small role.

Whether we get our year-end rally this year may very well come down to the Fed. If Powell & Company give investors the news they’re looking for, they could bid stocks higher into the holiday-shortened week and allow them to drift higher into 2019. If the Fed disappoints, we may see more weakness into year-end.

Let’s see if we get Rudolf or the Grinch this year.

3 Options Strategies for a Volatile Stock Market

It looked like we were out of the woods coming into December. President Trump met with China’s President Jinping Xi and the two sides reportedly hammered out a sort of verbal truce. Come to find out there’s a lot of confusion surrounding that deal. Making matters worse, the yield curve is on the cusp of inverting, spooking investors that a recession could be around the corner.

A day after rallying on reports of a trade truce, the Dow Jones Industrial Average shed 800 points, the Nasdaq fell almost 4% and the Russell 2000 dropped 4.4%. Ouch.

Even though markets were up big from the Thanksgiving-week decline — something that we weren’t surprised to see, historically speaking — the relentless selling on Tuesday caused plenty of concern. Will we revisit the lows? Embark on a rally into year-end? It’s impossible to say.

But that uncertainty hasn’t stopped option pros from making money. They’re doing it thanks to the versatility of the options market and various strategies investors can use to profit. Stock investors are left with three choices when it comes to trading: Long, short or flat. Options traders can profit from those biases as well by placing directional bets via calls and puts. However, there are other ways to profit, too.

Straddles to Get You Through Volatility

One strategy to use for volatile markets is the straddle. It involves traders buying both a call and a put with the same expiration date and strike price. Some investors may wonder, what’s the point of doing that? It looks like this:

With ABC trading for $65 a share, we need to “straddle” the security by buying 1 $65 put @ $1.10 and $65 call @ $1.00. Total debit equals $2.10, so we need a move of more than $2.10 by expiration.

The straddle trader doesn’t care which direction the security moves in, as long as the move is big. I’ve personally witnessed options pros utilizing this strategy to perfection over the past two months. Because they are taking on two debit trades, the underlying security needs to make a larger-than-normal move to become profitable.

But in a market like this — where the Russell is falling 4% in a day and the Dow is dropping by 800 points in a single session — options traders are getting the massive moves they need. It’s even better because they don’t have to pick the right direction.

That doesn’t mean traders are guaranteed a profit simply for entering the position. Quite the opposite in fact. Tuesday December 4th was a great example where long straddles paid off handsomely. When volatility is at the upper end of its range though, investors can benefit from a decline in volatility by selling straddles. That’s the nice thing about strangles and straddles (more on them in a minute): we can trade the volatility of the underlying security rather than its price. 

If You Don’t Like Straddles, Try the Strangle Strategy

Like straddles, the strangle strategy is also a play on volatility. However, the layout of the strategy is different. Instead of buying a call and put with the same expiration and strike, we’re going to widen the strikes. Literally think of the strike prices “strangling” the underlying security. It goes like this:

With EFG trading at $50, we’re going to buy the $48 put option for $0.75 and the $52 call option for $0.70. Our total debit for the trade is $1.45.

The strangle requires a lower net debit than the straddle, but the straddle will likely close in-the-money one way or the other, with the exception of the rare occasion where the underlying security closes directly at-the-money. In the case of the strangle, we need the underlying security to go through the strike price by the net debit amount.

In this case, our breakeven point is $53.45 or $46.55 on expiration. Of course, one big flush or rally could put enough profit in the trader’s pocket to make it worth their while to close the position early. In fact, most strangle and straddle traders do just that. 

But because strangles really need a big move, many traders prefer the straddle in the short term. Strangle traders can also consider the reverse iron condor. Instead of buying long calls and long puts, we turn each one into a spread. In the above example, it would look something like this:

Buy 1 $48/$45 put spread and buy one $52/$55 call spread on EFG.

Credit Spreads Amid Volatility

For those that are more comfortable trading levels and directions, they may consider credit trades. This comes in the form of bull put spreads, bear call spreads and cash-secured put trades. Of course, investors can sell naked calls and puts, but that’s rarely advised.

Unlike strangle and straddle buyers, premium sellers are looking for a decrease in volatility. Credit traders are natural beneficiaries of time decay, but in markets like this these strategies can pay off quickly if the traders gets the direction and volatility angles right.

What does that mean?

Say XYZ collapses lower, falling 10% in a single session on no news other than broad market weakness. Shares are hanging near support and are trading with highly levels of implied volatility. We opt to sell some cash-secured puts on the name. In the next session, the broader market has a relief rally and XYZ moves higher.

