Tom’s Weekly Newsletter May 10, 2023

Originally published via our newsletter previously. Subscribe for early access!

Fed Decision Day! 

Another rate hike today makes this the 10th one in over a year.

The FOMC, Federal open Market Committee, raised its benchmark borrowing rate by 0.25 percentage point.

The rate set by the Fed results in what banks charge each other for overnight lending.  Not that it also flows through to many consumer debt products like mortgages, auto loans and credit cards.

The market didn’t deem this bullish as it sold off and closed at or near its lows.

Corners of the Market

SPY – SPDR S&P 500 

TLT – iShares 20+ Year Treasury Bond ETF

One has to be careful when doing technical analysis that they don’t put so many indicators and oscillators, trendlines and arrows on the chart it looks like it is covered in a spider web, and one can’t even see the price chart of any style.

I have longer term trendlines as an ascending support line and a descending resistance line as was drawn in last week.

I two shorter similar lines in yellow highlighting a very short-term symmetrical triangle pattern.

Then I have a horizontal support line (shown by the green dotter line).

All of that drawn in and it doesn’t change the perception TLT is trading in a sideways trend.  And until it breaks one way or another I don’t see doing much with this.

UUP – Invesco DB US Dollar Index Bullish Fund

The yellow rectangle in the chart image above emphasizes the gap up in price back in February.

UUP price tested that as support for a day back in April. It has mostly traded sideway from April to present day, even with the security being in a 5-trading day up draft (the prior 5-trading days to today).

Today UUP broke that really tiny support line, but at least traded off its lows of the day.

Any kind of slide back could test a fill of that gap already mentioned.

Since we view what’s good  for the USD not so good for equities and vice versa, this sideways price action not helping with assessing where we see equities going.

USO – United States Oil Fund, LP

GLD – SPDR Gold Shares

It is good when the chart images show price action at work in the manner I teach they often times do.

I have taught that there tends to be an inverse trading relationship between Gold and US Equities.

That means when one is trading higher the other tends to trade lower and vice versa.

The last two trading days clearly show that.

While investors / traders try to decipher the Fed’s commentary about the economy and whether or not they can stave off inflation equities sold off while GLD has seen a bullish 3-day pop in price.

From the Desk of a CMT – XLI Chart Scans

Last week a sector RS scan prompted review of the XLI component stocks, and there are a lot.

When the scan was run again Tuesday evening (5/2/23), XLI was further down the list but its chart and momentum still leaned bearish.

A quick way to run through a stock list is displayed in figure 1 (note the chart is from last Tuesday).

By the time this posts we’ll be clear of the fed decision, so I’m going to post two case studies that focus on a low-risk entry approach.

Conditions will likely change between now and when these post on Thursday, so think more about the method and risk management than these specific names. 

Before jumping into the case studies, I wanted to mention that I really liked this exercise.

I don’t often scroll through this sector, and it was a really good reminder about how different industries within a sector also have relative strength and weakness.

Airlines, trucking companies, and rail companies are transportation companies, but with varying strength.

The reminder I carried with me was there’s opportunity in all areas of the market despite a strong media focus on ‘select’ names and meme stocks.

Be careful with names that have exceptionally low liquidity and do seek out stocks that suit you.

After scrolling through the XLI component stocks, two stocks approaching overhead resistance included DE (Deere) and UPS. DE is right up against resistance which could mean a quick whipsaw out of a case study, while UPS has a little more room to run.

Figures 2 and 3 provide the Fibonacci charts with the 20-day and 50-day simple moving averages (SMAs).

They are all geared towards providing objective support and resistance levels that are fixed, as well as objective trend identifiers to be sure we’re aligned with what is for the markets.

RSI is also provided.

