Option Investor

Daily Newsletter, Monday, 2/5/2018

Table of Contents

  1. Market Wrap
  2. New Plays
  3. In Play Updates and Reviews

Market Wrap

And The Correction Deepens

by Thomas Hughes

Click here to email Thomas Hughes


The market correction deepens as profit taking takes control of the market. That's what it has to be, profit taking because economic and earnings outlook remains robust. Today's data shows further expansion in earnings and economics that do little to inspire fear. What I expect to see for the near term is sector rotation as profits are reinvested and new money comes to play, longer term the secular bull market is likely to resume the uptrend. Articles published over the weekend in the Financial Times and Wall Street Journal report equity fund inflows on the rise and hitting all-time highs as forward outlook brightens and investor sentiment improves. With these conditions in play, market reversal doesn't make sense.

Asian markets saw deep declines on their first trading day of the week. The Nikkei led with a drop of -2.5% followed by -1% drops for most others. The move was driven on Friday's Wall Street decline but losses were not universal. The mainland Chinese Shanghai index rose nearly a full percent by the end of the day on optimism for growth. Elsewhere in the region Australia and New Zealand are both preparing for central bank policy statements that are not expected to produce much change.

European markets also fell although the losses were muted relative to Asia and the US. Likely due to their closing time and more specifically because that time coincides with the timing of the US markets test of resistance which occurred mid-morning. The CAC led with a loss near -1.50% with most others close behind.

Market Statistics

Today's trading is brought to us by the letters V, C and the number 5. The V is for volatility, today's action saw the broad market index make several high volume swings of 0.75% (or more). These moves took it down as much as -5% at the low of the day and left it down more than -3.0% at the close and -8% from the recent all-time highs.

The C is for correction as in the market is in the first real correction it has seen in 2 years. This move is not a trend breaker but could result in a period of consolidation and volatility for the market. The 5 is for 5% because that is how deep today's move took the broad market and blue-chip indices.

Economic Calendar

The Economy

Today's single economic release is the ISM Non-Manufacturing Index. The headline index came in at 59.9% and well ahead of expectations. Within the report Activity, New Orders and Employment all saw strong gains in January with growth better than 5 points from the previous month. Activity came in at 59.8, New Orders at 62.7 and Employment at 61.6; all indicative of accelerating growth. Backlogs and delivery times also rose in an indication of growing demand that will help sustain the economy in the coming months.

Moody's Survey of Business Confidence came in at 35 and unchanged from the previous month. The index is trending near long-term highs and well above recent lows, consistent with positive and stable business sentiment. Mr. Zandi says that global businesses are upbeat but there is particular strength in the US which he characterizes as "cheery". The forward outlook remains strong with most businesses saying conditions will be better in 6 months than they are now.

Earnings season is officially half over with reports in from 50% of the broad market S&P 500. Of that, 75 % have beaten EPS estimates and 80% have beaten revenue estimates, both above average. If the percent of companies beating revenue estimates remains unchanged it will be a high dating back more than a decade. The blended rate of growth is 13.4%, down a bit from last week but still quite strong and above any expectation. All 11 sectors are producing earnings growth, 10 of them are beating estimates with the 11th likely to fall in line by the end of the season.

Forward earnings expectations remain robust although a small kink has emerged. Now that tax reform is getting factored into growth estimates are rising but created a situation in which that growth is tilted toward the first three quarters of the year. Estimates for the 1st, 2nd and 3rd quarter have revised up to 16.9%, 18.3%, and 19.8% while the 4th quarter was revised down to 14.2%. It is important to note that these estimates are still heavily skewed by the energy sector which is expected to see earnings growth slow from triple digits to only high double digits this year.

The Dollar Index

The Dollar Index firmed in today's session, gaining about 0.33%, but remains within a narrow near-term range. The near-term range is at a support target that, if broken, could lead to significantly more downside. If however, it is confirmed as support, as it looks like it is, it could easily move back up. Based on this last round of central bank meeting I think the latter scenario is more likely. Nothing has happened to firmly alter current outlook but there has been enough to shift the balance of power into the dollar's favor. The ECB and BOJ were both less hawkish in their tone than what the market was looking for while the FOMC was a bit more. Resistance may be found at $89, a break above there may go to $90.20 and the short term moving average. Short to long-term range-bound trading is likely to persist.

