With Fed Behind Us, Markets Return to Fundamental Focus in October
August 23, 2016 Update
James Cordier & Michael Gross
Michael: Hello everyone, this is Michael Gross, director of research here at OptionSellers.com. I’m here with your October Option Seller Radio Show. Here with President, Founder, and head trader of OptionSellers.com, James Cordier. We have quite a bit to talk about this month. We’ve just come off a big Fed announcement, or non-announcement as you might say, and that’s what has been on the minds of investors this week. James, we just saw the news yesterday. What’s your initial gut reaction to this?
James: Well, the Federal Reserve keeps talking about raising rates and the economy getting better; however, we’re never quite ready to do it just yet. That’s exactly how the Federal Reserve spelled it out, yet again. It’s very difficult to see how the Federal Reserve raises rates when many areas around the world are still either negative rates or at zero. They do a very good job stabilizing the market, both the stock market and the value of the dollar, by bringing Federal Reserve governors on TV and talking about the economy. I think they’re playing interest rates like a very well tuned piano. If I was in charge, I’d have interest rates at 2% and other countries would raise theirs up to 1%, but I’m not in charge. We are going to simply understand the way the Federal Reserve implements their strategy and we are going to use it to our advantage. We see the dollar probably going sideways for the rest of the year. When economic data comes out a little bit bullish, the dollar will rise, and vise versa, and we’re going to play along with the song they’re playing.
Michael: James, I know a lot of our listeners probably listen when we talk about commodities and we’re saying they’re diversified. Then, we talk about the Federal Reserve. People usually think, “Well, what’s going to happen to stocks?” On our side, we’re thinking of how it’s going to affect commodities. Often, that can be more of a muted affect than it is in stocks, but we still keep an eye on that type of thing. So, you’re talking about the value of the dollar. Just for people listening that may be new to commodities, what does that usually mean for commodities prices if the dollar moves higher or lower or if interest rates move higher or lower?
James: Michael, that’s an interesting question and we do get that from time to time. Commodities, if you’re to lump them all in a basket, the value of the dollar would move that basket slightly north or slightly south. We feel that the dollar right now is fairly priced, which means that it won’t probably for the next 6-12 months have a whole lot of influence by itself on commodities. Quite often, you’ll see a slightly weaker dollar and investors rush into gold. For a slightly stronger dollar, investors are selling oil… that sort of thing. It’s really, truly a balanced market right now as far as the dollar. I think what’s most interesting about it, and what we utilize and take to our advantage, is that the talking heads love to say, “Well, this is going to create a stronger dollar. The stronger dollar or the weaker dollar is going to cause this or that to commodities.” It’s simply a sliding scale of a little bit of buying and a little bit of selling. This hysteria, if you will, when the Federal Reserve comes out and makes comments, what that does is it pumps up premiums and it pumps up excitement. I think that 6-12 months from now the dollar’s going to be trading practically exactly where it is, and you’re going to have bulls and bears talking about the dollar, what it means to commodities, and simply that is just discussion. I think it’s absolutely ideal for what we do. 12 months from now, when the euro is sitting at the exact same price, $1.24 or $1.25, a year from now than it is today, people are going to say, “Well, I thought all of this data coming out of the Federal Reserve of all this interest rate talk was going to cause all of these huge moves. I think that the Federal Reserve, the European Banking Union, the Japanese Central Bank, they all converse. They all do things in unison. One area of the world doesn’t move without the other one knowing what they’re doing. They’re in concert and it keeps currencies actually quite stable. The conversation on TV and the information that you read in blogs says quite different: Strong dollar = weak commodities. Weak dollar = strong commodities. I bet that we see the dollar trading over the next 6-12 months extremely close to where it is, and we’re going to let the talking heads continue to mention all of these huge moves that are likely coming in commodities and stocks. We’re going to use that to our advantage, which, as you know, we’ve been doing the first 9 months of the year.