Note:

• Nearby resistance at 385.84 with support at 367.38
• Short-term and intermediate terms trends are bearish (SMAs)
• RSI is in bearish territory

Note:

• Nearby resistance at 183.32 with support at 159.14
• Short-term and intermediate terms trends are bearish (SMAs)
• RSI is in bearish territory

The approach used these last few months is basic but focuses on risk management and keeping with the market conditions. You can make it your own but think about some of the anchors these case studies include:

• Use fixed, objective areas of support and resistance (Fibonacci, recent lows, and highs) for built-in money management and risk management
• Include objective trend tools (SMAs, channels) to stay with the trend
• Know the implied volatility (IV) environment so your strategies are appropriate and include a timed exit consistent with the impact of time decay

You can include technical tools for exits too, but if those tools do not provide a specific exit price, include a fixed value too. If you find your technical tools are capturing the move you want but your fixed price is taking you out, see if a reduced position size will allow more flexibility without increasing risk.

Now back to the case studies. DE is right up against resistance and the move to support is relatively small compared to UPS. However, the trend is bearish with a lower low, if realized, below our support. In this case consider the full move to support rather than 80%.

Note that UPS has a little more room to move before coming up against resistance so a bearish position may have some drawdown even if resistance holds. Consider waiting for resistance to be successful. The move down to the support level identified is substantial and we need to really think about an 80% move to that price.

Figures 4 and 5 provide IV charts for DE and UPS, respectively. 

High IVs favor a bearish credit spread while low IVs allow for a single option or debit spread.

Since DE is approaching its earnings date, we also want to see if there is any IV seasonality for shorter term options. There were some sideways trends for XLI component stocks too if a more complex strategy is your jam.

IV is slightly elevated but the seasonality in short-term IV makes a low IV strategy acceptable. After confirmation of the May 19th date on the Deere website (look in the Investor Relations section for the earnings date), options dated 5/26 to 6/16 will be explored using the Smart Search tool.

With earnings in the past and bigger moves as our framework for UPS, longer-term options were selected. And yes, I do feel old because I have to cringe when writing a 60-day option is considered longer-term.

Since the DE case study lends itself to a nice look at the probability charts, here are some prompts for UPS if you feel it offers you an opportunity that suits your style:

• What is your exit for an expected loss?
• What is your price target for a gain?
• Will you take partial profits and what is your criteria for a final exit?
• What date will you exit if neither price target has been reached?
• What is your max risk and what is the option value that represents your max risk?

Smart Search for DE

With expectations for short-term IV to rise into earnings and a plan to exit a simple put strategy by May 18th, the following helped inform selection of the May 26th 380 put:

• Odds that exceed 1:1
• Good open interest (OI)
• At/near the money

I crossed out the odds because all single puts results were below 1:1 and I prefer to use the probability tool (aka, “reality check”) in this article. Ditto to OI.

Consider reviewing bear put spread strategies for higher odds and alternatives with higher OI.

A May 26th option will be fighting time decay but since we expect IV to rise over time, we’re going to provide a user defined volatility value in the probability calculator to see if this increase in IV is sufficient to overcome time decay.

Figures 10 and 11 provide the probability charts and output using our updated data (quicker exit, higher IV). 

The lower curve for the blue cone represents the price for DE if it moved down 1 standard deviation (SD) each day and the upper curve represents price if it moves up one SD each day. Similarly, the red upper/lower curves represent 2 SDs up/down each day.

The original probability data on our risk graph page indicates a 28.49% probability of profit while the shortened time horizon and increased volatility increases this to 64.1% (if you consider a touch of the downside breakeven to be sufficient from a profit standpoint). Keep in mind we expect IV to rise into May 18th, not remain at 40 between now and the proposed exit.

No formal case study exit rules will be applied here. Instead, we’ll take the opportunity to track price movement through the probability and compare it to the strategy back test in the next article, which will post the week after earnings.

Before then, you may want to use 367.38 for the lower target in the probability information since that is the Fibonacci support level we referenced earlier and see how that impacts the results.

Regards,
Clare White, CMT

Great Stuff, Clare!