The U.S. Dollar & Oil Hold Clues About the Future

Another victim of the Star Spangled Banner of the Street,
Now you’re in the world of wolves, and we welcome all you sheep.

~ Hollywood Undead, “Been to Hell” ~

My name is J. W. Jones and I am an options trader. I wanted to get that out of the way so that readers who consider those of my ilk to be best regarded as the quiet family secret of carnival barkers, snake oil salesmen, and politicians can stop reading now. I understand your hesitation, but the world has changed.

Option trading volume is exploding as more traders become aware of the ability to establish trading positions for a variety of hypothesized scenarios while controlling risk with precision. For those who seek to thrive in the current market environment, I consider the routine use of option strategies to be essential in order to produce consistent profits.

In my weekly missives to come, I will endeavor to give a tour of my world. It is a world frequently visited by stock traders, but the locals in our world love tourists. It is these visitors to whom trinkets of little value can be sold with potential promises of great fortune, yet extremely small probabilities of success are realized.

We welcome a constant stream of guests, thanks in large part to an unending cacophony of various marketing efforts promising bountiful profits from simply buying options. Nothing could be further from the truth.

To our beloved and dazed visitors, on whom we depend to buy the worthless detritus we routinely offer for sale, we bid you welcome. The ordinarily reliable touchstones of your trading world become distorted in the world of options.

As an example, the basic trader’s maxim of “only price pays” is no longer true in the world in which I operate. While price does indeed pay, time decay pays more reliably for the options trader.

The trading screens of an option trader are populated by a menagerie of weird and seemingly exotic trade structures. This collection includes condors, butterflies, iron condors, iron butterflies, and verticals. These spreads as they are called exhibit the almost effortless ability to transmogrify as the result of minimal manipulation. Verticals become condors, butterflies become condors, and condors easily return to their vertical origin once again by basic adjustments to the trade structure.

An inexperienced trader who chooses to make an attempt to engage in these modifications should be aware that these operations are not for the novice. Massive capital dislocations can easily result from unschooled trade adjustments performed by aspiring practitioners new to our world.

The trading platform of an options trader is ruled by the three primal forces of options: price, time, and implied volatility. Our world exists within the financial construct, but is rarely utilized for its true value. All too often, stock traders mistake our world as a leveraged playground that operates congruently with the world of stock trading. Unlike stock trading which is as basic as checkers, option trading is a chess game. Stock trading is entirely based on one dimension, while option trading is three-dimensional.

To make matters more confusing, we option traders speak a different language wrought with subtleties of our nuanced approach to trading. For example, “selling a call spread” and “buying a call spread” communicate to the experienced option trader a radically different price expectation for an underlying entity. The nuances of this language serve to communicate clearly with other knowledgeable option traders and to confuse mightily beginners and wannabes.

My writing is an attempt to pull back the curtain of what I consider the intentional obfuscation of basic concepts of the world of options trading. This regular column will strive to be your guide in providing beginning option traders with ammunition that can fuel your quest for consistent profits and maximum probability skews. Your task as the aspiring options trader is to accept and enlarge upon these introductory thoughts and comments.

I welcome your comments, suggestions, and criticisms. This is my view of reality and it is not that complex. Welcome to my world. Option trading is a wonderfully varied environment which offers a wide variety The past few months have been a difficult environment for anyone that was bearish. The next few months may prove to be difficult for everyone regardless of directional bias.

We live in a world where headlines can move the market in split seconds as high-frequency trading robots cause flash rally’s and flash crashes regularly.

As an example, the price action in the Market Vectors Short Muni Index (SMB) on February 28^th demonstrates the impact that these high frequency traders have on illiquid underlying assets.

We certainly hope there were not any absent minded retail investors that got caught using market orders during the flash rally only to recognize losses as great as 5% or more in a matter of minutes.

The following chart illustrates a flash rally and the monster 40% plus rally witnessed in less than 1 minute. Can someone say fat-finger mistake?

Market Vectors Short Muni Index 1-Minute Chart

In addition to high-frequency trading, we have to constantly monitor the headlines coming out of Europe as one event or official statement has the potential to cause the Euro to rally or selloff almost instantly whether the information is fact or fiction.

We have traded small for the most part during the beginning of 2012 as market conditions have been volatile even if the volatility index (VIX) has not necessarily supported that view.

One after another, perma-bears have capitulated to the bullish camp and now we have pundits calling for the Dow Jones Industrial Average to move over 15,000 by the end of the year.

We both use strategies which in many cases would be considered contrarian by nature. Admittedly we will not get every move in the market correct, but what we will do is layout key areas that price action should migrate to in the form of key price levels across short, intermediate, and long term time frames.

Our objective is to provide readers and our members with actionable information which can be viewed objectively by both bulls and bears alike. With that said, the following viewpoint we have of the marketplace today runs contrary to the collective group of market pundits.

While most market pundits expect higher prices and stronger economic data, there is reason to believe that recent developments could be indicating that volatility may lurk ahead. Volatility could rise up and push equity valuations lower in the near term.

