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27 10.17 • Issue 536

OPTIONS’ OPTIONS

Options’ Options

27

Options on ETFs

32

Put a Cap in Drawdowns

36

Weekly Options: A More Precise Tool

38

Binary Options are Here to Stay

42

Volatility as an Asset Class

45

. . . are growing, and so are ETFs that offer exposure to options strategies. Put writing indexes provide risk-adjusted retuens over long timeframes. Options allow traders to take a more defined position on an underlying stock; Weekly options take this benefit one step further. Binary options are offered in several regulated markets to allow retail traders an easy way to access market moves. New tools for institutional & retail traders

FEATURES

45

Breaking up Amazon: It’s Not That Simple Amazon’s effect on the economy has been dramatic and there are legitimate antitrust concerns.

80

Trader

82

Closing Tick

80

Finding long-term success trading options. Revenge of the humans Cover by N E Torello

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Volatility is not to be feared. It is to be captured and turned to your advantage. Harnessed to seek DIVERSIlCATIONĂ?ANDĂ?HEDGEĂ?PORTFOLIOĂ?RISKĂ?5TILIZEDĂ?TOĂ? drive income generation. Volatility does more THANĂ?CREATEĂ?MARKETĂ?UNCERTAINTYĂ?Ă?)TSĂ?THEĂ?PATHĂ?TOĂ? uncovering new and powerful outcomes.

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10.17 • Issue 536

CONTENTS

MODERN TRADER Editor-in-Chief Daniel P. Collins dc@moderntrader.com Managing & Digital Editor Yesenia Duran yd@moderntrader.com Features Editor Garrett Baldwin

51

56 TRADES

13

TECHNIQUES & TACTICS

Buy

61

Paper Trade Options Basics Chart Patterns Trading Bearish Shark Patterns Technique Trading Social Media Sentiment Indicators

A technical gold play 14

Sell Chipotle: New health outbreak, new short

64

16

OCO More upside to Amazon?

67

18

Industries Do airline stocks have room to soar?

19

ETFs Retail’s revenge

20

Cycles Amazon, crude, gold & the big equity short

21

COT Beans, cocoa & cattle

22

Options Can Amazon keep this pace?

23

70

Technique Summer Weather Rally Primes Premium Pump

72

Technique The Bonus Trade

75

Advanced Technique Trading Weather driven Grain Markets

AFTER THE BELL 51

Appreciating scotch

54

The Macallan virtual reality experience cocktail

56

Save your season with these Fantasy Football picks

58

Big money thinks small

DEPARTMENTS 08

Editor’s comments on this issue & key industry trends 10

finance & politics

Earnings Amazon’s next conquest

26

Forex North Korean tension & the return of risk-on/risk-off

Short Interest Real talk on business,

Spin-offs Spin-offs outperform

25

Opening Bell

78

Tracking Stock Snapchat falters

54

81

Contributing Editors Steven Lord Murray A. Ruggiero, Jr. Assistant Editor Tamarah Webb Contributing Creative Director Nicholas E. Torello Advertising Sales Barry Weinberg Financial Ad Solutions Richard Holcomb Non-Endemic Ad Solutions ads@alphapages.com THE ALPHA PAGES, LLC Chief Content Officer & Publisher Jeff Joseph @alphapagesceo jj@alphapages.com Modern Trader Magazine The Alpha Pages 107 W. Van Buren Suite 204 Chicago, Ill. 60605 (312) 846-4600 Modern Trader Sunscriptions P.O. Box 1144, Skokie, IL 60076 Subscription Services (847) 763-4945 moderntrader@ halldata.com

Calendar

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October: Volatility

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ahead

We welcome your comments and suggestions at openoutcry@moderntrader.com Identification Statement: MODERN TRADER (ISSN0746-2468) is published monthly by The Alpha Pages, LLC at 107 W. Van Buren, Suite 203, Chicago, IL 60076. POSTMASTER send address changes to Modern Trader Magazine, P.O. Box 1144, Skokie, IL 60076. Allow 4 weeks for completion of changes. CPC IPM Product Sales Agreement No. 1254545. Canadian Mail Distributor Information: IBC/Canada Express, 7686 Kimball Street, Units 21 & 22, Mississauge, Ontario Canada L5S1E9. Canadian Subscriptions: Canada Post Agreement Number 7178957. Periodical postage paid at Chicago, IL and additional mailing offices. Send change address Information and blocks of undeliverable copies to IBC, 7485 Bath Road, Mississauge, ON L4T 4C1. Canada Printed in the USA Copyright © 2013, 2014 by The Alpha Pages, LLC. All rights reserved. No part of the magazine may be reproduced in any form without consent. The Alpha Pages, LLC believes the information contained in articles appearing in MODERN TRADER is reliable, and every effort is made to assure its accuracy but the publisher disclaims responsibility for facts or opinions contained herein. The articles and information contained herein are not intended to be investment advice, so be careful out there!

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Trading 6 Power Techniques

OPENING BELL

Issue and industry insights from 28-year trading industry veteran Dan Collins, editor in chief.

The evolution of options

Calls 7 Analysts’ on Amazon

33Timely Trade Ideas

45th Anniversary Year “Best Business Magazine”

The essential joystick for active investors since 1972

AMAZONED! AMAZONED!

— Niche Media Awards 2017

On the path to a $500B market cap is it for retail?

A year ago in our options issue (September 2016) we focused on the history and versatility of options. Here, we spend more time on their evolution and growth. When listed options were first launched, only calls existed and ordinary traders could only buy an option. Today, there are options listed on virtually every underlying, from equities to futures to 10.17 • issue 536 moderntrader.com exchange-traded funds. You can trade long-dated options, Leaps, or options with weekly expirations, and traders of all levels, from retail to institutional, use both long and While many professional options traders short options positions. have evolved from pure naked option Options can be used to create distinct writing, the strategy has had a rebirth with trading strategies and those strategies both professional and retail traders thanks are the basis for unique investment to historically low and continually shrinking products. In “Options on ETFs & ETFs volatility. This has some people worried on options” (page 28), we discuss the about what will happen when volatility intersection of options and ETFs, with returns for an extended listing agents creating period. Also, in “Binary investment products “Traders of options are here to based on Chicago Board all stripes are stay” (page 38), we Options Exchange (CBOE) strategy using all of the discuss the evolution and growth of these unique benchmarks. “PUT a tools in the products. cap on drawdowns” options tool Last month we (page 32), examines how box.” touched on the breadth these benchmarks have of disruption caused performed throughout by Amazon, as several experts we spoke the years. to cited how the Amazon revolution has What has become clear is that traders of affected the restaurant sectors and even all stripes — for better or worse — are fully the live cattle market. In this issue, we take using all of the tools in the options toolbox, a deeper dive into this effect. In “How even option writing. In “Volatility as an big of a risk is Amazon?” (page 47), asset class” (page 42), we discuss the Feature Editor Garrett Baldwin discusses evolution of managed options programs.

Options’ Options Binarys, Weeklys, Volatility, ETFs & more

how companies from various sectors view the Amazon threat. More than five dozen companies have identified Amazon as a threat to their business. It is always hard to apply antitrust laws written before the digital age to innovative companies in newly evolving sectors. In “Breaking up Amazon … It’s not that simple” (page 45), Baldwin talks to Diana Moss, president of the American Antitrust Institute, about the chances Amazon will be targeted for antitrust violations. What is clear is that the Amazon has shaken up the entire equity world and companies not even related to the broad retail sector are looking over their shoulders to see if Amazon has them in its sites.

Daniel P. Collins Editor-in-Chief, Modern Trader @moderntradered

Send your comments, criticisms and suggestions to openoutcry@moderntrader.com 8

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SHORT INTEREST

Real talk on business, finance, politics & alternative investments. Powered by the Daily Alpha at FINalternatives.com.

“Dan Loeb dissolves stake in Snap, but the stock is soaring.” That’s a headline over at Market Watch… It’s time to fire someone. Soaring? Snap stock was soaring on Aug. 14. And by soaring, the stock was up 6% to close the day at a whopping $12.60. Soaring… on the day that Snap employees were finally granted the opportunity to sell their stock after the IPO lockout period. Soaring… still well below its IPO level of $17 per share. Soaring… still an incredible downturn from its 52-week high of $29.44. We’ll beat our chest here. Back when this company went public, we advised readers to stay far away from this company until the lockout period expired. We argued that at this point, the markets would finally begin to determine the real value of the stock (see “Tracking stock,” page 78).

“We are not “I am going proud of the to go dark. result.” Then I will reemerge… as me.” These are the reported words of former White House Communications Director Anthony Scaramucci in a conversation with Huffington Post’s Vicky Ward on Aug. 1. The conversation allegedly took place shortly after Scaramucci left the White House after only 10 days in the role. ‘If it was up to me, he would be gone.” That’s Anthony Scaramucci ripping on Steve Bannon on “The Late Show with Stephen Colbert” on Aug. 14. Well…that was fast.

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That’s John Walker, EnerVest’s cofounder and CEO. Walker’s private equity firm isn’t — how do we put this — good with money. The firm was once worth more than $2 billion; but as The Wall Street Journal explains, the company is going to be leaving their pension, endowment and charity clients with pennies on the dollar. EnerVest started investing in the energy markets with crude prices around $90 per barrel. You know where this is going, right? The interesting factoid here is that there have only been seven private-equity funds worth more than $1 billion to ever lose client money. Losses of 25% are rare, according to the Journal’s article. EnerVest really outdid itself. When politicians go after hedge fund and private equity managers; you’ll hear a lot about this fund and what it did to pensioners’ money. This is the extreme example, and politicians love to make the extremes look like the center of the bell curve.

“Appaloosa disclosed a $3.7 million stake in shares of Alibaba, according to a Monday filing with the U.S. Securities and Exchange Commission.” Aug. 14 delivered the markets the latest round of 13-D filings, and we saw a sharp uptick in stakes of Alibaba Group Holdings (BABA). Everyone, it appears, is still a bit concerned about the price of Amazon stock and the ecommerce giant’s valuation. So, they’re all pouring capital into the “Amazon of China.” This will be an interesting test. Does the “of China” argument work for hype? It certainly has worked in recent weeks for the cryptocurrency NEO, which changed its name from AntShares and called itself the “Ethereum of China.” The currency added more than 500% in the first two weeks of August.

M o d e r nTr a d e r. c o m


OPEN OUTCRY

“Moore’s law specifically applied to the number of transistors on a circuit but can be applied to any digital technology. Any technology that is growing exponentially (i.e., ‘following Moore’s law’) has a doubling time.” That’s Dennis Porto, a Harvard academic and Bitcoin investor, in a conversation with Business Insider. Following the Aug. 1 “Hard Fork” of Bitcoin, prices rocketed north of $4,300 per coin. Porto argues that the digital currency is heading to six-figures. Meanwhile, others are arguing that the cryptocurrency is in a bubble and we’ll have the opportunity to relive Tulip Mania in the near future. It’s been an incredible experience to watch. At the end of 2015, we sat down with Tyler Winklevoss, who at the time was aiming to run the first SEC-regulated ETF for the cryptocurrency. At the time, Winklevoss outlined one of the most intriguing theses on why Bitcoin was pushing higher. This was one of the few generational investment opportunities of a lifetime, and those who followed his advice probably don’t need to read financial insight ever again.

Open Outcry Thank you for refreshing everyone’s memory, or lack thereof, of the entire MF Global debacle and John Corzine’s central role (August 2017). I was an MF Global account holder who withdrew most, but not all, of my excess equity from my account before it was stolen by John Corzine Unfortunately, in the United States, someone can get away with an audacious crime like Corzine’s, so long as they are wellconnected and protected politically, and wait a few years (in this case six years) before returning to the scene of the crime. [Modern Trader’s Editor-in-Chief] Dan Collins’ article does a great service of setting the record straight with the actual facts of what occurred. Some people just entering the futures arena may have no idea what actually happened, especially when some “journalists” prostitute themselves describing customers’ money as having been “temporarily...missing” as described in Collins’ article. It is beyond comprehension how these writers can look at themselves in the mirror. For myself, my funds were eventually returned after several years without adverse effects for myself or family. Unfortunately, many other people were not as fortunate and could not survive the long wait. Since no meaningful changes with any teeth have been made regarding the sanctity and safety of customers’ segregated funds, and my livelihood does not depend on the futures industry, I have permanently said good bye to any participation in that industry. It’s hard enough to turn a profit without having to worry that your money will be stolen by the custodians of your account. Thank you once again for setting the record straight with an accurate account of what actually occurred with MF Global. And, [regarding the recent redesign] I like the feel of the new paper as well as the new categorization of different topics. Sincerely, W. Ennis Nashua, N.H. Subscriber since 1996

In Open Outcry last month I responded to a reader, R. Roach from Tulsa, Okla., who objected to our editorial, “Face it Paris partisans, the climate agreement was a shakedown” (August 2017) and questioned the value of his subscription. I concluded the response with… We hope that you keep reading, but if your bubble is not big enough to accommodate articulated perspectives, which compete with your own thinking — perhaps you pitch in to help the environment, cancel your subscription… and save a tree. The response elicited more letters, including… Regarding the letter from R. Roach and [Joseph’s] response — keep up the good work!!! As a trader of 43 years I think the magazine does a fine job. There have been times that the editor/editorial section was not to my liking, however, it gave me pause to think of my position. And I did! This is the first time that I have written to you, and I thank you for a great magazine. Keep up the good work. G. Vanek Phoenix Subscriber since the ‘70s Only one reader chose to save a tree… After reading the [Joseph] reply to the [R. Roach] letter in the September issue I want to be removed from your magazine subscription. That was just ridiculous. R. Hovanec Bubbletown, USA* Former subscriber* * Publisher’s comments Jeff Joseph Publisher

Send your comments and suggestions to openoutcry@moderntrader.com M o d e r nTr a d e r. c o m

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We have been here through it all… 1972 Commodities Magazine & Financial Futures Contracts Launched

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Separating signal from the noise since 1972 ISSUE

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6

Trades High conviction ideas from top traders, analysts & insiders

Franco-Nevada: A technical gold play Q By Doug Busch A cup with handle formation is a consistent bullish continuation pattern. Stocks that can be bought as they pull back into a recent cup base are strong bullish plays. The Franco-Nevada (FNV) gold royalty company is a good gold play. FNV is already 32% higher year-to-date and sports a dividend yield of 1.2%. Earnings are moving in the right direction with three consecutive positive numbers in the last three quarters. The stock rose firmly in early August with active volume. It broke above a $76.37 cup base trigger on Aug. 10. Look to enter on a pullback at $77.50. On the weekly chart you can see the buy point above a one-year long weekly cup base pivot of 81.26, which would register an all-time high if taken out.

FRANCO-NEVADA CORP. (FNV) Source: ChartSmarter

This month in TRADES Doug Busch trades U.S. equities using traditional technical analysis with an emphasis on Japanese candlesticks. M o d e r nTr a d e r. c o m

Buy Franco-Nevada Chipotle: New health outbreak, new short

13 14

More upside to Amazon? 16

Do airline stocks have room to soar? Retail’s revenge Amazon, crude, gold & the big equity short

18 19 20

Sugar, forex & equities

21

Can Amazon keep this pace?

Amazon’s next conquest

25

22

Spin-offs outperform

23

North Korean tension & the return of risk-on/risk-off

26

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TRADES SELL

Chipotle: New health outbreak, new short Q By Joseph Parnes Chipotle Mexican Grill Inc. (CMG), the trendy Mexican-style restaurant chain founded in 1993, develops and operates more than 198 Chipotle Mexican Grill restaurants in the United States, 29 international restaurants and 23 non-Chipotle style restaurants. Denver-based CMG has become famous for its unique food services, while also becoming infamous for its candidacy as a long-term short position. Since 2015, CMG has signaled its short-selling potential and has been continuously recommended as a short. CMG relished its notoriety and its growth rate in 2015, sending the equity to an all-time high of $758.61 with a market cap of $15.19 billion, an earnings per share of 16.76 and a P/E ratio of 29.07. In the fall of 2015 the E. Coli outbreak at various stores in multiple locations across BIG LEVEL CMG took out a huge support level in July. Source: eSignal

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the United States, and the subsequent media coverage generated by the Center for Disease Control’s 2016 formal declaration of its direct association, led CMG to slash its sales and earnings forecast. This sent the stock’s price plunging from its then 52-week high of $521.52, a market cap of $12.82 billion, EPS of 0.77 and P/E ratio of 525.84, as of March 8 2017. During the same period, CMG was faced with a secondary offering of $2.9 million shares by a prominent shareholder activist, which further reducing the market’s trust in CMG. In July 2017 it was reported and confirmed that 130 customers in Sterling, Va., were contaminated by food from a Chipotle restaurant and infected by the norovirus. CMG has been unable to distance itself from its food poisoning reputation, and solidified its June 2017 guidance warning

that CMG’s operCHIPOTLE ating costs would Symbol: CMG be higher, and that Market Cap: its promotional mit$9.82 billion igation costs would 52-week high/low: rise significantly. $499/$336.51 Despite CMG’s mulEPS: 3.23 tifaceted attempts P/E: 103.81 to recover from its Short Range: damaging and hurt$330-$349 ful press coverage Cover Short: $199 as well as hindered Stop loss: $361 goodwill, CMG’s stock has continued to decline. Its continuous disappointing earnings have reinforced it as a volatile short position, with more declines in the offing.

Technical picture CMG warrants lower P/E multiples to reflect today’s slower growth rate versus its competitors. It has plunged with a down gap since mid-October 2015 with multiple plunge milestones. CMG soared above its 50- and 200day moving averages in late March 2017 after straddling those averages for most of Q1, establishing a clear reverse head-and -shoulder pattern before finally topping at $499 on May 16. CMG then began a stark decline, breaking below its 50- and 200day MA in June as well as its 50-week MA. The sell-off accelerated in July following the norovirus outbreak. CMG took out its three-and-a-half year October 2016 low, making the next clear technical support level the

In July 2017, it was reported and confirmed that 130 customers in Sterling, Va., were contaminated by food from a Chipotle restaurant. M o d e r nTr a d e r. c o m


SELL TRADES

2012 low around $240 (see “Big level,” left). This accelerated weakness pushed CMG into a Death Cross on Aug. 2, with the 50-day SMA crossing below the 200-day SMA, while the market traded below both. CMG last entered a Death Cross in late November 2016 and subsequently dropped from $576 to just below $400 in six weeks. It entered a Golden Cross (the bullish opposite of a Death Cross) this past March before rebounding 25%. CMG’s troubles are clearly not over, and the recent fundamental weakness following the norovirus outbreak has created extreme technical damage. Disclosure: The author has a short position in CMG.

DEATH CROSS CMG entered a death cross on Aug. 2 when the 50-day SMA crossed below the 200-day SMA while the market traded below both averages. This last occurred in November 2015 prior to CMG dropping more than 30% during the following six weeks. Source: eSignal

Joseph Parnes is an independent RIA with more than 30 years of trading experience. He specializes in short selling. @joseph_parnes

M o d e r nTr a d e r. c o m

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TRADES OCO

More upside to Amazon?

Yes: Amazon is different Q By Joseph Parnes Retail online giant Amazon Inc. has been the focus of intense investor speculation due to its pending acquisition of Whole Foods (WFM). However, those who have marked Amazon (AMZN) for a short position are being short-sighted and undoubtedly fail to see the opportunity to accumulate a position for solid long-term growth. Amazon’s downward momentum is not fundamentally sustainable, and its upward movements will be generated by high volatility within bid-ask prices resulting in a short squeeze. AMZN, currently boasting a stock capitalization of nearly $500 billion, was founded in 1994 and is headquartered in Seattle. The company engages in the retail sale of consumer products and service subscriptions in North America and internationally. From its humble inception focusing expressly on books, AMZN has expanded into unanticipated retail segments such as artificial intelligence, food, music, media content, publishing, manufacturing electronic devices and consumer products. AMZN’s June 2017 quarterly report indicated a 25% increase in its revenue to $38 billion while its operating income slid 51% to $628 million (adjusting for periods of earning expansion with increased investing). AMZN’s recorded capital investment

comprised of its yearly capital expenditure of $2.5 billion (up 46%) and its capital leases such as property and equipment — up 50% to $2.7 billion — has astonished the street. These numbers are indicative of AMZN’s demonstrative efforts to reinvest and refine its shipping capacity, digital video segment, Echo device and affordable cloud services solutions. Those who hold onto traditional methodologies and try applying them to AMZN fail to understand that AMZN has never followed a traditional business model. They are expecting corrections and retractions similar to other stocks, rather than embracing AMZN’s 20-year proven model as sufficient evidence that AMZN is different and has a unique growth metric. AMZN’s surprising acquisition of Whole Foods only serves to provide further support that the company has not topped off, and will continue with its forward momentum. This all has implications that will boost AMZN’s bottom line. Even in the face of a potential failure to acquire Whole Foods and expand its physical offerings, Amazon has proven itself capable of handling defeat, as it has with other failed expansion attempts (i.e., AMZN’s Fire phone). AMZN’s window for investors to purchase will eventually shut as AMZN continues to

Those who hold onto traditional methodologies, applying them to Amazon, fail to understand that it has never followed a traditional business model. 16

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evolve and reshape the future for both its shareholders and the world. Hence, keeping AMZN in your portfolio as a long-term growth solution is a smart and lucrative future investment. AMZN has broken the traditional valuation model since 1995 from its sporadic profitable quarters versus the belief of sacrificing profitability for growth. Its technical outlook indicates a status of reinforcement rather than divestment due to its P/E ratio dropping to low triple digits from a commanding high triple digits and has been on a clear pattern of ascension since 2016. Continually trading above its 50- and 200-day moving average, AMZN has been a picture of consistency leading to its rise through early June when its price temporarily breached $1,000. A sell-off has held above its July low near $950. Sporadic correction and retraction operating above 50-day MA may challenge support below this level, perhaps testing $910. Shorts in general are difficult to master because of the scarcity of float/liquidity, requiring a contrarian sense of objectivity and Amazon’s business model is equally contrarian by its nature. In the context of the market, AMZN is most solidly a long position and provides a unique opportunity for any portfolio accumulation. AMZN may not have reached the low of this correction, but there is more room on the upside. We recommend buying AMZN between $970 and $988 with a near-term objective of $1,108. Longer-term, we think that AMZN can reach $1,250. A drop below $903 would indicate further weakness, but AMZN will be back above the $1,000 mark relatively shortly. Disclosure: The author has a long position in Amazon. Joseph Parnes is an independent RIA with more than 30 years of trading experience. He specializes in short selling. @joseph_parnes M o d e r nTr a d e r. c o m


OCO TRADES

No: Amazon’s earnings tell Q By Bill Gunderson My first investment in Amazon (AMZN) was initiated on Feb. 5, 2015. At the time, the stock was trading at $377.72 per share. We finally started seeing those skinny margins begin to add up to some meaningful earnings and earnings expectations. If there is one thing that you pick up after two decades of following research reports as a professional money manager, it is that stocks and indexes follow earnings. It’s pretty simple. When earnings are going up, the index and stocks follow right along, unless of course the index gets too expensive. As long as the earnings continue to grow, the stock follows right along. Facebook (FB), Netflix (NFLX) and Amazon (AMZN) are good recent examples of that. When earnings growth begins to slow, so does the stock price appreciation. Stocks like Coca-Cola (KO), Cisco (CSCO) and Intel (INTC) are good examples of that. When earnings begin to decline, look out because the stock will follow right along. IBM, General Electric (GE) and Exxon (XOM) are good recent examples. This is why quarterly and annual AMAZON earnings reports Symbol: AMZN are watched so 52-week high/low: closely. They are $1,0831.31/$710.10 the best evidence Market cap: $472.77 billion and indicators EPS: 5.31 of the trajectory P/E: 185.47 of earnings and

future expectations. If a company misses expectations and guides lower, the stock immediately adjusts lower. Conversely, if a company exceeds estimates, the stock will almost always break out to new recent highs. We saw this with Boeing (BA) and Caterpillar (CAT) in late July. My initial long on Amazon in early February of 2015 followed expectations its earnings were finally starting to ramp up. After losing 52¢ per share in 2014, expectations were for Amazon to turn profitable in 2015, which it did. Amazon ended up making $1.25 per share in 2015 after that 2014 loss. But the real number that caught my eye was its 2016 expected earnings growth of more than 300%. AMZN exceeded that, reporting annual earnings of $4.90 per share in 2016, nearly 4X its 2015 earnings. By late October of 2016, my position in Amazon was up 105%, and we were headed into the last few weeks of a hotly contested presidential election. Amazon had become a bit pricey at that point, so I took profits on Nov. 2, 2016, at $776 per share, a gain of 105%. Initially, this turned out to be a good move as the election did not go as expected and the tech stocks suddenly took a back seat to the banks and financials. AMZN made multi-month lows in midNovember and earnings expectations began to ramp up once again. I got back in on Jan. 12 at $804.86 per share. The stock has been one of the biggest winners in the market in 2017. That Jan. 12

When earnings growth begins to slow, so does the stock price appreciation. M o d e r nTr a d e r. c o m

position was up more than 25% by June and earnings expectations continued to go higher as Amazon took on one business after another. By June 19, 2017, Amazon’s shares were up 50,293% since its 1997 debut. Amazon chief Jeff Bezos had become the second richest man in the world and would soon pass Bill Gates at #1. He actually did pass Bill Gates briefly in July on the morning Amazon hit new all-time highs. But then, something happened later that morning before the company was to report after the close. The stock and the Nasdaq began turning around and selling off quite aggressively. Amazon earnings fell far short of expectations after the market closed. It is hard for me to believe that some big players did not know that Amazon was going to whiff big time on its after-hours report. Nothing else would explain that sudden mid-day turnaround. Amazon’s Q2 earnings report was one of the biggest whiffs in a long time. I exited the long the following week. On June 19, AMZN was expected to earn $12.43 per share and continue to grow by 29% per year over the next five years. My five-year target was $1,635. Following Amazon’s disappointing report, the consensus earnings estimate for 2018 have plunged from $12.43 per share to $8.76 per share. This 29.5% drop in expectations is one of the quickest and most stunning turnarounds in the expectations for a stock. It is bit strange to see that the stock is only down 6.2%, while earnings expectations have plunged by 29.5%. It may have further to fall before earnings expectations rebound. Just when a company and its CEO seem invincible, you realize that the company is going through some severe growing pains. It’s time to look elsewhere while Amazon sorts some things out. Disclosure: The author has no positions in any of the stocks mentioned. Bill Gunderson is a wealth manager and president of San Diego-based Gunderson Capital Management, and the creator of the Best Stocks Now app. Issue 536

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TRADES INDUSTRIES

Do airline stocks have room to soar? Q By John Blank Summer is the time Americans look to travel to their favorite vacation spots, whether to a lake, a beach or the mountains; and this year folks appear ready to go. The Airline Transportation industry in July was ranked by Zacks Industry Rank System at #13 out of 265 industries. That puts this 25-company strong group in the top 5%. Year-to-date returns have been 19.8%, nearly doubling the 10.8% return of the S&P 500. This indicates a nice share price outperformance. Can it continue? Putting a share price bottom in July 2016, airline stocks soared in the second half of 2016 and first half of 2017, led by two of the three biggest players: American Airlines (AAL) and United Continental (UAL). Global commercial airlines made record net profits in 2016 of about $35 billion, according to the International Air Travel Association (IATA). That’s way up from nearly $14 billion in 2014, and about the same as in 2015. North American commercial airlines felt the upswing the most, representing about $20 billion of that 2016 profit. However, for 2017, forthcoming IATA travel revenue data may be lower. Airlines shoulder a lot of significant risks, particularly macro factors such as sudden shifts in personal disposable income and spending patterns, safety concerns over terrorist attacks, oil price shocks and analyst sentiment. All of these can turn quickly and weigh on airline profits. In addition, the United States’ welcome mats have been selectively removed from our airports. The world’s tourists (more broadly) have taken notice. Prior to March 2017—the time of the second Presidential executive order travel ban—New York had forecast an increase of 400,000 foreign visitors to the city in 2017. Forecasts made after the travel bans predicted a decline of 300,000 foreign visitors to New York in 2017. Let’s see what actually happens. The 18

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October 2017

TOP RATED INDUSTRIES Top stocks in top rated industries Source: Zacks

Industry Semiconductor Equipment-Wafer Fab Semiconductor-Discretes Retail- Consumer Electronics Soap and Cleaning Materials Auto-Foreign Glass Products Transportation-Airline Manufacturing-Farm Equipment Food-Meat Products Manufacturing-Material Handling

Top Stocks AMAT TOELY AAN RBGLY BAMXF APOG AFLYY AGCO SAFM DSCSY

LRCX VSH BBY UN DDAIF OI AAL DE TSN MCRN

ASML CONN CHD MZDAY DAL LNN

BEST IN FLIGHT Top rates airline stocks by Zacks. Source: eSignal

U.S. Supreme Court allowed parts of the travel ban to stand and will hear arguments and write its opinion on the travel ban later this year or early next year. As to longer-term risk management, look for order deferrals on large aircraft. This is an indicator of how airlines view future demand. The top Zacks #1 Rank (strong buy) airline picks are: Air France (AFLYY), American (AAL), Delta (DAL) and Southwest (LUV).

