(08/09/21) Worried About the Fed? Hedge With Options

Grinding markets can be exasperating and financially difficult times for active traders. But there are ways to manage these periods, says Joe Duarte of In the Money Options.

For one, by incorporating option strategies into trading routines investors can hedge their bets as well as produce income. And for another, it’s important to know that eventually a sideways trend will break to the up or downside, thus creating trading opportunities on the long or short side.

Still, option traders may have an advantage in the next few weeks as uncertainty regarding the Fed’s next move on interest rates and QE, as well as the repercussions engendered by those actions for MELA, the complex adaptive system composed of the markets (M), the economy (E), people’s financial decisions (L) and the algos (A). In fact, it is that uncertainty that is tied to the major advantages of options strategies: risk management via hedging opportunities and the ability to trade the markets with less capital exposure than that required for individual stocks or ETFs.

With that in mind, here is where we are as we start the month of August. The major indexes are grinding sideways with a slight upward bias. The market’s breadth is decidedly lacking, although it is not falling apart altogether. And the options market is leaning slightly to the bullish side. In other words, everyone is waiting for something bullish to happen while hoping to be on the right side of whichever way things actually break.

And as it has been for the last 18 or so months, most of what happens in the financial market will develop based on whatever the Federal Reserve says and does. Moreover, with the economy showing signs of both inflation and now a blockbuster employment report along with falling consumer confidence, whatever the Fed does will likely be amplified multifold by the algos.

In other words, aside from earnings reports and the general state of things in Washington, whatever the Fed says about its future plans in its Jackson Hole Wyoming soiree in late August will likely shape what stocks do for the rest of 2021.

Nevertheless, from a trading standpoint, it makes sense to reduce exposure slightly and to hedge via income-producing options strategies at the moment.

Patience and Options May Well Pay Off in Housing/Lumber Complex

Over the last few weeks, I’ve been writing about the interconnected housing and lumber sectors. Of course, neither sector is particularly sexy. But, until proven otherwise, they both have one big factor on their side: the fact that the supply and demand equation is tilted favorably toward them.

That’s because despite housing sales data suggesting that the top in housing is in, supply still dwarfs demand and home sales are likely to rebound, especially when homes are selling within days of being listed. And that’s the macro recipe for a bull market. Certainly, cost is an issue with many potential home buyers being currently priced out of the market. And if the Fed raises rates it will put a damper on things.

Think Supply and Demand

Still, as long as mortgage rates remain close the all-time lows, and there is no widespread economic issue—such as inflation getting completely out of control, or the jobs market falling completely apart as in March 2020, there is no major change in the wishes of many to move, either out of cities or into new states. And that means demand for housing is at its worst is likely to remain stable but more likely rising.

As a result, it makes sense to keep a close eye on the homebuilder stocks ETF (XHB) and to consider being patient with the shares, barring a clear breakdown of prices. At the same time, by applying well-selected option strategies investors can manage both time and potential price risk, as I describe at the end of this section.

So, as I stated last week, XHB has been consolidating and flirting with a breakout. Support remains in the $72 area with resistance at $76. A move above $76, could take the shares to $80 in a short period of time. Meanwhile, Louisiana-Pacific Corporation (LPX) is still in a basing pattern with resistance near $60.

Meanwhile, LPX seems to be getting to a point where short sellers are having to cover as Accumulation Distribution (ADI) is heading lower—a sign of active short sellers, and On-Balance Volume (OBV) is moving higher—a sign that algos are buying on dips as the number of shorts is starting to decrease.

If this pattern remains in place, it will mean that the odds of LPX moving higher over the next few weeks will increase, barring an all-out market meltdown.

In addition, the tiebreaking vote in whether the homebuilder-lumber complex can deliver a strong enough turnaround to make me turn all out bullish is what happens in the bond market where the US Ten-Year Note (TNX) yield looks to still be testing its own important resistance at the 200-day moving average.

And while bond yields rose on the better than expected new jobs number released on 8/6/21, and yields are now testing the 200-day moving average near 1.3%, the real test will come if and when TNX approaches the likely true decision point, the 2-2.1% yield band.

So, what’s a good way to manage lumber and housing stocks in the current market? A Buy Write (selling covered call options) strategy may make sense. That’s because if XHB and LPX stay in consolidating price patterns you can collect a premium for waiting for them to break out. If the stocks break out, you can always buy the option back and ride the uptrend. And if your sell stop gets hit you can close out the position. In other words, you can get paid for being patient while managing your trade via clearly defined exit parameters; something not available to investors who don’t trade options.

I own shares and have open option positions in LPX and XHB at the moment.

SPY Options Retain Slightly Bullish Stance

Last week, in this space, I noted option players were becoming a bit more bullish. Well, that general bent seems to have remained in place as call option buying increased toward the 8/6/21 expiration and spilling into Monday’s daily expire. The call volumes increased at the 442-443 area near the closing price for SPY which suggests traders are still betting on slowly rising stock prices.

In conclusion, the options remain more bullish than bearish, and the bullish sentiment seems to be rising—slowly for sure—but still rising.

Market Breadth Retains Bullish Bent with New All Time SPX Highs

The New York Stock Exchange Advance Decline line (NYAD) showed some improvement last week as it closed above its 50-day moving average while its RSI moved above 50 simultaneously. That combination, at least for now, negates what had been a potential sell signal.

So again, the market gets the benefit of the doubt. But it remains a somewhat soft benefit, as the longer the indexes make new highs without confirmation, the more likely will be the odds of a decline.