This week’s update will emphasize some of the reasons the market may be overextended right now, but it is not a suggestion that you become bearish or avoid any bullish options positions.
Rather, our objective is to be clear-eyed about the risks we face right now and why our strategy should remain focused on generating income as a way to profit and protect our gains even if the market declines again.
From a fundamental perspective, forward valuations haven’t been this high since 2002. This indicates that stock prices are a little “rich” and the trend is fragile.
All the job losses over the last few weeks have put the labor force participation rate at multi-decade lows. This is likely to add weight to resistance levels and should motivate us to avoid stocks in the home builder and basic materials sectors, among others.
And as we mentioned in last week’s update, the market is showing some signs of shifting sentiment. Nothing appears to be too problematic yet, but the potential for the S&P 500 to hit resistance at or around 2,930 is something we want to keep in mind.
On the bright side, Monday’s 3% rally was the biggest bullish day in six weeks. April 6 and April 8 were better, with gains of 7% and 3.4% respectively. But, interestingly, the same kind of news drove all three days’ gains.
In April, quickly falling death rates in some virus hotspots in Europe triggered the buying. On Monday, it was news that a new vaccine therapy may be ready more quickly than consumers expected.
Big Headlines Create Big Volatility
When traders have a mono-focus like this, the potential for surprises at resistance levels increases. For example, yesterday Stat News reported that vaccine experts do not see the preliminary results provided by this vaccine’s developer, Moderna (NASDAQ:MRNA), as strong enough to back up its claims of effectiveness. The major indices reversed lower after that news hit the market.
When traders become hyper-focused on a single issue, volatility tends to rise. Consider the bear market of 2018, which was triggered by a long back and forth over a resolution to the U.S.-China trade war.
The best way to deal with this kind of risk is not to bet against the market. Instead, we should be assertive about how we are managing our own bullish risks. This is one of the reasons we were eager to cover Nike (NYSE:NKE) with a short call on Tuesday, even though the stock was on its way higher.
If more unexpected bad news about the virus or a vaccine hits the market over the next several days, selling calls and collecting premiums gives us a hedge against potential losses and an opportunity to compound our income on the declines.
Because a hyper-focused market can lead to a volatility feedback-loop, we should discuss what we are watching that would trigger a more conservative outlook.
As you can see in the following chart, the S&P 500 hasn’t made much progress from where prices were at the end of April. This is true of several other asset classes as well. Gold and oil are higher, but the dollar and Treasury bonds are flat compared to last week.
Source: Charts by TradingView
Daily Chart of the S&P 500 (SPX)
Risk indicators are mostly unchanged as well. The CBOE SKEW Index (SKEW) and CBOE Volatility Index (VIX) are back to where they were last week.
What Would Trigger a Conservative Outlook?
Another index that we like to monitor closely for signs of market stress is the high-yield or “junk” bond market. However, here too, sentiment seems relatively flat.
The exchange-traded funds (ETFs) that hold high-yield bonds act as a good proxy for judging the health of the junk bond market, and we’re looking at the iShares High Yield Bond ETF (NYSEARCA:HYG) in particular.
It is not uncommon for junk bonds to give us warning of a weak market. For example, junk bonds sold off two months before the 2018 bear market, and in the chart below, you can see they failed to make corresponding new highs with the S&P 500 before the selloff this spring.
Source: Charts by TradingView
Daily Chart of the iShares High Yield Bond ETF (HYG)
Because government-subsidized borrowing is an important part of the current stimulus negotiations between the U.S. House of Representatives and Senate, this is a good indicator to monitor for weakness.
From a technical perspective, a break below $78 per share on HYG would serve as a good warning that we should wait before adding any new bullish positions in the portfolio. It would also be a sign that we should be more aggressive with any new covered calls.
Transportation stocks could also give us an early warning about a decline. Or, they could alert us about an upcoming bullish breakout. Most analysts haven’t been watching the transportation sector as closely as usual because of the distortions created by the novel coronavirus. But with the initial impact priced in, this is an important group to monitor again.
As you can see in the following chart, despite rising oil prices — which are usually a boost to transportation stocks — the Dow Jones Transportation Index has lagged the major indices and remained below its April highs. From a technical perspective, a break below 7,800 would be an alarming signal for stocks.
Source: Charts by TradingView
Daily Chart of the Dow Jones Transportation Average Index (DJT)
The Bottom Line on Options Here
We are currently in the doldrums of scheduled market news. Earnings season for the first quarter is essentially wrapped up. Most of the big monthly economic reports have already been released. This is when unexpected news can have a bigger impact on the market, and we need to be extra vigilant.
However, this is not all bad for options sellers like us. Despite the market’s positive momentum since late March, option premiums are still extremely high. This means we make a much larger percentage return when we sell calls or puts.
This is one of the reasons we have been so interested in closing our trades when premiums dip or rolling our options out for more income. The more we can take advantage of inflated premiums without unduly increasing our risk, the better.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.