Why these four? Share price momentum is clearly on (see “Best in flight,” above). The long-term Zacks value, growth and momentum (VGM) score is “A” in all four cases. There is more future growth to chase at a reasonable current stock price. John Blank is the chief equity strategist at Zacks. He covers the global financial markets for Zacks.com. @ JohnBlank100 M o d e r nTr a d e r. c o m


ETFS TRADES

Retail’s revenge Q By Matt Litchfield

Americans love stories about self-made men who built their business empires on sweat and ingenuity. Titans like Andrew Carnegie, Henry Ford, Warren Buffet and Bill Gates, and now it seems Jeff Bezos has joined their ranks. Nothing has captivated investors like Amazon’s (AMZN) share price cresting at $1,000, generating annualized returns close to 29% during the last decade and briefly making Bezos the richest man in the world in the process. Small wonder that so many are willing to overlook that Amazon only recently became profitable, thanks to cloud computing, not retail. And even then, its profit margin is so thin that buying a supermarket chain—the epitome of a low-margin business—like Whole Foods (WFM) will actually drag it higher. However, we’re not here to talk whether Amazon is still a good investment, but to point out that in a market addicted to stories, the company’s phenomenal growth has reached a point so extreme that exchange-traded fund heavyweight ProShare Advisors has filed paperwork with the Securities and Exchange Commission to create several new funds that are long online/short brick and mortar retailers in both an unlevered and 2x or 3x levered format to help investors reap more profits from the industry’s inevitable passing. But while most are blinded by Amazon’s success, a few remember that the best time to buy is often when there’s blood in the street and there’s no bloodier part of the market right now than retail. A year ago, we talked about looking for overlooked bargains and coming up with nothing but depressed retailers, not much has changed (see “Amazon, arbitrage & M o d e r nTr a d e r. c o m

retail ETFs,” Modern Trader, August 2016). Even the biggest brick-and-mortar retailers like Wal-Mart (WMT) and Home Depot (HD) are lucky if their stock prices are positive and only trailing Amazon’s by less than 20% compared to the previous year. But that relative lack of performance has only helped to make retailers relatively more attractive, and even as Amazon geared up for its last big push to $1,000, the largest dedicated retail ETF (the SPDR S&P Retail ETF (XRT)) found a double bottom and it wasn’t thanks to its 1.1% allocation to Amazon. We mentioned in that article that XRT is an equally-weighted fund where the close to 100 holdings start with same weight in the portfolio after each rebalancing, which means more volatile small-cap stocks play a much larger role in the portfolio than in market-cap weighted funds like the Consumer Discretionary Select Sector

SPDR Fund (XLY) or the VanEck Vectors Retail ETF (RTH) where bigger names rule the roost; with 16% and 20% of their respective portfolios invested in Amazon. Those large allocations to Amazon meant healthy returns to both funds in the 12-month period ending in July, although neither could keep up with the broader S&P 500. Until now, XRT’s broad base of retail stocks might have offered investors exposure to the wrong side of the retail trade, but that long list of names could mean the recent double-bottom is signaling the sector is starting to heal. If that is the case, market-cap weighted funds like XLY and RTH with large positions in Amazon could find themselves between a rock and a hard place if investors begin to shift from Amazon to more value-oriented names (see “ETF reversal?”). If that does come to pass, RTH could potentially suffer a double whammy from its concentrated portfolio. With just 26 of the largest names, any rally that involves smaller retailers or specific subsectors could leave investors missing the potential upside while simultaneously being exposed to profit taking in an overextended Amazon. Matt Litchfield is the content editor for ETF Global at ETFG.com. @ETF_Global

ETF REVERSAL? If Amazon corrects and challenges smaller retailers rebound, the equal weighted XRT will likely outperform market cap weighted indexes like the RTH. Source: eSignal

Issue 536

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TRADES CYCLES

Amazon, crude, gold & the big equity short Q By John Rawlins AMAZON (AMZN)

The Cycle Projection Oscillator (CPO) is a technical tool that employs proprietary statistical techniques and complex algorithms to filter multiple cycles from historical data, combines them to obtain cyclical information from price data and then gives a graphical representation of their productive behavior. Other proprietary frequency domain techniques then are employed to obtain the cycles embedded in the price. Amazon (AMZN) has been a top performer for several years, but the CPO did not capture the correction from its later July high. In fact, the sell-off has put AMZN close to oversold territory in the CPO as it anticipates the market to grind higher into December. This is a good buying opportunity. However, the CPO anticipates Amazon making a significant top at the end of 2017, which should set up an opportunity to short. Crude oil: After some volatile swings, crude oil has seemed to settle into a range in August. Don’t expect that to last. The CPO is indicating that the early August halting rally should top off around $50 and for crude to head lower into October, though it probably won’t take out the summer lows around $42 per barrel. Any fall sell-off should be seen as a buying opportunity as the CPO expects crude to rally sharply in Q4, challenging the 2017 high. That rally is expected to peter out by yearend and set the stage for a massive sell-off in Q1 of 2018.

CRUDE OIL

GOLD

Gold started 2017 off with a massive rally that has been followed by three large swings moving the shiny metal between $1,200 per ounce and $1,300 per ounce for most of 2017. The CPO is expecting gold to settle down in a range for the rest of 2017. The CPO indicates that the current short-term rally in gold has a little upside left before it will turn lower in the fall. However, it does not anticipate a major move, so any push to either end of gold’s 2017 range would be an opportunity for a range trade. S&P 500 (SPX): The CPO has been anticipating a major move lower in all of the stock indexes this summer, but each time this appears to be in the works, equities rebound to new highs. The most recent strength has moved the SPX into overbought territory in the CPO just as it is indicating a sharp move lower. Could the longanticipated sell-off be on the way? The CPO thinks so, and it could be huge, challenging the November 2016 election lows.

SPX

John Rawlins is a former member of the CBOT with more than 30 years of experience in trading and research. He co-developed the Cycle Projection Oscillator with an aerospace engineer. @cpopro1 20

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M o d e r nTr a d e r. c o m


COT TRADES

A look at long-term trends of commercial interest in the CFTC’s “Commitments of Traders” report. Market

Net Commercial Position

Currencies

4 Week Net Change +/-

Commercial Trader Momentum

Trend, Sideways, Reversal

AD

-71,209

Negative

Sideways

BP

21,158

Negative

Reversal -

CD

-41,516

Negative

Sideways

DX

-2,800

Positive

Reversal +

EC

-115,535

Negative

Reversal -

JY

138,464

Positive

Sideways

SF

-2,283

Negative

Sideways

MP

-119,200

Negative

Reversal -

-81,768

Negative

Reversal -

C

-152,586

Negative

Trend -

KW

-84,794

Negative

Trend -

S

-21,381

Negative

Trend -

SM

-22,915

Negative

Trend -

W

-16,159

Negative

Trend -

O

-3,490

Negative

Reversal Sideways

Grains BO

Rates ED

2,059,488

Positive

FN

394,070

Positive

Sideways

TY

-97,813

Negative

Sideways

US

-43,474

Negative

Sideways

GC

-103,343

Negative

Sideways

HG

-23,341

Negative

Sideways

PL

-15,067

Negative

Sideways

SI

-29,532

Negative

Sideways

CL

-422,066

Negative

Sideways

HO

-14,909

Negative

Sideways

NG

14,491

Positive

Reversal +

RB

-57,782

Negative

Reversal -

Metals

Energy

Softs CC

34,023

Positive

Trend +

CT

-24,441

Negative

Trend +

KC

12,469

Positive

Sideways

OJ

3,709

Positive

Trend +

SB

51,912

Positive

Trend +

Meats FC

-3,080

Negative

Reversal -

LC

-89,602

Negative

Reversal -

LH

-42,817

Negative

Reversal -

DJ

-66,175

Positive

Sideways

ES

-19,707

Positive

Sideways

ND

-48,573

Positive

Sideways

RU

24,152

Positive

Sideways

Indices

M o d e r nTr a d e r. c o m

Sugar, forex & equities Q By Andy Waldock Commercial traders in sugar futures have set another net long record position. The October futures contract has successfully defended the low mentioned last month, and the commercial traders appear to be forcing the weaker speculative positions out of the market. There is a growing disparity between the Indian sugar market supplies as reported by mainstream news versus what appears to be popping up on smaller grassroots sites. Many agencies have been calling for an increase because last year’s El Niño hindered production by at least 15%. However, the commercial sugar refiners don’t seem to trust what they’re hearing. The record-setting purchases by the sugar mills along with a widening spread between the October 2017 and March 2018 sugar contracts are both indications of nearterm tightness. We expect the October sugar futures to continue to rally through the last trading day (Sept. 29). Currencies: The currency markets have finally had some directional movement and are testing multi-year levels. Thus far, we’ve seen standard actions by the commercial traders who are scaling into their trades on a counter-trend basis. The U.S. Dollar Index is threatening its 2016 low near 91.50. Commercial traders maintained a net short position greater than 50,000 contracts the entire time the Dollar Index was trading above 100. However, net commercial purchases since mid-June are threatening to push the commercial trader net position into positive territory for the first time since early 2014. We expect commercial buying to show up at the lows, but their mid-range total position size indicates they are not ready to commit to a dollar bottom, yet. The euro is testing its August 2015 high around $1.20 and is clearly being pushed by speculators as they are long 1.85 contracts for every contract they’re short. This is the most bullish speculative COT ratio since November 2013. This is an overbought indication. Commercial short-selling could quickly force speculative losses on a decline to near-term support around $1.12. Stocks vs. bonds: Money flowing into the stock market equals “risk on.” Money moving from the stock market to the long side of the bond market equals “risk off.” Based on the action, we’re seeing in the COT report, we want to do two things. First, we don’t think bonds will attain the new high we mentioned previously. However, we do still expect to be able to sell them above June’s high. A pullback in the stock market, specifically the December Dow Jones futures, is inevitable. Speculators are long the Dow futures at an eight-to-one ratio. Speculators being washed out of their Dow positions are likely to funnel money into interest rate futures. The commercial traders are typically one step ahead of the speculators. Therefore, expect commercial traders to initiate short interest rate positions on a speculative flight to quality. Andy Waldock is a futures trader, analyst and founder of the brokerage firm Commodity & Derivatives Advisors. @waldocktrades Issue 536

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TRADES OPTIONS

Can Amazon keep this pace? Q By Dan Keegan On July 5, 1994, Jeff Bezos founded Amazon.com Inc. It was based in Seattle but its reach was worldwide. It started out as an online bookseller and eventually Amazon drove Borders Books into bankruptcy. It was a short life for Borders, which was portrayed as an evil predator to mom and pop bookstores, but Amazon would grow to become the real Death Star to brick and mortar retail stores. Amazon now sells just about everything online and it is even looking to deliver most of its products via drones. On May 5, 1997 Amazon (AMZN) went public at $18 per share. A year later it split 2X1, and would split twice more, 3X1 in January 1999 and 2X1 in September of that same year. AMZN stock has not split since and this summer it has breached $1,000.

Split adjusted, AMZN’s IPO price was $1.50. If you had invested $10,000 on the IPO date your investment would currently be worth $6,666,666.67 (see “Amazon explosion”). Jeff Bezos is battling fellow Seattle resident, Bill Gates, for the title of world’s richest person. In 2015 AMZN surpassed Wal-Mart (WMT) as the world’s biggest retailer. The current P/E for WMT is 18.4. The current P/E for AMZN is an astounding 186! If WMT had the same P/E as AMZN, it would be trading at $810. The market obviously believes that AMZN will grow much faster than Walmart, and that it will eventually dwarf Apple (AAPL), which also has a P/E of 18.4. Therein lies the rub. The trend is your friend and the trend is definitely pointing upwards, but the P/E seems ridiculous.

The trend is definitely pointing upwards, but the P/E seems ridiculous. AMAZON EXPLOSION Amazon stock has grown 700X since its 1997 IPO. Source: eSignal

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The first thing you need to do when looking at establishing an options position is to look at is the skew. If the demand for out-of-the-money puts is greater than equidistant out-of-the-money calls, then it is positively skewed to the downside and negatively skewed to the upside. That is the way that options on most equities trade. The SPDR S&P 500 exchangetraded fund (SPY) August 240 puts have an implied volatility of 11.28%, and the SPY August 255 calls have an implied volatility of 6.57%. SPY moves down much faster than it moves up, according to the skew. The AMZN September 935 puts have an implied volatility of 22.74% while the September 1065 calls have an implied volatility of 21.74%. It is a normal distribution as opposed to the asymmetric distribution in SPY. Ratio spreads are therefore out of the question. Here are two options scenarios to play on Amazon. Four weeks before the Sept. 1 weekly expiration AMZN closed at $988.90. The 1010 calls are trading at 12.10 and the 1015 calls are trading at 10.40. Going long five 1010-1015 vertical spreads at 1.70 would cost $850. That would be your max loss at $1,010 or lower on expiration. It currently gives you an equivalent share position of 25 long shares. Your max profit would be $1,650 at 1015 or higher at expiration. The 1020 calls are trading at 9.20. You can reduce your cost by selling the 1020-1015 call vertical at 1.20. You have a max profit of 1.20 ($600) at 1015 or lower and a max loss of 3.80 ($1,900) at 1020 or higher. The max profit, if you combine the two spreads, would be $2,250 at 1015, where the max value for both spreads begins. The most that you could lose would be $250 when AMZN trades below $1,010 or above $1,020 (see “Hitting the middle,” right). Before expiration as AMZN approaches $1,015 the spread would increase in value. It would be a marginal increase, expanding most during expiration week. On the downside, you could buy five Sept. 22 weekly 960 puts at 18.10 and sell five Sept. 1 weekly 960 puts at 10.60 for a cost of $3,750. That is your max loss on the trade. The equivalent share position M o d e r nTr a d e r. c o m


SPIN-OFFS

for this spread is short 25 shares. There is no exact profit for a time value spread like there is for a vertical spread. When the short side is expiring, you don’t know what the demand will be for the long side that has three weeks left. Currently the Sept. 1 put has an implied volatility of 20.76%, while the Sept. 22 put is at 21.40%. The ideal spot at expiration is $960 since your short goes out worthless as your long gains in value as it approaches $960. When AMZN moves in either direction adjustments should be made. When it moves up you could sell of your long puts and buy a cheaper put nearer to expiration. You could sell put vertical as well. Dynamic hedging gives you the greatest odds of success.

TRADES

HITTING THE MIDDLE By executing a bullish vertical call spread, you ensure a significant profit with defined risk. If you are confident Amazon will trade up to the $1,015 range, you can improve profit potential and reduce overall risk by also executing the short 10201015 call spread, though you would need Amazon to settle within the $1,010 to $1,020 range. Source: eSignal

Dan Keegan is an options instructor and founder of optionthinker.com.

Spin-offs outperform Q By Joe Cornell BEATING THE BENCHMARK Source: Spin-Off Research

M o d e r nTr a d e r. c o m

You can beat the Street. At a time when many professional investors lament that the proliferation of exchange-traded funds (ETFs) and widespread use of screening techniques have made it harder to find bargains in the stock market, one simple investing approach continues to outperform: spin-offs. Spin-offs have long been a fruitful investment area; a number of academic studies show that they historically have generated far better returns than the overall stock market. A spin-off occurs when a corporation issues stock in a subsidiary to its shareholders to create a new public company. A related corporate event is an IPO carve-out, through which a company sells the public a stake in a unit, while retaining the rest of the division. Sometimes, the remainder is later distributed to shareholders. The Bloomberg U.S. Spin-Off Index has surged 18.9% in the first seven months of 2017. The S&P 500 Index has increased 11.6% in that same period (see “Beating the benchmark,” left). The spin index Issue 536

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TRADES SPIN-OFFS

Last year, there were 35 total spinoffs, with a total market value of $100 billion. generated a total return of 182% in the past five years (versus 99% for the S&P 500). The Bloomberg US Spin-Off Index has produced a total return of 867% since its Dec. 31, 2002 inception. The S&P 500 generated a total return of 278.5% over the same time frame. Why do spin-offs outstrip the market? Spin-offs benefit from greater management focus and accountability as stand-alone

SPINNING RETURNS The Bloomberg Spin-Off Index has outperformed the broad markets over the last decade. Spin-Off Research

Total Return

YTD

5-year return

10-year return

Bloomberg Spin-Off Index

18.90 %

182.09%

246.20 %

S&P 500

11.65%

99.71%

109.21%

public companies versus when they were part of larger enterprises. The rational for spin-offs varies. Some companies wish to get rid of a weak or low-margin division that is detracting attention from the parent. Other companies seek to highlight the attributes of a desirable unit whose full value may not be reflected in the parent’s stock price. There also is pressure on management from the growing number of activist

investors, whose prescription for a lagging stock often is a breakup. Last year, there were 35 total spin-offs, with a total market value of $100 billion (see “2016 Spin-Off form,” below). Joe Cornell is the founder and publisher of Spin-Off Research, a Chartered Financial Analyst and author of Spin-Off to Pay-Off. @spinoffresearch

2016 SPIN-OFF FORM Completed 2016 spin-offs Source: Spin-Off Research

Completed Spin-Offs YTD No.

Parent

Symbol

Spin-Off

Symbol

Announced

Spin-Off Date

Ratio

1

Hilton Worldwide

HLT

Hilton Grand Vacations

HGV

2/26/2016

1/3/2017

1:10

2

Hilton Worldwide

HLT

Park Hotels & Resorts

PK

12/16/2015

1/3/2017

1:2

3

Varian Medical Systems

VAR

Varex Imaging Company

VREX

10/23/2016

1/28/2017

0.4:1

4

Biogen

BIIB

Bioverativ

BIVV

5/3/2016

2/1/2017

1:2

5

Hewlett-Packard Enterprises

HPE

DXC Technology

DXC

5/24/2016

4/1/2017

1:1

6

Hess

HES

Hess Midstream Partners

HESM

7/30/2014

4/5/2017

CO

7

Ashland

ASH

Valvoline

VVV

9/22/2015

5/12/2017

1:2.745

8

TEGNA

TGNA

Cars.com

CARS

9/7/2016

5/31/2017

1:3

9

SEACOR Holdings

CKH

SEACOR Marine Holdings

SMHI

11/30/2015

6/1/2017

1.007:1

10

Societe Generale SA

SCGLY

ALD SA

ALD FP

2/19/2017

6/16/2017

CO

11

Ionis Pharmaceuticals

IONS

Akcea

AKCA

3/27/2017

7/14/2017

CO

12

Vornado Realty Trust

VNO

JBG SMITH Properties

JBGS

10/31/2016

7/17/2017

1:2

13

Huntsman

HUN

Venator Materials

VNTR

4/26/2017

8/3/2017

CO

14

MetLife

MET

Brighthouse Financial

BHF

1/12/2016

8/4/2017

1:11

CO = Something ? 24

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M o d e r nTr a d e r. c o m


EARNINGS TRADES

Amazon’s next conquest? Q By Christine Short This spring Amazon (AMZN) celebrated its 20th anniversary as a publicly traded company. In that time, the Internet retailer has continually grown, now with the fourth highest market capitalization of all public companies at $487 billion. Only Apple (AAPL), Alphabet (GOOGL) and Microsoft (MSFT) come in higher. What started as a business looking to disrupt the bookstore industry has disrupted multiple additional sectors with their own inefficiency vulnerabilities. The Amazon everyone knows best is the online retailer. The core e-commerce business continues to grow thanks to the strength of Amazon Prime. Amazon’s ecosystem includes exclusive products, such as Amazon’s Kindle and Echo, which require access to Prime. During the past year, Amazon Prime memberships have nearly doubled, now estimated at 80 million with

AWS GROWTH PATH AWS has shown solid growth over 10 quarters. Source: Amazon

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almost half of all U.S. adults having Prime subscriptions. In fact, the company’s third annual Prime Day, held in July, was the largest ever global shopping event for Amazon, selling more than 40 million items. More individuals signed up for Prime than any other day in the company’s history. Given Amazon’s dominant market share, the company still maintains modest margins from its global scale and footprint. Amazon’s focus on superior customer service helps drive higher purchase frequencies, larger order sizes and an overall better customer experience. But Amazon isn’t just about retail anymore. Amazon Web Services (AWS) is one of the company’s most profitable divisions and is often thought of as a key engine of growth. AWS currently leads the cloud infrastructure industry, representing about 30% of the market. The company has seen AWS revenues grow by double digits yearover-year for the last 10 quarters (see “AWS growth path,” left). In recent years, large enterprises such as Netflix (NFLX) have migrated to AWS to be its platform provider, which validates its credibility and reliability. In addition, this year Amazon has begun expanding its web services in five new regions, including China, India and the UK. Heavy investments in global expansion on top of Google (GOOG) and Microsoft’s ascension in cloud computing will put pressure on

Amazon’s margins. On the bright side, the expected growth in cloud computing and the Internet of Things should support an optimistic outlook as Amazon continues to expand its web services. The latest industry Jeff Bezos has decided to take on is grocery stores. Amazon is trying to disrupt this space using a two-pronged method that invests in both online grocery delivery and brick and mortar locations. Amazon Fresh rolled out its invitation-only beta test grocery delivery service in the Seattle area in 2007, and currently owns a very small slice of the online food delivery market. In aggregate, online grocery orders account for 2% of all grocery shopping. The main reason for this is that many consumers want the ability to pick out their own produce and proteins, and Amazon realizes that there will always be a market for these people. As such, they began experimenting with Amazon Go earlier in the year in Seattle, a brick and mortar model that charges customers for the products they buy through an app on their phone, reducing the need to wait in a checkout line. The company made further moves into the physical grocer space in June when they purchased Whole Foods (WFM) for $13.7 billion. While it may seem like an odd choice for a retailer known for value pricing to buy a high-end grocer, it’s their customer loyalty and favorable employee policies that make them a desirable purchase. Also, with 450 stores, Amazon can get closer to their customer. There are endless debates on which, if any, retailers can catch up to Amazon. Typically Wal-Mart (WMT) is the only name mentioned with any confidence. Not only does it have the capital to even the playing field, but it also has the real-estate to establish the necessary warehouses. Their purchase of Jet.com in 2016, and of Bonobos on the same day of the Whole Foods acquisition, shows just how serious they are to reestablish themselves as the world’s largest retailer, and could potentially be a concern for Amazon going forward. Christine Short, Estimize senior VP, is an expert in corporate earnings who produces content highlighting Estimize data. @Estimize Issue 536

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TRADES FOREX

North Korean tension & the return of risk-on/risk-off Q By Abe Cofnas Currency trading in the coming months will require more attention to fundamental and sentiment analysis than usual. Rising tensions relating to North Korea’s nuclear capability are generating special challenges to currency traders. Currency price direction that commonly reflects economic expectations relating to monetary policy and interest rate differentials is being punctuated by sudden unexpected comments by President Trump and responses from North Korean leader Kim Jong-un. This war of words can distort price patterns. For example, bullish sentiment in the U.S. dollar grew on Aug. 4 due to a better than expected jobs report. However, bullish persistence was thwarted by increased geopolitical tension due to the North Korean situation, and in particular, following Trump’s “fire and fury” remarks of Aug. 8. The bearish reaction in the U.S. dollar/ Japanese yen (USD/JPY) currency pair and related pairs are leading indicators of what the future may hold for currency traders. Currency strategies based on reliable technical patterns and long-term fundamentals are being trumped by a return to riskon/risk off trading and safe-haven flows: the VIX increases, the yen and CHF get stronger and gold surges. They follow principles of crowd behavior. The initial reaction to an aggressive Trump tweet or a North Korean missile test or threat is to take capital out of harm’s way.

