Markets Continue to Surge forward, Santa Claus Rally in Full Effect: What is to Come?
With the S&P 500, the Dow Jones and the Nasdaq all surging over 2% this week, it looks like the Santa Claus rally is in full effect. What really stole the show last week was the CPI and PPI data coming in exceedingly cold see below, which added fuel to the belief that the Federal Reserve can begin to think about pulling back higher interest rates.
Although the term “Santa Claus rally” has a cute connotation, for big banks and other institutions, it could mean life or death for not only their performance but for even some of their livelihoods and careers. The business that these individuals have chosen is extremely competitive, so year-end performance chasing is a real thing that can happen from time to time.
Which leads us to where we stand today. This was the fastest recovery from a 10% drawdown in the last 10 years, and with the 10-year Treasury now below 4.50%, we may see it continue despite some very overbought conditions in the markets. What we have in the S&P 500 right now is a double time correction which I have not seen in quite some time (see below). This almost guarantees a pullback at some point, but as an option trader I won’t be waiting for it. You truly never know if or when a pullback will come to grant you favorable entry points, instead I’ll be implementing strategies to simply allow for it when it decides to show up.
My “go-to strategy” for environments like this is something called the diagonal spread. It is a “debit” strategy that is used in a low volatility environment (which we are currently in) that utilizes two separate expiration dates for both the long leg and a shorter one for the short leg.
What does this do exactly? The short leg of a set up like this has two purposes. First, since the short leg is a “credit” it allows for an offset in time decay. Since the short leg would be the further out-of-the money option it allows you to sit through a pullback without doing too much damage to your P&L.
I like to think of it as “test driving” your long idea through some bumpy times. This is true because the long leg has a further expiration and once those bumpy times are over what you are left with is a pure long position that allows you to sit through a pullback and collect a little bit of money while you wait.
A great example of this in action was my trade I posted yesterday in TSLA (see below):
It’s times like this where I emphasize the importance of strategy selection as something that is just as important as being in the right stock and being in the right direction. The current environment we are in, there is no shortage of stocks that are now in an uptrend, but unfortunately many of them look extremely overdone. The good news is in the past two weeks the breadth of the market has improved quite a bit with 66.30% of names now above their simple moving average. A couple short weeks ago that number was around 20%.
This has opened up new sectors for me to get excited about particularly the financial sector (see XLF below).
The financial sector has been languishing for quite awhile and going into the end of the year I’m excited to see some new opportunities open up in areas other than Technology and Communications that have dominated a great deal of this year.
One particular name that I’m looking at is (COF) (see below), where I may use my go-to diagonal strategy when the opportunity presents itself on Monday.
As balanced portfolios go, it is still important to have some names on the short side of things. Healthcare and Energy are the two areas of the market that are currently lagging, and that is where I’ll be looking to add some bearish exposure to my overall bullish basket. Oil did not participate in last week’s rally, selling off 1.81% (see below). Despite great performance on Friday +4%, I will likely use this bounce as a “bear rally” for good short entries on oil names.
One name I have been watching closely is EOG (see below). Since the market is strong I will not look to expect a lot out of my short names. This will likely cause me to use a more conservative options strategy like a vertical spread, that capitalizes both on offsetting time decay, lowering cost/risk, and setting for a specific target, $116 in this case.
With a shortened week and not too much economic data to look forward to, things may be a little bit sideways to sleepy for the next couple of days. For those of you who took advantage of this rally I would continue to do so and for those of you who haven’t, I truly believe it is not too late based on what I’m seeing. With the broad-based rally that we got and sector Improvement overall it may not feel like the best trade but being bullish right now is the right trade.