The daily chart of the Ipath S&P 500 VIX Short-Term Futures ETF (VXX) shown below illustrates that the VXX has seen strong volume in the past few weeks. Additionally the VXX appears to be trying to form a bottom.

With volatility at these levels, put protection is cheap and it would appear based on volume that the smart money is getting long volatility. Long VXX trades are designed to either act as a portfolio hedge or as a potential profit mechanism should a correction play out.

Ipath S&P 500 VIX Short-Term Futures (VXX) Daily Chart

By now most readers are aware of the rally that has been taking place in oil futures for the past few weeks. Nancy Pelosi came out with a statement blaming those evil speculators again while Republican Presidential hopefuls used higher oil prices as another key political topic against the current administration.

Just when the noise was starting to rise to a roar, the marketplace was quieted by a rally in the U.S. Dollar on February 29^th. The daily chart of the Dollar Index futures is shown below.

Dollar Index Futures Daily Chart

Do readers find it rather odd that just about the time when oil was on the lips of every media personality in the United States that the Federal Reserve issues a reverse-repo to pull in liquidity? Do you find it at all coincidental or could it be that Mr. Bernanke was told to slow down the rally in oil prices?

After the reverse-repo was performed, the Dollar soared higher and was showing continuation to the upside on Friday afternoon during intraday trade. The Dollar is potentially forming a bottom presently and the fact that the Federal Reserve is aiding in that formation presents additional risk for downside in the S&P 500 Index and precious metals in the near term.

For the past several weeks the U.S. Dollar Index has pulled back and the S&P 500 definitely took notice. However, the Dollar is on the verge of carving out a weekly swing low which could have legs to much higher prices.

While many pundits routinely mock the Dollar and trash it, in the event of a major currency or credit event in Europe the Dollar will be one of the key safe havens that large sums of wealth will migrate too.

If the Dollar Index Futures can push through the downtrend line illustrated on the chart above with strong supporting volume a much larger move higher will likely play out. Should that scenario play out, the S&P 500 Index will likely begin to rollover.

It should be noted that the S&P 500 has struggled on multiple occasions to break above the key 2011 highs. The S&P 500 Index daily chart below demonstrates the resistance directly above current price action.

S&P 500 Index Daily Chart

We have been bearish on the S&P 500 since price was testing the 1,330 price level. After the subsequent breakout we targeted the key 2011 highs as a last stand for the bears. If the Dollar finds a bottom and rallies sharply higher from current levels a correction in the S&P 500 will likely play out.

The other possibility would be a breakout over current resistance levels which would likely see the S&P 500 move to the 1,400 level if not higher in a matter of a few weeks. We are not leaning in either direction in terms of price action currently, but we are expecting the VIX to move higher in coming weeks and months ahead.

In our most recent collaborative missive, we discussed the fundamental case for gold prices going higher over the long term. Cleary the price action this week (specifically the price action on Wednesday February 29^th) has been bearish and we expect to see prices chop around with a potentially bearish view for the next few months.

Gold Futures Daily Chart

While gold has pulled back sharply, the likely move lower in coming weeks and months ahead will offer a strong buying opportunity for investors that are patient. If the Dollar breaks out to the upside which we anticipate, gold should move down into a significant low.

Should this scenario play out an entry point near the low will likely offer strong upside potential. In fact, it might be the last deep low before a prolonged period of choppy price action until the Dollar tops.

We firmly believe that as long as central banks continue to print money with wreckless abandon, the fundamental case for gold remains quite strong in the longer term.

We have received a lot of emails recently asking about our opinions on the future price action in oil. Even though the Dollar may breakout to the upside, oil has a risk premium built into the price already for potential geopolitical conflict. However, military action in the Middle East could easily push prices higher.

Should oil push higher and test the 2011 highs and breakout to the upside, the likely results will be a weakening in the domestic economy as gasoline and diesel prices would surge higher. A surge in oil prices has a direct implication to the domestic U.S. economy as the cost for nearly everything will rise. The daily chart of oil futures is shown below.

Oil Futures Daily Chart

Conclusion for what to expect next:

Ultimately we believe the two most critical assets to monitor at this time are the U.S. Dollar and oil futures. The U.S. domestic economy cannot handle significantly higher oil prices from the current levels without seeing business growth slow. Furthermore, if the Dollar rallies it could put pressure on the equity markets as well.

While the equity markets and the economy are not the same thing, it is important to note that higher oil prices at a certain point will become equity negative.

The VIX is sending a warning that market participants are too complacent and the Dollar is potentially forming a rounded out bottom. These two conditions paired with geopolitical risk in the Middle East represent additional risks to economic growth.

Furthermore, market participants cannot become complacent regarding the potential risk that Europe still poses. With the various risks listed above in mind, we are keeping position sizes small and are attempting to remain Delta neutral in our portfolios. Risk is beginning to elevate to extremes.

JW Jones