CURRENCY PARIS IN THE CROSSHAIRS These currency pairs likely will be sensitive to North Korean tensions. LIKELY REACTION TO CURRENCY PAIR SPIKE IN TENSION USD/JPY BEARISH GBP/JPY VERY BEARISH XAU/USD (gold) BULLISH EUR/CHF BEARISH

The challenge ahead is how to monitor and trade through these turbulent forex waves. A first step is to establish safe-haven patterns. A good idea is to have the Japanese yen (USD/JPY), gold (XAU/ USD) and Swiss Franc (USD/CHF) on your screen. If geopolitical news comes out, the five-minute pattern provides an early signal of the strength and seriousness of the reaction. This concept reflects the principle that a currency pair will remain in a pattern until news breaks it out of its pattern. A key metric for measuring the strength of the move is whether the pair involved is able to engender a sequence of new high or new low closes. The forex sector often is the first to read and react to geopolitical news. A second clue to provide insight into how the currency market is responding to North

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Korean tensions is realized by monitoring the CHF cross pairs. The Swiss franc gains strength during geopolitical tension. Knowing this, the CHF pairs should be generally bearish, and one of the best crosspairs to be watched is the euro/Swiss franc (EUR/ CHF) pair. Because the euro has been relatively strong due to economic conditions, how the euro reacts in the context of a North Korean crisis will be particularly revealing. Money will tend to flow out of the euro into the CHF. A strong euro will be no match for the strengthening CHF in the case of a riskon/risk-off market. This crosspair will provide a quick confirmation of whether the tensions are cascading throughout the currency markets. It will also provide confirmation of stress relaxation as tensions recede and the EUR/CHF returns to a bullish pattern. A third approach to trading the next North Korea provocation would be to find a currency pair that magnifies the move. The British pound/Japanese yen is such a pair. The pound has been bearish, independent of a rise in geopolitical tensions. This is mainly due to Brexit uncertainties coupled with a decline in consumer confidence and negative real wage growth. The pound will be particularly vulnerable to a safe-haven move into the yen and GBP/JPY will likely lose more than other yen crosspairs. Trading through tensions in North Korea and other geopolitical hotspots requires good timing skills and diligence. Nervous markets produce sharper spikes. Stops and resting orders can be dangerous as can holding positions overnight. Monitoring a set of underlying instruments (USD/JPY, XAU/ USD, EUR/CHF, GBP/JPY) will provide real-time clues to how global markets are reacting. An actual outbreak of hostilities will completely change the trading environment and present huge obstacles to trading. Margin requirements will certainty increase. Stops will be taken out with a great deal of slippage. The USD/JPY may strengthen by 1,000 pips. Central banks may coordinate intervention to stabilize the currencies. The best approach to trading in such a scenario would be to stand aside and let price action confirm a relaxation of tensions. Abe Cofnas is a fundamental forex trader and coach. @abecofnas M o d e r nTr a d e r. c o m


F E AT U R E

Options’ Options

FEATURE STORIES Options on ETFs & ETFs on options 28 PUT a cap on drawdowns 32 Weekly options: A more precise tool 36

Options products are constantly evolving. When listed options were first launched only calls existed and you could only buy them. The creation of additional products and strategies marches on, from weekly options to index options. Here, we look at the nexus of option and exchange-traded fund innovation to share the newest risk management tools. We also dig deep into the world of binary options — a backwater consisting of unseemly players just a few years ago, it now appears to have come of age with additional markets to trade and competitive players.

Binary options are here to stay 38 Volatility as an asset class 42

Finally, we go over the history of the use of options in managed programs. It tells the story of how volatility trading has moved from a niche strategy to a legitimate asset class. There appears to be renaissance, by both professional and retail traders, in option writing strategies. This could be a problem once volatility returns to more normal levels.

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Options on ETFs are growing, and so are ETFs that offer exposure to options strategies.

Options on ETFs & ETFs on options Q By Daniel P. Collins

There is a growing demand for options on exchangetraded funds (ETFs) as well as ETFs that deliver optionsbased strategies. It is the result of the endless pursuit of yield in a period of shrinking volatility along with the long-term trend toward passive investment strategies. On the latter, it may be fair to point out that movement toward greater investment in passive strategies may be more the product of financial innovation within that space than the more traditional — and frankly tired — debate between passive and active investing. We will delve into that later, but it will be good to remember why ETFs were first created, which was to make investing in certain financial products, strategies and asset classes easier for the retail investor. The first ETF created was on Standard & Poor’s depositary receipt (SPDR) and it allowed investors to gain access to the S&P 500. Before that, a trader would have had to trade S&P 500 futures, which was something restricted from most registered investment advisors (RIA) and thought to be too risky for the ETF OPTIONS GROWTH Options on ETFs have grown steadily during the last decade. Source: The OCC

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average retail trader; or a trader would have to try to replicate the entire 500-member index with individual stocks. “The ETF market has grown in leaps and bounds over the last few years because there has been a seismic shift from active management strategies to passive strategies,” says Bill Looney, CBOE Global Client Services, Head of New York (see “ETF options growth,” below). “In 2016 something like $800 billion in assets moved into ETFs — about $500 billion of which where new money flows and $300 billion were out of mutual funds and into ETFs.” The main factor for that growth is lower fees, which is not surprising. What is surprising perhaps is that it has led to growth in options trading. “A lot of growth in options volume [is] a direct result of that money flow into the underlying ETFs, where customers will seek to hedge, speculate or yield enhance through the use of those options,” Looney says. He attributes a lot of the options volume growth to premium selling due to the advent of weekly and shorter-term duration options. “Retail customers, RIAs [and] institutional customers seek to sell short-term premium because the yield capture from selling that volatility has proven to be extremely profitable over the last couple of years,” Looney says. “It creates higher risk-adjusted return, higher Sharp Ratios and overall the market has had no significant volatility even where a majority of people have gotten hurt trading those strategies in any meaningful capacity.” He has also seen an increase in traders selling puts. “This strategy has grown back to be in vogue with the retail and institutional community. It has been quite some time since we’ve seen this strategy being used by such a broad array of market participants. It is a very compelling strategy and it is a very compelling yield,” Looney says. In recent years, volume has concentrated in a few names; more than 50% of overall options volume occurs in 15 names, of those 15 names, ETF options like SPDRS, IWM, QQQ and EEM are included. M o d e r nTr a d e r. c o m


A lot of growth in options volume [is] a direct result of that money flow into the underlying ETFs. --Bill Looney

ETFs on options?

The logic behind PUT is that the ETF sells an at-the-money put and receives a premium. If SPX settles above the put it is out-ofthe-money and collects the premium. If SPX falls, you lose the value of the retracement minus the premium it collected. It will reduce losses in a down market, earn money in a flat market and restrict upside to the premium collected (see “PutWrite skinny,” page 30). Option writing has always been viewed as a risky strategy, which is why it makes sense to use it through an ETF structure. Recently, with the historically low volatility, more retail investors are looking to sell premium (see “Shrinking vol,” below). “The strategy is in vogue; it produces substantial returns over a longer period of time and customers that seek S&P exposure coupled with anywhere between a 20% and 30% blend of the Put Write ETF or that strategy creates for them a much higher riskadjusted return versus being long the S&P,” Looney says. “It is very compelling from that standpoint.” It provides yield in an environment where it is extremely tough to find SHRINKING VOL and in an asset class not typically Volatility as measured by the VIX has shrunk from already historic low levels. used to find yield. Looney expects to Source: eSignal see more of these options strategies offered in ETF wrappers. “It is a differentiator. It is impressive when you look at the research and the returns that these products can offer over a period of time. It is not a shortterm play, we are not talking about the VXX or some of the levered ETF products linked to volatility assets; those are a different animal,” he says. “But from the standpoint of strategy, generation of yield is easier to achieve in the equity market through the sale of options, given the market’s bull run of the last couple of years because those strategies

While options traders have turned to trading options on ETFs — as mentioned above — the main value of creating ETFs was to allow retail traders to access markets, strategies and asset classes in a simpler fashion. The Chicago Board Options Exchange (CBOE) has created a series of benchmark indexes that use options strategies to formulate returns. They have licensed ETF issuers such as Wisdom Tree and ProShares to create ETFs based on those benchmarks (see “Put indexes lower volume,” page 32). “We are seeing significant interest in these products. Wisdom Tree has licensed the Put Index (PUT) from CBOE, which sells one month at-the-money options on the S&P 500 Index. The asset growth in that is close to $200 million, up significantly in the last 60 to 90 days,” Looney says.

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“It is moving from being passive to more of a structured product where ETF issuers are using options as a tool to provide additional yield.”

--Kapil Rathi

have really panned out, so investors are seeking a portion of their portfolio dedicated to those strategies.” Kapil Rathi, senior vice president for options business development at CBOE, says the growth in ETF is a direct result of retail and institutional traders taking a passive approach. That passive approach is becoming more nuanced because of the new products available for issuers to create. Why should a trader, or RIA for that matter, learn the intricacies of options when they can buy a ready-made ETF off of the shelf? “These customers traditionally have not been that open to trading options. The ETF market has been a step up giving exposure to the derivatives by using ETFs as a mechanism,” Rathi says. “It is moving from being passive to more of a structured product where ETF issuers are using options as a tool to provide additional yield. It is going to be great for the options and ETF industry.” Looney reminds us that options have not been a part of these traders’ or managers’ tool boxes. Their focus is on growing assets. “What an ETF with an option-imbedded strategy does for those customers is it requires no options paperwork and it requires no transactional component, yet they benefit by having a professional money manager manage the transactional component of the options strategy,” Looney says. “With the creation of the ETFs, it opens our world and the options industry to a significant amount of new customers. If you look at the major wire houses like Morgan Stanley or Merrill Lynch, their financial consultants are not pushing transactional business, they are pushing managed money business. So products like ETFs with options imbedded strategies in them now becomes — pardon the pun — an option for those customers who would otherwise not be able to trade options. That is a huge potential growth factor in the options business as a whole,” he says. Rathi adds that more than 90% of RIAs are still not open to trade options in their portfolio, but if you present that same return they can generally get by using options in the form of an ETF and

all of a sudden it becomes a mainstream product easier for them to understand. “As an RIA I don’t have to sign [paperwork] or understand what a call or put is,” he says. Options strategy ETFs provide an easy-to-implement tool to professional advisors. “If a roboadvisor was to include an options-based ETF strategy within their offering, or if a wire house portfolio manager that manages an ETF basket includes these products in their mix, the money flow into that product is going to be meaningful,” Looney says. “It is a win-win for all parties. It is a win for end users, it is a win for issuers of ETFs to differentiate their offering and it is a win for CBOE to further educate, promote and advance the uses of our products as well as the benchmark products we have created.”

The active vs. passive myth

Too much is made over the active/passive debate. “What investors are really doing now is finding the proper balance between active versus passive strategies,” Looney says. “It obviously depends on the audience. An institutional customer is going to seek a much higher percentage of active management to justify the fees they are paying the manager versus a retail customer. That being said, the retail customer is getting much more astute about the fees they are paying, especially with the advent of roboadvisors.” Add that to the bull market environment since the equities bottomed in March 2009, and it has been difficult for the active manager to compete. “We have seen global correlation levels plummet over the last year; we have seen a significant uptick in the amount of sector rotation, whether it be healthcare into financials, out of technology, into energies, so on and so forth,” Looney says. “We see the market starting to behave in a more normal capacity where sector rotation is a bigger part of investment strategy as well as the mix between large- mid- and small-cap.” Seeking that balance is difficult because of the central banks, role and the fact that these are moving targets. “That is why you PUTWRITE SKINNY are seeing ETF issuers seek index The CBOE PutWrite Index produced superior risk metrics to S&P 500 licensing agreement to differentiate during the last decade. themselves,” Looney says. “To have Source: CBOE products available that permit a customer to gain access to more active strategies in somewhat of a passive basket known as an ETF.”

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PUTWRITE The Wisdom Tree Put Write ETF has grown steadily since launching. Source: eSignal

The breadth of index products has altered the active/passive debate because the amount and variety of indexes allows investors to pretty actively manager their portfolio with a diversified basket of passive investments. “The [word] passive is probably a misnomer, “Rathi says. “With the advent of [trading] tools and education, the retail market is better equipped, more knowledgeable and able to get almost the same — if not better — returns than what an active manager was able to provide them 10 or 15 years ago. I call it more advancement of the industry. The control is shifting more to retail. It is not so much passive versus active strategies, just a new way of trading.” When traders can create a portfolio of passive investments that capitalize on numerous asset classes and styles, that investor is creating a pretty sophisticated portfolio that in total appears to be more flexible, or active, than the sum of its parts.

Should retail write options? For many people, the notion that scores of retail investors are embracing options writing strategies is a flashing red warning sign, similar to the anecdote of getting stock tips from your cab driver. But Looney points out that investors have to operate in the environment they are in. “For people out there worried, they need to be just as worried about their long SPDR position as they do about their short SPDR put position, because if the market does roll over from its current levels, both of those scenarios would be losses for the customers,” Looney says. “If the market did see a sustained rollover, we

The breadth of index products has altered the active/passive debate. M o d e r nTr a d e r. c o m

certainly could see investors seek to use options for hedging purposes as opposed to yield purposes. We very recently have started to see an uptick in trading flows in the VIX options as well as the SPX options that indicate institutional investors are placing trades that would benefit from a market pullback (see “Breakout,” page 57).” But we have seen several mini spikes in volatility since the last major pull back in 2011. Traders always need to be vigilant. “It seems to be playing into the geopolitical/domestic political environment — with the new administration’s difficulties enacting a policy agenda, the market is growing a bit impatient,” Looney says. “Couple that with the geopolitical factors among Russia, North Korea and the Middle East — they are all contributing to a high level of investor angst.” A problem for investors in the zero-interest-rate period is where to go. “One of the things to consider is that the bond market is extremely overvalued as well, so it is very difficult for investors out there — whether institutional or retail — to find a cheap undervalued place to put their money. Despite these risks, and despite this nervous anticipation of a correction, we do see customers actively engaging in strategies and growing the pie,” Looney says. He adds that he has kept his eye on growth in assets under management in the Put Write ETF. “I have seen assets under management grow by close to $100 million during the past year. Clearly investors see the value in these strategies.” The development of various options strategies as well as their distribution through ETFs has not only increased the ability of traders to manager their own portfolio, it has fundamentally altered the active/passive investing debate. “With the development of the options-based ETFs that utilize CBOE index benchmark strategies as the baseline for these, we now open the door for a new level of customer penetration,” Looney says. “The ETF makes it much simpler for the customer to engage.” Not only engage but create portfolios that act more like an actively managed investment than a basic index investment or a standard actively managed mutual fund. It appears that ETFs are providing the value they were designed for.

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F E AT U R E

Put writing indexes provide enhanced risk-adjusted returns over long timeframes.

PUT a cap on drawdowns Q By Oleg Bondarenko

LONG-TERM PERFORMANCE METRICS The table shows annualized statistics from June 30, 1986 to Dec. 31, 2015 on the PUT versus traditional benchmarks. The chart shows performance over that period based on a $1 investment in each of those indexes.

An analysis of the performance of the Chicago Board Options Exchange’s (CBOE) two put writing indexes — the CBOE S&P 500 PutWrite Index (PUT) and the CBOE S&P 500 One-Week PutWrite Index (WPUT) — indicated that they provided superior risk adjusted returns to equity benchmarks. We compared the put writing indexes to the performance of traditional benchmarks, such as the S&P 500, Russell 2000, MSCI World and Citigroup 30-year Treasury indexes. A cash-secured put-write strategy systematically sells options collateralized by risk-free investment (U.S. Treasury Bills). The CBOE PUT and WPUT Indexes are designed to track the performance of a hypothetical passive strategy that collects option premiums from atthe-money (ATM) options on S&P 500 Index, and holds a rolling money account invested in Treasury bills (see “How it works,” below). Both strategies attempt to profit from high premiums of index options. The WPUT Index, HOW IT WORKS The profit/loss diagram shows the PutWrite Index valuation at expiration. As you can see, the Index outperforms the S&P 500 in down markets. It also outperforms the S&P in moderately up markets up until the level of premium collected, and then it underperforms. Source: CBOE

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which was launched in 2015, extends the PUT strategy to weekly S&P 500 options. Option premiums are collected weekly, instead of monthly. During an almost 30-year period, the PUT Index outperformed the traditional indexes on a risk-adjusted basis. The annual compound return of the PUT Index is 10.13%, compared to 9.85% for the S&P 500 Index. However, the standard deviation of the PUT Index is substantially lower — 10.16% versus 15.26%. As a result, the annualized Sharpe ratio is 0.67 for the PUT Index and 0.47 for the S&P 500 (see “Long-term performance metrics,” above). The data history for the WPUT Index, based on weekly options, begins in January 2006. During the last 10 years, the PUT and WPUT indexes delivered similar risk-adjusted performance and both outperformed the S&P 500 Index and other benchmarks on a risk-adjusted basis (see “Improving on what works,” right). The annual compound return is 6.59% (PUT), 5.61% (WPUT) and 7.09% (S&P 500). The annualized Sharpe Ratio is 0.52 (PUT), M o d e r nTr a d e r. c o m


During an almost 30-year period, the PUT Index outperformed the traditional indexes on a risk-adjusted basis.

IMPROVING ON WHAT WORKS The first table shows monthly statistics from 2006 through 2015 for the PUT and WPUT versus equity benchmarks. The second table shows annual statistics from the same period. The chart at the bottom shows performance during that period based on a $1 investment in selected indexes. Source: CBOE

0.50 (WPUT) and 0.46 (S&P 500). Relative to the PUT and S&P 500 Indexes, during the last 10 years, the WPUT Index has a lower standard deviation, beta with respect to the market and maximum drawdown. In particular, the standard deviation is 11.51% (PUT), 9.85% (WPUT) and 15.11% (S&P 500). The maximum drawdown is -32.7% (PUT), -24.2% (WPUT) and -50.9% (S&P 500). The longest drawdown is 29, 19 and 52 months, respectively. The WPUT appears to add an extra level of downward protection (see “Drawdown data,” page 35). Success of PUT & WPUT The reason the PutWrite strategies have been successful has to do with the nature of implied and realized volatility (see “Why it works,” page 35). The strategy takes advantage of well-priced puts. From 2006 to 2015, the average annual gross premium collected for PUT is 24.1% and 39.3% for WPUT. Premiums for WPUT are smaller, but collected weekly instead of monthly, which results in higher aggregate premiums. Selling one-month ATM puts 12 times a year can produce significant income. From 2006 to 2015, the average monthly premium is 2.01%. Selling one-week ATM puts 52 times a year can produce even higher income, but note that transaction costs can be higher with more frequent trades. Since launch of Weekly S&P 500 options, their trading volume has increased dramatically. In 2015, on average it was about 340 thousand contracts per day, representing 36% of all CBOE S&P 500 options.In 2015, weekly options volume averaged about 340 thousand contracts per day, representing 36% of all CBOE S&P 500 options.

High volatility premium indicates that the index options are richly priced. M o d e r nTr a d e r. c o m

Oleg Bondarenko is Professor of Finance at University of Illinois at Chicago, and he serves on the Product Development Committee of CBOE. This story is adapted from a white paper he wrote that was commissioned by CBOE. Issue 536

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Notice of Class Action Settlements If you transacted in Euroyen-Based Derivatives1 from January 1, 2006 through June 30, 2011, inclusive, then your rights will be affected and you may be entitled to a benefit. This Notice is only a summary of the Settlements and is subject to the terms of the Settlement Agreements2 and other relevant documents (available as set forth below). The purpose of this Notice is to inform you of your rights in connection with two separate proposed settlements with Settling Defendants Deutsche Bank AG and DB Group Services (UK) Ltd. (collectively, “Deutsche Bank”) and with Settling Defendants JPMorgan Chase & Co., JPMorgan Chase Bank, National Association, and J.P. Morgan Securities plc (collectively, “JPMorgan”) in the actions titled Laydon v. Mizuho Bank Ltd., et al., 12-cv-3419 (GBD) (S.D.N.Y.) and Sonterra Capital Master Fund, Ltd., et al. v. UBS AG, et al., 15-cv-5844 (GBD) (S.D.N.Y.). The separate settlements with Deutsche Bank and JPMorgan (collectively, the “Settlements”) are not settlements with any other Defendant and thus are not dispositive of any of Plaintiffs’ claims against the remaining Defendants. The Settlements have been proposed in two class action lawsuits concerning the alleged manipulation of the London Interbank Offered Rate for Japanese Yen (“Yen LIBOR”) and the Euroyen Tokyo Interbank Offered Rate (“Euroyen TIBOR”) from January 1, 2006 through June 30, 2011, inclusive. The Settlements will provide $148 million to pay claims from persons who transacted in Euroyen-Based Derivatives from January 1, 2006 through June 30, 2011, inclusive. If you qualify, you may send in a Proof of Claim and Release form to potentially get benefits, or you can exclude yourself from the Settlements, or object to them. The United States District Court for the Southern District of New York (500 Pearl St., New York, NY 10007-1312) authorized this Notice. Before any money is paid, the Court will hold a Fairness Hearing to decide whether to approve the Settlements. Who Is Included? You are a member of the “Settlement Class” if you purchased, sold, held, traded, or otherwise had any interest in Euroyen-Based Derivatives at any time from January 1, 2006 through June 30, 2011, inclusive. Excluded from the Settlement Class are (i) the Defendants and any parent, subsidiary, affiliate or agent of any Defendant or any co-conspirator whether or not named as a defendant; and (ii) the United States Government. Contact your brokerage firm to see if you purchased, sold, held, traded, or otherwise had any interest in Euroyen-Based Derivatives. If you are not sure you are included, you can get more information, including the Settlement Agreements, Mailed Notice, Plan of Allocation, Proof of Claim and Release, and other important documents, at www.EuroyenSettlement.com (“Settlement Website”) or by calling toll free 1-866-217-4453. What Is This Litigation About? Plaintiffs allege that each Defendant, from January 1, 2006 through June 30, 2011, inclusive, manipulated or aided and abetted the manipulation of Yen LIBOR, Euroyen TIBOR, and the prices of Euroyen-Based Derivatives. Defendants allegedly did so by using several means of manipulation. For example, panel banks that made the daily Yen LIBOR and/or Euroyen TIBOR submissions to the British Bankers’ Association and Japanese Bankers Association respectively (collectively, “Contributor Bank Defendants”), such as Deutsche Bank AG and JPMorgan Chase Bank, N.A., allegedly falsely reported their cost of borrowing in order to financially benefit their Euroyen-Based Derivatives positions. Contributor Bank Defendants also allegedly requested that other Contributor Bank Defendants make false Yen 34

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LIBOR and Euroyen TIBOR submissions on their behalf to benefit their Euroyen-Based Derivatives positions. Plaintiffs further allege that inter-dealer brokers, intermediaries between buyers and sellers in the money markets and derivatives markets (the “Broker Defendants”), had knowledge of, and provided substantial assistance to, the Contributor Bank Defendants’ foregoing alleged manipulations of Euroyen-Based Derivatives in violation of Section 22(a)(1) of the Commodity Exchange Act, 7 U.S.C. § 25(a)(1). For example, Contributor Bank Defendants allegedly used the Broker Defendants to manipulate Yen LIBOR, Euroyen TIBOR, and the prices of Euroyen-Based Derivatives by disseminating false “Suggested LIBORs,” publishing false market rates on broker screens, and publishing false bids and offers into the market. Plaintiffs have asserted legal claims under various theories, including federal antitrust law, the Commodity Exchange Act, the Racketeering Influenced and Corrupt Organizations Act, and common law. Deutsche Bank and JPMorgan have consistently and vigorously denied Plaintiffs’ allegations. Deutsche Bank and JPMorgan each entered into a Settlement Agreement with Plaintiffs, despite believing that it is not liable for the claims asserted against it, to avoid the further expense, inconvenience, and distraction of burdensome and protracted litigation, thereby putting this controversy to rest and avoiding the risks inherent in complex litigation. What Do the Settlements Provide? Under the Settlements, Deutsche Bank agreed to pay $77 million and JPMorgan agreed to pay $71 million into separate Settlement Funds. If the Court approves the Settlements, potential members of the Settlement Class who qualify and send in valid Proof of Claim and Release forms may receive a share of the Settlement Funds after they are reduced by the payment of certain expenses. The Settlement Agreements, available at the Settlement Website, describe all of the details about the proposed Settlements. The exact amount each qualifying Settling Class Member will receive from the Settlement Funds cannot be calculated until (1) the Court approves the Settlements; (2) certain amounts identified in the full Settlement Agreements are deducted from the Settlement Funds; and (3) the number of participating Class Members and the amount of their claims are determined. In addition, each Settling Class Member’s share of the Settlement Funds will vary depending on the information the Settling Class Member provides on their Proof of Claim and Release form. The number of claimants who send in claims varies widely from case to case. If less than 100% of the Settlement Class sends in a Proof of Claim and Release form, you could get more money. How Do You Ask For a Payment? If you are a member of the Settlement Class, you may seek to participate in the Settlements by submitting a Proof of Claim and Release to the Settlement Administrator at the address provided on the Settlement Website postmarked no later than January 23, 2018. You may obtain a Proof of Claim and Release on the Settlement Website or by calling the toll-free number referenced above. If you are a member of the Settlement Class but do not timely file a Proof of Claim and Release, you will still be bound by the releases set forth in the Settlement Agreements if the Court enters an order approving the Settlement Agreements. M o d e r nTr a d e r. c o m


(continued from previous page) If you timely submitted a Proof of Claim and Release pursuant to the class notice dated June 22, 2016 (“2016 Notice”) related to the $58 million settlements with Defendants R.P. Martin Holdings Limited, Martin Brokers (UK) Ltd., Citigroup Inc., Citibank, N.A., Citibank Japan Ltd., Citigroup Global Markets Japan Inc., HSBC Holdings plc, and HSBC Bank plc, you do not have to submit a new Proof of Claim and Release to participate in these Settlements with Deutsche Bank and JPMorgan. Any member of the Settlement Class who previously submitted a Proof of Claim and Release in connection with the 2016 Notice will be subject to and bound by the releases set forth in the Settlement Agreements with Deutsche Bank and JPMorgan, unless such member submits a timely and valid request for exclusion, explained below. What Are Your Other Options? All requests to be excluded from the Settlements must be made in accordance with the instructions set forth in the Settlement Notice and must be postmarked to the Settlement Administrator no later than October 5, 2017. The Settlement Notice, available at the Settlement Website, explains how to exclude yourself or object. All requests for exclusion must comply with the requirements set forth in the Settlement Notice to be honored. If you exclude yourself from the Settlement Class, you will not be bound by the Settlement Agreements and can independently pursue claims at your own expense. However, if you exclude yourself, you will not be eligible to share in the Net Settlement Funds or otherwise participate in the Settlements. The Court will hold a Fairness Hearing in these cases on November 9, 2017, to consider whether to approve the Settlements and a request by the lawyers representing all members of the Settlement Class (Lowey Dannenberg, P.C.) for an award of attorneys’ fees of no more than one-fourth of the Settlement Funds for investigating the facts, litigating the case, and negotiating the settlement, and for reimbursement of their costs and expenses in the amount of no more than approximately $300,000. The lawyers for the Settlement Class may also seek additional reimbursement of fees, costs, and expenses in connection with services provided after the Fairness Hearing. These payments will also be deducted from the Settlement Funds before any distributions are made to the Settlement Class. You may ask to appear at the Fairness Hearing, but you do not have to. For more information, call toll free 1-866-217-4453 or visit the website www.EuroyenSettlement.com. 1 “Euroyen-Based Derivatives” means (i) a Euroyen TIBOR futures contract on the Chicago Mercantile Exchange (“CME”); (ii) a Euroyen TIBOR futures contract on the Tokyo Financial Exchange, Inc. (“TFX”), Singapore Exchange (“SGX”), or London International Financial Futures and Options Exchange (“LIFFE”) entered into by a U.S. Person, or by a Person from or through a location within the U.S.; (iii) a Japanese Yen currency futures contract on the CME; (iv) a Yen LIBOR- and/or Euroyen TIBOR-based interest rate swap entered into by a U.S. Person, or by a Person from or through a location within the U.S.; (v) an option on a Yen LIBOR and/or Euroyen TIBOR-based interest rate swap (“swaption”) entered into by a U.S. Person, or by a Person from or through a location within the U.S.; (vi) a Japanese Yen currency forward agreement entered into by a U.S. Person, or by a Person from or through a location within the U.S.; and/or (vii) a Yen LIBOR- and/or Euroyen TIBOR-based forward rate agreement entered into by a U.S. Person, or by a Person from or through a location within the U.S. 2 The “Settlement Agreements” means the Stipulation and Agreement of Settlement with Deutsche Bank entered into on July 21, 2017 and the Stipulation and Agreement of Settlement with JPMorgan entered into on July 21, 2017.

