Bond Yields are Inverse to Bonds

It’s true. Bond yields are inverse to whatever activity is happening in the bond market. What is up is actually down, and what is down is actually up… confused?

Bonds are issued at face value with a coupon rate. For example: if I buy a bond for $100 (face value), it might have a coupon rate of 5% ($5). This would mean that the bond I purchased will return $5 (5%) if I hold the bond until maturity. This is called the coupon rate. The math is simple: $5/$100 = 5%.

But what if I decide I don’t want to hold that bond until maturity? There’s only one option… I can sell it. In fact, a lot of bond traders do just that – they buy and sell bonds and make money on the difference between what they bought it for and what they sold it for. And this is where the inverse relationship between yield and bonds come into play.

Let’s say I think the market is going to go up and I want to buy stocks. I decide to sell my bond so I can have more money to purchase stocks with. I bought the bond for $100, and it had a coupon rate of $5, for a total maturity value of $105. The yield on my bond is 5%.

Because other bond holders are thinking the same thing I am – that the market is going up and they want to buy stocks – there are a lot of sellers today. When there are a lot of sellers, the price of the bond goes down, but the yield goes up…

I can sell my $100 bond with a 5% ($5) rate for $99. I lost money *cue the tears*. The person who bought my bond, bought it cheaper than I bought it for, and their yield is much better. Here is the math…

Bought: $100 with $5 rate for a total maturity value of $105 = 5% yield ($5/$100=5%)

Sold: $99 with the same maturity value of $105 = 6% yield ($6/$99=6%)

Notice, the maturity value for the new holder is the same as it was for me when I held the bond ($105). But the new holder bought the bond for $1 less than I did. So that person got a discount, and therefore received a higher yield.

There is much more to bond trading than understanding how the yields work. So don’t run out there thinking you’re a bond wizard. Always do your own research before doing anything like that.

But, hopefully now you get the idea. Whenever yields are falling, that means there’s lots of people buying bonds. Whenever yields are rising, that means people are selling bonds.

I am no bond expert, but I do understand the basic concepts. I believe it is important to know because it might give a clue as to which direction the overall market is heading.

In general… VERY VERY general… When there are lots of bond buyers, and yields are falling, that means people are getting scared. They want to invest in the safety of bonds. U.S. treasuries/bonds are considered to be super safe. Less risk, however, equals less reward. Hence why yields are very low right now.

Ominous Signs in this Market Indicator

The stock market has been on a rip lately. The S&P has risen well above 3000, and currently sits at 3120.5 (^GSPC Chart). But how high will we go without a pullback? More importantly, how big will that pull back be?

Yesterday, while trying to find clues, I put the ‘On Balance Volume’ indicator on my SPY chart. This indicator basically gives you an idea of accumulation and distribution in the market; it tells you, in general, if the market is scooping up shares, or selling shares. I use the OBV from time to time, but have not used it in a while. What I found was scary.

SPY chart as of 11/15/2019

Notice the descending trend on the OBV indicator? More importantly, notice the pullbacks that have happened each time the OBV dropped in relation to the market rip higher?

At the end of last year we had a correction. The markets tanked for a couple months, and finally bottomed out on December 31. Since then the market has climbed to all-time highs setting record after record.

Our first substantial pull back of this year happened right after the May high. This is when the Trump administration basically said a deal with China was currently off the table. The markets did not like the news one bit, and down it went. From there it rallied to new all-time highs in July.

Same story in July – more negative trade news, and the market soon fell. However, the fed started to talk about lowering interest rates, and the market liked that. It soon rallied again in September and met up with the July all-time high. Then, of course, another pullback on… you guessed it… negative trade news. Since the pull back bottom in early October, we have rallied to even higher highs. The market is on a rampage!

But there are ominous technical signs that this is not sustainable without some sort of pull back or correction. Take a look at the chart one more time:

SPY chart as of 11/15/2019

The blue vertical lines are meant to show the market highs in relation to the OBV. The red arrows, of course, are pointing to the highs of the OBV in relation to the blue lines. The blue dashed line on the indicator shows the May OBV high, and the purple dashed line shows the July OBV high.

Notice, each all-time market high comes with a lower OBV high. This is divergence. The On Balance Volume indicator is showing divergence with the overall market.

