One Way to Handle a “Gap Up” Opening

TNX Daily 160913Good Morning, Friends. We have an FOMC meeting this week that could on Wednesday announce the beginning of the “tapering” process that will start to reduce the Fed’s monthly purchases at the long end of the yield curve (“quantitative easing”), currently running at an $85 billion clip. The Treasury market ($45 billion monthly) and m0rtgage backed securities ($40 billion) have of course loved this program, and even the prospect of a slowing, rather than an ending, has pushed interest rates higher and has also been an impediment for stock prices.

Since Fed Chair Bernanke began talking about tapering in May, the yield on the 10-year Treasury note has moved from 1.61 to as high as 2.98. Dr. Bernanke’s term is up in January, and until the weekend the leading candidate to succeed him was former Treasury Secretary Larry Summers. Dr. Summers, a brilliant economist – he’ll tell you so, himself, even if you don’t ask – is also considered something of a loose cannon who does not play well with others. He has also been skeptical as to the benefits of the quantitative easing program. Since bonds and, by extension, stocks, have evidently liked QE quite a lot, the prospect of a Summers chairmanship has been a negative for bonds, and a headwind for stocks.

In the face of opposition within his own (Democratic) party, Summers has now withdrawn his name from consideration. This has sparked a rally in bonds (yield were at 2.90% for the 10-year at Friday’s close, and at 2.79% now, a very large overnight move), and in stocks, with futures up 16.75 points at the moment over Friday’s close. So, for those who were hesitating to buy stocks, or don’t have as many as they would like, in retrospect, what can be done?

ESZ3 Hourly 160913For those of us who trade the 3-minute E-mini charts using the tools provided by Todd Mitchell’s training, nothing of course needs to be done. We’ll be buying retracements within the uptrend, and managing the resulting positions appropriately. We’ll be watching for signs of trend reversals, but not acting on them until there is clear evidence that they are occurring. In addition to day trading futures, however, I also work with stocks and options, and I don’t have as much exposure as I would like.

One approach is to set buy levels on a retracement; very few stocks have a trajectory that takes them higher without a pause, and since there is a major Fed announcement due on Wednesday afternoon, it seems plausible to me that even a large rally today and tomorrow will see some profit taking and position squaring on Wednesday that should provide better levels. The FOMC decision itself could also provide better levels – perhaps significantly better – for buyers. Unfortunately, although I have views as to what the Fed is likely to do, I don’t have any actual information. 

One of the techniques that I do employ when I’m underinvested and afraid of missing additional upside, but fearful of paying the top for stocks, is the “covered combo”. This involves purchasing half of what I consider to be a full position in a stock, for the sake of argument 100 shares. I’ll then sell a call and a put, earning two premiums. This is equivalent to being long stock, and short a strangle. To use a concrete example, a buy of MSFT at 33 could be combined with a sale of a Novemeber 34 call at .91 and a November 32 put at 0.87. The combined premiums are 2.65, bringing the net cost of the stock to 30.35. That’s a discount of 8%, a decent cushion. 

There are some drawbacks to this strategy; we do know that free lunches are pretty rare. A continued rise in the stock would result in the put expiring worthless, but the stock will be called away on a move above 34. In that case, if I still like the case for the stock, I can buy back the call and write another farther out of the money, further out in time, or both. If the stock declines below 32, I will be put, and will own a full position, but at a lower price of 31.175 (32 + 30.35/2). At that point, calls can be written, further reducing the net cost. MSFT also pays a reasonable dividend, so I won’t necessarily mind holding the stock while earning some additional option premium. 

The other drawback is less obvious. Because the position is short a put, sufficient margin has to be set aside to cover the purchase of the additional stock, if put. That isn’t a deal breaker, but it does reduce flexibility, and it makes it worthwhile to buy back the put sooner, if possible, rather than earlier. If the stock continues to come higher, time decay will take a bigger bite out of the premium on the put as it goes further out of the money. 

This is just one approach that can be taken for those of us who are sometimes tempted to chase stocks higher after a gap higher at the opening. I have never had much success doing that; if I have a bad case of the “can’t help its”, I find that it’s far better to reduce my initial cost by using options, either selling a call, or, as outlined above, selling both a call and a put. One of them will certainly expire worthless.

Best of luck today, Friends!

 

About the Author kevin

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