DRAWDOWN DATA WPUT had even lower drawdown than PUT and market indexes. Source: CBOE

Why it works Historically, the options implied volatility has considerably exceeded the realized volatility of the S&P 500 Index. From 1990 through 2015, the average implied volatility, as measured by the CBOE Volatility Index (VIX) is 19.8%, while the average realized volatility is 15.5%, implying the difference of 4.3% (see “Implied vs. realized,” below). High-volatility premium indicates that the index options are richly priced. As a result, put writing strategies have historically delivered attractive risk-adjusted performance.

IMPLIED VS. REALIZED Source: CBOE

volatility (VIX) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 ALL

S&P 500 Realized Volatility 15.4 13.6 9.4 8.3 9.5 8.1 11.5 17.6 18.7 18.1 21.6 19.7 25.1 15.7 11 10.1 9.4 15.8 35.2 24.1 16.5 20.8 12.6 10.8 11.1 14.3 15.5

23.1 18.4 15.5 12.7 13.9 12.4 16.4 22.4 25.6 24.4 23.3 25.7 27.3 22 15.5 12.8 12.8 17.5 32.7 31.5 22.5 24.2 17.8 14.2 14.2 16.7 19.8 Issue 536

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Options allow traders to take a more defined position on an underlying stock; Weekly options take this benefit one step further.

Weekly Options:

A More Precise Tool Q By: Russell Rhoads Short-dated options that expire on non-third Fridays, commonly referred to as Weeklys, were introduced by the Chicago Board Options Exchange (CBOE) in 2005. There was little attention paid to them and the volume in these non-standard contracts was modest. Five years later in May 2010, the first equity Weeklys were introduced on five different stocks. Presently, Weekly options are available for trading on more than 400 stocks, exchange-traded funds (ETFs), and equity indexes. Depending on the day, the percent of overall options volume that is attributable to Weeklys is anywhere between 35% to 50% across the CBOE option market (see “Growing week by week,” below). That chart shows the percent of average daily volume represented by Weeklys at CBOE from January 2011 to July 2017. In January of 2011, about 6% of the volume at CBOE occurred in Weeklys.

At that time, there were only about 70 products (stocks, ETFs and indexes) with Weeklys available. As mentioned above, that number has grown to more than 400 products. In July 2017, 32% of volume at CBOE occurred in Weeklys, which was a tad lower than the record of 33% in October 2016.

Why Trade Weeklys?

The core to the success of Weeklys relates to the time decay (Theta) nature of options. Theta measures the time value of an option, which dissipates at an accelerated pace the closer an option gets to expiration. Traders are either attempting to take advantage of time decay or they are trying to avoid it. Here are two examples of how traders may trade time value. First, is an example of how short-dated options that are in-the-money or have intrinsic value, and how they may be used to trade a short-term outlook for a stock. GROWING WEEK BY WEEK When a trader purchases a call or a put on a stock, Weekly options volume has grown steadily during recent years. Source: OCC the trader will most likely need the option to move in their favor before the option value approaches a break-even price. This extra price move that is required to reach the break-even price relates to the time value added to the options’ intrinsic value. Consider if Apple (AAPL) is trading at $157.25 and in traditional monthly options. To take a bullish position on AAPL a trader purchases an AAPL 150 call at $10 that expires in a month. The payoff for this option at expiration is shown in “Apple monthly,” right). Note the break-even price for this trade is $160. Now consider the same situation, but with available Weeklys. A one-week AAPL 150 call could be purchased for $8. This means the break-even on the trade is a little lower at $158. Therefore, if this trade is held until expiration of the option, the stock only needs to rise

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APPLE MONTHLY Source: CBOE

A THETA PLAY The most significant and actionable moves in an option contract occurs in the final week until expiration. Weeklys allow traders to trade this move four times a month. Source: CBOE

AN APPLE A WEEK Source: CBOE

75¢ to break even. Also, since there is very little time value in the option, this call will more closely resemble that of the stock performance (see “An apple a week,” above). On the second AAPL payoff diagram the stock only needs to move up 75¢ to reach a breakeven point as opposed to $2.75 in the case of the one-month option. Before Weeklys were available on stocks, a short-term bullish outlook on a stock did not necessarily make sense as an option trade. The option price would not replicate a move in the stock as well as a trader would hope due to the amount of time left until expiration. Also, the cost of an option may have involved too much time value to make an option trade an attractive alternative to purchasing a stock.

The decay of time value of at-the-money options tends to accelerate as expiration approaches. M o d e r nTr a d e r. c o m

The decay of time value of at-the-money options tends to accelerate as expiration approaches. Before Weeklys were available there were traders who would only get involved in the option market during expiration week to take advantage of this sort of option price behavior. As an example of this sort of time decay behavior, consider the iShares Russell 2000 ETF (IWM) trading at $135 with five trading days remaining until expiration. A five-day IWM 135 call is trading at $1.45. Five days later this option expires and if IWM is at or below $135, the option will have no value. “A Theta play,” above) shows the expected time decay for this 135 call, using the assumption that the underlying price does not move at all. Note the dramatic drop in the value of this at-the-money call that occurs during the last week of life for this option contract. Even more impressive is the drop in the last day or two, which is the type of time decay that would only show up once a month for traders to take advantage of in the past. Now they have the chance to benefit from this dramatic loss in option value through selling at-the-money options on a weekly basis instead of just once a month. One of the greatest benefits of options over an outright stock or futures contract is the ability to take a more precise position based on where a trader believes the market will go, or not go, and when. Weekly options drill down a little further, allowing traders to take even more precise positions. Russell Rhoads, CFA, is Director of Education for the CBOE Options Institute. @russellrhoads Issue 536

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Binary options are offered in several regulated markets to allow retail traders an easy way to access market moves.

Binary Options are Here to Stay Q By Daniel P. Collins

Binary options are based on a simple proposition; will X market reach Y level by Z time. Binary options ask a “yes” or “no” question, the answer of which creates a certain outcome. Binaries trade between 0-100, if the answer to the question is yes at expiration, the option settles at 100; if the answer is no, it settles at zero. It can be based on any underlying: a sporting event, election, economic report or unique situation, but is mainly based on existing markets. The modern history of binary options is a relatively short and sometimes ignoble one. The Iowa Market was launched in 1988, using binary-type contracts as a way to educate people regarding markets and operating under a no-action letter from the Commodity Futures Trading Commission (CFTC). They created binary contracts on the outcome of elections. What was learned from this is that people putting actual money down on an outcome were better at predicting those outcomes than certain so-called experts. Putting money on the line apparently created the incentive to do a little more homework. In fact, there is a long history of presidential betting markets and the idea that they have a strong predictive value. In the early part of this century, a number of nascent binary option exchanges — most of which were based outside of the United States — were developed often on events such as sports. “They weren’t exchanges; most of them were the offshore Cypriot bucket shops at the time,” says Dan Cook, director, business development for the North American Derivatives Exchange (Nadex). Cook says they were mainly based in countries with light regulations. “They were promoting binary options, but essentially it was

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a bunch of bad actors that were taking people’s money,” he says. “There were only about four or five technology providers. Some would have 200 affiliates, which were white-labeled websites. That was the difficult thing in trying to stop it. They would close one down and another would pop up. They would be saying 70% returns in 60 seconds. There were a lot of bad actors in this space.” There were also more serious ventures. Irish firm Intrade launched as a prediction market in 2001 and operated Tradesports, which offered contracts on various sporting events. Tradesports marketed itself as a way underlying commercial interests could hedge their exposure to wins and losses as well as a market for speculators. At the time officials of the CFTC often chose to ignore many of these markets, arguing that sports betting markets masquerading as futures exchanges were more a matter for individual state gaming commissions than the U.S. futures regulator. Intrade itself offered a popular presidential election market where traders could make bets on the outcomes of numerous U.S. elections. It became popular during the 2008 and 2012 elections and did provide some support to the notion that there could be a market where participants put up their own money. “We filed for presidential election contracts around 2012 and the CFTC said “No,” but you turned on CNBC and they are quoting the Intrade markets every day,” says Cook. Intrade had applied for Designated Contract Market (DCM) status with the CFTC, but that was not granted and the market was closed in the United States in 2013. By this time the CFTC had better actively monitored some of the more questionable binary option products and issued a fraud alert in 2013 geared at binary bucket shops.

Real Markets In 2004, Hedgestreet, which would later be purchased by IG Markets and rebranded as Nadex, became the first regulated DCM offering binary options. Users could open an account directly with Nadex without having a clearing M o d e r nTr a d e r. c o m


GROWING AN EXCHANGE Volume growth on Nadex Source: Nadex

arrangement with a futures commission merchant. All contracts are fully collateralized so there are no margin calls. Nadex offers contracts tied to underlying markets, including stock indexes, forex, commodities and events. It offers weekly expirations, daily expirations and numerous intra-day expirations. Futures markets have long had a reputation for eating new lightly funded participants up. Numerous studies have found that most new accounts bust out, usually because they are underfunded and traders misuse the available leverage. “They want to be a trader and they try and trade an oil contract and they have $10,000 in their account. They don’t stand a chance with a $1,000-a-point move,” Cook says. “What we wanted to do is give the average individual a way that they could be active in the financial markets, but in a sensible manner. They can trade the popular markets like gold and oil based on those actual underlyings, but they can do it at a lower cost with limited risk.” In its early days as Hedgestreet, Nadex toyed with the idea of creating contracts for potential hedgers where no market existed, such as gas at the pump, but more recently it has focused binaries on popularly traded markets. “What is popular are markets that people know and see on the news every day. They wanted to participate but they didn’t have the opportunity,” Cook says. “People like to trade currencies, but currencies are elusive because of high leverage. They were trading very large contracts. They were able to do that because of the high

“What is popular are markets that people know and see on the news every day.”

--Dan Cook

M o d e r nTr a d e r. c o m

leverage, which is great if it is moving in your favor; but as you know if it moves rapidly against you, people’s accounts can get crushed.” Nadex has grown in popularity, and volume (see “Growing an exchange,” left). It has added market makers, and in 2010 allowed for trades to be intermediated, though most customers still trade directly through exchange accounts. Tom O’Brien and his son, Tommy, COO of TFNN, not only trade binaries but also operate TFNN Corp., a fulltime trading education business with live content all day, talking trading and taking calls with a variety of hosts. Tommy trades binaries and directs many traders to the contracts. He says many new traders are part-time traders without the ability to monitor positons 24 hours, so the defined risk nature of binaries is a huge benefit. “Defined risk is a huge deal,” Tommy says. “They know that if they are putting up $25 to get $75 that is all they are putting up. We all know the currency markets are brutal. It is a safer way to do it. They can start out small with recreational trades; the barrier to entry is not very large, they don’t have to wire in $10,000.” He adds that they want to be in the market and they want defined risk. “They know they are not going to wake up in the morning and find out they lost $10,000; if they got a couple of thousand at risk, they got a couple of thousand at risk and they know what the risk is.” O’Brien says, “I trade gold all of the time, but I will never trade it again in the futures market. It doesn’t make sense because the spreads on Nadex are $1 at most. Gold is going to bust up or down $10 in a heartbeat. They can trade gold $6 in-the-money with a couple of hours to trade. That can move. That is a low risk, high reward trade.” They take advantage of the intraday contracts to trade economic reports and news. “When [the EIA oil inventory report] is coming out at 10:30 and [hourly] binaries are expiring at 11 or noon, and your option is at 5; that is a small amount of premium you are paying when news is breaking. There can be a lot of volatility on those numbers,” Tommy says. They also can trade volatility by buying an option strike below the market price and selling one above it. “If gold is trading at $1,200 per ounce, you buy a binary at 1210 [and] you sell a binary at 1190. You are looking for a $10 up or down move. And a $10 out-of-the-money binary is going to be really affordable in gold,” Tommy says. “You are paying maybe $20 on each side, so you are putting up $40 in total, and if one of them expires in-the-money you get $100 in value.” O’Brien says having defined risk allows traders to make bets before news and in volatile markets too risky for straight futures, such as during the recent presidential election spike. “I wouldn’t have wanted to be trading futures that evening, but it made sense with binaries.” Jim Prince is head trader and educator with the Greatest Business on Earth, an educational portal for BarCharts.com, who initially looked at binaries a few years ago and is now hooked and encourages new traders to trade them. “People get involved in trading and are often undercapitalized. Binaries gave that individual a good opportunity,” he says. Issue 536

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BINARY BYRDS Source: NYSE

UNDERLYING SECURITY Apple (AAPL) Amazon (AMZN) Alibaba (BABA) Boeing (BA) Conoco Philips (COP) SPDR DJIA Trust (DIA) iShares MSCI EAFE Index (EFA) iShares MSCI Emerging Markets Index (EEM) iShares MSCI Brazil Index (EWZ) iShares China Large Cap ETF (FXI) SPDR Gold ETF (GLD) Gilead Sciences inc. (GILD) Market Vestors Gold Miners ETF (GDX) iShares Russell 2000 Index ETF (IWM) McDonald's (MCD) Netflix Inc. (NFLX) Proctor & Gamble (PG) Powershares QQQ ETF (QQQ) SPDR S&P 500 ETF (SPY) iShares Barclays 20+year T-Bond (TLT) United States Oil Fund (USO) Ipath S&P 500 VIX (VXX) Financial Select Sector ETF (XLF) Energy Select Sector SPDR (XLE) Exxon (XOM)

BYRDS SYMBOL APQ AZQ BLQ BOQ COQ DMQ EFQ ETQ EZQ FIQ GDQ GIQ GMQ IWQ MLQ NFQ POQ QBQ SYQ TEQ USQ VXQ XFQ XLQ XOQ

“As I started to delve into it, one thing jumped out: capitalization — you didn’t need to lay out a bunch of capital. That has always been [difficult] for newbies. They open up an account for $5,000, blow through that and never come back. You can open up an account for $250 at Nadex and try your hand and still experience some of those emotions. That and the aspect of risk. Whenever you open up a trade you have a known risk.” Prince has developed a binary trading course. “It is a great launching point; I don’t care if you have $250 or $250,000 to trade with, if you don’t understand how the markets work, it is not going to matter. Binaries allow you to start with a small amount at your own pace. It is a fantastic tool to begin your trading career with.” After being the only regulated exchange for a while, Nadex is now facing more legitimate competition. The Cantor Exchange lists binary options on forex markets and has recently offered weather market binaries. Working with AccuWeather, Cantor offers contracts on hurricanes tied to specific zip codes, rain days, and will soon offer snow contracts. As opposed to Nadex, Cantor is looking at creating markets that are particularly appropriate for the unique attributes of binaries. “Our interest is mostly trying to figure out where binaries have a real strong economic purpose, says Richard Jaycobs, president of Cantor Exchange. “Weather is a perfect example. If it snows and somebody has to pay someone to plow their parking lot, that is real 40

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money. We are looking at a whole new class of binaries and weather is the best example of that.” Cantor offers protection for a hurricane landfall. “You can actually go out and say, I have a house on the Jersey shore and if a hurricane landfall occurs within 75 miles of the zip code that my house is in, I want to get paid, maybe the amount of the deductible I have on my insurance,” Jaycobs says. “If you buy a binary contract and a hurricane happens near your house this season, it may cost me $800 to $1,200 to get $10,000 worth of protection. We think those are more interesting kinds of contracts.” The contracts are listed on tradewx.com and are valued at $1, so you basically buy the specific dollar amount of protection you are looking for. Cantor has two other weather-related contracts on rainfall. Small businesses that depend on vacation rental income can hedge the cost of bad weather. Right now it is only in the vicinity of Atlantic City, but the goal is to expand regionally and nationally. “The product that people want — and this is the key part of our strategy — varies by area. There are some areas where people don’t care about rain, they care about wind; there are some areas where they don’t care about rain or wind, they care about hail damage. We have the technology to get very particular with risk and offer them,” Jaycobs says. Their target customers are small businesses up to institutional. People hedging exposure of $10,000 to $100,000. “All of it focused on trying to identify some hedging community that can benefit from the product, which is not insurance but fills a gap in what insurance would do and nothing,” Jaycobs says.

Equity Binaries Both Nadex and Cantor are regulated by the CFTC, but more recently the NYSE has moved into binaries with Binary Return Derivatives (ByRDs), which are binaries listed on underlying equities and exchange-traded funds. Because of this, they are regulated by the Securities and Exchange Commission and must be intermediated. Currently there is one brokerage platform, Ally Invest, which recently bought Trade King, that offer ByRDs. The market, which launched in March 2016, is targeting mostly retail investors who want to generate income with known risk. Contracts are valued at $100 and are listed five weeks out, expiring every Friday. An added complication is that contracts are settled to the volume-weighted average price, which can vary more in value than the actual underlying settlement. It is an easier product to understand and trade than regular equity options. It is a limited risk/limited reward product that can generate income with known risk. Like all binaries there is no leverage invovled. There is no risk of buying stock or selling stock. There is no tax implication of selling stock. ByRDs are just getting started and have their own unique challenges, but they benefit from previous binary markets. Binary options offer a simpler way to speculate on a known market or create a new market based on their simple metrics. Every trade can be broken down to a “yes” or “no” question with precise odds based on a value from zero to 100. They appear to have come of age. M o d e r nTr a d e r. c o m


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F E AT U R E

Options-based trading strategies have always been a niche, but like all trading strategies, options-based strategies are getting more complex.

Volatility as an Asset Class Q By Daniel P. Collins The history of managed money in the futures world since its early days in the 1980s has been about one thing: Trend following. However, a niche strategy that dates to the first options on futures contracts has been option writing. Prudent traders since the launch of options have used the product to mitigate risk, but there had to be someone on the other side of those defined risk long options positions. Soon strategies were developed to earn consistent returns by selling option premium. For a majority of the trading community, options were a one-way tool, so options sellers had the advantage of setting their own price. When founder of Warrington Asset Management Scott Kimple started trading options more than 20 years ago, most options managers were pure premium sellers. “Back then before tech homogenized a lot of trading and got everyone on the same valuation models, you did have some pretty extreme options mispricings,” Kimple says. “My mentor was a pretty aggressive premium seller and [earned] amazing returns taking advantage of those mispricings.” Option selling strategies had a reputation for producing strong returns for several years before a volatility spike came and wiped many of them out. As soon as it was over there were people to take their place, or the same strategies rebranded to avoid meeting a high-water mark following deep drawdowns. “They were either long-term sellers or short-term [sellers] trying to

get within the inflection point of time decay,” Kimple says. “Now you have some fairly sophisticated players in multi-billion dollar shops and there has been more sophistication that has come into it.” That sophistication, and the broader acceptance of selling premium as a strategy (see “Options on ETFs & ETFs on options,” page 28), has made things tougher for premium sellers. More traders are willing to take the other side of option trades. “People didn’t really understand options; the technology that we have today in terms of rapidly being able to adjust option prices based on models didn’t exist,” Kimple says. “You did see wide markets. Back then you would get into a fast market, the few market makers would blow the spreads up $5, $10, $15 wide and would make their month on a couple of fast markets. Efficiency has been added that has minimized the number of fast market conditions.” There was still risk. “It might have been easy for the real good ones but with that extreme volatility in those mispricings, it was more like the Wild West,” Kimple says. “The business had become more institutionalized, technology has probably leveled the playing field, there is more advanced work on options and options pricing, and there are more option specialists.”

The Year 2008 As noted above, premium collection strategies have come in and out of fashion, but the 2008 credit crisis meltdown knocked many out of the game. Even the best practitioners of the strategy realized that they would never move to the next level of money management until they dealt with the inherent risk associated with pure naked options writing. One firm that earned outside returns for several years — LJM Partners — decided to alter their approach following the crisis. Actually, LJM had already offered more measured strategies with lower risk and less dependence on pure premium writing, but after 2008 it incorporated some of those methods into all of their strategies. It involved adding long options positions that reduced risk and its

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reliance on premium collection. “Our Aggressive strategy, which was a pure option writing strategy now shares a lot of the characteristics of our more conservative programs; this is because we have found that that is a much more efficient way to avoid those steep drawdowns like we had in the Aggressive Program in 2008,” says Lauren Savino, managing director, LJM Partners. LJM’s Aggressive program earned 68.10% in 2003, 53.76% in 2004, 42.21% in 2005, 37.71% in 2006 and 21.25% in 2007 before dropping 48.05% in 2008. Its Moderately Aggressive strategy also gained more than 20% in each of those years before losing 18.69% in 2008. Its Preservation and Growth Strategy earned 12.12% in 2008. “We added some long put positions in the portfolio that would offset some of that true options writing exposure, that is how that strategy was positive in 2008,” Savino says. “The philosophy was that pure option writing wasn’t for everyone so we wanted to create a risk/reward profile that was more appropriate for an investor that has a lower risk tolerance.” LJM’s performance during that period was superior to most similarly geared options strategies — even the Aggressive. LJM was not alone. The industry produced a wrath of innovative options strategies after 2008 that sought to harness underpriced options in addition to simply collecting premium. This trend grew so noticeable that we dubbed this group “volatility value traders.” They were not all the same, but each utilized long option positions to hedge exposure to pure naked option writing and, in some cases, sought returns from underpriced premiums. An added bonus for these managers was that institutional investors were all of a sudden picking up the phone. Once they were volatility value traders instead of simply naked option writers, there was more institutional interest. The growth and growing validation of the CBOE Volatility Index (VIX) helped legitimize volatility as an asset class. It also gave tools to hedge volatility exposure.

Instead of being ignored by institutions, some option managers are being actively courted. “Today, even when you talk to pension endowments some of the big institutional investors, they put out RFPs for option writing strategies to bring in a certain amount of income,” Savino says. “That is a big shift from my first few years working at LJM.” LJM has even launched a 40-Act version of their Preservation and Growth Strategy and are managing about $650 million in it. “That is actually where most of our assets are today. It is a very different space from when we were just a CTA,” she adds. “Liquidity, volatility, open outcry and technology are the four big significant changes in [the space],” Kimple says. “Liquidity used to be kind of thin in the short options space, that has been somewhat democratized.” He adds that the advent of weekly options has improved liquidity. “When I started there was one options expiration per month. Now you have got multiple expirations. You see these big banks come in and participate in Weeklys.” LJM still earns money through collecting premium, but is better protected in the case of a volatility spike and can earn positive returns from long option positions. “We are always net short [volatility] whether volatility is high or volatility is low,” Savino says. “The majority of the time there is still going to be a positive spread between the implied volatility and realized volatility. That is what we have seen for the last 18 months. So even though we have seen volatility trending lower — when you look at VIX as a measure of volatility — the realized volatility has also been significantly depressed for a long period of time.” That said, LJM includes long volatility positions in their portfolio to offset risk. “We always try to stay neutral when it comes to the market but there is a short [directional] bias just based on the fact that we want to offset some volatility risk,” Savino says. Robb Ross began trading options in the late 1990s when volatility was high. He saw S&P options providing a premium of SHRINKING VOL 12% on at-the-money options 30 While volatility has gone through extended periods when it was depressed before, the days out. “That was the price of vast majority of days the VIX has settled below 10 occurred in 2017. fear in the market for what people Source: eSignal are willing to risk to sell you safety,” Ross says. “I [thought at the time], there is a way to take advantage of this without just being a straight option seller.” He developed his Alternative Hedge Program, initially dubbed Scantily Clad straddles (see: Options naked straddles: A more modest approach,” Futures, January 2011), which is a Delta covered premium strategy. While unique, the strategy followed the trend of accessing the value of option premium while maintaining solid risk management models.