After the July market high, the market pulled back. The OBV might have predicted this, as it could not reach the May OBV high. Same story for the September rally – the OBV might have predicted that one as well. This time, the September OBV could not reach the July OBV high or the May OBV high. And here we are today. The OBV is right at the September OBV high, but well below the July and May OBV highs.

Quite a tongue twister that last paragraph was. LOL! But you get the idea.

There is one other ominous sign the OBV is giving me. Notice the OBV has been slow to rise during this current rally when compared to the other rallies? That is showing that there is lack of conviction in this move. It seems market players are leary about moving forward on the current trajectory. The other rallies showed steeper OBV rise.

As I always say, this does not guarantee a pull back or correction will happen any day now. There is no “holy grail” of market indicators. The OBV is no exception to that. This is just something I noticed and wanted to share.

This post is my opinion only, and should not be taken as advice. Always do your own research before making any investment decision. Seek professional and licensed advisers if you are unsure.

The Leveraged ETF Killer!

Leveraged ETF’s can be a great way to make some good money. But there are risks associated with these ETF’s that are specific to them. That specific risk is called contango.

Leveraged ETF’s use futures contracts to achieve their multiple. They may use any number of futures to achieve this: oil, corn, mini’s, soy beans, etc. etc., the list goes on. But when using futures, there is a problem.

Contango is what happens when the leveraged ETF purchases front month futures, closes them out, and then purchase the next contract for more money. Example: Let’s say I buy a futures contract for $100. Later in the month I close that contract out, and purchase the next month’s futures for $101. Because that new contract cost $1 more, I can now buy 1% less than I could the previous month. No big deal, right? That’s just 1%. However, multiply that by 12 months and you are looking at a 12% loss annualized.

Contango can and will eat away your leveraged ETF gains.

Sometimes, the new contract purchased is cheaper, and that actually helps your ETF. This is called backwardation. Example: I purchase a futures contract for $100, and I sell that contract at the end of the month. I then purchase the next months contract for $99. I can now purchase 1% more. This helps the ETF and your position.

Leveraged ETF’s on the surface seem like a great thing when you are sure of the direction of that ETF. However, there are risks, like contango, that are real and can degrade your position pretty quickly.

It is my opinion that leveraged ETF’s are best suited for day trading or small swing trades. Holding leveraged ETF’s from month to month can be dangerous.

How Does Short Selling Work?

Short selling is a way to potentially make money in a bear market. When stocks go down, you can profit. Crazy concept huh? After all, as the saying goes, “buy low, sell high.” With short selling, the saying goes, “sell high, buy low.”

This is actually a strategy used by many, even in bull markets. There are always short selling opportunities. Do I short sell? Nope, never have. I do buy put options, which is kinda-sorta the same thing.

So what is short selling?

You borrow shares from your broker and sell them on the open market. Later on – if your analysis was correct and the share price drops – you buy the shares back at a cheaper price than you sold them for, and you keep the difference as profit.

Let’s say ABC is currently selling for $100 per share. You have done your research and proper analysis, and you think ABC is going down. So, you enter a “sell to open” order with your broker, for 100 shares. Your broker lends you those shares and they are automatically sold for $10,000 ($100 per share times 100 shares).

The $10,000 goes into your account, as that is what you sold them for. But DO NOT SPEND THIS MONEY, lol… the trade could go against you.

A week goes by and ABC is down $10 per share to $90. Woo hoo!! Fantastic analysis you did. You decide to close out your position by placing a “buy to close” order. The order is executed, and you just bought the shares back for $9,000 ($90 per share times 100 shares). The broker gets their 100 shares back, and you keep the difference of $1,000 ($10,000 you sold for minus the $9,000 you bought them back for).

Short selling was a bit confusing to me when I first learned of it. I thought, how in the world can you make money when a stock goes down. Well, if your broker is willing to lend you shares, that’s how. You do need a margin account to place short trades. And, of course, margin accounts can be very dangerous for a multitude of reasons.

If you are interested in short selling, contact your broker to find out what you need to do. Also, DO YOUR RESEARCH AND KNOW WHAT YOU ARE DOING FIRST!!

The Put/Call Ratio Charts

In the Dumb Money Trader Facebook Group today, I posted this pic with the comment “I look at put/call ratios from time to time. In specific, $PCSP and $PCALL. Noticed that both bottomed today. Bottomed where they’ve been hitting bottom for quite some time. These charts sometimes coincide with what the market does – the same seesaw effect. Meaning, if PC hit bottom, the market may pullback soon.

