Here’s A Yummy Opportunity For Options Traders
March 7, 2023
jeffwood
As expected, Fed Chairman Jerome Powell spoke and the markets reacted… in a big way! Not only was the Fed behind on inflation, initially calling it ‘transitory’ while doing nothing about it, but now the Fed is saying they didn’t anticipate the latest mismatch between supply and demand. As a result, interest rates will likely need to be higher than previously anticipated.
Wow.
We knew that interest rates were going to be “higher for longer”, but now the Fed is putting 0.50 basis point increases back on the table. Despite dropping down to a 0.25 increase the last time around, they are now saying it may not be enough and may need to go back higher.
How many more ways can the Fed misread the economy?
They were late getting started and they were bad at judging what needed to be done. And now we’re left to pick up the pieces. The market heard the news loud and clear and sold off all day.
The good news is that the S&P 500 (SPY) is still above the 200-day simple moving average, and it’s resting on top of the 50-day simple moving average. The other good news is that we’re still well within the up-trending channel established in October of last year. We’re still making a series of higher highs and higher lows along the way.
John Hutchinson and I were talking about how we think this is actually a good thing for the markets.
‘How,’ you ask?
There is potential that Powell just gave an indication of what will happen when the Fed meets in two weeks. That means we may have just pulled all that volatility forward and we won’t have to go through it again during the March 22nd meeting.
That meeting will be the first time in the new year we see an updated dot plot of where the Fed thinks terminal rates will go. I think we’ll see interest rates up to 6.0%, even if not announced right away. But we may have just seen that negativity priced into the markets after yesterday.
The U.S. Dollar Index Bullish Fund (UUP) tracks the performance of the U.S. Dollar and while we could be a corrective wave and head lower from here, we did just cross above the 200-day simple moving average. If that trend continues, the markets could be in for a wild ride. UUP was on the rise from June of 2022 through October. So as UUP was making new highs, the overall market was making new lows.
A sustained cross above the 200-day SMA line from here is a potential bearish indicator of what’s to come in the markets, but again, one day above a trend line does not make a new trend. It’s just something to keep in mind.
Are you worried about how to trade in this market condition? Do you want to hear how others are trading, regardless of what the Fed does?
We just held our three-day Investor’s Blueprint Live conference and I want to give you another chance to get in on these little-known, proven, and profitable strategies before we retire them in our “IBL Greatest Hits” archives.
My trade today is a seasonality play. Yes, the market is down and we will have to figure out what the Fed nonsense means in the longer term, but this stock has risen over the next 8-week period 84% of the time.
I’m speaking of YUM Brands (YUM). They run KFC, Taco Bell, Pizza Hut, and others. The average gain over the next 8 weeks is 8.24%. This data is based on 25 years of data. I would certainly like to see it move higher than its 20-day moving average or even a 50-day moving average would be better.
The next 8 weeks would get us out to May 1st, but to give it a little extra room, I’ll look at options 1 month out from our estimated time frame, so I’ll look at June options.
If I believe in seasonality and what the data is telling me, I’m bullish on this stock, but the 16-JUN options are expensive! A $125 at-the-money option is $7.20 (or $720 per contract)!
What does that option get you? It gets you the ability to buy 100 shares at $125 and it gives you the right to “unlimited profit potential” should the stock keep moving higher and higher.
But I have data that says the average move higher is “only” 8.24%, so why would I buy unlimited profit potential if I don’t need it? I will cap my potential gains by selling an option that is about 8% away from the at-the-money call. That means I’m looking to sell a $135 call because I don’t think the stock is likely to go higher than that by 16-JUN.
Buy to open 16-JUN 125 call for a debit of $7.20 (always try for the mid-price or lower when buying options).
Sell to open 16-JUN 135 call for a credit of $2.20 (always try for the mid-price or higher when selling options).
The debit spread is going for $4.70 net debit at the time of this writing.
A move up to $135 by expiration would give you a profit potential of $530 on a $470 risk. That means we’ve just constructed a trade that gives you a better than 1:1 reward-to-risk.
As a debit spread, you need to know that this spread will ‘decay’ over time if the underlying price remains lower than about $131, so you’ll want to see the stock start moving in your direction right away. Be prepared to bail on the trade if the stock remains flat or heads slightly lower.
Of course, the stock doesn’t move straight up, but here’s how the stock did last year. A modest 11.5% gain if you just traded the stock.
If you have any questions, comments, or anything we can help with, reach us at any time.
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Jeff Wood
Editor, Filthy Rich Dirt Poor
Coach, Options Testing Lab
Any trade or trade idea discussed is for educational purposes only. They will not be tracked as an official trade recommendation.
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