The Gold Index

Gold prices remain under pressure as the dollar firms and the outlook for growth remains stable. The metal has seen some support due to dollar weakness and geopolitics but the conditions that led to that move are evaporating. The dollar looks poised to move up within a long-term trading range while geopolitical hurdles have not led to major fallout. Today's action left spot prices trading flat and below the $1,340/$1,350 resistance zone but also above support at the short-term moving average. The metal appears to be in reversal within its trading range and if so could go as low as $1,280 or $1,260. The indicators are consistent with a fall from resistance and test of support and both are gaining strength. The short-term EMA is the target for support at this time, a break below that would be bearish.

The Gold Miners ETF GDX continues to move lower within its long-term trading range. The ETF created a long red candle shedding more than -1.0% and closing just above support at the midpoint of the range. The indicators are both consistent with a possible move lower although I would expect support to be strong at $22.60. A break below $22.60 would be bearish within the rage with targets near $21 and then $22.00.

The Oil Index

Oil prices fell more than -2.0% as profit taking is spurred on by rising rigs and output. The latest data shows US output rising above 10 million barrels and to levels that offset to a large degree the impact of OPEC's production cut. Add to this the latest rig count data and there is little reason to think supply or capacity is dwindling and that is eroding near-term support. The number of US rigs fell by -1 but that was more than made up for by 4 new rigs in Canada and another 24 elsewhere in the world. Today's action left WTI trading near $64 with a chance of moving lower.

The Oil Index fell more than -3% on oil's decline in price as forward earnings growth and sustainability come into question. The index moved down to my support target at 1,300 where it bounced. The indicators remain bearish so further testing of support is likely in the near term. Longer term, oil prices remain high relative to the past 2 years and at levels fueling earnings growth. If growth outlook remains stable the index should recover from this correction and move back up to test the recent highs. The risk is the oil price outlook, oil prices are expected to fall back to $52mlater this year. When that happens the index is likely to fall with it.

In The News, Story Stocks and Earnings

Wells Fargo made headlines they didn't want. The bank has come under fire from a Federal Reserve which has just today sworn in its new chairperson. The Fed has chosen to curtail Wells' growth outlook and remove four of the current board members. The move comes in the wake of the Fed calls "widespread consumer abuses and compliance breakdowns" and was taken well by the market. The bank, Wells Fargo, once a darling of the market and now fallen from grace, fell more than -8% on the news.

Lululemon announced in the after-hours session that its CEO was stepping down. The move is due to his failure to meet their standards of conduct AKA he used his position for sexual exploit. In the statement, the company's board said it is already looking for a replacement and reiterated current guidance. Shareholders were not reassured, shares fell more than -2.5% on the news.

The VIX made the single largest one day move I think I've ever seen. It moved more than 33%, breaking past all resistance targets and deep into what I would call correctional levels. Price action closed at the high of the day creating a marubozu candle with a shaven top. The move is consistent with a possible reversal but I really have to question the commitment behind it. Based on past price action in this index, and in light of current market outlook, I would say this is a decent time to fade the market. If it doesn't retreat to lower levels we may have a bigger correction brewing.

The Indices

Today was a down day no doubt about it but it wasn't all selling. There were some signs of buying on the way down and a bottom was hit. How strong the bottom is and how long it lasts are yet to be seen. The Dow Jones Industrial Average led in terms of losses. The blue-chip index shed more than 1,500 points at the low, the biggest one day point drop in history, but bounced back to regain some of that loss by the close. Regardless, today's decline surpassed -5% in total depth and closed with a loss near -4.5%. The candle is long and red, come with strong and growing momentum and plenty of room to move lower. Downside target is the long-term moving average and uptrend line which are both near 23,500.

The S&P 500 comes in second with a decline near -4.10%. The broad market index created a large, strong red candle moving down from the short term EMA in confirmation of Friday's crossover. This move is indicative of change within the short term trend with the possibility of moving lower. The indicators are both consistent with lower prices but neither has signaled a reversal. Downside target is the long-term moving average near 2,600.

The NASDAQ Composite posted the 3rd largest decline, just over -3.75% at the close, and created a long strong red candle. Today's move confirms resistance at the short-term moving average and a change in trend that could take it lower in the near to short term. The indicators are both bearish and gaining strength, consistent with today's decline and lower prices to come. A move lower may find support at the long-term uptrend line or the long-term 150 day EMA both of which are near the 6,800 level.

The Dow Jones Transportation Average comes in last with a decline of -3.15%. The transports created a long, strong red candle with shaven bottom indicative of decisive movement. The indicators are bearish and moving lower, consistent with lower prices, although stochastic is reaching oversold condition. A move lower may find support at the long-term moving average near 10,100 or just below along the long-term uptrend line.