Somebody replied to it basically asking what I meant, and what is the PC ratio telling me. And his question was my inspiration for this blog post. So here we go!

First, the only 2 PC charts I use are 1) $PCSP (put/call ratio for the S&P 500) and 2) $PCALL (put/call ratio for the entire market). There are others, but I will not get in to them right now.

The P/C ratio chart (I call them PC’s) is the ratio between puts and calls. Remember from options 101 that puts are bearish, and calls are bullish. To know what the ratio is you simply divide all the puts by all the calls.

Let’s say there are 1000 puts and 500 calls. The put/call ratio would be 2 (1000 puts divided by 500 calls). Now let’s say there are 500 puts and 1000 calls. The put/call ratio would now be .5 (500 puts divided by 1000 calls). Lastly, let’s say there are 1000 puts, and 1000 calls. The put/call ratio would be 1 (1000 puts divided by 1000 calls).

So now that you know the basic math involved, let’s discuss the basic theory behind this ratio.

According to Investopedia, a ratio above .7 is considered bearish, and below .7 is considered bullish. That is, above .7 means there are more people buying puts than buying calls. Which can be a bearish sign. Why .7? Simple. Since people typically buy more calls than puts, using a ratio of 1 would not be “accurate” to determine market direction because that would imply a 1 to 1 split between puts and calls. So, the investing gods decided .7 was a good “middle” point. Honestly, past what I just told you, I don’t know any other reason for .7 being “neutral.”

Now, what can this ratio tell us? I use these charts from time to time, to help me determine which direction I think the market is going. If I open this chart and see a rising PC, I may go easy on my bullish bets. But if I open this chart and see a falling PC, I may increase my bullish bets. I have noticed that this ratio sometimes coincides well with market moves. Meaning, I have noticed that some very bearish days in the market was preceded by a rise in the PC ratio.

If people are getting bearish, they’re not going to buy calls, and vice versa if people are getting bullish. So, if the PC is rising, that can be a sign that people may be getting more bearish because they are buying more puts. If the PC is falling, that can be a sign that people are getting more bullish because they are buying more calls. As always, does this mean it’s guaranteed bearish or bullish sign? Absolutely NOT! But the more tools you utilize to make investing decisions, the better off you might be. No one particular “indicator” is going to be 100 % accurate.

Investing is like a puzzle – You have to put all the pieces together to see the bigger picture.

The Credit Spread

The credit spread is a very popular options strategy that, not only allows you to collect premium, but also limits your risk should the underlying do the opposite of what you thought it would.

There are 2 types of credit spreads: Short put verticals, and short call verticals. They are also called bull put verticals, and bear call verticals. I like short put and short call better, so that’s what I’m going to use for this article.

Short put verticals are used when someone is bullish on the underlying; they’re hoping to profit if the underlying stock rises in value. On the contrary, a short call vertical is used when someone is bearish on the underlying; they’re hoping to profit when the underlying stock declines in value.

The general idea is to sell the more expensive option, and buy the less expensive option (both within the same expiration). Selling the more expensive option nets you a premium – a credit that you receive in your trading account. Buying the less expensive option provides you with “insurance” that caps your maximum risk on the trade.

So how do you enter a short put or short call vertical? Let me tell you…

For my example, I am going to use a hypothetical stock, and the strike prices will be 100 and 105. And, of course, the same expiration date will be used when I enter this trade. The 100 strike will be $5 and the 105 strike will be $3. I will not include any brokerage fees either. And yes, you will have some kind of brokerage fee I’m sure. With that said, let’s begin!

I am bearish on stock ABC, and I decide I want to enter a short call spread to collect premium. Currently, ABC is trading for $100 per share. So, I pick the 100 strike to sell, and the 105 strike to buy. When I sell the 100 strike (at the money) I collect the $5 premium (credit) that this contract was selling for. I simultaneously purchase the 105 strike (further out of the money) for a $3 debit. Note: 1 option contract is 100 shares, so multiply the premium by 100 to determine actual total cost. In this case it would be $500 collected (credit), and $300 paid (debit)

The full credit I receive is the difference between the premium collected, and the premium paid. In this trade that is $2 per contract ($5 credit minus $3 debit). The $2 credit is deposited into my trading account ($200 total for the one contract). But, of course, before I entered this trade I determined what my risk vs. reward was. And because spreads are defined risk, it was easy to do so.

