Digestion and Apathy

If the equity markets’ resilience during the last several weeks hasn’t surprised you, then that makes one of us. This idea of market support was confirmed by a note I read this morning from an institutional options trader with whom I worked in the past.

But before we get into some telling market data, the important thing is that this sideways action has not prevented us from making money. Proof takes the form of the United States Oil ETF (USO) collar trade that we sold yesterday.

If you have not already done so, please sell the USO spread. When the final tally came in yesterday, we banked a profit of about 130% on the collar trade.

We did, however, want to circle back and break down how we came to the profit we did. The trade we executed is commonly referred to as a spread or a collar or a risk reversal. Such a trade can have many parts to it but the important factor is that it is executed as a package deal. The idea of the trade is to express a view in a cost-conscientious way. Accordingly, we bought the USO October $10 calls at 56 cents and sold the USO October $8.50 puts at 32 cents to bring the cost of our “package” trade to 24 cents. Simply put, we spent 56 cents but got back 32 cents right away to give us a net outflow of just 24 cents to put on the collar trade.

Institutional options traders actually execute these types of trades based on the total cost of the spread and not where the various pieces are trading. Looking at these trades as a package gives us the ability to assess quickly how the combination is doing.

Yesterday, we sold to close our calls at 73 cents and bought to close our puts at 18 cents to create a net inflow of 55 cents. If we take our inflow of 55 cents and compare it against our initial outflow of 24 cents, we arrive at the 130% gain by using a numerator of $0.73+$0.32-$0.18-$0.56, divided by a denominator of $0.56-$0.32, and then multiplying by 100 to convert to a percentage.

Coming back to the equity markets, this morning we again saw risky assets mostly trade lower, but the S&P futures moved higher. In fact, the SPDR S&P 500 ETF (SPY) has opened higher 18 of the last 25 days with only one day worse than a 0.15% dip on the down days. Essentially, the market has been immune to any sort of negative overnight news and continues to hold up extraordinarily well. Hearing this statistic would cause one to think the market is continually making all-time highs but, in fact, the market has been in a phase of sideways digestion and consolidation.

While at the same time, if we look at a risk-on exchange-traded fund (ETF) like iShares Russell 2000 ETF (IWM), we will see that yesterday it traded at its lowest non-holiday total volume in 10 years, even less than the half-day Christmas Eve total volume in 2015. The inability of the market to carry the momentum through the trading day, coupled with lack of volume, dictate that we take a step back to reassess what the market is telling us. We will continue to look for market dislocations and to bring you profitable trades like USO. Just stay tuned for future updates.