Not only does the trader have time decay working in their favor, but they got the direction right and implied volatility is falling. This “vol crush” can suck premium right out of this trade and it wouldn’t be unusual to see gains of 40% or more on a day like this.

The downside of course, is we don’t collect two premiums — like we would with a short straddle or strangle trade — and if we’re wrong, we can be in trouble. So while many of these strategies can pay off big time for options pros, they can be downright lethal for novice option handlers.

How History Says Stocks Will Do From Thanksgiving Until Year End

The stock market has been a big concern for bullish investors lately, as all three major indices have been decimated. Investors remain on the defensive as interest rates remain in flux and as trade-war worries with China persist. It’s caused many to question whether the bull run in stocks is over and whether the economy is on the cusp of a recession.

The rationale is certainly valid. The Federal Reserve may or may not still be on autopilot, hiking interest rates into oblivion. The White House may or may not work out a trade deal with China at the G20 Summit. In fact, further tariffs could come against China if no progress is made. Real estate prices in leading markets continues to stagnant while new home sales and building permit data remains suspect. Multiple sectors are in deep bear market territory, while the S&P 500, Dow Jones Industrial Average, Nasdaq and Russell 2000 are all below their respective 200-day moving averages. Most of FAANG is in or near bear market territory as well.

The cherry on top? How the stock market performed during the week of Thanksgiving.

With markets closed on Thursday and closing early on Friday, it was a short week. But that didn’t stop the S&P 500 from falling 3.8%. While most of those losses were realized on Monday and Tuesday, it was still the fifth-worst weekly performance during Thanksgiving week dating back to 1930.

Wow. Plenty of reasons to be bullish, right?

In fact, maybe that’s the case. 

So Bearish It’s Bullish

Despite the poor performance, there is a silver lining here. According to the data, the S&P 500 has now finished lower during the week of Thanksgiving 36 times since 1930. That’s roughly 40% of the time, spanning almost nine decades. However, the median return for the rest of the year has averaged out to a 2.1% gain.

Now, most investors can acknowledge that a 2.1% gain is pretty futile, even if it does come in only five weeks. However, bulls would breathe a sigh of relief right now if they were to find out that the market was going to finish higher into year-end rather than continue to flush lower. Further, just because that’s the average return, doesn’t mean the results can’t be higher.

We segmented the data even further, looking at years where the stock market was positive on the year going into Thanksgiving week. Of those 36 times where the S&P 500 fell during Thanksgiving week (excluding 2018), 21 of them came when the index was positive for the year. Of those 21 occasions, 20 of them ended up posting positive gains into year-end. The one time it didn’t came in 1964, where the S&P 500 slipped 48 basis points into the end of the year.

What’s more, the years where the S&P 500 was positive on the year going into Thanksgiving week and declined that week, ended the year with an average gain of 4.13%. For the record, the S&P 500 was year-to-date positive going into Thanksgiving week this year.

Each year is full of new circumstances and different obstacles. 2018 is certainly no exception to that. That said, the historical data is on the side of the bulls. At least on this front.

Black Friday, Cyber Monday and the Healthy Consumer

There may be a plethora of reasons to be bearish right now, but consumer spending isn’t one of them. As the unemployment rate and jobs reports continue to put together impressive results, consumers are feeling good. The decline in oil prices — another topic for another day — is making gasoline cheaper. Wages continue to trend higher, putting even more money in shoppers’ pockets.

Our first real test for how consumers are feeling began during the very week we just observed. With pre-Black Friday deals starting on Thanksgiving and running all the way through Cyber Monday, U.S. consumers have been loading up on gifts at a record pace.

Adobe Analytics “tracks sales data from 80 of the top 100 internet retailers in the U.S., including Walmart and Amazon,” according to CNBC.  

According to Adobe Analytics, shoppers spent $6.22 billion online during Black Friday, a new record. That represents more than 23% year-over-year growth and comes even after consumers spent $3.7 billion the day before. While some economists thought the tough comps in 2018 would equate to flat or negative growth compared to 2017, that doesn’t seem to be the case anymore. Many are now expecting year-over-year growth, a positive amid a sea of negativity for corporations.

On Cyber Monday, that shopping momentum continued. Consumers doled out over $7.9 billion on the day, up almost 20% from the prior year. This also topped the $7.8 billion estimate that came ahead of Monday, following the rosy results from the prior few days.

So while the Fed or worsening trade wars could certainly derail the bullish train just now leaving the station, there is reason for some optimism going into December. The question will turn to whether bulls can run with it … or if momentum will fizzle out.

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