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Actionable Insights for Traders

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Lou Mercer: . I'm here with Randy and Adam. And we're talking actionable insights. What idea do you have for traders right now?

Randy, what actionable insight do you have for traders today?

Randy Frederick: So let me show my chart here, because one of the things I want to do is I want to put yesterday's move in volatility into perspective. So if you look at your chart here, what you're seeing is a chart of about ten years' worth of VIX. Now what I've done on this VIX is I've highlighted the last time we had volatility as low as we saw last week, all the back in 2006 and 2007, towards – right at the end of 2006, so it would have been November, December, and then also in January of 2007. That's the big white arrow that you see on the far left there.

Then the financial crisis came, and look at the spike in the VIX, up there at the top where you see the '08 financial crisis. The level of the VIX – when you put yesterday's move into perspective, you realize how miniscule and insignificant it was relative to not only the magnitude of the spike, but how long the spike stayed up there. Even when the spike finally started to come down several months later, it took probably well over a year or two before it even got back to where we've seen right now.

Additionally, I've also shown some other well-known economic or geopolitical events that have come into play in the meantime. So the Greece panic, when we first started hearing about Greece, and the fact that they were bankrupt, and that if they fell out of the Eurozone, that it might cause the Eurozone to break up, and the euro currency to go away, and all that, we had a pretty sizeable spike there in the VIX that you can see, where I've got the term Greece panic put in.

Then there was the time when we had a downgrade in US credit, and there was a – there was a banking panic, if you will, that never really materialized into anything, but people were very worried about what does this mean. We had a pretty sizeable VIX spike that also sustained for a while.

And then there was this period of time which was one of those things that caught everyone off guard, and that was China devalued its currency, and everyone panicked, and one again, it was one of those things that ultimately ended up being a complete non-event. But there was a huge spike in the VIX.

And then finally, the Trump election. Just before the election, people were very worried, what I thought was a worry that Trump would get elected – maybe it was a worry that Trump wouldn't get elected. I don't know. But even that spike in volatility, as you can see, was significantly higher than the one we saw yesterday.

I have been a student, a studier, a – an analyzer of the VIX –

Adam Johnson: A sage. A sage.

Randy Frederick: what's fascinating is the long term average of the VIX, including all these spikes, of course, is pretty close to 20. Yesterday's move didn't even get us to that level. So it's a – it was a very, very small move by – when you compare it to some of these other big events. And this doesn't even go all the way back to some of the previous things, like this doesn't include the internet bubble, when we had some pretty big spikes in – back then.

Randy Frederick:  Yeah.

Adam Johnson: I mean, think of all those spikes. And they get progressively lower.

Randy Frederick: Yeah.

Lou Mercer:  Or we're always taught the market does not like uncertainty, but you can make an argument that since the election, we've been more uncertain than ever.

Randy Frederick: We've had a lot of uncertainty.

Adam Johnson: Right.

Lou Mercer:  The VIX kept going lower.

Adam Johnson: And we're used to it.

Lou Mercer: Randy, can you talk a little bit about the relationship between the S&P 500 and the VIX itself?

Randy Frederick: Yeah, of course. I mean, I think that most people kind of understand that the VIX and the S&P 500 move opposite each other. They actually move opposite each other on a day to day basis, 80 percent of the time. One of the – I think there's a lot of misunderstandings about the VIX. The first one is that the VIX is not an instantaneous measure of volatility, although a lot of people think it is. The VIX is actually supposed to forecast where it – volatility might be in the next 30 days. The second thing is that trading of VIX options, trading of options on SPY, none of that has anything to do with the VIX. The only thing that affects the VIX are options traded on the cash SPX index, of which about 90 percent is institutional volume.

And one of the reasons I believe, and you've heard people sort of allude to this, but not really point – pinpoint it, is that you hear people say, "Well, maybe people aren't using traditional means of hedging the downside." In other words, they're not using S&P cash index options anymore. Maybe they're using other instruments.

But I've not read anyone say, "Well, what are those other instruments?" So what do I do? I do what I always do. I go back and I start looking at numbers. They're moving over to SPY. The reality is the total aggregate open interest on SPY is 50 percent higher now than it was – than it is on SPX. So not only are the retail investors who have always been in SPY there, but the institutions are moving there as well.

The big question is I don't – still don't know exactly why that is. It may be because there's better liquidity, although there's a lot of liquidity in the SPX. But –

Adam Johnson: Maybe it's just the decimal place moved one place over, right? So it's not as _____, right?

