Making Hay: How To Turn Stock Market Mayhem To Your Advantage In March
March 2018 Video Podcast
James Cordier & Michael Gross
Michael : Hello everybody. This is Michael Gross of OptionSellers.com here with head trader James Cordier. We’re here with your March OptionSellers.com video podcast. James, as we head in to March here, what’s on everyone’s mind is the obviously the big development we had here in February. Big stock sell-off, it’s on everyone’s mind right now… stock investors are busy brushing themselves off, wondering what’s next. Over here in commodities, we didn’t really see a lot of movement in the markets themselves, but we had some developments in the option and option volatility. Why don’t we start off this month by maybe just talking a little bit about what happened in stocks themselves.
James : Michael, it’s interesting, a couple of years ago we had BREXIT. We had Switzerland leaving the European Union, we also had the election outcome a year and a half ago. All these events didn’t really change fundamentals on a long-term basis, but what they did do is they injected a lot of volatility. The 3,000 point drop in the Dow Jones here just a couple weeks ago did exactly that. It turns out that there’s something called the volatility index in stocks. There was an instrument that was built for people to go short or long on it. It seems as though everyone was way short volatility. In the stock market, that got unwound, it developed a 3,000 point drop in the Dow Jones, and now we’ve got to the stock market recouping quite well. It’s probably going to continue to rally everything as far as we can tell. The U.S. economy looks good, the global economy looks good, stock profits look excellent right now. Volatility spiked in a dramatic way. For ourselves selling options on commodities, we saw volatility index spike as well. Precious metals, energies, and some of the foods did have a spike. In many cases, a lot of the positions we had did increase in value during this large increase in volatility. It’s not always fun when this happens, but it is absolutely a key ingredient in option selling. It allows us to sell options, as you know, 40-50% out-of-the-money. Without that creation that happens every 6-12 months in the volatility index in commodities and in stocks, we wouldn’t be able to do what we do. It’s a key ingredient and it did happen this past month. We’re very excited about the opportunities that it has now in selling options.
Michael : It was kind of ironic, James, because you and I were watching this unfold, we were watching the stock market take a nose-dive, and we’re watching our commodities boards and basically nothing is going on. We have gold and silver prices staying silver, the grains and foods were business as usual, crude took a little bit of a sell-off, tied into stocks, but that was really the only one. Over in natural we had to sell off, but that was really already under way. It didn’t have much to do with stocks. Yet, you saw option volatility spill over from that stocks and it increased the value of those options temporarily, but now you’re seeing that come off a little bit. Is that right?
James : It is. The volatility index in the stock market is practically to the same level as it was prior to the 3,000 point sell-off. In commodities, it has now come back about 75% of the level that it was at. The fundamentals never really changed at all, especially in commodities, and I think it sets up a great landscape for doing what we do. We’ll find out relatively soon.
Michael : You know, a lot of people, they want to get diversified from stocks. That’s one reason why they’re interested in selling commodities options in the first place. You know, it was interesting… on CNBC they had an article about on the biggest day down in the Dow it was down, what…1,075 points or something like that? They ran an article that there was only 7 stocks higher that day and 2 of them were cereal and tobacco. It was Kellogg and one of the tobacco companies- I forget which one. CNBC’s analysis of that was, “well, even when stocks are down, people will still eat and they’ll still smoke”. That’s a point we make constantly is that no matter what’s going on, people still need to eat, they still need to drink coffee, and they still need to put gas in their tanks.
James : The breakaway from the correlation from the stock market was very evident on that day. Gasoline and crude oil and soybeans and coffee… business as usual. That’s why a lot of our clients like being diversified away from the stock market. On that occasion, we did see the volatility index increase options on commodities, as well, and that’s just a key ingredient for us doing the business that we do. They did increase while we were in them. We just see, going forward, just a great opportunity to use that additional premium to position clients.
