Stocks Fell Off A Cliff In Late August – What To Do Now by Gary D. Halbert
FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
September 1, 2015
IN THIS ISSUE:
- 2Q GDP Came in Much Stronger Than Expected
- Stocks Fall Off a Cliff in Late August – Now What?
- Options 101: How to Use Them to Your Advantage
- Introducing ZEGA Financial’s High Probability Options Strategy
- Why Option Selling (Writing) Can Be So Attractive
What an absolutely CRAZY couple of weeks we’ve just been through! The collapse of stock prices around the world has stunned investors. By some measures, the plunge in the Dow and the S&P 500 in August was the worst in 75 years, even worse than the Crash of 1987. While I advised readers to reduce long-only equity exposure significantly in April and May, I was not expecting a 15% spike down in just a few trading sessions.
Later in today’s E-Letter, I will introduce you to the latest money manager to make it on to our recommended list. This money manager specializes in buying and selling options on stock index contracts. This is one of the more unusual strategies I have seen over the years, but when you see the results, you’ll understand why I’m so excited to add ZEGA Financial to our stable of recommended Advisors.
Before we get to the above issues, let me briefly comment on last Thursday’s better than expected report on 2Q Gross Domestic Product.
2Q GDP Came in Much Stronger Than Expected
The Commerce Department released its second estimate of 2Q GDP showing surprising growth of 3.7% (annual rate), up from 2.3% in the first estimate in July, and well above the disappointing 0.6% in the 1Q. The latest number was considerably higher than the pre-report consensus of 3.1%-3.2%.
The report cited positive contributions from consumer spending, exports, state and local government spending and nonresidential fixed investment. The price index for gross domestic purchases, which measures prices paid by US residents, increased 1.5% (annual rate) in the 2Q, in contrast to a decrease of 1.6% in the 1Q.
While the latest estimate of 2Q growth is encouraging, things still don’t look good for the 3Q. The Atlanta Federal Reserve’s GDPNow estimate for the latest week shows 3Q GDP rising only 1.2%, down slightly from the previous week’s estimate. This number will change as the Atlanta Fed gets more input, but it does not look like the better than expected momentum in the 2Q will carry over to the 3Q. I’ll keep you posted.
Stocks Fell Off a Cliff in Late August – Now What?
Unless you’ve been living under a rock, you know that stock markets around the world collapsed in the last couple of weeks. By some measurements, the latest plunge was the most severe in 75 years. On Monday of last week, when the Dow Jones plunged over 1,000 points on the open, the market closed more than four standard deviations below its 50-day moving average. Not even the crash of 1987 got that oversold relative to trend.
From the high in June to the intraday low on August 24, the Dow lost over 15% of its value. While I advised my readers to reduce exposure to long-only equity strategies in April and May, I did not expect such a dramatic collapse. On the other hand, with a market that has been virtually straight up for over six years, you can never rule out something like this.
There were multiple worries around the world that sparked the global selloff. There were fears that China’s economy was slowing much more than its government admitted, not to mention that its stock markets lost apprx. one-third of their value in June and July, and the government devalued the yuan by 4% from August 10-12.
There was also a growing fear that the US Federal Reserve would hike the Fed Funds rate at its September 16-17 policy meeting, a fear that continues today despite the recent rout in the equity markets. In addition, the recent Greek bailout had not been finalized, and there was still concern that Greece could leave the EU. There were other factors, of course, but these were the most cited catalysts for triggering the plunge.
Stocks drifted lower in the days leading up to Friday, August 21 when the Dow closed down over 500 points. It was widely expected that the People’s Bank of China would announce new measures over that weekend to stabilize its stock markets. However, no such news was announced over the weekend, and stocks around the world plunged lower on Monday morning, August 24.
The pre-open consensus on that Monday was for the Dow to open 500-600 points lower. Yet in just a couple of minutes, the Dow was down by 1,086 points on the open! Volume spiked, of course, and the VIX (volatility index) soared to the highest level since late 2011.
While the Dow and the S&P 500 have recovered modestly from the close on Monday, August 24, no one knows if we have seen the bottom yet. I wouldn’t bet on it! I will not be surprised to see these markets at least test the lows seen last week, if not move even lower before we’re done.
Options 101: How to Use Them to Your Advantage
Now that stock market volatility has soared, this may be a good time to consider some of the potential advantages of using options on stock index futures. Also, since I will be introducing you below to our newest recommended money manager – that invests in options on stock indexes – today may be an opportune time to review how options work, and how they can be profitable in the right situations.
Without getting too technical, here’s what you need to know about options as it pertains to this discussion. The buyer of an option contract pays a “premium” for the right to buy (“call” option) or the right to sell (“put” option) the underlying asset at a later date at an agreed-upon price.
Buyers of options often do so as a sort of insurance policy to protect them against large market moves in the wrong direction. Hence, they realize there is a good chance the options they buy will expire worthless (more on this below).
The seller (also called “writer”) of an option contract earns the premium paid by the buyer and is obligated to sell or buy the underlying asset at the agreed-upon price within a specified period of time– if exercised – and that is the key point.
The majority of options on futures are never exercised and die worthless. In that case, the seller (writer) of such options gets to retain the full premium paid by the buyer.
Let’s take a look at the Chicago Mercantile Exchange (CME) where options are traded for the S&P 500 Index and the Nasdaq 100 Index. Many options traded on the exchange were never exercised and expired worthless.
Put differently, the sellers of CME options were often able to keep the premium they received from buyers.
This is very important because the money manager I’m about to introduce you to sells options on stock indexes traded on the CME.
Introducing ZEGA Financial’s High Probability Options Strategy
ZEGA Financial, LLC is an investment manager based in West Palm Beach,