Michael: James, I like that analogy you used of a sliding scale. A question I get often, as well, is people want to talk about commodities and they say, “Well, if the dollar is going up or down is this a good time to buy or sell commodities?” It’s really, in some ways, irrelevant because the dollar is really only one factor that can affect the price of commodities. If you have a strong set of fundamentals, that can override the value of the dollar. It’s really kind of a head wind or tail wind, if you will. If it is indeed moving the way you foresee it, it’s not much of a wind at all. So, the markets really fall back to focusing almost exclusively on the core fundamentals, which makes things a little bit simpler on our part or on anybody selling options. Do you agree with that?
James: Exactly. Absolutely. For example, let’s say we have a slightly weaker or slightly stronger dollar the rest of the year. One of the markets that I know we’re going to touch on today is oil. A lot of people are interested in it because it has fallen off recently. There is discussion that maybe it’s going to start to rally some day. Russia and some of the other OPEC nations are going to discuss production figures coming up. The bottom line is this: oil in the United States supplies are at all-time highs when production worldwide is at all-time highs and we’re going into slow demand season. Whether the dollar is slightly stronger or slightly weaker, we know and feel exactly the direction of oil. If it has a little bit of a head wind or a little bit of a tail wind, for our practices it matters very little. We’re not day-traders, we are paid to wait, we make long-term decisions based on where the market can’t go fundamentally, and we love discussions about people talking about the dollar and what it means to commodities. It plays right into the hands of what we like to do.
Michael: So, if somebody’s listening that’s selling options or maybe they’re not a client yet and they’re trying to figure out just to see how this works, how do they use this? They see the Fed yesterday, well the Fed held steady again. Is there a way they incorporate that? I think what we’re saying is it’s kind of a non-factor right now. Is that correct?
James: You know, the Fed announcement, I think, is the perfect example and what we’ve noticed over the past 48 hours. The idea is the Federal Reserve doesn’t raise rates. No one really thought they were going to. I think the odds were placed at 19%. So, there’s an 81% chance they weren’t raising rates; however, they choose to hold off on any interest rate rise. The dollar falls about a penny next to the euro and investors rush into gold and silver, so gold goes up approximately $20 in 2 days and investors are buying calls in gold because we’re going to have a weak dollar and because interest rates aren’t quite as strong as what they thought they were going to be. Investors rush in to buy gold calls at $1,900 and $2,000 strike price. That is how you utilize and take advantage of all of this Federal Reserve discussion. Gold at $2,000… gold at $2,000 requires inflation. It requires more dollars chasing fewer goods. Inflation requires oil to go to 100 and not to 30. It requires soybean and corn prices to be at all-time highs instead of the levels they’re at right now. The entire world is over-producing commodities at a level never seen before, and it was done, in fact, to provide China with the needed goods. China is done building buildings. They don’t need any more copper, they don’t need any more zinc, and no more nickel is required. There are 30 cities in China right now the size of New York waiting for inhabitants. Iron ore producers, copper producers, and zinc producers spend billions of dollars to start producing commodities to provide China with needed goods and now they’re not needed. These commodities are very deflationary right now; they’re over-produced at a time when demand is down. Gold’s chance of getting to $2,000 in the next 6 months is kind of like the Cleveland Browns winning the Superbowl this year. Could happen, but I’d bet against it.
Michael: Not likely. Well, let’s move our discussion into the markets a little bit. We’ve covered the Fed and we’re going to talk a little bit about energy markets this month, because we have some real key seasonals in the energy markets in October. First one is the natural gas market, which we are featuring in our newsletter this month. James, at this point in time, we had a discussion before the show here about natural gas and kind of shades of gray of being bullish and bearish. You can have a big bank of bearish fundamentals, and yet there can also be some bullish things around the corner that may help you think you can balance things. That’s one of the beauty of options selling is you don’t really have to be black or white. You can make money in those shades of gray. That’s what we talked about, but we’re going to talk about the bearish side of natural gas right now simply because that’s where we’re at at this point. We have a strong seasonal coming up, some supply issues… do you want to talk about that and what we’re thinking right now in the gas market?