The maximum profit potential is the credit that I received. In this situation, that was $200 ($2 times 100 shares). The maximum risk potential is the spread width (distance between strikes) minus the credit received. In this situation, the strike width was $5 and the credit was $2, so my max risk potential is $300 ($3 difference times 100 shares).

ALWAYS determine risk BEFORE entering a trade. This should be your first step in deciding if the trade is worth it.

So, if ABC stays below $100 per share by expiration, I will keep the entire credit of $200. Remember, this credit was pretty much automatically deposited into my trading account when I placed the trade.

But what if ABC rises above $100 per share by expiration? Well, a couple things: 1) Break even or 2) lose your max risk… Remember that premium I collected? Well, to find the break-even price for ABC (the price in which you will not lose any money, nor will you keep your credited amount) you simply add the premium collected ($2 in this case) to the lower strike price ($100 in this case)… to break-even, I need ABC to stay below $102 per share ($100 strike plus $2 premium collected). Should ABC rise above $105 per share, I will lose my maximum risk of $300.

If ABC stays between $102 (break-even) and $105, you will get to keep some of the premium you collected, but not all of it.

And that’s really it. Pretty simple! But remember, I entered this short CALL spread because I was BEARISH on the underlying. If I was BULLISH on the underlying, I would have entered a short PUT spread. The short put spread is done the exact same way in reverse.

With a short put spread, you sell the higher strike and buy the lower strike. And, to determine the break-even, you subtract the premium received from the HIGHEST strike. If you recall, with a short call spread, you sell the lower strike and buy the higher strike. And, for break-even, you add the premium to the LOWEST strike.

It’s important to note that there are many different ways you can enter spreads. For instance, you can focus on in the money, at the money, or out of the money options. You can also widen the strike width beyond the 5 wide example I used.

Before you place your first vertical spread trade, you MUST understand them 100%. Even though they are defined risk, and your loss potential is capped, it is still a loss that can happen.

To Short… What Does That Mean?

The concept of shorting really tripped me up when I first started investing. Before that, I always assumed the only way to make money investing, was to buy. You know – “buy low, sell high.”

But, what I soon learned was that “sell high, buy low” was also a very valid concept. In fact, once I figured this out, I knew that I was going to be able to make money regardless if the market was bullish or bearish. Of course, you still need to know what you’re doing… but in theory, money can be made in a bull or bear market; recession or crazy hot economy. Makes no difference.

But what is shorting? Short selling is the borrowing of shares from ones broker to sell in the open market, and buying those same shares back at a cheaper price and profiting on the difference. Let me explain:

Let’s assume I am bearish on company ABC (hypothetical company). I think they suck, and I think they will drop 5% in price within a week. Currently, ABC is selling for $100 per share. I want to short them, so I open a short position via my trading platform for 10 shares. When I “Sell to Open” via my broker, my broker then lends me the 10 shares I requested, and they are automatically sold on the open market for $1,000 (not including fees).

So, to recap: I borrowed 10 shares from my broker and sold them for $100 per share netting me $1,000 that is deposited into my trading account.

A week goes by and ABC stock did exactly what I thought they would – they tanked 5%. WOO HOO! What a great analyst I am! So ABC is now selling for $95 per share – $100 minus $5 (5% of $100) equals $95. I decide to close my position by placing a “Buy to Close” order.

Now I am buying back the shares that I borrowed, so I can return the borrowed shares to my broker. But, I am buying the shares back at a cheaper price than they were when they were loaned to me… so I get to keep the difference. I sold ABC for $1,000 (10 shares at $100 per share), and bought them back at $950 (10 shares at $95 per share) to give the 10 shares back to my broker. I get to keep the difference – $1,000 minus $950 equals $50. I just made $50, or 5% on my return. FANTASTIC!

The example I gave was for short selling stocks. However, there are other ways to short like buying put options. A put option… simply put (LOL LOL)… is an option contract that you purchase when you think the underlying is going to fall in price. But put options are for another article. Just know that with a put option you are not borrowing anything, rather, you are buying with your money a security that will allow you to profit when the underlying falls in price.

Understanding short selling broadened my horizon in terms of investing. With a good understanding of short selling, it is entirely possible to profit in a bear market, the exact same as you can in a bull market. But, like any other investment type, short selling carries certain risks that other strategies do not. As always, it is absolutely necessary for you to educate yourself on whatever you do BEFORE you do it when it comes to investing or finance.