Randy Frederick: It is. And for a retail investor, that makes sense.

Adam Johnson: Sure.

Randy Frederick: Because a typical – the notional value on an SPX option is around $200,000. That's a big piece of money –

Adam Johnson: Right.

Randy Frederick – for an individual investor. But for a multibillion dollar hedge fund, it's not. So why would a hedge fund buy ten SPY options when they could do the same hedging with an SPX? I don't know. That's the big question. But that I think has a little bit to do with why we're seeing volatility trend lower.

And then the final thing I want to mention, just because I've got it up here right now, is this chart that I've – that I've super-imposed on top of this VIX chart is a grid that shows every time since the VIX was introduced that it has closed below ten. And in fact, prior to last week, there had only been ten times that that's ever happened.

And once again, I think people make wild forecasts that are not based on any fact or data or historical patterns. And one of the ones that we've seen a lot in the last couple of weeks, just before this big move, was that because the VIX is at 27 year lows, that means the bull market's ending, and we're going to have a big crash.

Well, the reason I put this grid together and I sent this out on Twitter, and I also included it in my weekly report –

Adam Johnson: It's a great chart.

Randy Frederick: – was that there's never been a time yet since the VIX was created that a record level VIX below ten has created a market pullback. In fact, a month later, you can see there was only one time that the market was actually lower a month later. And even going out an entire year, while it was lower in most cases, the worst scenario, and this was mentioned in one of the previous panels, was during the financial crisis, a six percent decline a year later. Most cases, we're down one, two percent, which is – that's yesterday. That's one day.

Lou Mercer: Yeah.

Randy Frederick: So there's no precedent. That's not to say it can't happen, but the likelihood of a major meltdown in the market simply because complacency was at record lows, there's just no previous history that that's ever occurred. There's always a first time, but I would be very surprised, given the fundamental economic backdrop that we've talked about, that that could happen.

Adam Johnson:  Well, and you know what, something interesting. If you look at the action yesterday, because here we were coming off this record low VIX, and what we did we do? We went down two and a half percent and stopped.

Randy Frederick: Yeah.

Adam Johnson:  And today we're bouncing.

Randy Frederick: Yeah.

Adam Johnson: So – which is exactly your point.

Randy Frederick: Yeah.

Lou Mercer: And now the Dow's up triple digits today as we speak.

Adam Johnson: Right.

Lou Mercer:  So let's take a look at my chart here. I'm taking a look at an oil index. And what we've seen here for the better part of the last year is just this range that oil has been trading in between. And really, the setup right now is where are we. Well, we're not at the high or that previous ceiling. We're not at the low or that previous significant support level. We're kind of right in the middle.

Adam Johnson: OPEC purgatory.

Lou Mercer:  What's your opinion on which direction this would go from here?

Adam Johnson: I think there is far greater pressure on the sell side than there is the buy side, and that is because if you simply look at the Baker-Hughes index of rigs, you know, they count the number of rigs on a weekly basis. It has been up something like 45 out of the past 48 weeks. US shale producers just keep producing more oil. They're not producing as much oil as OPEC has tried to cut, but remember, we're the big buyer. So – and oil is – oil moves based on marginal demand. So if we're the big buyer, and yet our own guys here in this country are supplying more, that marginal demand isn't magnified through the market.

So to answer your question, if we're in the middle of the range, do I have a bias? Yeah. It's to – it's to the downside.

Lou Mercer:  So even if we look at what's going on in Washington, if there's deregulation, you're saying that'll allow more producers to come online in the US?

Adam Johnson: Yes, assuming that price doesn't go below the point where they're incented to produce. But, you know, US shale producers have figured out how to be profitable in the low thirties.

Lou Mercer:  Yeah, so I think that's a key point, is that there are some other factors in play here, and that is that not only is oil shale production up, but the technology is getting more and more affordable, as it often does. The more it's used, the more widely it is adopted, the cheaper it gets. And so even as oil prices come down, the ability to produce profitably –

Adam Johnson: Right.

Lou Mercer:   – has gotten lower and lower and lower, and there, as you say, are some down now in the $30.00 range that they can – that they can produce that and make a profit.