James: Michael, for natural gas over the last several years, natural gas production always ramps up going into winter for heating needs starting in December, January, and February. Usually, if it’s a colder winter than normal, natural gas would rally if it’s more of a mild 4th quarter and 1st quarter and prices seem to ease. It seems as though natural gas usage in the winter isn’t as great as it used to be. For whatever reason, we’ve had much milder winters in the Northeast over the last several years. As we build up production going into the winter season, it just seems to be more than what’s needed. Keep in mind, when predicting commodity prices, if there is one more barrel of oil than the world needs what does the price do? It falls. If there’s one more bushel of corn than the world needs, the price falls. If there’s one extra BTU of natural gas than the world needs, the price falls, and right now we’re sitting at all-time record highs in the United States for natural gas supplies. It’s well over the 5-year average and, once again, if we don’t have an incredible difficult winter in New York, Philadelphia, and Boston, prices are heading lower. I know natural gas is certainly not at high levels. Some of the winter contracts are at $3.40, $3.50. That could likely be a high watermark, and even though we’re going into the winter season the heating season is probably about 60-90 days away. We don’t see the market getting up anywhere near $3.75-$4.00, simply because we’re sitting on record supplies. So, as investors do buy natural gas, and they inevitably do going into the winter season, we’ll be looking at call selling opportunities at such extreme levels that we feel very good about making that an opportunity over the next 30-60 days.
Michael: James, that’s a good point you bring up. You mention in the newsletter, too, that natural gas meets a lot of the criteria we use for identifying ideal options to sell. You’re talking about record supplies right now, supplies as of the last EIA report about 9.3% over the 5 year average for this time of year. We’re still at an all-time record for this time of year at 3.49 trillion cubic feet, which is a record-level, of course. If you’re talking about the seasonal, for those of you listening if you want to see the seasonal chart, it is featured in our October OptionSeller that comes out next week. The seasonal for natural gas, I was matching it up to the price chart earlier this week, and it tends to peak in June and then fall off. Then, we have a secondary rally into October as those distributors you were talking about start accumulating that inventory again. The market has, you know, it doesn’t always look like a seasonal chart, but for the most part it has tended to follow that pattern. If we look at that seasonal chart once we hit October, the thing just looks like it falls off a cliff. Nothing saying that it’s guaranteed to happen this year, but historically that has been the pattern. It’s something to watch for. It’s one of the reasons we like selling the calls. James, as you mention in the newsletter this month, because of that volatility right now you can sell calls above the market almost double the price of natural gas. I know those are the type of strikes you like to sell.
James: Well, it’s interesting, Michael. So often, a lot of our clients or perspective clients are familiar with selling options on stocks and I’ve talked to many clients, they want to introduce me to what their experiences have been, and they talk about selling puts and calls on individual stocks 5% out-of-the-money. I just wonder how they get a chance to sleep at night. Natural gas is one of the markets that has historic volatility. Going into this October timeframe, it’s uncanny how the market likes to rally. It has done that recently, and here we are at the end of September looking into October. A natural gas rally looks likely. It has been kind of building on it. Lo-and-behold, you can sell calls on natural gas double the price. Sometimes I pinch myself when I talk about opportunities like that, but that’s exactly what we take advantage of. They’re not sexy. You’re selling options for $600 or $700, but what we’re trying to do is put odds in our favor. When you can find a fundamental opportunity along with a seasonal opportunity, and that’s what we’re combining when we’re selling natural gas calls this winter, along with the fact that you’re selling options 100% out-of-the-money. Like the Cleveland Browns, it’s not a sure thing, but I like our odds.
Michael: All right. Let’s move into the crude oil market a little bit. You’ve been a bear on crude for a long time. Going back to this spring you were on CNBC a couple times and had a lot of people bullish then looking for a big rally, OPEC talking, and the whole time you continued you never changed. You said if it’s bearish it’s bearish, we sold calls and we sold calls all the way down. That has been a cascal, not only for some of the things that we are doing, but maybe some of the people that have listened to what we’ve been saying or reading our articles. Here we are at the beginning of October, the oil is still in the mid-40’s. What’s your take on crude now? Are we still bearish or do we still think selling calls is a good idea? What are your thoughts?