The long awaited and hard to predict correction has arrived. It's been two years since the last and is overdue, to say the least. Now that it is here it is time to watch the charts and wait for bottoming and consolidation... when that happens the charts will give us the signals, and that will be the time to act. In the near term expect volatility to persist, the market to reverse on a dime and headlines to instill to fear. So long as forward earnings and economic outlook remain bullish so will I. I am neutral for the near term, bullish for the short and long.

Futures trading hit new lows in the after-hours session, there could be some big declines in the morning.

Until then, remember the trend!

Thomas Hughes

New Plays

Stand Aside

by Jim Brown

Click here to email Jim Brown
Editor's Note

With the small caps at 2-month lows and the market imploding, patience is required. I added a bunch of new plays in the Option Investor newsletter on a "buy the dip" risk on trade when the futures were positive in the afterhours session. Before I could finish the play descriptions the futures had gone to -20. As I type this they are now -50. The Hang Seng Index opened down -3.2% in Hong Kong and Asia is following our decline. There is no reason to try to jump into the chasm at Tuesday's open. There will always be another day to trade.


No New Bullish Plays


No New Bearish Plays

In Play Updates and Reviews

Buyer Revolt

by Jim Brown

Click here to email Jim Brown

Editors Note:

Bids evaporated and the Dow declined 800 points in less than 15 minutes. This was a once in a generation event in the market. At least I hope it is once in a generation. The Dow was down -1,600 points at the low for the day and lost -1,175 at the close. The Nasdaq lost -273 points. That is not a typo. The market is in meltdown mode but at these levels there may be a rebound in our future.

I am suspending the new update schedule until the volatility passes.

Current Portfolio

Stop Loss Updates

Check the graphic below for any new stop losses in bright yellow. We need to always be prepared for an unexpected decline.

Profit Targets

Check the graphic below for any profit stops in green. We need to always be prepared for a profit exit at resistance.

Current Position Changes

KTOS - Kratos Defense
The long position was entered at the open.

If you are looking for a different type of trading strategy, try these newsletters:

Short term Calls and Puts on equities = Option Investor Newsletter

Credit spreads and naked puts = OptionWriter

Long term option investments = LEAPS Investor

3-6 month Option Trades = Ultimate Investor

Iron Condors = Couch Potato Trader

BULLISH Play Updates

KTOS - Fratos Defense and Security - Company Profile


No specific news.

Original Trade Description: February 3rd

Kratos Defense & Security Solutions, Inc. provides mission critical products, solutions, and services in the United States. The company operates through three segments: Kratos Government Solutions, Unmanned Systems, and Public Safety & Security. The Kratos Government Solutions segment offers microwave electronic products; satellite communications; technical and training solutions; modular systems; and defense and rocket support services. The Unmanned Systems segment provides unmanned aerial, ground, and seaborne, as well as command, control, and communications systems. The Public Safety & Security segment designs, engineers, deploys, operates, integrates, maintains, and operates security and surveillance solutions for homeland security, public safety, critical infrastructure, government, and commercial customers. The company serves national security related agencies, the department of defense, intelligence agencies, and classified agencies, as well as international government agencies and domestic and international commercial customers; and critical infrastructure, power generation, power transport, nuclear energy, financial, IT, healthcare, education, transportation, and petro-chemical industries, as well as government and military customers. Kratos Defense & Security Solutions, Inc. was founded in 1994 and is headquartered in San Diego, California. Company description from FinViz.com.

Earnings Feb 26th.

We played Kratos several months ago when they were just beginning to win contracts for their target drones. Now they are winning contracts and have vehicles in advanced tests as attack drones that can fly with F16s and F35s and function as ground attack aircraft and aerial defense aircraft.

Kratos has found a niche in the unmanned aircraft business. Last week they were chosen to participate in a multi company award for $998 million for the Air Force TETRAS program. This is to develop a multi function drone that will be used for Command, Control, Communications, Computer Intelligence, Surveillance and Reconnaissance or C4ISR. The military sure loved their alphabet soup names.

Also last week, Kratos completed the first milestone in the Enterprise Ground Services (EGS), Command and Control System-Consolidated (CCS-C) and the transition of the Military Satellite Communications (MILSATCOM) satellite C2 system into the EGS. I don't know what all of that means but it is part of the Air Force Enterprise Space Battle Management Command and Control system (BMC2) currently being developed.

The key point here is that Kratos has been winning these awards nearly every week and they are rapidly integrating themselves into every phase of the military's attack and defense communications network in addition to their highly intelligent drone division.

The prior week Kratos announced that numerous high performance unmanned drone aircraft had completed multiple missions for customers around the world in tactical and threat representation missions. They do sell to other customers than the US military.