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Volatility has contracted so much that many traders are asking if the VIX is broken. Kimple points out that of the 26 instanced where VIX closed below 10; 17 of those have occurred this year (see “Shrinking vol,” page 43). “We think the markets will regress to more normalized volatility patterns at some point,” Kimple says. The question is, if prepared, will all these managers and traders trading volatility short? Folks like Kimple and LJM have navigated numerous volatility cycles. --Scott Kimple “My competition is an option trading program that has a track record from 2012; if they have got doubledigit returns, they are selling volatility,” Kimple says. He worries that managers who have maintained those strong Back to the future returns during the low volatility period between 2013-2017, they While firms like Warrington and LJM have survived and thrived are taking on too much risk. “The only way they have been able through multiple market cycles by including prudent use of long to do that is by ramping up their risk and when — not if — volatility option positions and not being completely exposed to the forces increases; these are going to be the guys taken out on a stretcher. of volatility; pure premium selling appears to be on the rise. That is always the case (see Volatility cycles,” below).” “The big story is this untried untested central bank activity has Kimple adds, “People say to us, ‘Your returns aren’t what they caused volatility to be abnormally low. It has caused an interest [used to be],’ We say that is because we are good risk managers. in the space, especially in short volatility,” Kimple says. “The only You have options traders that have made strong returns over way to make money the last couple of years has been in the short the last few years because they have been taking excess risk. volatility space. It has caused a dramatic increase in structured The canary in the coal mine for these guys is if you look at their product related to getting short volatility. You have volatility intermonth returns for January/February 2016, August 2015 tourists; people who are relatively new to the space who have and October 2014.Their intermonth drawdowns would be very come in – realizing the only way to make money is selling volatility instructive and would be a bit scary.” — doing it in a highly risky fashion.” The options-writing strategy is more accepted by both Kimple says the trade may last for a while but warns that it is institutional and retail, and it could be happening at the wrong time. crowded. “Recently when volatility has picked up [traders have] come in and smashed it back down. However, at some point when “My concern is if that acceptance is based on people who know it comes unhinged, like it did in January and February in 2016 – what they are doing and who are able to sustain the next volatility the last time we had an extended period of higher volatility —these spike?” Kimple asks. “It is frustrating that every time we’ve gotten a guys are going to get creamed.” volatility spike it is a matter of hours or days before it is fully retraced. That is not normal, it is a direct result of central bank activity [and it] is VOLATILITY CYCLES something that can’t last forever.” The VIX experienced multiple years of depressed volatility prior to the market crashes in Kimple may sound like Chicken 2000 and 2008. Little, but at some point the market Source: eSignal will have an extended volatility spike, and there are more people short volatility than ever before. “That is what is going to test the current generation of volatility traders,” Kimple says. “What happens when you have a Dow that drops 1000 points and doesn’t bounce back and take out the all-time high, a day, a week, a month later? What happens when the market goes down and stays down?” If we know anything about the markets, it is that it will happen. The question is when and how prepared you are for it.

“Every time we’ve gotten a volatility spike it is a matter of hours or days before it is fully retraced. That is not normal … it is something that can’t last forever.”

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AMAZONED! AMAZONED! ? That’s a question that many investors are asking about retail companies as Amazon continues to digest more and more market share of the U.S. retail sector. But there’s another group of people who think that antitrust laws could carve up Amazon. This month, we dig into the antitrust speculation, analyst expectations and Amazonization of the American economy.

Amazon’s effect on the economy has been dramatic and there are legitimate antitrust concerns, but any attempt at a fix may be fraught with risk and potential unintended consequences.

Breaking Up Amazon… It’s Not That Simple Q By Garrett Baldwin In June 2017, The City University of New York (CUNY)/ Queens professor of digital economics Douglass Rushkoff penned one of the more compelling arguments on the future of Amazon (AMZN) and the U.S. economy. His title was simple: “It’s Time to Break Up Amazon.” The thesis came in the wake of Amazon’s $13.7 billion bid for Whole Foods (WFM), a move that led to a sharp sell-off of grocery rivals’ stocks. The Amazonization of the American economy is rife with concerns about the effect on labor, anti-competitive threats and chatter about a potential monopoly that will suck value out of every market Amazon enters. With 30% of all online and offline retail sales growth and 40% of Internet cloud service demand, what will stop Amazon from dominating everything? More important, what exactly has helped the company reach this point? Rushkoff explains that past antitrust efforts to end monopolies in the 20th century industrial economy centered on efforts to prevent companies from gaining control of the distribution platforms.

Whether it be a trucking company trying to control roads, an oil company owning pipelines or a telephone company owning the wires; the distribution platform is a critical consideration. In this digital economy, the ecommerce “platform is the business.” Rushkoff writes, “Netflix content sells its platform, Apple’s devices sell its supposed ‘ecosystem.’ Amazon’s book business, like Uber’s cab business, was just an easy foothold—the low-hanging fruit of an existing but inefficient marketplace—through which to establish a platform monopoly. From that beachhead, the company then pivots to other verticals.” Amazon has a unique competitive advantage that provides key research data that competitors simply lack. Amazon had 43% of all online retail sales in 2016, according to Slice Intelligence. As an individual product category grows in popularity, Amazon can then develop its own private label version of the product and begin to sell it on the platform in direct competition. From there, Rushkoff proceeds to argue that the company doesn’t consider its long-term influence as it expands. In the digital age, Rushkoff argues that Internet services and capital can scale up in a way that real companies and the real world cannot in the future. Rushkoff is arguing, in theory, the idea that Amazon’s monopoly potential is unlike anything that the world has seen. Not only is it a threat to capitalism, but it is also a potential dagger into the heart of the world economy. While the author seems uncertain that

On the matter of antitrust issues, there is a fine line between technological progress and the goals of breaking up firms due to market share growth tied to that progress. M o d e r nTr a d e r. c o m

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current antitrust regulations can be applied to this issue, his article is the reason we are exploring this issue today. For a better understanding of Amazon, the current state of antitrust laws and why this company is unlikely to face legal retribution, we turned to an expert. We sat down with Diana Moss, president of the American Antitrust Institute (AAI) in Washington, for more insight into Amazon’s legal issues, problems facing antitrust advocates and a better understanding of the role of digital platforms in the 21st century economy. Moss, an economist who has been with AAI for 17 years, argues that Amazon’s story is part of a broader narrative on antitrust issues that have been building for three decades. “Over 30 years of lax enforcement with declining competition, as indicated by higher levels of market concentration, we’ve got growing inequality gaps, slower rates of market entry and a number of other problems,” she says. However, in the case of Rushkoff’s argument, she unpacks a handful of issues at the heart of Amazon’s platform and antitrust matters. “The development of the online platform and the coverage of platforms across multiple, adjacent markets on which other technologies reach is — from an economics standpoint — not a new idea. Network platforms and interoperability are old, fleshed out economic ideas. What is interesting is how enforcement approaches them,” she says. At the core of the issue on the platform is the economic concept called the essential facility. “The essential facility is typically a network — whether it’s a transport system, a pipeline, a transmission system, a railroad — that displays, in many cases, natural monopoly types of characteristics. For market entrants, rivals and competitors to reach the consumer, they have to go through the essential facility. They have to gain access because it really doesn’t make sense in some cases to have more than one big network,” Moss says. In the public utility, having more multiple transmissions lines would be duplicative and wasteful. For this reason, the markets have true monopoly regulation. However, Moss notes that online platforms are a way to think of modern essential facilities that are based on digital platforms. She notes, however, that this doesn’t necessarily require regulation. “Regulation is really reserved to the most extreme mortgage failures that we can identify in our economy. There is a lot of talk right now about regulating these platforms. We do not think that’s a great idea at all. ” At the core of this sentiment is the notion that Amazon and Google (GOOG) are not carbon copies of the old essential facilities and networks that the United States saw in the 20th century manufactur-

ing and transportation-based industrial economy. “We still have regulation in many public utilities because of these older facilities. But online platforms as essential facilities are different. There has to be some form of access to the facility, to the technology, to the platform, so that rivals can operate on top, adjacent to, or in a complimentary non-restrictive way to bring value, new products and services to consumers,” Moss says. “Antitrust [experts] are grappling with this over these platforms. What is complicating this is that the Googles and the Amazons and the Facebooks of the world have engaged in acquisitions and consolidation in markets that may not immediately raise antitrust concerns.” On the matter of antitrust issues, there is a fine line between technological progress and the goals of breaking up firms due to market share growth tied to that progress. Moss argues that the future requires more than just thinking about the concept of breaking up monopolies or platforms. “You can’t stop innovation,” Moss adds. “I don’t think we all want to be Luddites. Technological progress brings many benefits in many ways, but it is a process that requires more guidance and structure through a more coherent policy that includes more than just antitrust. Antitrust is really important, but when it comes to promoting competition in the economy and technological progress, you need a national policy on promoting innovation that’s pro-competitive and pro-consumer.”

The Path to Antitrust Is it possible that Federal agencies or a state’s attorney eyeing a governor’s mansion will target Amazon in the months or years ahead? It depends on the context. “One thing antitrust must do is continue to look forward,” Moss says. “All merger analysis is forward-looking; it looks at markets, not as they currently are but as they are likely to be. Antitrust has to broaden the lens within using existing tools to make the connections between the types of acquisitions and consolidations in conduct in these very complex ecosystems that the platforms live in. And to do that, you need smart, creative, aggressive enforcers.” She adds that the current political environment isn’t up to meeting those challenges; citing the lack of leadership at key agencies, unfilled positions and the threat of using anti-trust as a political weapon instead of smart policy. In the current environment, Moss doesn’t expect that the Federal Communications Commission or the Department of Justice would bring a large antitrust case against Amazon. The idea that the agencies would bring an amorphous case that posed concerns about competition and how Amazon might be leveraging its market power doesn’t lend itself to the current system. “The laws and the guidance of the agencies are not built that way,” Moss says. It is more likely that agencies would address Amazon the same way that we have witnessed antitrust efforts with Google in recent years. “They would look at conduct, how the platforms conduct themselves, and whether they’re engaging in exclusionary conduct that’s limiting competition and or

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misdirecting resources. Or they would look at mergers and acquisitions,” Moss says. If agencies bring a case against Amazon and Whole Foods, Moss argues they would take a fairly specific view to that particular transaction and how it affects competition. In this case, they may examine the space of procurement of natural and organic foods, and the logistical distribution segment in terms of how those products are distributed to consumers. “It has to look through the lens of merger control by defining markets and looking at how the transaction could harm consumers, choice and innovation; and how it would affect price. And then the answer will be whether there is a competitive issue or not. Antitrust has less ability to bring much broader concerns to bear on how a company is behaving in its ecosystem. There has to be a hook through the law, she says. Moss adds that there is a possibility that Federal agencies bring a case over Amazon and Whole Foods. It may come down to how much competitors begin to complain. “The agencies really listen hard to how other smaller firms are going to be affected by this type of transaction,” she says. “The more vocal smaller entrepreneurial, innovative competitors can be about this type of consolidation, the more it will get on the radar screens of the agency. The problem is they have to sort of beat the fear factor, the intimidation factor.” Such drum-beating is common in the agribusiness industry. However, companies that step forward and compete do fear retaliation. “We saw, this was an issue in Sysco-U.S. Foods. There were smaller alternative suppliers and food systems that absolutely would’ve been

affected by that. But they think twice about stepping forward because they’re dealing a very large and powerful company,” Moss says. However, when it comes to Amazon’s platform, antitrust will remain on alert but open to growing progress. “Technological innovation, digitalization, development of platforms is fine, as long as antitrust takes an active role in promoting one of two strategies. One is to promote access to platforms. We call this intra-system competition. So that’s having a Google or an Amazon [with] an access system that is really open and non-discriminatory. And because folks have to use a platform that that access is open and available.” Moss’ other strategy is that antitrust groups promote the development of multiple platforms that compete head to head. Unfortunately, it appears that we operate in a world right now that doesn’t have either strategy in place. “We have neither good intra-system competition where you know because we see competitive issues emerging around the platforms; nor do we have good intra-system competition because we don’t have competing, multiple platforms,” Moss says. In the end, there may be an attorney general in a state somewhere who is eyeing the governor’s mansion who will want to generate a name. The laws are not in the favor of anyone seeking a broad swipe at the firm. More important, the acceleration of the Amazon economy will continue, and simply breaking the firm up into separate pieces certainly isn’t going to alter the decline of jobs and dramatic overhaul of the economy.

Amazoned! The threat Amazon is posing to competitors and potential competitors.

companies. A Barron’s writer argued that grocery stores were largely immune from Amazon because Americans like to go to the grocery store. Another writer on April 1 argued that Home Depot (HD) and Lowe’s (LOW) held “a rare position in retailing: They are virtually Amazon-proof.” Perhaps Jeff Bezos was listening as this summer Amazon entered the grocery business in a big way with its planned acquisition of Whole Foods (WFM). And Amazon’s deal to sell Kenmore products from Sears led to a short-term dip across the board in the home improvement space. The creeping threat of Amazon has even led to a new word entering the English Dictionary. The term “Amazoned” – the destruction of value by ecommerce – has been pitched and is awaiting consideration from the Collins Dictionary. To gain an understanding of how significant Amazon’s threat to potential competitors is, we reached out to our friends at Sentieo, a digital research platform that helps investors identify trends and unique investment stories. The hedge fund platform revealed an interesting trend. During the last few years, we’ve seen more and more

How Big of a Risk is Amazon? Q By Garrett Baldwin Amazon’s increasing reach across the global economy has been nothing short of remarkable during the last decade. While the brick-and-mortar retail sector has experienced the most pronounced decline in the last decade, Amazon saw an increase in market capitalization of 1,910% from 2007 to 2016. We have witnessed financial publications speak of Amazonproof companies during the last 12 months. At the forefront, Barron’s had listed companies in the grocery business and the home improvement retail industries as “Amazon resistant” M o d e r nTr a d e r. c o m

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It may come down to how much competitors begin to complain. companies list Amazon as a”primary threat” in its competitive risk section in their annual report. Dozens of companies list their reliance to Amazon Web Services and Amazon’s distribution platform for sales. But we were more interested in the 68 companies that view Amazon’s increasing migration into their core activities as a threat. That is more than President Donald Trump poses to the markets. And the spectrum is quite revealing. First, one must be intrigued by the growing threat Amazon has

presented to the music and entertainment industry. Second, more and more major companies with strong growth potential and reliable cash flow are dedicating larger portions of their Form 10-K to address the competitive threat. This story opens up a broader debate on one of the growing agreement that reporting threats needs to improve for investors. In 2014, an ACCA report indicated that investors are increasingly concerned about the quality of risk reports. A conference determined that 80% of respondents argued that companies

NAMING THE ENEMY Here is a list of companies who have identified Amazon as a threat to their business.

AUTO PARTS U.S. Auto Parts Network, Inc. (PRTS) CLOUD, ENTERPRISE SOFTWARE, DATA Endurance International Group (EIGI) 8x8, Inc. (EGHT) New Relic (NEWR) Red Hat (RHT) Otelco Inc (OTEL) Internap Corp (INAP) LogMeIn Inc (LOGM) CDW Corp (CDW) Vonage Holdings Corp. (VG) Godaddy Inc (GDDY) Gigamon (GIMO) CSG Systems International, Inc. (CSGS) Shutterfly, Inc. (SFLY) Brocade Communications Systems, Inc. (BRCD) Hewlett Packard Enterprise (HPE) COUPONS Quotient Technology (QUOT) ECOMMERCE ITEX Corporation (ITEX) Alphabet (GOOGL) CommerceHub Inc (CHUBA) Overstock.com, Inc. (OSTK) Etsy Inc (ETSY) Liberty Interactive Corp (QVCA) Wayfair Inc (W) Priceline Group Inc (PCLN) Mercadolibre Inc (MELI) Liberty Tripadvisor Holdings Inc (LTRPB) Tripadvisor Inc (TRIP) 48

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EDUCATION Barnes & Noble Education (BNED) Dream Homes & Development Corp (DREM) FILM AND ENTERTAINMENT, Video MSG Networks (MSGN) News Corp (NWS) Viacom, (VIAB) Netflix, Inc. (NFLX) World Wrestling Entertainment, Inc. (WWE) TiVo Corp (TIVO) E. W. Scripps Co (SSP) AMC Entertainment Holdings Inc (AMC) Trans World Entertainment Corporation (TWMC) Shenandoah Telecommunications Company (SHEN) Harmonic Inc (HLIT) Neulion Inc. (NEUL) Cable One (CABO) Lions Gate Entertainment (LGT) Dish Networks (DISH) AMC Networks (AMCX) Liberty Broadband Corp (LBRDA) Limelight Networks, Inc. (LLNW)

MUSIC AND STREAMING Liberty Braves Group (BATRA) Pandora Media Inc. (P) Loton Corp (LIVX) CUR Media Inc. (CURM) PAYMENT SERVICES Mastercard Inc (MA) Planet Payment (PLPM) Vantiv Inc (VNTV) GH Capital (GHHC) RATINGS REVIEWS AND MARKETING Bazaarvoice Inc (BV) Yelp Inc. (YELP)

RETAIL G-III Apparel Group, Ltd. (GIII) Kirkland's, Inc. (KIRK) Differential Brands Group Inc (DFBG) Tilly's Inc (TLYS) Systemax Inc. (SYX) Cabelas Inc (CAB) Barnes & Noble (BKS)

HARDWARE Logitech International SA USA (LOGI) HOME AUTOMATION Control4 Corp (CTRL) IMAGE RECOGNITION Digimarc Corp (DMRC)

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were overloading the risk factors to ensure that they had detailed anything that posed a threat. However, the process had watered down the risk report and obscured the key risks to the organization. It is clear that Amazon is not just a problem for brick-andmortar retailers anymore. Yet, while this list is quite robust, perhaps it’s more interesting to wonder why so many companies haven’t quite taken the responsibility to mention Amazon by name. From Sears to

Wal-Mart (WMT), from GroupOn (GRPN) to Krogers (KR), executives aren’t addressing the threat by name. Or perhaps they’ve chosen to just ignore it. Perhaps that’s why one in every 10 companies during the second-quarter earnings season received questions during their conference call on whether Amazon posed a threat to the company. Analysts and investors are tired of waiting for this insight. Instead, they’re choosing to identify their enemy (see “Naming the enemy,” left).

The “experts” are unanimous bulls on Amazon

Amazon’s View from the Street Q By Garrett Baldwin According to TipRanks, 33 Wall Street analysts rate Amazon a “strong buy” and have set a consensus price target of $1,174.68 over the next 12 months (see “It’s unanimous”). That represents 20.09% upside from the closing price on Aug. 16. Most revealing about Wall Street’s bullish view is that not a single analyst tracked on the accountability platform has issued a “sell” position. The most recent initiation of coverage occurred on Aug. 14 by IT’S UNANIMOUS TipRanks analysts all rate Amazon a buy. File: TipRanks chart

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SunTrust Robinson analyst Youssef Squali, who set a Buy rating and a price target of $1,220. Squali is rated No. 27 out of 4,627 analysts on TipRanks. Squali has a success rate of 73% and an average return of 19.6%. What has him so bullish about Amazon? While he noted that the company isn’t cheap, he argued that the company is “fundamentally compelling” given its domination in the ecommerce space, where it maintains market share of 40%. As we noted in previous coverage, Amazon is on pace to capture 50% of that space by 2021. Squali also cited several other factors. “Combined with a growing wave of physical store closings, rise of online private labels and strengthening of its logistics network, this move should help Amazon accelerate the pace of disruption of retail to gain share both offline and online,” Squali wrote in a note to clients. Issue 536

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AFTERTHEBELL L i f e , Lux u ry & t h e P u r s u i t o f H a p p i n e s s

Buying two lots:

Appreciating scotch After The Bell has extensively documented the phenomenal global increase in whisky consumption. This month we look into rare Scotch whisky as a distinct alternative investment asset class. Q By Andy Simpson Our guide to the world of exceptional rare whiskies is Andy Simpson, the renowned scotch authority at Scotland-based Rare Whisky 101. Andy is among the select few to be honored with the designation of Keeper of the Quaich — an exclusive international society of Scotch whisky experts. INSIDE The information that AFTER THE BELL follows appears in his Macallan’s Grand Slam mid-2017 report on the 53 European rare whisky The Macallan virtual secondary market and reality experience cocktail auction trends, which 54 is a reliable leading inSave your season with these fantasy foorball dicator for U.S. auction picks prices. 56 As for the two lots? Big money thinks small Buying at least two 58 bottles of desirable whisky at a time is the advice we consistently hear from whisky experts. One for long-term appreciation, the other for immediate appreciation.

portfolios (see “exotic collectibles” below). But it has gone beyond hobbies into real indexing. “Beating the benchmarks,”(page 50) illustrates Scotch whisky’s performance as an alternative asset class in its own right. Longer term, the Liv-Ex Fine Wine 100 out-performs all but scotch, while ADR shares of British Diageo plc (DEO), the world’s largest producer of spirits and a key producer of beer, out-performs the broader traditional equities market. Solid gold, as opposed to liquid gold, comes in a close second over the first half of 2017. However, scotch remains at the helm from a pure

investment perspective over both the first six months of 2017 and the longer term.

Market Overview As the secondary market for rare scotch continues to mature, we are seeing increased liquidity in what was once a relatively illiquid market. The trading costs associated with selling rare whisky are reducing as auctioneers compete for the best stock. Bottles are easier than ever to sell and prices are at all-time highs, so it is little surprise that we are seeing such significant increases in the number of

EXOTIC COLLECTIBLES Lloyd’s rates the average holdings of “Passion Investments.” Source: Lloyd’s Banking Group

Amount in USD (estimated)

Hobby Investment or new asset class? Evidence shows a broad–based acceleration of interest in alternatives and investments of passion. This was borne out by a report by Lloyds Banking Group in late 2016, which illustrated the average holdings of high-net worth investors among those that hold “hobby” investments in their M o d e r nTr a d e r. c o m

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BEATING THE BENCHMARKS This chart shows unique niche whisky & wine investments versus traditional benchmarks.

bottles sold. Through the first half of 2017, the market for rare whisky has experienced unprecedented growth. The number of bottles of Single Malt Scotch whisky sold at auction in the UK increased by 47.25% to 39,061. The value of collectable bottles of Single Malt Scotch whisky sold at auction in the UK rose by 93.66% to an all-time high. As would be expected, the average per-bottle price has risen to a new record of $370, up from $282 just 12 months prior. The Macallan’s secondary market dominance extends and it now accounts for almost 30% of every dollar spent at auction in the UK. The brand now has a 12.71% share of all bottles sold and 28.90% share of the dollar value. The incredible rise in recent times for The Macallan 18- and 25-year-old indexes shows no sign of slowing with the vintage 18-year-old index adding 142.10% in value in 2016, and the 25-year-old index delivering 77.83%. The volume of bottles of rare, desirable whisky sold on the open UK auction market is at an all-time high. We continue to see online and traditional whisky retailers starting their own auctions in order to compete in an increasingly crowded space. The days of retailers being able to snap up private collections at less than market value, add on a hefty margin, and retail them are now long gone. There appears to be seemingly 52

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limitless demand for and interest in the old, rare and exclusive bottles of scotch no longer available through traditional retail outlets. No matter how many bottles are sold at auction, demand continues to outstrip supply. Compared to the same six months last year, the first half of 2017 has seen a near 50% increase in volumes, and a 100% increase in the value of bottles sold. For the full year, 2017 is expected to be another record breaker as the charts and forecasts show.

What does it mean?

Sham dram

In late July at the Devil’s Place Bar in the St. Moritz Hotel, Waldhaus Am See saw an unnamed Chinese guest spent $10,277 for a single glass of Macallan 1878 vintage Scotch whisky. Despite the labels on the darkcolored glass bottle, which state that the whisky was distilled in 1878, and was matured for 27 years, whisky experts believe the nearly 140 year old single-malt bottle was fake. The hotel has launched a full investigation after a number of whisky enthusiasts challenged the bottle’s authenticity and Macallan owner, the privately-held Edrington Group, is assisting with the investigation. Tests are likely to analyze the cork, glass, label and liquid and may take up to six months. The hotel has promised to return the money to the guest if the liquid proves to be counterfeit.

Scotch’s lengthy bull-run clearly looks like it wants to continue. But speculators should keep a close eye on a significant dip in prices for the less desirable bottles. In May 2012, a bottle of Glengoyne “Fly Fishing” sold for $650. In June 2017 a bottle sold for just $60; a loss of 90.8% and a clear reminder that selecting the wrong bottle can be as surprising and punishing as any illiquid investment. We remain optimistic about scotch’s credentials as an alternative investment, but only, for the right bottles. Andy Simpson is the co-founding director of Rare Whisky 101 (rarewhisky101.com), rare whisky analysts, and brokers, and a Keeper of the Quaich. @WhiskyInvestor

Devil’s Place bar in St. Moritz is a Mecca for whisky lovers from around the world. With more than 2,500 different kinds of whisky, it is reputed to have the world’s largest collection. M o d e r nTr a d e r. c o m


LIQUID MARKETS AFTER THE BELL

In 2014, The Macallan accounted for the top 10 priced bottles sold at auction. In 2017, a new record has been set...and it is Macallan again

Grand slam In April, a collection of Macallan single malt whiskies set a new world record price for any lot of whisky sold at auction, selling for more than $993,000. The Macallan in Lalique Six Pillars Series – The Legacy Collection, a set of six stunning crystal decanters containing the rarest of The Macallan’s single malts aged from 50 to 65 years old, complete with an ebony cabinet from Lalique – was auctioned by Sotheby’s in Hong Kong. The winning bid by an unnamed buyer almost doubled the pre-auction estimate for the lot, which was predicted to sell between $260,000 to $500,000. The lot was sourced direct from the distillery. Housed in a bespoke natural ebony cabinet created by Lalique Maison, the Legacy Collection also holds six Macallan Fine and Rare miniatures; two from each of the 1937, 1938 and 1939 vintages (signifying the zenith of Lalique’s contribution in the French Art Deco period), and six pairs of Lalique Macallan glasses, each serial numbered to commemorate the unique partnership. Autographs of the masters behind the collection are also included inside the cabinet and allow for the buyer to have their own name M o d e r nTr a d e r. c o m

engraved within it as well. Since its inception in 2005, The Macallan in Lalique Six Pillars series has captured the imagination of collectors around the world. In 2014, The Macallan accounted for the top 10 priced bottles

sold at auction; eight out of 10 sales being decanters from The Macallan in Lalique series. In 2015, The Macallan was the most valuable whisky brand at auction, accounting for more than 25% of the total value traded at auction.

