The market has surprised us since the U.S. election, and options trading can allow you to play the action without putting too much money at risk. But first, here are some things to consider.
Should you chase the incredible momentum higher in financial stocks like Goldman Sachs (GS) or Bank of America (BAC) using call options? Or should you short the parabolic move higher in Caterpillar (CAT) and the industrials using put options?
Every Monday morning, I write to my subscribers about the bull and bear views of the previous week, describe potential market-moving events for the upcoming week, review all of our open positions, and my favorite section, “What Traders are Saying.”
In “What Traders are Saying,” I often write about what my trader intuition is telling me based on short- and longer-term trends in option order flow. I also share the conversations I had during the past week with my trading and hedge fund associates. Here’s what I wrote this past Monday:
The election result was a great surprise to many. And because of that, many traders had not positioned themselves for a Trump victory. And even worse, many of the top investment houses had predicted if Trump had won, the market would drop 5% to 10%. Instead, the S&P 500 gained 3.77% on the week.
Because traders were positioned incorrectly, there was a massive rotation out of growth stocks and yield stocks, and into sectors such as Financials (up 11%), Biotech (best week since 2000) and Copper (up 12%) that many believe will perform well under a Trump presidency.
Yet what is interesting about this giant rotation is that traders are making significant assumptions about President-elect Trump’s future policies. As one trader noted, “Money is trying to position itself IMMEDIATELY, based on what it PERCEIVES might happen next year or way out in the future.”
This type of forecasting and rotation may turn out to be right but as we know, in this rapidly changing world, forecasting has proven to be extremely difficult. I’ve always found it amusing that companies such as Caterpillar (CAT) or International Business Machines (IBM) forecast earnings five years in the future and traders position their trades based on the forecasts. How could these companies have any clue about the rapidly changing world of technology or the state of the global economy that far in the future? Similarly, it will be interesting to see if traders have made the correct assumptions of the new administration’s policies in the weeks and years to come.
So should we chase the incredible momentum higher in financial stocks—or short the parabolic move higher in the industrials?
Personally, I’m not doing much trading right now. Rather, I tend to stick by famed hedge fund investor Jim Rodgers’ trading rule says, “One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do … I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I wait for a situation that is like the proverbial shooting fish in a barrel.”
Options on Financial Stocks
But if you’re looking for action and want to take a shot on the long side in the Financial Select Sector SPDR ETF (XLF), which rallied approximately 11% last week, without putting too much capital at risk, you could buy call options on the ETF.
On Tuesday, with the ETF trading at 22, a trader executed a MASSIVE trade when he bought 340,000 XLF March 23 Calls for approximately $0.56. That’s a $19 million buy! If you want to put on a bullish financials position, you could buy the exact same call options.
The most you can possibly lose on this trade is the premium paid—$56 per call—if XLF closes below 23 on March expiration.
Your breakeven on this trade is 23.56 on March expiration.
However, if the XLF continues its mercurial move higher, you would make $100 for every $1 the ETF moves above 23.56.
Options on Caterpillar (CAT)
Conversely, if you think this “Trump Rally” is unsustainable, you could buy a Put option on a stock like CAT, which has rallied $10 since election night.
Unless you have a special arrangement with your broker, you will not be able to outright short a stock like CAT. However, if you buy a put, which is a bearish position, you have the potential to profit if CAT falls.
For example, you could execute the following trade:
Buy Caterpillar (CAT) January 90 Puts (expiring 1/20/2017) for $3.
The most you can lose is the premium paid, or $300 per put purchased, if CAT closes above 90 on January 20, 2017.
Your breakeven is at 87.
You will make $100 for every point the stock drops below 87.
However, if you put on these trades and they go against you (which can happen in the blink of an eye in this crazy market), I recommend the quote about another hedge fund titan, George Soros:
“Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.”
“In other words, no matter what you do in this crazy environment, be sure to remain flexible and be willing to cut your loss short should things go seriously against you.”