Michael : So, we got a little bit of a surge in volatility, that pushed premiums up, and now that’s coming off. The premium is coming back down a little bit, but now we’ll have that historical volatility in the market. One thing you and I have talked about is now that opens up opportunities for us to do some strategies that maybe we weren’t able to do before.
James : Right. In 2017, we saw volatility come down steadily the entire year, which really produced a great return for a lot of option sellers last year. Chapter 10 in the Third Edition of our book, we talk extensively about credit spreads. We haven’t had the opportunity to do that the last year or two because volatility has been low. The influx of volatility that happened over the last 30 days now allows us to do this. It is probably the most safe, sound option strategy there is. With the additional premium now, we’re looking forward to positioning in that fashion the next 6 months or so.
Michael : Okay. One observation we were making as well is when volatility is up in options, obviously that’s when we want to sell them, but when the volatility is higher there can actually be less risk in selling the options because you’ve already had that surge in volatility. So, often times the path of least resistance is to come back off that volatility after you sold them.
James : We saw that the months after the BREXIT, we saw that months after the Trump win during the election of 2016, and, boy, we did quite well right after that period. We expect that to happen again this year. We’ll see if that’s how it plays out.
Michael : All right. As we head into March, we’re going to show you a couple ways maybe you can do just that. We’re going to move on to our feature markets segment and we will cover that in just a couple minutes. Thank you.
Michael : All right. So, we’re back with our markets segment this month. The first market we’re going to talk about this month is the natural gas market, a market that’s near and dear to our hearts. Natural gas, if you’re unfamiliar with commodities, it’s a great market for selling options. There’s a ton of liquidity there and also you can sell options very far out-of-the-money, so it’s one of the core markets you want to focus on if you’re building an option selling portfolio. One of the first fundamentals that we look at when we look at markets like natural gas is going to be the seasonal tendency. As we know, seasonal tendency charts are not guaranteed by any means, but they do give you an average of what prices have tended to do in past years at different times of year. What we find is there are underlying fundamentals that tend to drive these every year. We’re going to take a look at the ones in natural gas right now. James, do you want to talk about that and why we see this type of movement in gas prices often in the past?
James : It’s interesting, Michael. Often, suppliers want to bulk up for seasonal demand in winter, and everyone is basically building supplies going into December, January, and February. If the winter, especially in the Northeast, falls just a little bit shy of expectations or it’s 5 degrees cooler or warmer than normal, the supply actually is more than ample and prices usually start coming down in January and February as we see that we’re going to have enough natural gas and we’re not going to be running out. Again, here in the United States, we’ve had an extremely mild winter. Philadelphia, New York, and Boston, it has been some 10-15 degrees warmer this year than normal, and prices have come down just like seasonally they do. Supplies of natural gas this year are surprisingly low. Right now, we are approximately 23% below the supply of last year. We’re 19% below the 5-year average. That is because we’ve been exporting natural gas, something brand new to the exporting ability right now here in the United States. It’s setting up really nicely for the seasonal rally that we’re expecting. Natural gas right now is near it’s 12-month low here as we end February, often where it is this time of the year. Seasonally, what then happens is suppliers start building supplies then for summer cooling needs, which is like May, June, and July, and that often will give us a price spike starting in March and April.
Michael : So, what you’re saying is this is really a factor of distributors accumulating that inventory, driving demand at that wholesale level, which is really what’s pulling prices higher… at least it has in the past.
James : Exactly right. If we get through the winter, and it looks like we are again this year, prices usually come down because we are more than well supplied this time of the year. What wholesalers do for summer demand for cooling needs, especially in the Northeast, is they start building supplies and that demand boosts the prices starting in March, April, and May, and it’s setting up quite well to do that again this year.
Michael : You know, it’s interesting, James, we talked about stock prices coming down earlier and a lot of people noticed a correlation and said, “oh, natural gas prices came down with stock.” That price really had nothing to do with that move in stocks. Natural gas prices were already coming down as a result of just normal seasonal tendencies. Wouldn’t you agree with that?
