The stock market had been stuck in a rut for more than two years. The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) was running flat for 2016 until the bounce from the Brexit flash correction. But now the SPY is up almost 5% year-to-date, and up 3% for the past 12 months.
Click to Enlarge It took 13 months to do it, but we now have a new high for the SPY. However, we are rallying on deteriorating fundamentals. There’s more than $13 trillion stuck in negative rates. he global central banks continue to see it fit to print money to try and spur economic growth. In spite of all their efforts, growth is mediocre at best.
The conundrum is that individual companies like Apple Inc. (NASDAQ:AAPL) or Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL) are not expensive. Companies typically have been able to successfully manage their P&L by cutting costs.
Technically, this rally has room to run. Momentum traders have been waiting for this all-time high. To them, this confirms the breakout, so they are likely to chase the S&P 500 higher.
But at some point, fundamentals will have to matter again. For now, we are stuck trading headlines. The Brexit was one important headline, and the U.S. Federal Reserve’s next move will be another. In headline trading, I prefer to trade mid-term ranges, so I avoid short-term risk even if I have solid weekly levels.
Today, we’ll look at a way to trade mid-term risk without being exposed to immediate losses.
Trading the SPY
Trade #1: Sell the SPY Oct $225/$230 credit call spread for 55 cents per contract. This is tighter than my usual comfort zone, but I am willing to try it out with the SPY at all-time highs. I stand to earn 12% as potential yield if successful. To win max gains, I need the SPY to close under $225 per share by mid-October. In the right portfolio, I would be comfortable to take this trade alone. However, you could consider …
Trade #2 (optional): Sell the SPY Oct $190/$185 credit put spread for 37 cents per contract. This is also a bit tighter than my usual comfort zone, but these are impressively daring markets. Potential yield for this SPY trade is 8%. To win max gains, I need the SPY to close above $190 per share mid October.
Taking both trades would constitute an iron condor. This is a neutral trade that requires the SPY to close between $190 and $225 per share by mid-October. The trade would then pay a total premium of 92 cents per contract. This would lower the maximum dollars at risk, raising the overall yield to 20%. Price buffers from the current SPY ETF price are 5% to the upside and 11% to the downside. (And this trade can be modified to suit any account size or risk tolerance.)
Managing the theoretical chances of success is crucial to running a successful credit spread book. I don’t let the trades run against beyond repair. Longer-dated credit spreads tend to be easier to manage than those with only a few days on the clock.
I am not obliged to hold these trades through expiration, and I can close either for partial profit or loss.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and stocktwits at @racernic.