What's fascinating about oil is that the long held conventional wisdom was that low oil was good for the markets, but as we saw in the spring of – or in the winter of 2016, January and February mostly, if oil prices get too low, that's a problem, because then oil companies can't make money. They have to lay people off. They start defaulting on their junk bond debt. There's all kinds of ramifications there. But if oil gets too high, that's a problem as well, because then people have no more money to spend for expendable income, because they're putting it all into their gas tank.

But we've been in a sweet spot for oil for quite a while, where I think it's likely we'll continue there for a while. And to me, that's somewhere between probably $45.00 and maybe $65.00 or $70.00. We have – we've been mostly in the lower half of that area. But it's likely, given what you were talking about, that we're going to be there for a while, wouldn't you think?

Adam Johnson:  Oh, absolutely. Yeah. I'm calling oil a range trade, and I've even tightened it up. For me, it's $45.00 - $55.00. And $55.00, wait a minute, you'd short oil at $55.00? Well, you have shale producers actually that get quite aggressive hedging their own production at $55.00. And the other thing is OPEC put together their cuts back in November, and there was only one month since November where they actually held to their quotas. They cheated the whole rest of the time. There's a lot of oil out there.

Randy Frederick: They've got a long history of that, don't they?

Adam Johnson: Yeah, they sure do.

Randy Frederick: And their revenue is based on the volume of oil shipped –

Adam Johnson:  Yeah.

Randy Frederick:  – not the price of the oil shipped.

Adam Johnson: Thank you. Exactly right. Well put. That's why you're the strategist at Schwab.

Lou Mercer: All right. Any other direction we can take with oil? Any sectors that might outperform compared to energy with energy prices going down?

Adam Johnson: Well, it's certainly good for the airlines.

Randy Frederick: Well, I would say two things to keep in mind. If oil does remain range bound, as Adam suggested and as I've suggested, then you – that's where your technicals come into play, right? As you see the range, as you see it get down towards the bottom end of that range. And in fact, we just saw this really just in the last couple of weeks. We saw oil dip down into the $42.00, $43.00 range in West Texas.

Adam Johnson: Right.

Randy Frederick: We hadn't seen in quite a while. It turned around and shot right back up from that.

Adam Johnson: Yes.

Randy Frederick: And a part of that was driven by some new agreements between Russia and within the OPEC countries. But for whatever reason, is that is a technical support level, and it causes them to take action, then we'll oftentimes see it run back up. And if your upside that you just mentioned is accurate, then that potentially is a point where you might start taking a little bit of profit off the table.

Adam Johnson:  And, you know, just for the option loving traders among us, and let's face it, who doesn't enjoy trading options in this crowd, if you have an asset – in this case oil – that seems to have a reliable range, you can trade that range using options. So when it gets down to the low side, when oil gets down into the $45.00 area, you sell puts on the names you like, or you sell puts on the oil ETF. Meanwhile, if it gets up to $55.00, you sell the calls. So you're bracketing. And you give yourself another five percent cushion on either side. That's – you know, I call that kind of trade the trade that keeps on giving. I love trades like that.

Randy Frederick: Yeah. Now that's not to say there's no risk there.

Adam Johnson: No. Correct. You're right.

Randy Frederick: If the traditional levels of support and resistance hold up, it does tend to boost your probability of being successful if you –

Adam Johnson: Right.

Randy Frederick: – manage your trades based on those levels.

Lou Mercer:  And we just talked about a low VIX. That also influences how much premium you're bringing in. And right now, we're not on the higher end of that right now.

Adam Johnson: No, I know, it's – yeah. You're not making as much selling or writing premium now as you have historically. There's still a little bit of money to be made.

Randy Frederick: Yeah.

Lou Mercer: But if you're going to buy it anyway, why not take in some premium?

Adam Johnson: Yeah. Exactly right. I want to get paid while I wait.

Lou Mercer: All right. Let's take some questions. Our first question is from Tom in Texas. Have you had bad trades – or, excuse me, how have your bad trades shaped your trade plan?

Randy Frederick: Wow. Good question.

Adam Johnson: Yeah. They ruin my day is –

Randy Frederick: You know, I think we – this is true not just in trading, I think, but in everything in life. You learn more from your mistakes than you do from your successes.

Adam Johnson:  Yeah.

Randy Frederick: When you succeed, I think you oftentimes fool yourself into think it was because you were just really smart, and in reality, it may have just been luck. But when you fail, it's not usually bad luck. It's usually because you did something stupid. So I think every one of your bad trades should teach you a lesson, and it's amazing how when you make a mistake, then you'll end up making that same mistake again a year later, because you forgot how dumb you were and you did it again. And so I learn something from every bad trade.