James: It’s interesting, Michael. The phenomenon right now in oil is just bearish on so many fronts. If, in fact, you have oil right now trading around $45-$46 a barrel, if we did have a rally to 50, 52, or 55, there is so much investment ready to go online in places like Texas and the Dakotas. What they’re able to do is open up new wells, sell futures to lock in $55 and $60 oil one year out and two years out, that brings on yet more supplies. At the same time, you have Russia producing all-time record supplies. Libya is back to near record highs. Iran and Iraq are at record highs. This market is likely headed into the 30’s going into the holiday timeframe, which as most people know is actually the least demand for oil. The fact that we can sell oil strikes for winter delivery at 60, 65, and 70, we think is a great opportunity. We are long-term traders, as everyone knows who has been following us even slightly. We sell winter contracts in spring and summer so we did this 3-4 months ago at the $80 level. Not sexy, quite boring, but we are paid to wait. Would we still sell calls in oil? Yes we would. We think that is going to be one of the more high probability trades for the 4th quarter of 2016.
Michael: It’s a great way to point it out. You’re talking about record supplies. Still record supplies here in the United States, as well. Last report last week was 62.7 million barrel supply here… that’s an all-time high. Just to put it into perspective, last year we broke the last record set in 2015. That was at 54. We are substantially above last year’s record and we don’t profess to say option selling is easy, but when we’re talking about simple… when you have that big of a supply issue, it doesn’t tell you what price is going to do, but it certainly makes it difficult for a market like that to jump and have a substantial quick rally. I think that’s something our readers listening to here, it’s not easy but it can be simple and that’s just an analogy. Would you agree with that?
James: Michael, the ability to sell options as far out as we can, both time and in price, probably isn’t for everyone. A lot of investors who dabble in commodities on their own, they probably think a long-term investment is 2 weeks to 30 days. That’s just fine. There’s a lot of information about selling options 30, 60, 90 days out. I’m sure there’s many ways to take advantage of both buying and selling options. Over decades of trading commodities and over a decade of selling options on commodities, this is the best way that we’ve found to approach that market. I’m sure there’s several ways to do it. We love the idea that we’re putting the odds in our favor. If we have some 5-10% more oil in storage in the United States than we did last year, and oil fell to $27 a barrel last year, and fundamentals are more bearish than 12 months ago, does that mean oil is going to go to 27, 26, or 25? Not necessarily, but it does tell us it’s probably not going to 65 or 70, and those are the bets we make for our clients.
Michael: Alright. And when you throw the seasonal into that, again, February crude oil we had a seasonal chart pulled up and we’ll probably be featuring that at some point next month. Boy, you look at this seasonal chart and historically after driving season is over, crude oil prices seem to just fall in the tank all the way into the beginning of the year. Certainly can add an extra factor onto that bull-bear seesaw when you’re considering possible price direction.
James: Exactly. Right now, we feel that crude oil has a fair value of around $40. We see it falling $5 below that in low demand season and $5-$10 above that in high demand season. If you’re able to trade crude oil twice a year, you’d be buying in December and selling in June and you wouldn’t have to do anything else, but do it every year because you’re simply putting the odds in your favor. Over the next 10 years for investors who are able to look out that far, I bet you’d be right 8 or 9 or 10 times out of 10.
