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February 22nd, 2023
The Reason Behind The Recent Selloff
I think the market got confused yesterday. Trader’s Reserve is having the big Investor’s Blueprint Live conference NEXT week.
See, we have a bad knack for having a conference right as the market sells off, so we were expecting this to happen next week, not this week. Maybe this means we’ll be in the clear.
All joking aside, we do need to get to the bottom of why the market fell apart yesterday after a three-day weekend. Inflation is coming back, the job market isn’t falling apart, and companies are giving lower guidance during earnings season. I’m looking at you, Home Depot (HD).
Investors are fearful that the Fed will announce a pivot, but not the kind they are looking for. There is chatter that the Fed will push rates higher than 5% and that they will keep them there for longer. This may even mean going back to 50 basis-point increases.
One problem with the market comes in the form of this chart, released after the flash Composite Purchasing Managers’ Index (PMI) report came out yesterday:
I was running a webinar for Options Testing Lab when this news came out and I said I didn’t understand why a better-than-expected Manufacturing and Services number would drive the markets down.
I was stumped.
Manufacturing is still contracting, but getting better, and the Services industry is growing. What could be wrong with that? Then I remembered that good news is bad news in this environment.
An increase in demand for both Manufacturing and Services will keep the labor market strong and could continue to drive prices higher, thus pushing inflation higher.
The Fed doesn’t have inflation under control before the economy is showing some slight signs of improvement. And that means sticky wage inflation that Powell and the Fed like to talk about.
That is partially what is driving the fear behind higher interest rates, above 5%, and having them stay there for longer than anticipated.
When there’s a major pullback, like what we saw yesterday, there’s one trade I turn to over and over again. It’s a broken-wing butterfly on the S&P 500 (SPX).
First, I like to wait for those big down days – I’m looking for the SPX to make an average true range move to the downside. The SPX dropped 81.75 points, but the average true range of the last 14 bars is 60.9. This means the move is outside the normal move.
Next, I start looking at expirations around 45 days. We don’t have anything that fits the bill exactly. In this case, I don’t mind looking at the weeklys. I’m not as concerned about open interest or volume on the SPX options.
For the sake of this example, let’s look at the 14 APR options.
The issue is that the weekly strikes are inconsistent, going from 10 to 25, and even 50.
Let’s go back a week and look at the 31 APR 23 options instead.
I’m looking to buy a -0.15 delta option to start. Look at the chart below and at the 3700 strike price. That has a lot of open interest – over 10k. That’s an area that is likely to be defended by the big banks.
Now, I want to go lower by $10 and sell two options. In this case, the 3690 strike is $10 lower than 3700.
Lastly, I want to go down $20 from the option I sold and buy an option. In this case, that means buying the 3670 since that is $20 lower than 3690.
This position can be put on for a credit of 1.10. The buying power required is $892.
The risk profile shows the SPX can drop a standard deviation move before 3/31/23 and the trade can still be profitable at expiration. There’s also no risk to the upside of the trade.
For this type of trade, I would manage the trade at 21 days-to-expiration or when I’m able to close the trade for 50% profits – whichever comes first.
A profit of $55 may not seem like much, but that’s a 6% return on buying power that you can easily make in a few days if the market rebounds from current levels.
What happens if the market keeps going down? The market can drop by 7% from current levels before it even comes close to the profit triangle on the left side of the screen above.
Like any trade idea, this is just something for you to consider, model some practice trades, and see if it’s a tactic that is worth your consideration. It doesn’t work all the time, but even during 2022 when the market was falling, there were periods of retracements that were enough to make this tactic profitable.
If you have any questions, comments, or anything we can help with, reach us at any time.
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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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