My – and I think Joanna talked a little bit about it in one of the previous segments. You learn from your mistakes. What you learn is how not to lose a lot when you make a mistake. You can't eliminate your mistakes. You're going to make them. But learning how to minimize the losses, not the number of losses, but the magnitude of those losses –

Lou Mercer:  And the idea there is really to have a trade plan going forward.

Randy Frederick: Right.

Lou Mercer:  Is it a long term investment? Is it a shorter term trade? Don't confuse the two. If it's a long term investment, diversification is key. Don't own too much. If it's a shorter term trade, at what point are you going to admit you're wrong? Set a stop order or some disciplined way of getting out of that loser.

Adam Johnson:   And can I give Tom a little piece of homespun advice? So Tom, I was short US Steel. It was one of the best calls I've ever made, but I gave myself a B minus, and here's why. I shorted this thing at $37.00. I covered it at $28.00. It's now trading about $19.00. I was worried about my cost basis, and preserving my gains. Okay, I made 24 percent. I could have made call it 50 percent. Because I was anchoring that cost basis.

It's not about what I was thinking a month ago. It's what I think is going to happen over the next month. And that's where I went wrong. That's why I graded myself a B minus, even on a winning trade, because it could have been an A, you know?

Randy Frederick: Sure.

Lou Mercer:   All right. Let's take our next question. Alex from Florida, is the strategy of sell in May and go away still relevant this year, given the turmoil in Washington?

Randy Frederick:  Yeah, that's a great question. So the challenge with the turmoil in Washington, not just on this particular old adage, which historically has been – I've done – like a lot of things, again, I never believe anything I hear unless I've done the numbers myself. And I love to go back and crunch numbers, and I've published a couple of things over the past year or so. I went back – probably each of the last three years, around this time of year, I've probably put out some updates on this information.

On a very long term basis, sell in May and go away has worked. It has not worked very well in the last 10 to 15 years. So it's been far less effective. In fact, it's about a coin flip. We've had some good years where we've done really well during that period of time. If you go back very, very long term, it has worked.

But the challenge with the Trump administration is that it's not a typical administration. He's not a typical Republican, and things are different now than they've ever been. And frankly, I've grumbled a lot lately that my job is more difficult than it used to be, because I just can't rely on historical patterns to repeat themselves, because things in Washington are so different right now.

So I think it all depends on what happens with the stuff we were talking about earlier. Does Trump remain? Does this issue that flared up yesterday blow over? Does Trump resign? Do we go into an impeachment process, and ultimately – or do we get Mike Pence? All those things could come into play over the next – between May and typically it's about – it's about Labor Day or whenever the September timeframe comes into play.

Adam Johnson: Right.

Randy Frederick: I don't know. It's hard to say. I think this is a tough one to call, given what's going on.

Adam Johnson: So one of the themes that I've been focused on for my subscribers is what I call the two Es, earnings and employment. With earnings growth of 11 to 13 percent, which is incredibly powerful, and full employment – in other words, unemployment is only 4.4 percent – that is a very powerful combination.

So if you just focus on the two Es, earnings and employment, that is an incredibly compelling reason to be in stocks. So admittedly, for me, even though there's the whole sell in May and go away thing, I'm focused on the two Es, earnings, employment. I'm staying with my stocks. I feel very good about being in the market right now, and picking, you know, good fundamental stories.

Lou Mercer: And Randy, you always say the May to September time period is not bearish, it's just less bullish.

Randy Frederick:  That's another good point. Again, historically, if you look at it, the market has in the long term history performed better between September and May than it has between May and September, but net/net, May and September was actually net positive overall. There have been years of course where it's been down, but net/net, it's actually just been less bullish, not bearish.

 

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Schwab Trading ServicesTM includes access to StreetSmart® trading platforms, the Schwab Trading Community, and Schwab trading specialists (a Schwab brokerage account is required). There are no fees to use Schwab Trading Services. Other account fees, optional data fees, fund expenses, and brokerage commissions may apply. Schwab reserves the right to restrict or modify access at any time. Schwab brokerage account online applications that have the “Schwab Trading Services” box checked will automatically be enrolled. For questions, call 888-245-6864 to speak to a Schwab Trading Services representative.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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