With Kratos rapidly advancing their capabilities and winning larger and larger contracts, they are likely to seen even more business once the defense funding is approved by congress.

Shares did NOT decline in the market selloff last week. I am recommending an options only position using a longer term option and we will hold over their earnings on Feb 26th.

Position 2/5/18:
Long May $12.50 call @ $1.10, see portfolio graphic for stop loss.

VIPS - Vipshop - Company Profile


No specific news. Only a minor decline in a weak market.

Original Trade Description: January 27th.

Vipshop Holdings Limited, through its subsidiaries, operates as an online discount retailer for various brands in the People's Republic of China. It offers a range of branded products, including women's apparel, such as casual wear, jeans, dresses, outerwear, swimsuits, lingerie, pajamas, and maternity clothes; men's apparel comprising casual and smart-casual T-shirts, polo shirts, jackets, pants, and underwear; women and men shoes for casual and formal occasions; and accessories consisting of belts, fashionable jewelry, watches, and glasses for women and men. The company also provides handbags, such as purses, satchels, duffel bags, and wallets; apparel, gear and accessories, furnishings and decor, toys, and games for boys, girls, infants, and toddlers of all age groups; sports apparel, and sports gear, and footwear for tennis, badminton, soccer, and swimming; and skin care and cosmetic products, including cleansers, lotions, face and body creams, face masks, sunscreen, foundations, lipsticks, eye shadows, and nail polish. In addition, it offers home furnishing products comprising bedding and bath products, home decors, and dining and tabletop items; small household appliances; designer apparel, footwear and accessories; and snacks, health supplements, and occasion-based gifts, such as chocolates, moon-cakes, and tea. Further, the company provides consumer financing, supply chain financing, and wealth management services. The company provides its branded products through its vipshop.com, vip.com, and lefeng.com Websites, as well as through its cellular phone application. Vipshop Holdings Limited was founded in 2008 and is headquartered in Guangzhou, the People's Republic of China. Company description from FinViz.com.

VIPS has about a 6% market share in e-commerce apparel in China. Currently there is a battle in progress for market share among numerous major players including Alibaba and their various websites. They all exist in come part under the Alibaba umbrella.

Tencent (TCEHY) and JD.com (HD) are two of the major online players. They just announced an $853 million stake in VIPS. Tencent bought a 7% stake for $604 million and JD.com put up another $259 million to increase their stake from 2.5% to 5.5%. FYI Tencent owns a 21% stake and Walmart owns a 10% stake in JD.com. These are major players who believe VIPS is going to grow significantly.

VIPS is the 4th largest business to consumer online retailer in China behind Alibaba's Tmall, JD.com and Suning, in that order. Over the last 12 months VIPS increased its active customers by 22% to 6.5 million. The company is expanding out of apparel and accessories and into things like pharmaceuticals. On Alibaba's Singles Day, VIPS handled more than 10 million orders. Analysts expect VIPS revenue to grow 33% in 2018 and earnings to grow 43%.

Why is the investment by JD.com and Tencent so critical? Tencent has 980 million monthly active users on WeChat and JD.com has 266.3 million active customers. They are going to make these customers available to VIPS. Remember, VIPS only has 6.5 million customers but they have the products that Tencent does not have. This means VIPS sales are going to explode.

VIPS has earnings on Feb 19th. I am recommending we buy a cheap call and hold over the earnings event because good things are likely to come out of the report.

No stock, just buy the call. The stock is rising quickly but it could reverse just as easily.

Position 1/29/18:
Long Mar $19 call @ $1.15, see portfolio graphic for stop loss.

BEARISH Play Updates

JBL - Jabil Inc - Company Profile


No specific news. New 52-week low.

Original Trade Description: January 31st

Jabil Inc. provides electronic manufacturing services and solutions worldwide. The company operates through two segments, Electronics Manufacturing Services and Diversified Manufacturing Services. It offers electronics design, production, and product management services. The company provides electronic circuit design services, such as application-specific integrated circuit design, firmware development and rapid prototyping services; and designs plastic and metal enclosures that include the electro-mechanics, such as the printed circuit board assemblies (PCBA). It also specializes in three-dimensional mechanical design comprising the analysis of electronic, electro-mechanical, and optical assemblies, as well as offers various industrial design, advance mechanism development, and tooling management services. In addition, the company provides computer-assisted design services consisting of PCBA design, and PCBA design validation and verification services; and other consulting services, such as the generation of a bill of materials, approved vendor list, and assembly equipment configuration for various PCBA designs. Further, it offers product and process validation services that include product system, product safety, regulatory compliance, and reliability tests, as well as manufacturing test solution development services. Additionally, the company offers systems assembly, test, direct-order fulfillment, and configure-to-order services. It serves automotive and transportation, capital equipment, consumer lifestyles and wearable technologies, computing and storage, defense and aerospace, digital home, healthcare, industrial and energy, mobility, networking and telecommunications, packaging, point of sale, and printing industries. The company was formerly known as Jabil Circuit, Inc. and changed its name to Jabil Inc. in June 2017. Jabil Inc. was founded in 1966 and is headquartered in St. Petersburg, Florida. Company description from FinViz.com.