Michael: I agree. I actually had a guy call in a couple of months ago. I might have even mentioned it on this show. That’s exactly what he did. He had traded commodities and that was the only commodity trades he did. He worked for an oil company and he traded twice a year. I’m not going to sit here and profess what his results are, but according to him he did very well with that. It’s a good observation. James, I want to take a minute here and just preview our upcoming newsletter for our listeners. The October issue of the Option Seller Newsletter will come out next month. You should have it in your e-mail box by October 1st and you’ll probably get the hard copy a few days after that. James, nice article you were quoted in in Barron’s this month in the orange juice market. Also, an article that we brought to our readers attention in the newsletter was an article published called Option Funds for a Nowhere Market, and Barron’s actually started to come around and talk about times to sell options, here’s options that are fun, they sell options for you, and they’re starting to get on the bandwagon so we applaud them for that. We gave our take on the article and I think anybody that has ever sold options would be interested to hear and take a look at this piece because you make some really good points there. We do have our natural gas market featured in this month’s issue. We’re going to be hitting some of the points James talked about today and, also, highlighting some potential trading opportunities there. We also have our Option Seller Institute piece where we’re going to talk about the 5 advantages of commodity options over stock options. Some key differences there for those of you who have only sold stock options, there are some things in commodities you might not be aware of, and this piece could really open your eyes. If you have an interest in possibly diversifying, this is the piece you want to read. James, let’s move into our strategy section of our radio show. We’re going to talk about one of your favorite strategies today, which is the strangle. Maybe start off by explaining to our listeners what a strangle is.
James: Well, Michael, when we are bullish or bearish on a particular market, we call that a directional investment. If we are bullish on the price of soybeans, we are going to sell puts with the idea that that market is going to be trending higher. If we identify a market with bearish fundamentals, for say coffee, we are going to sell straight calls expecting steady to lower prices. The most lethal trade we do is when we successfully identify a market that is fairly valued. When we have the ability to sell a call and a put simultaneously on a commodity and it does trade sideways for a period of time, we kill it. When we’re looking at the different commodities that have historic volatility and we’re able to sell a put, say, beneath silver, 30%, 40%, 50% below the given price, and at the exact same time sell a call 100% above the current market value, think about that. One position is babysitting the other while you wait for decay, because certainly over a 6 month period silver is going to have some days when it’s up $0.50, but it’s also going to have some days when it’s down $0.25. The chance for a market to stay inside of 150% trading range is enormous. Having a put and a call on at the same time, not only does one take care of itself as far as babysitting while you wait, but you’re actually setting yourself up to make money on both sides. You have much smaller risk, you have much smaller margin required to put on the position. Talk about sleeping at night… try being a short from double the current price or being long from half of its price. You can sleep pretty well and that’s why we like it so much. When we create a portfolio for a client, we anticipate the client wanting to sleep at night, and, you know, I will not put on a position for anybody that requires nervousness or sleepless nights. Think about being short from double the price, being long from 50% of the price, and I think you might find yourself sleeping like a baby. I know I do.
Michael: I know it’s one of our favorite strategies – certainly a bread and butter strategy. It’s one we talk about quite a bit in our book, The Complete Guide to Option Selling: Third Edition. Those of you who haven’t read that yet can get it on our website at a discount – OptionSellers.com/book. James, you talk about a number of spread strategies in the book. One thing that people bring up to me sometimes is, “All you guys do is sell naked and I don’t like to do that. I’ve never done that.” The fact of the matter is, that’s not true. We do quite a bit of spreads. We love to spread the market when we can. We certainly like to mix naked positions in, as well, but we’re looking for the optimum option play, whether that’s a spread or a naked position. When you talk about strangles that fits right into that little framework there. You’ve got the balancing effect. One thing a lot of people don’t know about spreads, or at least commodity option spreads, is you also get sometimes a higher ROI because the margin drops for those. Is that how it works in strangles, as well?
James: It is how it works in strangles, as well. For anyone listening today who has had the chance to read the Third Edition of The Complete Guide to Option Selling, something that Michael participated incredibly well in writing, chapter 13 is the Maserati of all commodity option sales and it describes what we like doing best. When we are able to strangle the market and spread the call and the put, that is the best locked-in opportunity that I can think of. We’ve probably sold options contract numbers in the millions over the last several years. If there’s a favorite trade that we like to do to lock in opportunity and reduce risk, that is the Maserati of all trades and that’s the iron condor that we talk about in chapter 13 of our book. When volatility is small and movements in commodities have been slow, it is not ideal for writing spread trades. What we have now with the Federal Reserve and the Brexit and negative interest rates in Germany, we have so much uncertainty and we have so much pumped up premium, both in puts and calls, it is ideal for that strategy and we implement it all the time. While I look for new opportunities each evening, Monday through Friday, that’s the first trade I look for. So, that is something we definitely enjoy doing. We are very large proponents of that.