James : Right. The natural gas market is so liquid. It takes no cues from any other market. The price of Apple stock has absolutely nothing to do with the supply of natural gas, the demand, or the price. It was in a downtrend here in the last few weeks just as the seasonal entails, and it was again this year. Natural gas definitely uncorrelated from the stock market and this year proved it as well.
Michael : Let’s take a look at some of the fundamentals of where we find ourselves right now at the end of February, as far as supply goes. First of all, we’re going to take a look at the current chart, which looks a lot like that seasonal one. It looks like we may be at a low right now, technically looks like we’re a little bit set up for a rally here. Is that what you would expect it to look like this time of year?
James : Michael, we could almost overlay the seasonal that we were just looking at and it lines up extremely well with this year’s pattern. The market is oversold right now, as the stochastic on the bottom of the chart describes. We really like the idea of the fundamentals being slightly bullish right now. We have nearly 20% below the 5-year average on supplies here in the United States. We’re going to be exporting more natural gas this year than ever before. As we get into the spring and summer cooling season, we do expect a nice bump up in natural gas prices, setting up, what we think, is a very good put sale for new option traders.
Michael : Okay, good. That supply situation James was referring to, this shows the last 4 years. You’ll notice this line here is indicating this year where supply levels are. We are, as James mentioned, about 19% below the 5-year average as far as supplies go. So, this is where we are now. It sets up a fairly bullish fundamental supply picture, as you mentioned, James. There’s another side to that equation and that’s also the demand side. Why don’t you talk a little bit about that?
James : The country is trying to get away from coal – electric power plants. We’re switching off into more cleaner utilization. Natural gas is going to be a big winner with that. Starting this year, having more so in the coming 3 or 4 years, but we are looking at record demand here in the United States for natural gas, combined with the fact that we are some 20% under the 5 year average on supplies sets up a nice bullish situation here for the next 3-6 months.
Michael : I noticed, too, when we were looking at this bump for projected record demand in 2018, that came evenly from both residential and industrial demand sides… possibly speaking to a stronger economy, tax cuts, what have you, that are maybe at least partially driving that in addition to what you mentioned with coal fired plants switching over to electricity.
James : Right. Definitely a push for greener production of energy here in the United States, and I think this chart shows it really well.
Michael : Let’s take a look at a trading strategy here for those of you that are watching this. You put together a strategy here for, and obviously we’re doing a number of different things in our portfolios, but for the person watching at home that maybe wants to try it out or at least just see how it works… this is the strategy you suggested.
James : We like the idea of selling September natural gas puts at approximately the $2.25 level. You can see where we’re trading right now. Often, with a seasonal rally that may or may not take place, we think it will this year, I think it’s set up quite well, natural gas is probably going to head up towards $3… maybe $3.10 or $3.20 this summer. We’re going to be some 30-40% above this strike price. We should have very fast decay in selling the $2.25 put. The market should stay a long ways away from it. The whole idea about trading seasonalities or trading fundamentals using short options is look at the variance you have in the market. This is a very large window for the market to stay above. If we have strong fundamentals and if we have a strong seasonality, can natural gas fall below $2.25? Of course it can; however, we really like the odds of this position going forward over the next several months. Fundamentally, natural gas should not fall below this level. Seasonally, natural gas shouldn’t fall below this level and we have record demand this year. It’s definitely a trade that we like going forward. I think it’s a great investment.
Michael : So, what you’re saying for those viewing this at home, yes everything looks bullish here. That doesn’t mean it still can’t come down in the meantime to here, here, or here. That’s why you sell the option in the first place. You’re not trying to pick the bottom, you’re just saying it’s not coming here. So, we can go down here and it doesn’t matter what it does, even if we’re a little early or late on the trade, you still win at the end of the day if it stays above that strike.