Expected earnings March 15th.

Jabil reported earnings of 80 cents that beat estimates for 78 cents. Revenue of $5.59 billion also beat estimates for $5.5 billion. They posted wide guidance for Q1 of 50-74 cents on revenue of $4.75-$5.50 billion. Analysts wre expecting $4.76 billion.

By all rights Jabil shares should be rising but the decline that started in September has accelerated with Wednesday's close a 52-week low. With the Semiconductor Index showing increased volatility in what could be a topping process, the lesser known chip companies are declining.

Position 2/1/18:
Short JBL shares @ $24.33, see portfolio graphic for stop loss.
Alternate position: Long March $24 put @ 70 cents, see portfolio graphic for stop loss.

VXX - Volatility Index Futures - ETF Description


MAJOR volatility event. Pay close attention! Market volatility exploded on Monday. The Dow was down -1,600 at the lows and there was $3.5 billion in sell on close orders on the NYSE. Bids were evaporating faster than rain on a 140 degree sidewalk in Texas.

The VXX spiked $11 in the regular session to $43.94 and just over our entry point at $40.95. No harm, no foul because we know it will always move lower in the future. However, in the afterhours session the VXX spiked to $65. This is why you should ALWAYS has catastrophe stop losses on a futures product.

A reader emailed me saying a friend was short 1,000 shares. When the $21 spike came in afterhours, Ameritrade closed that position for a $35,000 loss. They did not have a protective stop loss.

I wrote in the last newsletter that we were not using a profit stop in this position because it could be hard to re-short the shares after a volatility event. That is just trade management for a profitable position. In ANY SHORT POSITION you should have a catastrophe stop loss to avoid the position turning into a major loss. Had this person had a stop loss at their entry point, they would have been closed for a breakeven and they would be sleeping a lot better tonight.

Readers should always assume the potential for the worst possible outcome of a short position. Trade smart!

For those not in this position OR wishing to increase their future profits, entering a new position at these levels is free money. We know the futures product is flawed and will eventually move lower because of the futures roll over. I am recommending we enter a new short at the open on Tuesday.

Sell short VXX shares, currently $56. This will average up our current basis and increase our future profits.

Original Trade Description: September 18th.

The VXX is a short-term volatility ETF based on the VIX futures. As a futures product it has the rollover curse. Every time they roll to a new futures contract, they have to pay a premium and that lowers the price of the ETF. It is a flawed product with a perpetual decline built in from the monthly roll over in the futures contracts.

As evidence of this flaw, they have now done four 1:4 reverse stock splits. The last five reverse splits occurred at $13.11 (11/2010), $8.77 (10/2012), $12.84 (11/2013), $9.52 (8/8/16), $12.77 (8/22/17). The prospectus says it can reverse split anytime it trades under $25 for a prolonged period and the splits will always be 1:4.

We know from experience that the VXX always declines. The last two times we shorted this ETF we had a $7.23 and $5.98 gain.

Unfortunately, put options are expensive with a volatility instrument at this price level. The only recommendation is to short the ETF and forget it. If we do get a prolonged rally into year-end we could see a sharp decline in the VXX over the next 2-3 months. This will be a long-term position. This is not a 2-3 week play. I can guarantee you, if history holds, we can play this until it splits 1:4 again at $10. Once we are in the position and profitable I will put a trailing stop loss on it. We will take profits and then look for a bounce to get back in.

The VXX is hard to short. Shortsqueeze.com says there are 19.9 million shares short out of 26.7 million shares outstanding. The shares are out there and being traded because the volume on Monday was 29.6 million. You have to tell your broker you really want to short it and make them find the shares. Sometimes it takes days or even a week before your broker will find you the shares. Trust me, be persistent and it will be worth the effort.

I had held off after the 1:4 reverse split because the options were expensive and I was expecting volatility in September from the budget battle and debt ceiling hurdle. With those issues pushed out into December, the volatility is dropping like the proverbial rock. Several readers have already emailed me asking when I was going to put this position back in the portfolio.

Position 9/19/17:

Short VXX shares @ $40.95, see portfolio graphic for stop loss.

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