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AFTER THE BELL LIQUID MARKETS

The Macallan virtual reality experience cocktail I don’t need an excuse to enjoy rare scotch whiskies, but news that The Macallan and Baptiste & Bottle, a bar located in the Conrad Chicago, had joined forces to create a virtual reality cocktail experience provided some intriguing editorial cover. So, I rang up David Sweet, long-time operator of the Whisky Live (whiskylive.com) tasting events around the country, and our go-to whisky resource, to join me to be among the first to experience the recently-developed The Macallan Rare Journey — a technology-infused cocktail that takes guests on a multisensory journey via a virtual reality headset. The $95 cocktail features The Macallan Rare Cask, aged in the top 1% of all casks maturing at The Macallan distillery. The finished cocktail is a marriage of Bodegas Tradicion 30-year Oloroso Sherry and The Macallan Rare Cask. Raquel Raies, The Macallan’s first female National Ambassador conceived of this unique cocktail experience. Raquel personally walked Dave and I through each step of the immersive cocktail featuring a mossladen box, a curious acorn, dry ice and three empty glasses. As Raquel talked us through the “acorn to bottle” distillation process and The Macallan story, we learn that the distiller owns nine out of 10 sherry casks in the world. The casks used to make Rare Cask come from sherry houses that no longer exist, which is one of the reasons why Rare Cask retails for nearly $300 a bottle; and that this is such a rare experience. Rare Cask’s rich ruby-red whisky celebrates three of The Macallan’s greatest prides: Exceptional sherryseasoned oak casks, rich flavor and beautiful natural color. The interaction of spirit and wood alone delivers the 54

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beautiful range of vibrant natural colors and flavor complexities that distinguish The Macallan whiskies; these signature characteristics reinforce the brand’s position as one of the world’s truly great single malt whiskies. Ultimately, we put on the virtual reality goggles and fly through vineyards to sherry bodegas and end at the Macallan distillery and Easter Elchies house, the spiritual home that appears on every bottle of The Macallan. By the time the virtual trip is done, the cocktail is waiting for the guest to enjoy, along with side cars of Sherry and Rare Cask to sip on individually. This allows the guest to see how each spirit tastes on its own as well as together. As for the VR cocktail experience? Dave declared it “a unique and intriguing tasting experience that utilizes all of the senses to explain the history and craftsmanship that goes into producing special select bottlings of Macallan,” adding that it enhanced his appreciation for the intricate detail behind the brand. As for the Rare Cask, it’s very dark red for a scotch. The scent is rich with dark cherry, raisins, cocoa and a whiff of citrus. The sherry, chocolate and apricot nectar flavors are immediately apparent. The finish is elegant. The entire Rare Journey cocktail experience is certainly unique and engaging. But in the end, it is all about the Macallan Rare Cask, which is exquisite all on its own. The $95 cocktail was fun, and we find a two-lot purchase of Rare Cask by the bottle to be the more prudent trade. Photos top to bottom: Raquel Raies, National Brand Ambassador for the Macallan; Drink menu at Chicago Conrad’s Baptiste & Bottle; The Macallan Rare Journey VR Cocktail

M o d e r nTr a d e r. c o m


AFTER THE BELL SPECULATOR

Save your season with these fantasy football picks Q By Garrett Baldwin With NFL season on the horizon, it’s time to take a look at our Fantasy Football value picks. Last year, we nailed it on Drew Brees, Jordan Howard, Frank Gore and Dwayne Allen. We missed pretty badly on Duke Johnson, Demaryius Thomas, Mohammed Sanu and Eli Manning. But fantasy football is all about value. Get half of your final eight picks right, and you’re looking at a team capable of making a run to the championship. This year, we’re looking again at 16 players who might save your season.

The high upside picks Quarterback: Ben Roethlisberger: You’ll probably only want to start him at home. But when he’s playing in Pittsburgh, watch out. The addition of Martavis Bryant makes this a top three offense in the NFL. Matthew Stafford: It seems like everyone hates this guy, but with a questionable run attack in a conference that is stacked with good offenses, the Lions will live and die by Stafford’s arm. He’s a great player to draft and pair with another quarterback that has solid games on the docket. Phil Rivers and Andy Dalton come to mind.

Running back Derrick Henry: He’s going mid-7th round. I’m taking him at 66th overall. If Demarco Murray gets hurt, you’re looking at a top-five back. If Demarco Murray gets hurt, you’re looking at a top 25 back, which is fair value in the previous round. Joe Mixon: If the Cincinnati Bengals stop with the loyalty to veterans (another way of hurting your team and guaranteeing poor outcomes), then Mixon will get 18 to 22 touches per game and run away with rookie-of-theyear honors and have numbers close to Adrian Peterson’s rookie year. 56

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Wide receiver Jarvis Landry: The loss of Tannehill is going to curb the expectations for Devante Parker. Jay Cutler throws the ball to possession receivers. Jarvis Landry moves the chains...and the Dolphins will be throwing a lot if Cutler is there ruining everyone’s dreams in Miami. Jeremy Maclin: Possession receivers in the slot receive lots of targets. Maclin will lead Baltimore receivers in catches and yards. Yet, people are valuing him and his teammates the same. This is a number four receiver who will offer number two value.

Tight end Rob Gronkowski/Coby Fleener: This is the year to take Rob Gronkowski. For a TE, you’re looking at about 168 points on the year (assuming he stays healthy) in the early third round. That is better than all but eight wide receivers (and there is a lot of uncertainty between after you pass through the top 10 receivers). If you’re drafting Gronk, you’ll need insurance. That can be found late with Coby Fleener as a bounce back candidate.

to double down. This year, Manning has a shaky running game behind him, and four outstanding receiving threats in Odell Beckham Jr., Brandon Marshall, Sterling Shepherd, and tight end Evan Engram. Tyrod Taylor: A top-eight quarterback going number 16th overall in drafts. Madness.

Running back Jonathan Williams: Mike Gillislee did wonders in Buffalo last year as LeSean McCoy’s backup. Williams is better, and Buffalo is going to run the ball. He is a great value in touchdownonly leagues where points are a premium. Ten touchdowns are possible by the end of the year. Alvin Kamera: Remember when Darren Sproles played for the Saints and broke off 60-yard screen passes? It will be similar this year.

Wide receiver Randall Cobb: Wide receiver is so deep and uncertain that a guy who was borderline top 12 in 2015 is sitting at a consensus 44 this year. Do people think that Jordy Nelson and Devante Adams are going to catch everything? Cobb is healthy again, and he’ll be all over the field. Eric Decker: He’s the number one receiver in Tennessee, he has a better quarterback in Mariotta than he did in New York, and he is the team’s only red zone threat. Great value.

Tight End Fantasy sleepers for late in your draft: Quarterback Eli Manning: Sometimes you just have

Julius Thomas: This is a scheme play. Adam Gase made Thomas a star in Denver, and Jay Cutler made Martellus Bennett a star in Chicago in 2014. Thomas can play, M o d e r nTr a d e r. c o m


SPECULATOR AFTER THE BELL

(Top)Rob Gronkowski. (Bottom) Ben Roethlisberger.

and Gase will make sure he’s open with Parker taking the top off the defense. Austin Hooper: Upstart and stillunknown Atlanta Austin Hooper is a guy with a lot of upside. If you’re going to take a tight end early, remember that Kelce, Gronk and Reed have injury risk. So, be sure to reach for a guy who can finish the year in the top 10 and not cost you dearly this season.

Buyer beware:

(Top) Disney, ABC Television Group. (Bottom) Keith Allison.

Check the average draft position before you pick these players • Round 1: Jordan Howard. Last year, he was a deep value. This year, he’s going in the first round of drafts ahead of Demarco Murray and Todd Gurley. Howard is the center of the Chicago offense, but the Chicago Bears are a very bad team, that could abandon the run very early. • Round 2: Leonard Fournette: Someone in your draft is going to take him early, but this is not the same player as Ezekiel Elliott and the Jaguars are not the Cowboys. Take Isaiah Crowell or Lamar Miller instead given their more stable floors. • Round 3: Brandin Cooks: You have to believe he is the second coming of Randy Moss, but this passing game will still run through Gronkowski this year. Cooks is more of a low-end #2 who will have boom or bust weeks. Not what I want in a number one receiver, but take at a price. • Round 4: Allen Robinson: He’s a rebound candidate, but you have to trust Blake Bortles. No reasonable person trusts Blake Bortles, not even his parents. M o d e r nTr a d e r. c o m

• Round 5: Ameer Abdullah: The hype train is heavy with this one, as Abdullah is getting a lot of love in preseason drafts. • Round 6: Kelvin Benjamin: The addition of Christian McCaffrey makes him a risky proposition. • Round 7: Emmanuel Sanders: Is Paxton Lynch really going to be the quarterback this year? • Round 8: Rob Kelley: Avoid Washington running backs not named Samaje Perine. • Round 9: Jamaal Charles: His knees scare us. Why take him when John Brown is available? • Round 10: Houston Defense: The second defense usually comes off the board in the 10th round. Meanwhile, Corey Coleman will still be available, and the depth you get right here for a bye week is critical.

• Round 11: Kenny Britt: Can you name the starting quarterback of Cleveland? If not, you should be looking at bounce back candidate Marvin Jones or rookie speedster Zay Jones. • Round 12: Kenneth Dixon: This is cheating, but it’s also a reminder that Dixon is out for the season due to knee surgery. That said, if you’re setting up on auto draft, make sure you remove him from your late round selections. • Round 13: Stephen Gostkowski: This is right around the place where we start to see a kicker run. Meanwhile, Jonathan Williams in Buffalo, Ted Ginn in New Orleans, or super-handcuff Darren McFadden are waiting to help teams build depth. Personally, I don’t even draft a kicker in a live draft. • Round 14: Blake Bortles: Thou shall not draft Blake Bortles. Issue 536

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AFTER THE BELL REVIEWS

Book Value Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing By Joel Tillinghast Columbia University Press Published: August 2017 312 pages Format: Hardcover & e-book List price: $29.95 (£24.95)

Do not invest emotionally using your “gut”; Do invest patiently and rationally. Do not invest in things you don’t understand, using knowledge you don’t have; Do invest in what you know. Do not invest with crooks or idiots; Do invest with capable, honest managers. Do not invest in faddish or fast-changing, commoditized businesses with a lot of debt; Do invest in resilient businesses with a niche and strong balance sheet. Do not invest in red-hot “story” stocks; Do invest in bargain-priced stocks.

Thirty-six-year veteran fund manager Joel Tillinghast shows investors successful stock market investing in this informative manual. One of the most persuasive tips Tillinghast offers is to only invest in businesses that you understand, which explains how an obscure economist came to launch the market-beating Fidelity Low-Priced Stock fund nearly 28 years ago. Tillinghast explains how the best investment risks are those that you can analyze and that offer favorable odds. Unless you have taken the time to understand the details, complexity is your enemy. Big Money Thinks Small points out that some investors may develop a false sense of confidence after reaping large profits on luck bets. More often than not high-stakes gambles backfire, not only hitting you in the balance sheet but also taking a mental and emotional toll. To remain emotionally focused in such a volatile profession, Tillinghast provides a very useful checklist written for investors at all levels. These principles can be seen as a useful list of do’s and don’ts:

This practical, no-nonsense guide doesn’t reveal specifics on where to invest, but it does speak to the value of human judgment, so you can generate your own informed choices. Tillinghast urges investors to act cautiously and follow primary steps to successful investing and he provides tables and figures to give a psychological breakdown of traits of successful investing. He also addresses relevant questions including how to anticipate market changes. Tillinghast explains how to be patient, self-aware and how to plan methodically, which will pay far greater dividends than flashy investments. In Big Money Thinks Small, some discussions are fairly basic; such as how to select trustworthy money managers; but other are more robust points, such as how to value stock properly. Tillinghast teaches readers how to learn from their mistakes and his own: He stresses avoiding emotional decisions, investments that you don’t understand well, bad people and unstable business. While most of these lessons are pretty basic, it doesn’t hurt to be reminded of them because it only takes one bad decision to lose a fortune. Big Money Thinks Small explores the tools investors need to ask the right questions in any situation and feel empowered to think objectively and accordingly about portfolio management. --By Tamarah Webb

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TRADING PIT AFTER THE BELL

1

1

CQG trading executing platform

2 Live price monitoring via CQG

2

3 Live portfolio monitoring

3

4 Development of new strategies

4 5

Irene Perdomo: Co-founder and principal Firm: Devet Capital Investments Limited Strategy: Systematic market neutral (commodities) Location: London

5 ABN AMRO AIF 2016 award

BREAKOUT AFTER THE BELL

If at first you don’t succeed … throughout the year, according to BI. MRA specialized in analyzing global market risk and executing transactions on behalf of institutional investors, according to its website. Business Insider reported in April that “50-cent” had already racked up $89 million in losses in the hope of a spike in the VIX. Those losses grew to $150 million prior to the recent winner. Apparently, the moniker is in reference to the size of the bets he makes. Business TRY AND TRY AGAIN Insider noted that the trader’s “50-cent’s” losses grew to $150 million prior to its recent losses in the hope of a spike in the VIX. identity has been traced by the Source: eSignal Financial Times to Ruffer LLP, a $20 billion London-based investment management firm. According to the story, “50cent” is reinvesting the recent profits into more long out-of-themoney VIX calls.

Business Insider has been reporting on the unusual trading activity of a mystery trader who placed a profitable short equity bet to the tune of $21 million on the Aug. 10 move in the CBOE Volatility Index (VIX). The trader dubbed “50cent” by independent broker-dealer Macro Risk Advisors (MRA) has made a series of unsuccessful volatility bets

M o d e r nTr a d e r. c o m

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The Past 12 Months of MODERN TRADER…

The Trouble with Restaurant Stocks Inside our meatiest issue ever Feature Stories: Our look at the sector’s risk factors and the new automation technologies that will fuel further growth included a never before published short-trade thesis on restaurant stocks developed by hedge fund research portal, Senteio, an interview with former McDonald’s CER Ed Rensi on the sector’s challenges and hopes, the restaurant sector’s MENU index ETF, what cattle futures are telling us about higher beef prices and more than 40 restaurant stock picks and pans. Special Reports Included: A profile of a volatility trader with a successful 20-year track record, Golden Brackets: Strangles Provide Sizeable Yield, ABC: Symmetry, Harmonics & Patterns, Trading the Locomotive Breakout, Renko Bricks, Our 11 Favorite Assets That We Will Never Trade Away, The Morton Steak House Legacy, Five Favorite Mail Order Meats, New Book, Music & Media Reviews and our guest editorial calling out the folly of a mandated federal minimum wage increase.

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TECHNIQUES&TACTICS 6

Essential, time-tested trading strategies

PAPER TRADE

Options can be simple tools or extremely complex tools depending on your goals. Here we start at the beginning.

Options Basics Q By: Michael Thomsett

expiration month. The last trading day is the third Friday. After an Many stock traders have heard of options but do not really option’s expiration, it ceases to exist and becomes worthless. understand them. Others assume they are complex and high-risk. This does not always have to be true, as many forms of options are • Strike price: The strike price is the fixed price at which conservative and straightforward. exercise will occur. So, an option with a strike at 25 will be A major hurdle to developing a working exercised at $25 per share. knowledge of options is terminology. The options To properly describe an option, you need to clarify INSIDE industry is full of exotic terms and phrases; this not all four of these terms. “An option’s components” TECHNIQUES only confuses outsiders but discourages them. So (right) shows a listing with all terms spelled out: the & TACTICS here is an attempt to explain the basics, if only to underlying McDonald’s (MCD), expiration month, Trading Bearish provide a starting point. day and year, strike price and type of option (in this Shark Patterns An option has no tangible value; it’s a contract case, a call). 64 that grants its owner specific rights. Every option The option is highly leveraged, averaging between Trading Social Media has four standardized terms that distinguish one 3% and 5% of the price of 100 shares of the Sentiment Indicators 67 option from another. These cannot be transferred or underlying stock. But because it will expire by a changed. They are: specified date, the value of the option (known as its Summer Weather Rally Primes premium) tends to decline as expiration gets closer. • Underlying security (or asset): All options are Premium Pump An option buyer can never lose more money than the written on a specific underlying security (a stock, 70 cost of the option, so risk is limited to the value at index, ETF or futures contract). This can never The Bonus Trade the time of purchase. be changed. So as part of identifying an option, 70 Options can also be sold. A seller grants all the underlying security also has to be defined. Trading Weatherof the rights of exercise to a buyer, including • Type of option: There are two types of options. driven Grain Markets the risk that an option can be exercised. In that A call grants its owner the right—but not the 75 case, option sellers will have 100 shares called obligation—to buy the underlying asset (100 away (through selling a call) or will have 100 shares of stock in the case of a security). A put shares put to them (by selling a put). grants its owner the right—but not the obligation—to sell the It is important to keep in mind the following points about options: underlying asset or security. 1. The rights granted through an option to buy or sell, are never • Expiration date: All options expire on a specific date. infinite. Expiration is a fact of life in options trading. For monthly equity options, that is the third Saturday of the

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TEC H N IQ U E S & TAC TI C S PAPE R TR AD E

“An option has no tangible value; it’s a contract that grants its owner specific rights.”

2. Terms can never be exchanged with other terms; they are fixed and permanent. 3. The most common form of listed option applies to 100 shares of stock. An easy method to keep different options and positions in mind is to check the following four-part list describing the four possible simple types of trades, which are as follows: 1. Buy a call (buy the right to buy 100 shares). 2. Sell a call (sell to someone else the right to buy 100 shares from you). 3. Buy a put (buy the right to sell 100 shares). 4. Sell a put (sell to someone else the right to sell 100 shares to you). Directional ideas also define whether to buy or sell, and whether to use calls or puts. “Matching trades” (right) summarizes how this works.

AN OPTION’S COMPONENTS

Know your Greeks Another consideration for how options can be valued is through a series of factors known as the “Greeks.” The first of these is Delta. Calls have positive Delta between 0 and 1, and puts have negative Delta between 0 and -1. Delta represents the level of price move in an option you expect to see, based on changes in the underlying. If the underlying moves one point, you expect it to move point for point with the underlying. A 0.50 Delta means you expect a 50¢ move for every $1 of movement in the underlying price. The second Greek is called Gamma. This is the rate of Delta‘s speed of movement. It is the momentum (or acceleration) of the Delta. High Gamma implies a high level of responsiveness by an option to movement in the underlying. A third Greek is Theta, which measures

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time decay. As expiration approaches, the rate of time decay in the premium of the option increases. Theta measures the degree of price change in the option for an equal move in the same time period by the underlying. Theta is going to be different for at-the-money options (when the strike price is at or near the current price per share) than for in-the-money or out-of-the-money options. This “moneyness” measures the distance between underlying price and strike. Vega, a fourth Greek, defines change in call or put premium value for each change in volatility. The volatility is an estimate of how much movement you will see in the option over time and based on a series of assumptions based on current conditions in the underlying and in the option itself. It is extremely important to understand the Greeks before you begin trading options. The Chicago Board Options Exchange (CBOE) provides a free calculator ( cboe.com/trading-tools/ calculators), which performs the various calculations of the Greeks. To anyone new to options, what constitutes long and short positions can be confusing. Following is a table that explains it. M o d e r nTr a d e r. c o m


PAPER TRADE

MATCHING TRADES A long call or short put is equivalent to a long position in the underlying, and vice versa.

Call buyer Call seller Put buyer Put seller

Increase in Price Positive Negative Negative Positive

Decrease in Price Negative Positive Positive Negative

A difficult aspect to options trading is in understanding the differences between long and short. A long option is a buy of either a call or a put. A long trader buys the option as a first step and closes it later. A short option is a sell position. In this case, the first step is a “sell to open” and the last step is a “buy to close,” so the sequence of events is reversed: sell, hold and buy. With these distinctions in mind, the question remains: Are options always high-risk? Some types of options trading are highrisk. Selling calls, for example, without also owning shares of stock, is a “naked” trade and could lead to significant losses. But on the other side of the risk spectrum, selling a call when you also own 100 shares of stock is a very conservative trade. It generates income, but you still M o d e r nTr a d e r. c o m

earn a dividend as well. This “covered” call eliminates the risk of a short sale. In the event of exercise, you are required to deliver 100 shares at the current price. Having those shares on hand makes this an easy final step. And if the strike of the covered call was higher than your original cost per share, you also get a capital gain on the stock. In between the uncovered or naked call and the covered call is broad range of trades. These run the full range from high-risk to extremely conservative. So the two overall rules about options are: Learn the terminology and trading rules, and understand the true risk level before making a trade. An excellent way to learn about options trading without putting money at risk is to “paper trade” first. This is a system of trading in an artificial or “virtual” portfolio that behaves exactly like the real thing; but no money is placed at risk. Many exchanges, brokerages and trading platforms offer paper trading. Once you learn the basics, you need to decide for what purpose you will trade options. Options can be used to take directional bets on an underlying market,

TEC H N IQ U E S & TAC TI C S

“It is extremely important to understand the Greeks before you begin trading options.”

as a risk management tool or as a bet on movement in volatility. The great benefit of options over trading an underlying security or futures contract is that you can define your risk and make a much more precise trade. When buying an option, whether as a directional play or for risk management purposes, you only risk the premium you pay. Selling naked options entails more risk, but not any greater risk (other than leverage) than in an outright position in an underlying security or futures contract. When using options it is best to first define what you are trying to accomplish. Are you making a directional bet? Are you hedging an existing position? Are you looking to benefit from an expected spike in volatility? Once you know that and have an understanding of the Greeks so you know where to expect prices to move based on the movement of the underlying, you can decide on which options tools to use. Michael Thomsett is author of 11 options books and has been trading options for 35 years. Thomsettpublishing. com @michaelthomsett Issue 536

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TEC H N IQ U E S & TAC TI C S C H A R T PAT TE R N S

C H A R T PAT TE R N S

Applying classic chart patterns to current trading opportunities

TEAM TRANSPORTS Below are the component stocks in the Dow Jones Transportation Average.

Trading Bearish Shark Patterns

Stock Alaska Air Group Inc C.H. Robinson Worldwide Inc. Cirrus Networks Holdings Ltd. CSX Corp. Delta Air Lines Inc Expeditors International of Washington Inc. FedEx Corp. GATX Corp. J.B. Hunt Transport Services Inc. JetBlue Airways Corp. Kansas City Southern Kirby Corp. Landstar System Inc. Matson Inc. Norfolk Southern Corp. Ryder System Inc. Southwest Airlines Co. Union Pacific Corp United Continental Holdings Inc. United Parcel Service Inc.

Q By: Suri Duddella The modern world has seen plenty of disruptions in its path of modernization. Disruptive innovations are necessary along with new technologies and new entrants to provide faster and more efficient technologies, methods and services going forward. The past disruptive technologies include the Sony Walkman, Minicomputers, increased computer storage, iPods, the Kindle, the iPhone and much more. The world should look at these disruptive technologies as a positive force to make products and services easily accessible and affordable for the masses. Amazon (AMZN) has been at the forefront of disruptive technologies since 1999, as it is changing how people interact, eat, work, shop, dress and travel. Amazon’s big attraction for consumers is its low prices with free shipping. Amazon achieves this ultra edge of affordable low price and convenience through high-tech innovations,

superior supply-chain management and its fulfillment network. A secular shift in consumer behavior with Amazon’s technological innovative ideas has given Amazon a stronghold in e-Commerce and retail sectors. Their recent acquisition of Whole Foods Market (WFM) is an example of grocery disruption. But it has also created major disruptions in the cloud services, retail and transportation sectors. In 2013, Amazon’s CEO Jeff Bezos introduced the world to its futuristic delivery plan of using drones. With drones and self-driving trucks, disruption is headed for transportation. Amazon is preparing its transportation disruption using cutting-edge technologies, innovative logistics and massive fulfillment networks. Technology disruptions affect industries across all sectors. Drones and self-driving trucks will affect the transportation sector along with the trucking, insurance, con-

“Drones and self-driving trucks will affect the transportation sector along with the trucking, insurance, construction, auto parts and hotel sectors.” 64

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Source: CNBC

Symbol ALK CHRW CNW CSX DAL EXPD FDX GATX JBHT JBLU KSU KEX LSTR MATX NSC R LUV UNP UAL UPS

struction, auto parts and hotel sectors. The Dow Jones Transportation Average (DJTA), also known as the Dow Jones Transports, is made up of airlines, railroads and trucking companies. The DJTA is the oldest U.S. stock index, compiled by Charles Dow, co-founder of Dow Jones & Company, and dates back before the Dow Jones Industrial Average. This index consists of airlines, railroads, trucking; and delivery services and marine transportation stocks (see “Team Transpoports,” above). Here, we will present a five-point Harmonic pattern formation (Bearish Shark) in the DJTA ($TRAN) and how to trade it.

5-Point Harmonic Patterns The foundation and trading concepts of Harmonic patterns were introduced by H.M. Gartley in 1932. Gartley wrote about a five-point pattern (known as Gartley) in his book, Profits in the Stock Market. Few other authors have worked on this pattern M o d e r nTr a d e r. c o m


C H A R T PAT TE R N S TEC H N IQ U E S & TAC TI C S

GARTLEY BULLS & BEARS Below are examples of the Gartley bull and Gartley bear five-point Harmonic pattern. Source: SuriNotes

and its symmetry in markets. Fibonacci ratio analysis works well with any markets and on any time frame. The basic idea of using these ratios is to identify key turning points, retracements and extensions along with a series of market swings. The derived projections and retracements using these swing points will give key price levels for price targets or stops.