James : All investors know that timing the market is practically impossible. Trying to pick these small swings in the market are very difficult. All we’re simply doing is saying the market’s not going to fall below this level. As long as natural gas stays here, here, or higher, these natural gas puts expire worthless. Of course, as a seller, we get to keep the premium.
Michael : Very good. Let’s go ahead and move into our next market, which will be the cotton market.
Michael : Okay, we’re back with our second market this month, which is going to be the cotton market. Before we talk about cotton, there’s something I wanted to point out form our last segment in natural gas and the cotton market. These strikes we’re talking about right now have been made available by that last burst of volatility we got from the stock market. These strikes we are looking at probably weren’t available a couple weeks ago. When we’re looking at them now they are. So, this is kind of the fruits that option sellers can benefit from, from these little inputs of volatility into the market. So, let’s talk about cotton. It’s our next market for this month. The first thing we’re going to look at is the seasonal tendency for cotton. Obviously, we tend to see a rally up through the springtime months and then we see a sharp drop off. James, do you want to explain that or why that has tended to happen historically?
James : Michael, this chart you can almost mirror over the grains of the United States. Basically, corn, soybeans, and wheat often planted in the spring and then harvested in summer and fall, and as the angst of the weather problems subside, so does the price. Cotton is planted in the south and, of course, it’s planted early in the year. So, as we’re planting in February, March, and April, there’s possible excitement about not exactly perfect weather. Users want to get insurance and they want to purchase cotton prior to planting season. As we reach April and May, we have a very good idea about how much cotton we’re going to be producing that year. End users get to stay off as far as needing to get a lot of cotton around them. So normally, once the commercial buying stops, the market usually starts coming down in May, June, and July. Interestingly, this formation so far has mirrored almost perfectly with what’s going on so far in 2018. We have a really nice setup looking just like this with a decent rally that started about 3 months ago. It’s starting to look like this already.
Michael : Similar to that natural gas trade where you have the seasonal pattern tending to line up very closely with what we’re seeing in the actual price chart this year. Let’s take a look at where our fundamentals are this year as we look at the cotton market. The big story, ending stocks, stock/usage ratio… looks like they’re pretty healthy levels this year, James.
James : They are. Cotton supplies in the United States are going to probably be exceeding the 10-year level that we had. In other words, we have cotton stocks that are going to be highest since 2007. Supplies look more than plentiful. We’ve planted just a great deal of cottonseeds so far this year in the south, and we’re probably going to have a bumper crop, the weather looks ideal, and planting went extremely well. With supplies in the United States at a 10-year high, the chance for a large rally going into harvest seems quite low. We really like the idea of selling calls.
Michael : Yeah, that stocks/usage ratio at 30%… if you’re unfamiliar with the importance of these 2 figures, ending socks and stocks/usage ratio in agricultural commodities, we do have a piece on that on our website. It’s a tutorial. It’s at www.OptionSellers.com/agriculture . There’s just a brief video but it shows you the importance of these 2 figures. They’re the core measurements of supply and demand. They’re both baked into these things. With the highest in 10 years and, James, you alluded to it, next year, if they harvest all the acres they’re planning on putting in the ground this year, we could see these numbers even climb more. Outlook for cotton is somewhat bearish fundamentally, lining up well with that seasonal. Let’s go to the strategy we’re talking about this month. You’re recommending a call selling strategy. Do you want to talk a little bit about that?
James : We are. We have cotton trading in the middle 70’s right now as planning season starts wrapping up. We’re probably looking at price pressure in the 3rd and 4th quarter. We really like the idea of selling cotton as high as the $0.90 level. The fact that we’re going to have practically a record supply and a record production this year at a time when supplies are nearing a 10-year high, the chance for approximately 20-25% rally going into harvest seems quite small. Cotton can fall, it can stay the same, it can actually rally quite a bit between now and harvest season. It has certainly a long way to go before we get to our strike price. This option at the $0.90 call strike price is trading around $700-$800. We think that is a very low hanging fruit for later this year and we think that we’ll probably be covering that position around $100 well before option expiration. The decay on that option looks terrific and the odds of cotton reaching that level is quite miniscule.
