Options Trading Insights: Markets Continue Higher After Consolidation 12-4-23

Markets continue to move higher Friday after brief consolidation, what next? 

The S&P 500 put in an 11% return for the month of November followed by another three quarters of a percent this week.  Many traders  including myself thought that if there was to be a pullback that it would most likely occur this past week.  What we got instead was some consolidation followed by a breakout on Friday after chairman Powell’s speaking engagement (see below).

Although he was largely cautious in his language the market largely ignored any cautionary words from him. Simply put, the economic data seems just right to support early rate cuts in 2024. At the end of the day,  that’s all the market seems to care about. Just last week alone we got 5.2% revised GDP, core PCE directly inline at 0.2%, and finally softer ISM manufacturing of 46.7 vs, 47.9 expected.  If you are not a data junkie, these numbers basically imply that the Fed might actually be able to thread the needle right into a soft landing.

If you were wondering if it was too late to go along going into the end of the year my answer is pretty simple:.  It’s not.  The only difference now is you have more to choose from more than just the “Magnificent Seven” that’s been taking the market higher all year along with the AI craze.   

The good news about Santa Claus rallies is that it oftentimes leads to increased Market breadth,  which is exactly what’s happening.  Several weeks ago only 20% to 30% of all stocks were above their 50-day SMA’s,  as you can see below that breath has drastically changed to well over 70%: 

This is good news for broadening your stock selection and looking to sectors that have been largely ignored for the past 6 months.   If you notice below you’ll see the sector strength increasing drastically in certain groups in the past week when compared to a year ago:

Although the rally may seem long in the tooth if you’re sticking to the same technology plays,  it is simply early innings for some of the other sectors particularly healthcare, basic materials, Industrials and real estate.  Financials have been steadily outperforming for a while now and as long as the 10-year treasury remains below 4.50% that trend will likely continue as the housing market recovers, new home sales increase, and companies (particularly small caps), are able to secure better financing terms at lower rates.

Forgotten names such as Alcoa (see below) in the basic materials sector are breaking their long-term downtrends and showing positive-sloping moving averages for the forest time in months.

The next question is what strategy is appropriate for this environment that we are currently in?  As an options trader answering that question is the important final step in optimizing your success.  

We are currently in a low volatility environment,  the stock is at an early stage uptrend,  and there are multiple areas of overhead resistance. Either a straight call that is slightly in the money or a diagonal spread would be the most appropriate for this situation. The risk graph on a diagonal spread (see below), allows you to collect a premium while waiting for the stock to reach its first target.  After that, the risk graph will be the same as a straight call (see second graph).  

BUY AA 27 Calls DTE Jan. 5th 

SELL AA 29.50 Calls DTE Dec.15th,  

Initial risk:  $161 net 

Initial reward: $135, unlimited after Dec.15th. (see below)  

The reward converts to “unlimited” after the short leg expires on Dec. 15th. $135 does not seem like a great deal for risking $165, but it is a temporary cap which allows you to “test drive” your long call for two weeks and potentially earn a higher return later on.  This strategy is ideal in a situation where markets might base or pullback before moving higher again. Exactly the market we currently find ourselves in.

One last name I will mention which falls in the consumer defensive sector, but to me exhibits more of a retail quality is Target.  I love this store, and yes they sell food but I’d compare this place more to a Kohls than a Kroger! (see below)

Again with volatility so low, TGT straight calls using an elevated delta of 65-75 allows for a less bumpy ride while you wait for it to gather steam and head to higher levels from previous months.  

When comparing names like like this to what has worked all year like NVDA (see below), these stocks seem like there is much more potential upside than the same old tech plays:

So this week I challenge you all to think outside of the box.   What has worked the past few months looks like it won’t anymore into the end of the year.   

Look for new names, new sectors, and new opportunities and you’ll see that this Market might just be getting started after all!