GARTLEY BULLISH

Pattern Identification

GARTLEY BEARISH

theory. The best works have come from Scott Carney in his books on Harmonic Trading. Carney also discovered patterns: Crab, Bat, Shark and 5-0; and added depth of knowledge with Fibonacci ratios and established trading rules to improve risk and M o d e r nTr a d e r. c o m

money management. His pioneering work is impressive, and has opened newer trading styles and careers for many traders. The primary theory behind Harmonic patterns is price/time movements, which adhere to Fibonacci ratio relationships

Harmonic pattern identification can be a bit hard with the naked eye, but once a trader understands the pattern structure, it can be relatively easily spotted by Fibonacci tools. The primary harmonic patterns have fivepoints: Gartley, Butterfly, Crab, Bat, Shark and Cypher patterns. These patterns have embedded three-point (ABC) patterns and four-point (ABCD) patterns. All the price swings between these points are interrelated and have harmonic ratios based on Fibonacci. Patterns are either forming or completed “M” or “W-shaped” structures, or combinations of “M” and “W” in the case of three-drives. Harmonic patterns (fivepoints) have a critical origin (X) followed by an impulse wave (XA) followed by a corrective wave to form the “EYE” at (B), completing the AB leg (see “Gartley bulls & bears,” left). Then, this is followed by a trend wave (BC) and finally completed by a corrective leg (CD). The critical harmonic ratios between these legs determine whether a pattern is a retracement based or extension based pattern and defines its names: Gartley, Butterfly, Crab, Bat, Shark and Cypher. One of the significant points to remember is that all five-point and fourpoint harmonic patterns have embedded ABC (three-point) patterns. All five-point harmonic patterns have similar principles and structures, and they differ by their ratios to identify them and locations of key nodes: X, A, B, C, D; but once one of the patterns is understood, it may be relatively easy to grasp knowledge of others. It may be helpful for traders to Issue 536

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TRANSPORTS SHORT A short signal in for the Bearish Shark Pattern was initiated on July 18. By Aug. 1, $TRAN was approaching the first profit target. Source: SuriNotes

action point D. The projections are computed using Fibonacci ratios like 62%, 78.6% of XA leg and added to the action point (D). The extension ratios—1, 1.27, 1.62, 2, 2.27, 2.62—are computed for potential target levels. The primary target zones are marked computed from D as 62% to 78.6% of the XA leg (or largest of XA and CD) as the first target zone and 127% to 162% as the second target zone. Target Zone1: (D + XA*0.62) to (D+XA*.786) Target Zone2: (D + XA*1.27) to (D+XA*1.62)

Shark Engaged

use an automated pattern recognition software to identify these patterns rather than relying on the naked eye, which could produce false positive signals.

Trade Entries and Stops The most effective trades in these five-point patterns are reversal price-action ones combined with a reversal trend change from the reversal zones at point “D.” It could be a bullish pattern or a bearish pattern. Usually, “D” is identified by a confluence of projections, retracements and extensions of prior swings (legs), universally called a reversal zone. The entry criteria and pattern validity are determined by various other factors like volatility, underlying trend, volume structure within the pattern and

market internals. If the pattern is valid and the underlying trend and market internals agree with the harmonic pattern reversal, then entry levels (EL) can be calculated using price-ranges, volatility or some combination. Stops are placed above/below the last significant pivot (in five- and four-point patterns it is below D for the bullish pattern, above D for bearish patterns).

Target Zones Target zones in harmonic patterns are computed based on the retracement, extensions or projections of impulse corrective swings and Fibonacci ratios from the action point of the pattern structure. For example, in Gartley’s bullish pattern, the target zones are computed using XA leg from the trade

“The primary theory behind harmonic patterns is price/time movements, which adhere to Fibonacci ratio relationships and its symmetry in markets.” 66

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The following example shows an auto-generated Bearish Shark (five-point) pattern formation in the DJTA (see “Transport short,” left). After a steep rise in $TRAN from January 2016 to June 2017, prices may have formed a top as it builds a Bearish Shark pattern. The Bearish Shark pattern is a variation of the Gartley pattern with different retracement and extension ratios. A Bearish Shark pattern formed after extending beyond both point X and point A. Point “B” also formed at a critical 61.8% XA level. How to it trade it. 1. A potential completion zone is formed in a cluster around 9600 to 9800. This indicates a Bearish Shark pattern is complete with an entry level (EL) below 9661. 2. On July 18, 2017, $TRAN closed below the entry level (EL) to trigger a short trade at 9661. 3. A stop is placed above point D at 9763. 4. The first target zone is set at 89629133. The second target zone is set at 8112-8469. Suri Duddella is a 20-year veteran pattern-based, algorithmic trader and author of Trade Chart Patterns Like the Pros. @tradepatterns M o d e r nTr a d e r. c o m


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Short-term social media sentiment analysis can help improve trading systems

Trading Social Media Sentiment Indicators Q By: Philipe Saroyan With the growing popularity of social media and its induction into investment and trading metrics, there is a growing interest in studying it’s ability to predict market movement. Here, we review prior research and attempt to answer the question of whether or not it can be a valid predictor of stock and currency returns. In seminal research from University of Pennsylvania Professor Philip Tetlock, there is a distinguishing factor between sentiment and information given news or media release. New news, or information, such as earnings and/or economic developments, has permanent effects on stock returns. This is opposite to the so-called sentiment effects given news, where the media may just be repeating themselves with news that has already been put out in the public domain. This is what’s called a media effect, and it

does still have an impression on stock returns; but only temporarily. The major point of his sentiment research is that negative news, which is new information, can cause greater risk-adjusted returns in stocks, up to one quarter after the release. The research also shows that stock returns were quickly reversed with so-called sentiment effects from news. In this case, the focus is on social media quantified by the five-day raw score gathered from Social Market Analytics (SMA). The raw score is an

unweighted, unbiased statistic of social media from Twitter and StockTwits. This is our proxy for the so-called Social Media Factor (SMF), which can filter real news and information, as well as what is pure sentiment. When the five-day raw score is positive, it will generate a buy signal, and when the five-day raw score is negative, it generates a sell signal. Because this requires some sophisticated text analytics via computer coding, the best way to replicate this SMF indicator is to either license

ª

HOW IT WORKS This flow chart on sentiment analysis goes through all of the factors and variables that can be a cause and effect to a stock’s price return. Source: Highcharts.com

“When the NAV price is at a discount to the previous day’s average price, this creates a sell signal.” M o d e r nTr a d e r. c o m

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the data through SMA, or to gather some end-of-day data from similar data vendors.

Data & Methodology One possible way to emulate the five-day raw score is to simply compile data from Sentdex online and take a five-day moving average of its data on the spot euro. Sentdex provides multiple sentiment indicators for different markets and trading instruments. The company, also in the explanation of the data, shows the difference between keyword usage and weighting versus a neuro-linguistic programming (NLP) method. The data from SMA uses a proprietary NLP algorithm, which weights and synthesizes data from StockTwits and Twitter. This is important to understand because the source of the data is purely from social media. This would be our best proxy for sentiment with regard to a SMF, which is expounded in prevailing research. The Sentdex source on the other hand, will generate an indicator from news sources, which is also relevant, but more a proxy for the sentiment given news as described, and illustrated in “How it works” (page 65).

“The sentiment trader should be ready to take profits when the OSI is outperforming the five-day raw score.” 68

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An alternative method is to test sample data from Accern for free via Quantopian. That company provides a sample set of news sentiment scores on the entire stock universe for the period of August 2012 to February 2014.

Proprietary Sentiment Indicator One of the baseline indicators the Options Sentiment Indicator (OSI) is our noise trading indicator calculated and summed up using total open interest of underlying options. For this dataset, we use the Euro ETF (FXE). It differs from traditional put-call ratios in that it is able to explain all option buying and option writing activity; whereas, traditionally, a put-call ratio can only explain the buying activity, without accounting for positions that were sold to open. The indicator generates a buy signal when there is net call buying and net put writing; effectively a synthetic long futures contract bought by the collective market. And, it generates a sell signal when there is net put buying and net call writing, equivalent to a synthetic short futures contract. The calculation can be seen later on in this article.

Backtested Strategy Results “Keeping score” (below) summarizes the portfolio statistics for each sentiment trading strategy on the euro. The backtest period is from May 2014 to May 2016. Notice the five-day Raw Score indicator, it has the best risk-adjusted performance of all the data sets. “Taking the next step” (right) shows the portfolio statistics when incorporating an added sentiment indicator based on whether the ETF’s Net Asset Value (NAV) is trading at a premium or discount. This is an additional sentiment trading indicator called the Closed-End-Fund Discount (CEFD) indicator, which is ideal for discounting sentiment as a trading tactic. For the CEFD indicator to generate a buy signal, the NAV should be trading at a premium from the previous day’s average price; this confirms a buy signal for the CEFD indicator. When the NAV price is at a discount to the previous day’s average price, this creates a sell signal. The indicator’s formula is:

This indicator is contrarian, opposite the other two indicators, which are

KEEPING SCORE Summary portfolio statistics results.

DATA SET

SAMPLE SIZE 5-Day Raw Score 477 Euro ETF 477 OSI + 5-Day Raw 86 Score OSI 86

WINS 257 224 43

HIT RATE (%) 53.88% 46.96% 50.00%

48

55.81%

MU (MEAN)* 8.810% 6.63% 2.53% -0.94%

RHO (S.DEV)* 5.76% 5.77% 3.39%

SHARPE RATIO 1.5 1.1 0.7

3.08%

-0.3

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TAKING THE NEXT STEP Portfolio Statistics with CEFD indicator. Source: sourcegoeshere

DATA SET

SAMPLE SIZE 477 88

Euro ETF 5-Day Raw Score + CEFD Indicator OSI + 5-DAY RAW 46 SCORE + CEFD CEFD Indicator 477 OSI + CEFD Indicator 175

WINS 224 52

HIT RATE (%) 46.96% 59.09%

MU (MEAN)* 6.63% 2.19%

RHO (S.DEV)* 5.77% 1.94%

SHARPE RATIO 1.1 1.1

27

58.70%

1.25%

1.57%

0.8

236 91

49.48% 52.00%

2.53% 0.03%

5.77% 2.24%

0.4 0.0

coinciding indicators. Notice in the results from “Taking the next step” that the risk-adjusted performance for all the data sets are pretty much the same, except for the Euro ETF, which exceeds the five-day raw score + CEFD indicator.

Differentiating Sentiment Indicators Because the five-day raw score and OSI are non-correlated (-0.019 correlation) they are useful in gauging sentiment for the tactical trader. One way to look at this is that the performance from your proxy for the SMF is your main sentiment equity line; any extra profitability coming from the coinciding OSI is simply noise, which should be a reason for profit taking. In other words, when backtesting and tracking the performance of both indicators, whenever the OSI touches or crosses over the five-day raw score, that means most of your profits from trading sentiment is noise. With that said, the sentiment trader should be ready to take profits when the OSI is outperforming the five-day raw score (Social Media Factor). The five-day raw score indicator has a positive correlation (0.4) with the underlying FXE. The greater this number, M o d e r nTr a d e r. c o m

the stronger tendency for prices to be correlated with sentiment. This also gives rise to a contrarian viewpoint. If raw score were to reach an extreme, chances are the prices have topped, with a near perfect correlation. In this case, the correlation is moderately positive. Yet the correlation for OSI is slightly negative, making it ideal to implement as a coinciding—as opposed to a contrarian—indicator. With that said, we would expect the two indicators to repel each other anytime they were to come close, where the OSI shouldn’t be outperforming the five-day raw score with regard to sentiment, all things remaining equal. In the flow chart, you will notice the expressions, “information given news” and “sentiment given news.” It’s important to note that the former can be construed as a leading indicator, where the latter is more of a lagging indicator. Sentiment given news does not produce sustainable excess returns and adds no real information that can be discounted; while sentiment given news is simply noise. Once again, it must be pointed out that the OSI is still able to profit from the noise, capturing profitable temporal price swings as a trading program.

“OSI is still able to profit from the noise, capturing profitable temporal price swings as a trading program.”

OSI Summary The OSI is an intraday indicator based on end-of-day data without momentum; each day’s buy or sell signal is valid for that day only. From the backtest results we see a winning percentage at or greater than 50% with the OSI; this is in line with previous statistical tests from all population datasets when testing the OSI. The options data for constructing the daily trade signals was compiled from Market Data Express, summarizing the total open interest from FXE. When combining this indicator with the five-day raw score and CEFD indicator, the backtest results improved significantly with a winning percentage of 58%, albeit generating much fewer trade signals. In short, a sentiment prediction model can profit from the noise, and when combined with a noise trading indicator such as the OSI, our proxy for the SMF shows improved results. Philipe Saroyan is a freelance writer who works on sentiment research, digital content creation and web development. Issue 536

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Dry weather in the Northern Plains created a soybean scare and perhaps an opportunity for value traders.

Summer Weather Rally Primes Premium Pump Q By James Cordier In our analysis of corn and soybean markets from May and June, we highlighted a burdensome supply picture. However, for both markets, we suggested summer weather rallies might offer opportunities for selling inflated call premium. If you’ve been waiting for one of those, you now have it. In the first half of July, soybean prices rallied roughly 13% while corn prices jumped more than 10%. Why? Weather. But not where you might think. A ridge over the Dakotas has brought a spell of hot, dry weather to crops grown there. And while you may not think of North and South Dakota as soybean country, more than 14% of the U.S. crop is grown there. Does that mean that the U.S. corn or soybean crop is in danger of a substantial loss? Probably not. The irony of this summer’s weather is that while Dakota crops are certainly stressed, crops in core growing regions of the Corn Belt in Illinois, Indiana and Ohio are experiencing near ideal conditions. However, that has not stopped the weather bulls from blowing their annual trumpets.

The Fundamental Facts Yes, there is a weather issue in the Northern Plains. As of mid-July, 72.8% of North

Dakota and 72.4% of South Dakota are in a drought. Wheat, soybeans and corn have all rallied as a result (see “Summer scare,” right). Here, we focus on soybeans. Corn will likely be the least affected of the three because less of it is grown in the Dakotas, and wheat is a different animal altogether because it has more of an international aspect. The fear is this: Although only 14% of the U.S. soybean crop is grown in the Dakotas, even a slight drop in yield could have a noticeable impact on ending stocks. For instance, the U.S. Department of Agriculture’s projected average yield for the 2017 soybean crop is 48 bushels per acre. If that drops only by two bushels per acre, soybean ending stocks could drop by nearly 40% of current projected levels. Worthy of consideration? Of course. But it will take one heck of a crop setback in the Dakotas to have a two-bushel per acre impact on the entire crop – especially with a virtual greenhouse effect occurring in the central and eastern growing regions. The market could be starting to realize that soybean prices were sharply off their highs in the second half of July. This is largely the result of a moderating near-term weather outlook and a ho-hum USDA supply demand report on July 12.

“It will take one heck of a crop setback in the Dakotas to have a two-bushel per acre impact on the entire crop.” 70

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The USDA projected U.S. soybean ending stocks for the 2017/18 crop at 460 million bushels – slightly lower than the average estimate of 485 million bushels, but still at their highest levels since 2006/07 (see “Big crop,” right). This is largely the result of crisp demand. More importantly, the USDA raised global ending stocks to 93.53 million tons, up from 92.22 million tons last month. This is largely the result of higher production out of South America. The key is this: While it’s true that the USDA estimate does not yet reflect any yield loss to the 2017/18 crop, the market is likely already in the process of pricing it in. Worlds don’t end because the crop gets a bit of yield shaved off. What happens is that prices will adjust higher to reflect the slightly lower supply. The problem with weather markets is that nobody knows how much lower that supply will be, and thus, they just buy, buy, buy – often blindly. The result is that weather markets will often price in a worst-case scenario – producing a surge in both prices and volatility – only to come tumbling down later when the damage turns out less than the worst-case scenario. Thus, trying to time or short-term trade weather markets is futile and not recommended. But for option sellers, these can be the best of times. Surges in volatility can make the ridiculous strikes discussed in past articles, available to traders. It is common for retail traders to get whipped into a frenzy and bet on a worstcase scenario. The option seller can take a position to profit from anything less – and in some cases – even if a worst-case scenario occurs.

Too Late to Sell Bean Calls? Traders used to trading the underlying futures contract may feel they need to time the market right, to pick the top so to speak, to make money on a price retreat. This is not necessarily so when selling options. Thus, even when a market has crested and prices are in decline, a call seller can still make money. This is especially true in the case of weather markets. Why? Because the volatility created by the M o d e r nTr a d e r. c o m


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SUMMER SCARE As of mid-July, 72.8% of North Dakota and 72.4 percent of South Dakota are in a drought. Source: eSignal

BIG CROP The July 12 USDA crop report projects U.S. soybean ending stocks at their highest levels in more than a decade. Source: eSignal

weather rally can remain in the option long after the rally is over. In soybeans, this is often true even after the critical podding season has ended and the crop has, in essence, been made. Thus, although the primary risk of crop damaging weather is over, the option market is not yet reflecting this. These can be excellent times for selling options. While the short-term weather forecast is moderating, longer-term Dakota weather models remain unclear. We are not here to predict the weather; nor should you. What M o d e r nTr a d e r. c o m

is clear is that to get a two-acre per bushel reduction in total U.S. yield, it will take a nearly 50% loss of the Dakota soybean crop. This would put 2017/18 U.S. ending stocks somewhere between 240-290 million bushels. This appears to be the worst-case scenario the market was pricing in in July. While that would almost certainly require a price adjustment higher, it would still be the second largest ending stocks in 10 years. As discussed earlier, worst case sce-

narios are by definition unlikely. If weather moderates ahead of soybean podding in August, soybean prices will likely adjust lower. Another spate of hot weather could give prices another jolt. We would view such rallies as opportunities to sell over inflated call premium to weather speculators unfamiliar with the core fundamentals. The early July weather rally was such an opportunity in both soybeans and corn. Keep alert for another one in the coming weeks. Traders should consider the March Soybean 13.00 call on rallies and even the 14.00 call should prices break above July highs. Weather rallies are tough on shortterm traders. But they can bring the gravy for fundamentally informed option sellers. Use the public excitement to the benefit of your bottom line.

Commodity Markets This concept is true for most commodity markets that have measurable seasonal tendencies. While we have been talking about grains in general and soybeans in particular, other commodity markets provide opportunities from periods of seasonal related volatility. Coffee, for example, often provides opportunities from spikes in volatility due to the threat of frost, which occurs in our summer months as coffee is mainly grown in the Southern Hemisphere. In most years the residual inflated premiums persist past the point where there is a legitimate risk of a frost induced spike. In trading options, and trading in general, the key is to find an edge. In a sense all trading is value trading and successful option writers attempt to find value in premium. A common clichĂŠ of option writing is that the option writer is picking up nickels in front of a steamroller. While we could dispute this characterization, the point for the trader is to find trades where that steamroller is further down the road and that premium levels have risen to the point that they are able to pick up quarters. James Cordier is author of The Complete Guide to Option Selling, and president and head trader of OptionSellers. com, a wealth management firm specializing in option writing portfolios. Issue 536

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Everyone likes a bonus, and options offer a unique way to book extra profits with little risk.

The Bonus Trade Q By Robb Ross

Sometimes life hands us unexpected opportunities, like getting selected to shoot a basketball from half court for a $10,000 prize. You only need two qualifications: get selected and make the basket. Everyone likes to get a bonus; traders are no exception. The bonus trade was discovered after decades of option trading and testing. It is a secondary chance to increase a profitable trade or turn a losing trade into a winner. On occasion, this profit can be substantial. This trade works with options on futures, stocks or exchange-traded funds (ETF). The first part of the trade involves owning a long option contract. This strategy works with either puts or calls. There are many

reasons to have a long option position. The trader could have bought the option in hopes of a directional move, but there are other scenarios as to why a trader would be long an option. They may have bought puts as insurance for a long-only portfolio. This is common for equity funds. They are long stocks and will buy puts as insurance against a down move. There are also spread scenarios: Calendar spreads, credit spreads, debit spreads, ratio spreads, butterflies, iron condors, etc. Each of these option strategies is used for a specific purpose and involves at least one element that is long an option. When these positions are being rolled off, a bonus trade opportunity presents itself.

“The risk on the trade is actually the miniscule time value on the call.” 72

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WHY OPTIONS MOVE To understand the value and movement of option prices, you need to understand the Greeks.

ɆRho:Interest rate. Why sell an option and take a risk if the return on the option is equal to or less than a riskfree interest rate? This is why risk-free interest rates are used in the option model calculation. ȺdŚĞƚĂ͗Time value. How much time (life) is left in the option? Obviously, options that expire much further down the calendar road will have more time value (Theta). ɁsĞŐĂ͗Volatility. The more volatile the underlying entity is the more that effects the price of the option. ȴĞůƚĂ͗Measures how much the option should move based upon a move in the underlying entity. A Delta of 20 means that for every $1 the underlying moves the option should move 20¢. ȳ'ĂŵŵĂ͗Tells us how much the Delta should move based upon a move in the underlying. If the Gamma is 10 and the Delta is 20, a $! move in the underlying would now cause the Delta to move from 20 to 30; hence a move of 10.

The bonus trade is a two-step process: own an option, and then simply engage the underlying futures or equity. Most times, because the option is way in-the-money, the trade will put you in a near Deltaneutral position. Options have several components that are referred to as the “Greeks.” The mathematical model for options is based on calculations of the Greeks and traders need to understand how they work (see “Why options move,” above). Here, we use examples from options on futures, but the bonus trade will also work with options on equities and ETFs. The bonus trade involves owning an in-themoney option. M o d e r nTr a d e r. c o m


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SQUEEZING EXTRA PROFIT The bonus trade allowed us to nearly double our profit in one day. Source: eSignal

A Crude Bonus A trader placed a crude oil futures call debit spread in October 2015. The trader bought the 47.00 November call and sold the 48.00 November call. The 47 calls were bought for 66¢ and the 48 calls were sold for 44¢, creating a net debit of 22¢ (-$220/contract). This was the max risk. By Oct. 9, 015 crude oil futures had moved to $49.67 per barrel. The 47 calls were now worth $2.85 and the 48 calls $2.04. If exited on Oct. 9, the result would have been a $590 profit (81-22= 59 or $590) on the trade, not including commissions. But instead of rolling out of the long call, it was time to engage a bonus trade. The call had 18¢ of time value. This can be calculated by adding the $2.85 premium in the call to $47, which equals $49.85 and subtract the futures price ($49.85-$49.67 = 18¢). This would be the entire risk on the bonus trade. To engage the bonus trade the trader exited out of the short 48 calls, leaving a long 47 call position. Next the trader shorted the underlying futures at $49.67 (see “Squeezing extra profit,” above). The safety aspect of this trade is that if M o d e r nTr a d e r. c o m

November crude oil kept rising, the risk on the trade is actually the miniscule time value on the call. If the market rallied the in-themoney call value will move 1 to 1 with the short futures. In this case there was 18¢ of time value. If the price rose to $100 the cost would still be 18¢ (see below). Futures: 49.67 – 100.00 = -50.33 Option: 100.00 – 47.00 (strike price) = 53.00 53.00 – 2.85 (cost of the option) = 50.15 50.15 – 50.33 = -0.18 From a Delta perspective, the bonus trade starts off as a near Delta neutral trade. Remember, Delta is a measurement of how much the option will change in price for a change in the underlying. A long futures position has a Delta of +1.0 because for every 1.0 point move in the underlying futures contract, the options contract moves 1.0 point. A short futures position has a Delta of -1.0. For every point in a down move the option will move -1.0. This seems redundant, but is important when trying to understand options. In the case of this trade, the short futures

has a Delta of -1.0. The 47.00 call has a Delta of 0.99. Therefore the position is at a Delta of -1.0. A Delta of +/- 0.5 is what the bonus trade is looking for. The trade is almost Delta neutral with a lot of upside potential. The 18¢ is the time value when we got into the trade. So, even if crude oil rose above $50 in a short period, the risk is still just the time value. Now the reward portion is twofold. Let’s say the market drops to $47, which is our call strike. The call would then have a Delta of 0.50; the futures are still at a Delta of -1.0. The position would then have a Delta of -0.50. Since we are short the futures, this turns into a profitable trade. The next trading day, Monday Oct. 12, the November crude futures closed at $47.09. The 47.00 call is now worth 84¢. The volatility is at 48% and the Delta is 0.5273. This has turned a -1.0 Delta to a -0.4727 Delta. Because the trader is short the futures at $49.67, this is a really good one-day event. The profit on the futures is $2,580 ($49.67 – $47.09 = $2.58, $2,580 on a 1,000-barrel contract). The option has dropped in value from $2.85 to 84¢. We exited the 48 short call at $2.04 for a net loss of $1.60, and the 47 long call at 84¢for a net profit of 18¢

Bonus trade 48 call: Sold @ $2.04; Bought @ 44¢; P/L = -$1.60 47 call: Sold @84¢; bought @66¢; P/L = +0.18 Futures: Short @$49.67; Exit @ $47.09; P/L = +2.58 2.58 + 18 - 1.60 = 1.16 * $1,000/barrel Issue 536

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TURNING A TRADE By entering a bonus trade, we were able to add additional profit. Source: eSignal

= $1,160 - $590 (profit without bonus trade) = additional $570 in profit The bonus trade, one day later, with very little risk, added another $570 in profit nearly doubling the total amount made. If the price of crude dropped to say $40, the profit could have been even more pronounced. However, it’s best to exit the trade when the option Delta hits 50%. At this point, the option is all time value. For long puts the trade works just the opposite. The trader goes long the underlying futures. This trade starts near a Delta neutral position. If the price keeps dropping then the put is a hedge against the futures so there is downside protection. However, if the price rises the Delta difference will become more positive. If the price reaches the put’s strike then there will be a Delta difference around 0.5 with the long futures at +1.0 and the long put at -0.5.

Euro bonus On July 18, 2017, with the September euro currency futures trading at 1.1599, a trader bought a weekly euro 1.1700 put at 131 (131 points in-the-money) with an

expiry on July 28. The next day, July 19, the September euro dropped 44 ticks and closed at 1.1555. The option is now worth 162. The gain on the initial trade is 31 full ticks or $387.50 (0.0031 * 125,000 contract size). There are 17 ticks of time value left on the option. Instead of exiting the trade, the investor decided to place a bonus trade. Since the trader already possessed the long put, they then went long the September euro futures at 1.1555. On July 20, the euro rallies 100+ points and closes at 1.1660. The 1.1700 weekly put is now worth 75. The trade is held to July 21. The euro continues to rally and closes at 1.17135. The futures has gained 158.5 ticks ($1,981.25). The weekly euro 1.1700 put is now worth 39. The option is completely at its all-time value. The trade is exited. The trader lost 123 ticks on the option, but gained 158.5 ticks on the future. That is a net gain of 35.5 ticks or $443.75. The trade risked the initial time value of 17 ticks ($212.50). Therefore the bonus traded added another $231.25 (see “Turning a trade,” above). When the trader owns a deep in-the-

“The bonus trade works best when you can pick up a long option at a discount.” 74

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money option, many times there is not enough liquidity to allow the trader to exit at a fair price. Therefore, a bonus trade will lock in a set amount of risk and also give the chance to receive a bonus if the market moves against the option before expiration. The cost is the time value of the option. The trader doesn’t have to be in an existing long option trade to engage in a bonus trade. You could just buy an option and engage in a bonus trade near expiration. But then again they could just buy an opposite out-of-the-money option. So, instead of owning an in-the-money call option and shorting the futures, you’d just buy a put at the same strike price as the call. Same goes for the long put side. Instead of having an in-the-money put and going long the futures, the trader could buy the out-of-the-money call at the same strike as the put strike price. This would be a synthetic bonus trade. As long as the time value is equal or better than the bonus trade then it would be a synthetic. The bonus trade works best when you can pick up a long option at a discount. This would actually guarantee a profit even if the market moved sideways or against the futures position. Robb Ross is the founder of White Indian Trading Co., and the author of the upcoming book, 21st Century Technical Indicators. M o d e r nTr a d e r. c o m


ADVAN C E D TEC H N IQ U E TEC H N IQ U E S & TAC TI C S

ADVANCED TECHNIQUE

The plethora of derivative products in the grain complex provides opportunities for profitable trades in weather-driven markets.