Michael : Excellent. Part of the benefit if you’re using seasonals when you’re deciding which option to sell, these 2 things are almost perfectly matched because seasonals are not a perfect recipe. For right now, the seasonal tendency for cotton, it may not start declining until March or April, if it does at all. Even if you’re here and even if it does rally a little bit more and you’re not right at the beginning, that’s okay because, as James is saying, your strike is way up there at the $0.90 level and you’ve got plenty of wiggle room here to be wrong for a while, so to speak.
James : That’s exactly right. That’s why we sell options on commodities and we don’t try and predict the small moves, just based on fundamentals, levels that the market cannot reach and will likely not reach. We’re not correct all the time. Every once in a while, the market might move in that direction, but selling options that far out-of-the-money using the fundamentals is a very good long-term strategy.
Michael : If you’d like to read more about our research pieces on these 2 markets, of course they’ll be available on the blog. You’ll also want to make sure you get this month’s Option Seller Newsletter. That should be out at the end of this week, which would be March 2nd. The newsletter will go in the mail and that’s when the e-copy will go out. We will be featuring the natural gas market and trade strategies there. The cotton market will be on the blog, so if you want to read more about those be sure to get them. Let’s go ahead and move into our Q and A section and we’ll answer some questions for our viewers.
Michael : We’re back with our Q and A session for this month. Our first question comes from Rob Reirick of Ithaca, New York. Rob asks, ” Dear James, you refer often to credit spreads in your book; however, I rarely hear you mention them in your market segments. Do you still recommend option credit spreads and, if so, why not features on them?”
James : That’s a very good question. The layout and the description of our trading philosophy in our book is very detailed. When we’re giving examples for option sales in crude oil or cotton or anything else, we’re basically just laying out primary examples of where we think the market probably won’t reach. We often don’t talk about a more elaborate trade, which is a credit spread. We feel that credit spreads are probably the most opportune way to take advantage of high premiums and, at the same time, have a very conservative position where it locks in certain types of risk as involved with not just being a naked put or a naked call. We are looking at the next 5-10 years of utilizing credit spreads. We don’t talk about them a lot. They are something we’re going to be utilizing a lot in the future. Basically, when we’re talking about examples for option selling, we’re basically talking about straight fundamentals and levels that the market won’t reach. We are absolutely huge proponents of credit spreads and for our clients we will be doing those often now and in the future.
Michael : This isn’t the only letter we got on this, James. Because you may want to read more about credit spreads and see examples, maybe we will start incorporating some of those into some of our examples in the future and showing you, the viewer or the reader, how to actually do it.
James : As our viewership gets more further along with understanding option selling, I think that’d be a very good idea to elaborate a little more on the actual positioning that we do at home for our clients.
Michael : Let’s get to our next question here. This is from Kevin Woo over Cupertino, California. Kevin asks, “Dear James, with the outlook for inflation growing, do you see a favorable outlook for commodities ahead?”
James : Good question. As a basket of commodities for 2018 and 2019, we do see it in uptrend in primary prices. Basically, picking out a particular one that might outpace the other ones, I think that’s difficult to do. We’re looking presently at some of the best demand for raw commodities that we’ve seen for probably the last 10 years… from China, from Europe, from the United States. Of course, there’s some infrastructure spending ideas that are coming down the pike here in the United States. We do see commodity prices probably increasing this year anywhere from 5-15%. That might be led by precious metals, that might be led by energies, but, as a whole basket, we do like commodities going forward in the next 12-24 months. Of course, as option sellers, it doesn’t really matter if the market has inflationary factors that do increase commodity prices; however, if we do see that developing and we do see that on the horizon, we simply change our slant to a slightly more bullish factor as opposed to selling calls that are going to be out-of-the-money that are probably not going to be reached. We might utilize more 60% of our option selling as a bullish structure. In other words, selling puts under what we think might be a slightly higher commodities market in 2018 and 2019. I think that’s a great question and we are somewhat favorable on commodities. As a general theme, we do see the market going slightly higher this year and next year.
