WASHINGTON, March 18, 2016 – Today, as usual, Rush Limbaugh will host “Open Line Friday,” as he does every week. Today as well, Wall Street celebrates its slightly less frequent third Friday of the month festival, “Options Expiration Friday.” It’s the day, the time and the place where the latest batch of options comes to die.
Options: A simple definition
To oversimplify, options are temporary bets on whether stocks or other investments will go up or down over a certain period of time. When time’s up, options holders either “exercise” their options—which we can define as a temporary, contractual bet giving the option holder the right to buy or sell a stock or other vehicle at a set price—or they watch those options expire worthless.
Each “Call” option gives the option holder the right to buy, for example, 100 shares of stock at a set price. Calls become valuable as the actual stock price moves above that set price, known as a “strike price.” Contrarywise, each “Put” option gives the option holder the right to sell 100 shares of a stock at a set price. Puts become valuable as the actual stock price moves below the strike price. (More details on this in another column.)
How options influence markets on options expiration days
Whatever rules still remain operational on Wall Street these days, monthly options expiration action tend to exaggerate the general movement of stocks over the preceding week, as HFTs and big investors and funds jimmy stock prices around in order to pick off hapless investors and institutions whose options positions are exposed and hovering close to the strike price of certain options.
So today, naturally, since stocks have been almost ridiculously bullish this week, they’re getting one final push today—at least from traders who’ve recovered from last night’s green beer drinking binges—enabling holders of in-the-money options the chance to exercise them at a favorable price, thus buying (or selling) stocks below or above the market as strategy dictates.
In other words, we’re having a nice day, but it’s mostly because of fun and games. The next real market pulse-taking will start after 2 p.m. this afternoon when the options fun times out, or, perhaps, on Monday when investors have had a weekend to sort out whether they believe in the markets’ rally—which is currently built on thin air—or whether it’s time to bail again.
The McClellan Oscillator
Markets are again “overbought,” meaning that according to the venerable McClellan Oscillator (symbol: $NYMO, a technical measure signaling potential price reversals on either the upside or downside), we should get at least a brief pullback in stocks very soon.
If you believe in the rally, the pullback is the time to pick up stocks—not today. In a raging bull market, it’s okay to “chase” stocks if their upward move seems inexorable. But in an iffy bull scenario built on smoke and mirrors like this one, it’s best to hold back a bit, wait for the pullback, and see if it continues or if the market is ready to make another run. Our guess is that if this happens, it will happen Monday or Tuesday.
Today’s trading tips: Holding the fort
Actually, these are potential Monday trading tips, meant as usual as areas of research as we look for stocks we might like to buy. In this column, which is really the Maven’s trading journal, we let you know our thoughts and the major moves we make or are about to make. But we’re not issuing recommendations, just research we’ve done. It’s your choice as to whether you want to add our opinions to your own research before buying or selling.
In other words, we ain’t fiduciaries. We’re just small traders and investors trying to make a buck like everybody else, and we’re sharing the information. Yes, we used to do this professionally, but now we’re just out there fighting the system like you are.
That said, we’ve been slowly adding to our fairly large positions in preferred stocks and “baby bonds,” given the likelihood after this past Wednesday’s Fed announcement that interest rates will remain relatively stable for the foreseeable future. The reasons why this is are really too complex to explain, but we’re comfortable with this scenario.
Preferred stocks trade like common stocks, except that they carry a fixed dividend, which tends to make them trade more like bonds. I.e., when interest rates are going up or likely to go up, preferred stock prices go down; but when interest rates are going down, preferred stock prices go up. In the current environment, rates are actually flattish-to-down, so preferreds are still okay to buy, particularly “term preferreds” with specific redemption dates—meaning that the issuing institution will call them back at “par” value (usually but not always $25).
Similarly, “baby bonds” trade like stocks, but are really debt instruments that operate pretty much like preferreds. These, too, generally (but not always) have a par value of $25 at their initial issue price. (They don’t usually sell under a conventional IPO, something we’ll explain in another column.) Baby bonds also have an expiration date like regular bonds and term preferreds.
How preferred stocks and baby bonds generally work
Given the market violence we’ve experienced in both Q4 2015 and Q1 2016, we’re comfortable holding a pretty good-sized batch of these issues. We’re a bit older now, semi-retired, and can use some predictable income.
But you rarely achieve capital gains in these investments, unless you’ve been canny enough to buy some of the better issues for less than par, i.e., less than $25 generally. If these instruments mature or are called in x-years, you’ll get your final dividend and $25 per share, no matter what you originally paid for the shares.
We’ll assess our current preferred positions over the weekend and decide whether to add to them, sell some of them, or pick up some new ones. After seeing how markets behave on Monday, we’ll share some of our thoughts on these issues and name a few names. In the meantime, if this kind of investment interests you, explore some of the terminology online so you understand how these investments work. (Or not.)
A particularly good site that we use with some regularity in our research is The Yield Hunter. Loaded with really useful information, links and occasional narratives, it’s put together (or so he says) by a regular guy like you and the Maven.
“Mr. Hunter” has made it a point to systematically invest in preferreds, baby bonds and a few other issues like REITs from time to time over many years, and, frankly, he’s made some good suggestions in a bad market, along with providing useful tips on surviving downturns, during which even seemingly safe preferreds can take a hit like anything else. Check this site out if you’re interested in exploring these investments, which few individual investors know anything about.
But also—don’t forget to have a good weekend. We obsess on stocks and stock markets here so you don’t have to.