Trading Weather-driven Grain Markets Q By: Paul D. Cretien From the middle of June through July this summer, the weather in the western United States has been too hot for corn, wheat and soybean crops. “Summer heat makes grains explode” (right) shows the effect of hot weather that followed a more moderate period from March through early June in which the three September futures contracts experienced declining prices. Although wheat futures were in the middle of the price declines from March through early June, the hot weather in June and July had its greatest effect on wheat. September wheat futures escalated from a -2% cumulative price change to up 15% from June 23 to June 28. “Summer heat makes grains explode” also shows that September corn and soybean futures rose along with wheat, although the hot weather had a lower effect on corn and soybeans. The difference in price changes for the three grains in early July 2017 suggests potential trades that depend on wheat futures falling back toward their usual relationship with corn and soybean futures, or perhaps lower in price. Because corn and beans rest at a zero cumulative price change on July 11, 2017 (while wheat is at +15%) it is easy to imagine the spreads between grain futures declining though their delivery date in September.

Grain ETFs

SUMMER HEAT MAKES GRAINS EXPLODE The hot weather in June and July had its greatest effects on wheat. Source: CME Group

Cumulative Percentage Price Changes.

ETFS CORN & WEAT The WEAT ETF has been more volatile than corn based on cumulative percentage price changes. Source: Teucrium

Cumulative Percentage Price Changes.

In addition to grain futures, there are several exchange-traded funds (ETFs) with price movements that closely reflect those of the underlying futures contracts. The Teucrium Corn Fund (CORN) mirrors corn futures, the Teucrium Wheat ETF (WEAT) follows wheat futures and the Teucrium Soybean ETF (SOYB) mirrors soybean futures. CORN and WEAT are shown over the April to July period in “ETFs CORN and WEAT” (right). Both of the ETFs have price increases in July, although WEAT started rising earlier and is more volatile than CORN.

ª

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TEC H N IQ U E S & TAC TI C S ADVAN C E D TEC H N IQ U E

WHEAT & CORN CALLS Volatility in wheat has been greater than corn during the western heat wave in July.

DELTA NEUTRAL Source: CME Group

Source: CME Group

THE SKINNY ON CORN OPTIONS Traders can monitor the upper and lower breakeven levels through a study of call prices. Source: CME Group

The total variation in WEAT, a cumulative increase of 10% from March 1, is smaller than the variation in wheat futures, 15%, but it is still wide enough to suggest a spread trade among the grain ETFs might be profitable. A trader could sell WEAT and buy CORN in anticipation of a reversion to the mean on the basis of the two futures contracts.

Using Options Options trades are also possible; buying wheat puts until the price of wheat falls to the level of corn or below in terms of cumulative percentage price changes. After wheat achieves a lower price, buy

September or December calls on wheat and look forward to the next short-term peak in price. Trading ETFs in place of grain futures contracts is dependent on the close fit in price movements between ETFs and futures. ETFs that do not have a bullish or bearish bias usually have the objective of reflecting the price changes in near-term futures contracts. If the spreads between futures prices decline, price differences between the ETFs that follow them should correlate closely. Options on the grain futures are also potential sources of trading profits as the result of weather effects on grains. “Wheat

“The difference in price changes for the three grains in early July 2017 suggests potential trades.” 76

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and corn calls” (above) shows that the option price curve for calls on wheat is higher than the corn option price curve. This difference is expected due to the options market noting the weather-related surge in wheat futures prices compared to the price movement in corn futures as well as wheat’s normal higher volatility. In the March to July period wheat was more volatile than corn, and the higher volatility is reflected in a higher call price curve. An option price model for corn futures is shown in “The skinny on corn options” (above). The dollar variances between market prices for the calls and prices predicted by the log log parabolic (LLP) options pricing model are too small to suggest trades taking advantage of underpriced or overpriced calls. However, the upper and lower breakeven prices (futures prices at expiration that would result in zero profit from a delta-neutral spread trade between calls and an M o d e r nTr a d e r. c o m


ADVAN C E D TEC H N IQ U E TEC H N IQ U E S & TAC TI C S

“The price of grains has a strong impact on markets such as livestock and energies.”

underlying futures contract) indicate the options market’s forecast of price ranges near expiration in December for corn futures. The breakeven price spread is $4.55 to $3.51, compared to the current December price for corn of $4.0475. For strike prices near the current wheat futures prices on July 11, 2017, the breakeven prices for wheat are $6.38 to $4.72; an average of $5.55. The averages, or mid-range breakeven prices, are close to the underlying futures prices on July 11 as the options market forecasts a spread up and down from the current price. A trade planned to take advantage of the current price differences would result in a maximum profit, using the lower breakeven price for wheat and the upper breakeven price for corn, of the futures price spread. Trades in July 2017, based on futures contracts expiring in December 2017, include Delta-neutral spreads on corn, wheat, soybeans and live cattle. Each trade is made in reference to the upper and lower breakeven prices for calls because those are expiration price ranges that the options market considers reasonable in light of predicted volatility of underlying futures prices. An example of the delta neutral trades is shown in “The skinny on corn options” and “Delta neutral” (page 74).

Know your Delta As shown earlier, corn is not as volatile as wheat and because of the volatility difference, it is expected that Delta-neutral M o d e r nTr a d e r. c o m

CORN DELTA NEUTRAL Large fluctuations in the price of corn create losses for a delta neutral trade. Source: CME Group

trades in corn should perform better than delta ETFS SHOW EFFECT OF GRAINS ON LIVESTOCK neutral trades in Livestock (live cattle and lean hogs) prices often wheat. “Corn delta follow movement in grain prices because of the cost neutral” (above) of feed. shows that the maximum profit on the trade occurs at the strike price chosen to trade calls against the underlying futures contract. For this reason we are not looking for volatility in this delta neutral trade, but prefer futures prices that stay close to the middle of the expected cattle and hog futures. price range. A glance at the profit and Grain futures, options and ETFs offer loss column of Delta-neutral confirms that serious losses occur when the futures price a wide range of potentially profitable trades. Because they are subject to the strays too far up or down. Futures price changes that threaten the high and low loss same strong seasonal and weather-related forces, any anomalies in the price of ranges would require protective trades to the various derivative products offer an reduce risk. opportunity for a profitable trade. As shown in “ETFs show effect of grains There are many ways to counteract the on livestock” (above) the price of grains risks and take advantage of unusually large has a strong impact on markets such as price spreads. A careful study of the various livestock and energies due to corn’s use prices and their relationship to each other for feed and in ethanol. After falling in price provide clues to the curious trader. through the early part of 2017, the feed grains for cattle and hogs stabilized and began to increase in April, resulting in price Paul Cretien is an investment analyst increases for the ETF COW that combines and financial case writer. Issue 536

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TRACKING STOCK

Modern Trader provides cutting-edge actionable market research while holding analysts accountable. And, when we publish specific recommendations, we will also let you know how we did.

Snapchat falters Post IPO blues

On June 15, SNAP settled at its initial IPO price of $17 and then dropped another 30% throughout the summer, accelerating on FTSE Russell’s announcement in July, and dropping further to $12 on its Q2 earnings miss (see “SNAPped,” right).

More Brexit profits

April 2017 In our April cover feature we took a critical look at the imminent initial public offering of Snapchat (SNAP). While much of the professional analyst world was foaming at the mouth for the most anticipated IPO of the year, our contributor Garrett Baldwin highlighted numerous red flags for the social media darling. The first of which was a structure that did not grant voting rights to the initial investors. This questionable structure soon bit the nascent social media player. Confirming our outlook and adding to the summer sell-off were index creators S&P, Dow Jones and FTSE Russell’s decision in late July to exclude Snap from its indexes because of Snap’s share structure that denies public investors voting rights. Being left out of the indexes is likely to limit Snap’s growth potential going forward. Other red flags included its lack of profitability and an apparent lack of a pathway to profitability as well as questions over the veracity of the company’s user growth metrics. But that did not stop prominent Wall Street firms from pounding the table as Goldman Sachs, Citi and Jefferies were among the 12 firms assigning preIPO “buy” ratings. Modern Trader’s pre-IPO feature advised that “investors would be wise to sit out the Snapchat IPO and wait for the market to price the company accordingly in six to nine months”. Despite the warnings flags, SNAP had a successful rollout, opening more than 40% above its $17 IPO price and rallying above $29 on its second day of trading. However, reality soon set in and SNAP has steadily declined since its March 2 IPO. 78

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March 2017 Last month we highlighted how traders may have profited from suggested trades from a series of articles in the December 2016, March 2017 and April 2017 issues of Modern Trader. Author Paul Cretien highlighted the likely fallout from the Brexit vote and how it would play out in currency markets. The broad notion was that countries that compete for exports with Britain would attempt to devalue their currencies, which had grown expensive versus the pound due to the effects of Brexit. Here we point out a specific trade. At the time “Brexit and the currency wars,” Modern Trader, March 2017, was published, the pound had dropped 15% since June 2016, and appeared to have found a base level. Meanwhile, the Australian dollar had increased more than 5% during that time. The article suggested that selling the Australian dollar and buying the British pound on March 1 would potentially be profitable. A trader who sold the Aussie on March first could have exited the position on May 10 with a $2,960 profit: 7645 – 7349 = 296 ticks * $10 = $2,960. A trader going long the pound on March 1 at 1.2349 and exiting on May 10 at 1.2992 would have earned $4,018.75. In reviewing the currency data on July 23, it appears that the same trade might be repeated, selling the Aussie dollar and buying the British pound. M o d e r nTr a d e r. c o m


TRACKING STOCK

SNAPped Source: eSignal

March 2017

SIX-MONTH LOOKBACK Below are the trade recommendations from our March 2017 issue, along with an analysis and grade on how they worked out. Dept.

Author(s)

Security or Sector

Forecast

Value (as of Mar. 1, 2017)

Grade

Outcome

Buy

Michael Thomsett

Van Eck Vector Coal (KOL)

Bullish

$13.41

ΔΔΔΔ

Sell

Joseph Parnes

Ralph Lauren (RL)

Bearish

$80.57

ΔΔΔΔ

Forex

Ashraf Laidi

USD

Bearish

101.47

ΔΔΔΔΔ

DJ Shanghai Index

Whipsaw

440.37

ΔΔΔΔ

Natural Gas

Whipsaw

$28.51

ΔΔΔΔ

Euro

Whipsaw

1.058

ΔΔΔΔΔ

Coffee

Short vol.

1.40

ΔΔΔΔΔ

Soybean meal

Bearish

$336 per ton

ΔΔΔΔΔ

Crude oil

Bearish

$53.95

ΔΔΔΔΔ

Yum China (YUMC) Zions Bankcorp.. (ZION)

Bullish Bullish

$26.50 $46.53

ΔΔΔΔΔ Δ

Umpqua Hldgs. (UMPQ)

Bullish

$19.35

ΔΔ

Bank of Internet (BOFI)

Bullish

$32.11

Δ

Baidu (BIDU)

Breakout

$176.44

ΔΔ

KOL rallied close to 10% in early spring before dipping below its March 1 level by mid-May. It rebounded in summer and is up 10% from March 1. After remaining in a range for March and April, RL dropped more than 15% in May, but did not reach Parnes' short target. It is currently around $75. While much of the fundamentals behind Laidi's call--Trump Administration protectionism and tax policy--have not happened, the dollar has steadily declined since March 1. The CPO anticipated the April sell-off in the Shanghai Index, but not the sharp upward correction that followed. The CPO called the Q1 gas sell-off but expected it to last through March and April before reversing. Gas reversed early and the subsequent rally did not last through summer as anticipated. The CPO expected the euro to sell-off into May before reversing and rallying sharply through the summer. The sell-off short and the rally came a little early. Coffee sold off from March and never challenged the short call positions Cordier recommended. Soymeal sold off sharply through the end of June before reversing in July. Crude oil has sold off sharply in waves, followed by upward retracements, since March 1. YUMC has rallied more than 40% since March 1. ZION dropped below $40 by mid April. UMPQ dropped more than 10% in the spring before rebounding back to March 1 levels. BOFI set its 52-week high on March 1 before dropping close to 30% before rebounding in July. The pattern called for traders to go long BIDU above $189 or short below $162. A long was initiated in May that would have been stopped out in June. If traders gave the long a little more line they would have been rewarded as BIDU is currently up roughly 25% from entry level.

Cycles

John Rawlins

Technique

James Cordier

COT

Andy Waldock

Spin-Offs

Joe Cornell

Industries

John Blank

Chart Patterns

Suri Duddella

Note: Forecasts are scored A (weakest) to AAAAA (strongest) based on actual outcomes. M o d e r nTr a d e r. c o m

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TRADER

Looking for liquidity where it exists

Parvataneni: Mitigating risk with options Q By Yesenia Duran LJM Partners has done with options what few funds have been able to do—be successful for a very long time. The managers of the 2017 Pinnacle Award winner for best options strategy in 2016 and past Futures Top Trader of the year have spent about 20 years managing portfolios of options on the S&P 500 Index futures, and its Moderately Aggressive strategy returned 19.01% in 2016, is up 10.01% year-to-date through July, and has been positive 13 of the 15 years since inception. It’s an impressive track record that is replicated in the two other strategies managed under LJM. “We are net short volatility, meaning we are primarily options sellers, but we also hold long positions closer to the money to help mitigate risk,” says Anish Parvataneni, LJM’s chief portfolio manager. “What we are trying to do is capture the difference between implied volatility and realized volatility—and that can be risky.” Chicago-based LJM Funds Management was founded in 2012 as an affiliate of LJM Partners to offer a mutual fund version of the strategies. LJM Partners has been managing alternative investment strategies since 1998. LJM offers its volatility strategy in three risk levels: Aggressive Strategy, Moderately Aggressive Strategy and Preservation & Growth (P&G). The strategies seek to provide a return stream uncorrelated to equities or fixed income.

“We are trying to capture the difference between implied volatility and realized volatility— that can be risky.” Parvataneni got into options specifically because they have an element of quantitative math to them and that means they have less dependency on subjective factors. Whatever it is, it’s working, as their other strategies have been doing well: the Aggressive Strategy was up 25.40% in 2016 and 10.89% year-to-date through July, and P&G, was up 13.66% in 2016 and 6.05% year-to-date through July. LJM does not attempt to forecast market direction, it initiates market neutral positions by simultaneously selling deep-out-of-the-money calls and puts, followed by appropriate adjustments based on movement of the 80

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underlying S&P 500 futures. The greatest risk entailed with the LJM Aggressive and Moderately Aggressive Strategies occurs during periods of excessive volatility, specifically large gap movements. Because the probability of a gap movement of 10% or more in the S&P 500 Index within a 30-day period is far greater for downward market movements, the trading strategies employed by LJM are cautious of downward spikes. As many fund managers will tell you, especially options writers, risk management is key to staying successful. “Sudden and extreme market movements can challenge the strategy, but we hold long positions to help mitigate risk,” says Parvataneni, who joined LJM in November 2010 from algorithmic trader at Jump Trading LLC. LJM was already a highly successful option writing CTA, but adjusted its approach in the Aggressive and Moderately Aggressive strategies in 2008—incorporating many of the risk mitigating strategies of P&G into these other programs. LJM P&G’s goal is capital preservation in down markets and stable and consistent performance in many market conditions. “Sudden and extreme market movements are typically to the downside. While we could take a short-term loss in this scenario, quick downward market movements typically cause volatility to rise and allow us to sell options contracts at higher premium levels,” he says, adding that many of the most common option writing strategies, like a covered call, hold a significant amount of assets in an underlying equity investment. So, the goal of these strategies is very different from ours, it’s to help mitigate the downside of an equity investment. LJM runs a pure option strategy. “We don’t hold any underlying assets—in our case we don’t hold the S&P 500— just options on S&P 500 futures. So our goal is to produce an uncorrelated return stream and in fact our strategies range in correlation to the S&P from -0.05 to 0.28,” he says. “Part of our risk management process is to assess ‘known unknowns’—like the presidential election, Fed announcements, Brexit, etc.—and the risk-reward payoff in the market leading up to these events to determine whether we want to reduce risk or slow our contract writing. This is big part of our strategy,” Parvataneni says.

LJM FUNDS/ LJMPARTNERS Founder: Anthony J. Caine Strategy: Options AUM: 1.15+ billion Location: Chicago

M o d e r nTr a d e r. c o m


CALENDAR

U.S. economic data & select global influences

October: Volatility ahead? Q By: Daniel P. Collins Vital October Statistics*

M o d e r nTr a d e r. c o m

9

10

11

12

13 16 17

18

DJIA1

S&P 5001

NASDAQ COMP. 2

Rank

7

7

6

Up

40

41

25

Down

26

25

20

0.93%

0.81%

Average % 0.65% Change

Best & Worst October- % Change Best

1982/2002 +10.6%

1974 +16.3%

1974 +17.2%

Worst

1987 -23.2%

1987 -21.8%

1987 -27.2%

19 20 23

24

25

Issue 536

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Chicago PMI | Redbook | Consumer Confidence

Dallas Fed | Farm Prices

GDP | Consumer Sentiment

International Trade | Consumer Comfort | EIA Natural Gas | Kansas City Fed

ECB non-monetary policy meeting

Bank Reserve Settlement | MBA Mortgage | Durable Goods Orders | FHFA House Price | New Home Sales | EIA Petroleum Status

FOMC Meeting

Redbook

Chicago Fed

*Courtesy of Stock Trader’s Almanac 2016 ©2015 John Wiley & Sons Inc. 1 1950 21971

Existing Home Sales

Philadelphia Fed | Consumer Comfort | Leading Indicators | EIA Natural Gas Report

Bank of Japan Monetary Policy Meeting

MBA Mortgage | Atlanta Fed | EIA Petroleum Status

Import and Export Prices | Redbook | Housing Market

Empire State Mfg Survey

Consumer Price | Consumer Sentiment

Bank of England MPC Announcement and Minutes

PPI-FD | Consumer Comfort | EIA Natural Gas

Bank of Canada Policy Interest Rate

MBA Mortgage | Bank Reserve Settlement | JOLTS | FOMC Minutes

6

NFIB Small Business Optimism | Redbook

5

OECD Composite Leading Indicators

Employment | Wholesale Trade | Wholesale Trade | Consumer Credit

4

Labor Market Conditions | TD Ameritrade IMX

Chain Store Sales | International Trade | Consumer Comfort | EIA Natural Gas | Treasury STRIPS

ECB non-monetary policy meeting | Reserve Bank of Australia Interest Rate Statement

3

Mortgage | Employment | Job Creation | PMI Services | ISM Non-Mfg | EIA Petroleum Status

2

Redbook

Construction Spending | Consumer Spending | PMI Manufacturing | ISM Mfg

Modern Trader Monthly Trading Calendar - October 2017

A year ago we pointed out that despite October’s history as a month in which market crashes occur, the major stock indexes have average positive returns in October and the month falls in the middle of the pack in terms of average performance during specific months. What is clear is that volatility — measured by the range of price movements — tends to pick up in October. Not only has October produced market crashes, but it has also been a month that has seen significant market spikes. The broadest range in price in the S&P 500 per month

has occurred in October in four of the last nine years. So what does that tell traders as we enter October 2017? If they are writing options, it would suggest going further out on the price curve in selecting strikes or perhaps to be careful of short volatility positions. The bottom line is that stocks tend to move more significantly, in either direction, in October. And as of the end of July 2017, with all the major stock indexes at or near all-time highs, the risk of a major move is clearly to the downside.

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CLOSING TICK

Guest Editorial

Revenge of the humans Q By Doug Litowitz

How ironic. Bloomberg is reporting that most of the new quant strategies adopted by asset managers aren’t generating any, uh, quantifiable positive returns, let alone alpha. Allow me to explain in a moment of schadenfreude. For years I’ve listened to tedious, unproven projections and inflated rhetoric about the promise of big data, quantamental strategies, roboadvisers, machine learning, web scraping and artificial intelligence. I’ve been told that humans were passé. I’ve been handed the new quant bible, Homo Deus by Yuval Harari, which argues that human beings are merely algorithms made out of meat, and the best we can hope for is to merge with supercomputers. Ah, yes, the golden future. Temperamental traders replaced with placid robots, and portfolio managers replaced with data managers that don’t swear, drink or womanize. After all, only a PhD can design an algorithm that web scrapes for how many times Target

loop” for the time being. How magnanimous. It’s like my laptop telling me that I have to leave the house and move into the little room above the garage. Many of us anticipated this failure (see “The quantitative tipping point,” right). First, algorithms only work ceteris paribus, i.e., in a closed system where all other things are equal. But a closed system is never the case. Markets are affected

Computers cannot understand symbolic human communication because they lack any social context.

It’s like my laptop telling me that I have to leave the house and move into the little room above the garage. is searched on Google, and then combines this with credit card records from Visa and compares this to Facebook “likes” and adds a prediction based on photographs from drones circling the parking lots, puts all this alternative data into context with the historical movements of the stock and the indexes generally, and arrives at a nearly infallible prediction of how the stock will move. And it will even learn from its mistakes. I even heard that one of the new prophets of AI conceded that we should “include humans in the 82

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by wars, famines, political posturing, central bank interventions, mass delusions, apocalyptic rhetoric, crypto-currency survivalists and even the weather. No computer can figure all this out. Second, computers cannot understand symbolic human communication because they lack any social context. The economy is a human construction and it is symbolic and cultural all the way down. There is no mathematical formula lying below the surface waiting to be discovered. No matter how fast an algorithm is, it cannot listen to an investor presentation and decode clues, get an intuitive feel for situations, pick up vibes and develop a feel for what the speaker may be feeling. Consider the battle over Herbalife (HLF). No matter how good a computer could crunch the numbers, the decisive factor moving the stock price was a monumental clash of egos between Bill Ackman and Carl Icahn. No algorithm can compute pride, narcissism, recklessness, self-promotion and feigned indignation. These same factors are at play in most if not all companies. M o d e r nTr a d e r. c o m


CLOSING TICK

It’s not cuttingedge to stick your own hand inside a puppet and then let the puppet tell you what to do.

The great philosopher Immanuel Kant said, “Out of the crooked timber of humanity, nothing straight was ever created.” This means that as long as human beings are running the show, everything that they touch — from politics to economics to relationships — will be largely irrational, chaotic, indeterminate and contestable. The upper hand will always go to the human being who has studied non-mathematical subjects like history and psychology. It’s true that in closed systems like chess no human can beat a computer, but the superiority of the computer is only made possible by reducing the messiness of the real world to the artificial construct of a game. Need further proof? Consider waking up to find that the entire market was down because a maniacal dictator halfway around the world sporting a bad haircut is shooting nuclear-capable rockets in our direction. Please tell me what computer, what algorithm, can reduce that to a mathematical formula? Third, there is a problem of the commons. Once a single firm uses an AI strategy, other firms copy it, and this reduces the spreads and eliminates the edge. If all the computers are learning from each other and their own mistakes, they will eventually reach parity and eliminate any edge for a single fund. And yet the myth persists even among legends. Dealbreaker reported that Paul Tudor Jones II had cut “15% of the humans” at his hedge fund (as opposed to cutting 15% of the furniture?), and proclaimed, “No man is better than a machine, and no machine is better than a man with a machine.” Anyone who has watched Jones give a Ted talk knows that he is concerned with corporate justice, alleviating poverty and with improving education. But surely he knows that we’ve had the world’s most powerful computers for decades, and yet these problems persist. To think that computers can solve investment problems but not other human problems is M o d e r nTr a d e r. c o m

The quantitative tipping point Investment banking firm Jefferies recently produced the white paper “Quantifying Intuition: Mapping the Data Science Landscape in the Hedge Fund Industry,” which argues that we have reached a tipping point where data science is now, and will increasingly be, of strategic importance to all hedge funds. The paper had the following five main themes. 1. Data science is an exciting, innovative and critical business strategy issue – but it also remains a completely amorphous one. This is not limited to hedge funds. CEOs across all industries are feverishly working to understand the impact of disruptive technologies on their businesses. 2. Hedge funds are in different stages of embedding data science across their organizations – but funds of all shapes, sizes and strategies are increasingly dedicating headcount and resources to the space. Jefferies estimates more than 20% of the current Billion Dollar Club has someone who spends at least half their time focused on the issue. 3. “Excel is not a strategy.” PMs, analysts and traders want to understand possible solutions, ranging from unstructured big data feeds to machine learning tools or technology consulting. Even firms that may not have a long history of quantitative experience are elevating this issue to understand what potential exists. 4. Successfully implementing data science across hedge funds can be tricky, and cultural challenges may create unintended inefficiencies. It’s not enough to say: “Get me a quant, any quant!” Hedge funds are idiosyncratic organizations, and they need to think strategically about the purpose, implementation and execution of these solutions for their specific firm. 5. Many questions remain about data science – ranging from legal and regulatory to existential. Will machines eventually out-invest humans? We’re still in the nascent stages of these innovations and their long-term implications are still taking shape.

to divide the world artificially, and wrongly. At bottom, computer worship is simple paganism — a person carves a god from a piece of wood and then claims that the god created him instead of vice versa. We do the exact same thing when we create and then bow down before our own metallic creations. Corporations are not people. And neither are computers. SIRI is not your friend, and your Japanese sex bot is not your wife. It’s not cutting-edge to stick your own hand inside a puppet and then let the puppet tell you what to do.

Doug Litowitz is a hedge fund lawyer and former law professor. Issue 536

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Higher, faster, further. Why not more beautiful?

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