Michael : That’s a great point you made there as well, James. I’m glad you addressed this, because this is a question we get often… “What do you think commodities will do? Is it a good time to be investing in commodities?” The point you made is as option sellers it doesn’t really matter if it’s a bullish or bearish year for commodities. We’ve had some of our best years in bear markets.
James : Absolutely.
Michael : It kind of goes back to one of those points we’re always making about diversifying your assets. If you have some of your assets in equities, real estate, or what have you, most people invest by buying assets hoping for appreciation. It goes back to that importance of diversification, not only of asset class into that commodity asset class, but also diversification of strategy, where as in what you described, you can benefit even if prices are moving lower, so you have a strategy equipped even in a bear market and you can potentially benefit from that. The importance of diversification is strategy.
James : As option writers, you can be diversified to where part of your portfolio is looking for a slight uptick in prices while other markets that, whether you’re in stocks or commodities, and then other commodities might have bearish fundamentals and you might take a slightly bearish stance to those 2 or 3 markets. The idea of being diversified and having a portfolio that doesn’t necessarily need the stock market to rally, the commodities market doesn’t have to rally, this really gives a lot of versatility for a client or ourselves to diversify a client and have them be profitable, whether the stock market or commodities market goes up, down, or sideways. Often the market does go sideways. Right now, we have a very strong stock market, but over the last 10 years it normally doesn’t do that. In commodities, we normally have 1 or 2 really banner years out of 10 but, for the most part, commodity prices realize fair value, and selling puts and calls far above those markets can be very fruitful as we found out.
Michael : Of course, if you want to learn more about the entire option selling strategy, you’ll want to read our book The Complete Guide to Option Selling. It’s now in its Third Edition through McGraw Hill. If you want to get a copy at a discount, or you get it at Amazon or in bookstores, you can buy it through our website… that’s www.OptionSellers.com/book. Thanks for watching our Q and A session, and we’ll now wrap up our podcast for the month.
Michael : We hope you’ve enjoyed this month’s OptionSellers.com Podcast. James, we have in March, coming up, possibly our first interest rate hike. Do you have any comments on that or things investors might want to watch out for in the upcoming month?
James : I think the realization of interest rates going up is going to really hit home. In March, we’re going to have the first rise of interest rates in 2018. There’s a lot of debate whether it’s 3 rate hikes or 4 rate hikes. It’s not going to matter that much. The dollar should be on more firm footing after the 1st hike, and then we’ll see where it goes from there. Higher interest rates are in the future and, we think, the U.S. economy and economies around the world are probably very well ready for that to actually take place. We think that’s going to create more opportunities in some of the strategies that we’re implementing. We’ll see.
Michael : For those of you that are considering managed option selling accounts with OptionSellers.com, you probably saw the announcements over the month that as of May 1st, we will be raising account minimums to $500,000 for new accounts only. So, if you currently have an account under that level it’s quite all right. You’ll be grandfathered in, but as of May 1st, all new accounts will have to have $500,000 as the minimum. We are almost fully booked through April, so if you want to grab one of those last consultations through April to try and get in ahead of that minimum change, you can call Rosemary at the office. The number is 800-346-1949. If you are calling from overseas it’s 813-472-5760. Of course, you can always send an e-mail as well to firstname.lastname@example.org. If you’re watching our podcast today and you like what you read, be sure to subscribe to our YouTube channel. You can also get us on iTunes and, of course, you can subscribe to our mailing list on our website at www.OptionSellers.com. If you request any of our free materials there you’ll automatically get on our list and we’ll send you a notification any time we have new videos or podcasts. Thank you for joining us this month. James, thank you for your analysis on the markets this month.
James : Likewise, Michael. Always happy to.
Michael : … and we will talk to all of you in a month. Thank you.