Michael: James, let’s for our listeners, we talked about a strangle here. A lot of them probably listening have only sold stock or index options, they’re not familiar with how far out-of-the-money you can sell in commodities. So, James, maybe just to give an example using one of your favorite markets, the silver market, we did have an article on silver on our blog this month for anybody that wants to read it, but maybe give our listeners an example. Maybe not necessarily a trade you’re doing but maybe just something they can look at to illustrate how a strangle would work in the silver market.
James: You know, Michael, a lot of our listeners and practically anyone who is a baby-boomer, give or take 5 or 10 years, are probably familiar with the price of oil and the price of silver. It seems like those 2 or 3 markets, you can probably throw gold in there as well, are kind of familiar with what those prices are. Not necessarily that they’re investing in them, but they seem to keep an eye on them, kind of like the price of gasoline. I get from my father-in-law all the time, he talks about the price of gas and, “James, can you get that down a little bit?” and he’s happy when it does fall. He always calls me or sends me a text saying, “Thank you for pushing the price of gas down.” So, there are 4 or 5 markets that people follow very closely. The silver market is interesting. It’s trading around $20 an ounce right now. For our listeners today, how many of you would, who are involved with commodities trading, how many of you with silver sitting at $20 would feel that buying silver at $13 is a good opportunity and you’d probably do it? Okay, I see the hands going up around the country. Likewise, with silver sitting at $20 an ounce, how many of you listening right now would sell silver at $40 if given the opportunity? There’s even more hands going up. When you’re putting on a strangle, for example, in silver, you can sell the $13 put, which makes your negative, your implied long position of $13. If you sell a $40 call, your implied short position is like selling silver at $40. That’s the beauty of the strangle. That’s the beauty of selling options on commodities because you can sell them so far out-of-the-money. You’re short silver from $40, you’re long silver from $13, and like the football team I was talking about before, I would take that bet any day.
Michael: What kind of premium are they going to bring in for something like that? Stocks they might pull in a strangle of a hundred or a couple hundred bucks. What would they pull in on a silver strangle like that?
James: Basically, you are taking in $600, $700, $800 per side. So, let’s say you’re taking in $1,400 and, like we mentioned a moment ago Michael, margin is reduced when selling covered options or selling strangles. To hold that position is probably $2,000. Think of the ROI, so silver stays below $40, stays above $13, your $2,000 investment returns $1,400. I know we’re oversimplifying things, but this is the kiss approach. If you do it each year, and not every trade is profitable and it doesn’t always work that easy, but when you think about it those are pretty good odds. They’re odds we take advantage of for all of our clients and maybe for some of our listeners listening to us today.
Michael: Great example, James. For those of you listening, we are using examples here to illustrate concepts so you can understand how this works. It doesn’t necessarily mean we are recommending that trade right this minute, but we want you to be able to understand how everything works. So, if you are looking at different markets or reading some of our articles, you understand what we’re talking about. James, thanks for your pretty good insight this month. I think that our listeners that are listening right now are going to be able to benefit from some of that. I want to close this month by a couple of announcements here. We want to update our waiting list for new accounts. We are currently now booked out to November for new accounts, but we do have a few slots remaining for November. If you’re interested in booking a pre-qualifying interview, just contact Rosemary. The number is 800-346-1949. If you’re one of our listeners from overseas in Europe, Asia, Australia, a lot of calls from Australia this month, James. Don’t’ know why, but maybe they’re running our show down there. If you are calling from overseas, you can reach us at 813-472-5760. I’m glad everybody’s able to listen this month. We wish you a great month of selling premiums. James, thank you for your insightful commentary this month.
James: My pleasure, Michael. It’s always great doing this show and hopefully do it for many, many years to come.
Michael: Everybody have a great month. We will talk to you next month.