Beware of One of the Biggest Market Disconnects in History

As a market analyst, my job is to make sense of the markets and to uncover the real reason stocks rise and fall — and then use that information to help others profit. My methods go far beyond just buying a good quality stock or shorting a pricey one, though.

Countless hours of research go into finding what I call “disconnects” between where a stock is trading and where it should be trading based on past precedents, peer values and earnings growth potential.

An example of a disconnect is a weak stock or index that’s moving higher, or possibly even moving lower, but hasn’t fallen fast enough given the data.

And what I’m seeing today is one of the biggest disconnects I’ve seen. It makes absolutely no sense!

“S&P 500 companies have posted negative growth for six straight quarters, a stretch that’s been exceeded only once since 1936. That was the seven-quarter slump of the 2007-2009 recession.” – Bloomberg

The chart below will help you visualize just how insane the market’s behavior currently is:

The orange line represents actual earnings for the entire S&P 500, which peaked in late 2014 and have been declining ever since. In most other cases, this would spell a bear market for the S&P 500, but not now.

The white line represents the value of the index, which has now broken far above the earnings line — a situation we’ve only seen a handful of times over the past 40 years. Exceptions to this rule were the 1987 crash and recession that followed, the dot-com bubble and subsequent bust, and the Great Recession of 2008.

If you’re seeing a pattern to these events, you now know why I’m concerned.

Stock prices increasing so far above earnings growth might be acceptable if we had just come out of a global recession and the world was expecting strong growth on the horizon, but that’s not the case. We are currently seven full years into an economic expansion. Data and history both tell us that it’s likely time for a slowdown in economic growth (which we are already seeing).

At the end of the day, I am concerned about, at minimum, a near-term drop in the stock market. But rather than sit on the sidelines, there are tools that can be used to combat volatility and the market insanity.

In particular, there is one strategy that not only reduces your risk, but also increases your chances of success to as high as 90% per trade. That is because you can profit whether a stock — or index — goes up, down or sideways.

I’m talking about spread trades, and in this particular case, bear put spreads. While this strategy requires a little more work, it is the best way to play this overbought market that keeps drifting higher.

What is a Bear Put Spread?

In a nutshell, this strategy exploits the time value of options and plays other investors against one another to gain a statistical advantage over the market. It’s a relatively simple bearish strategy that involves two options on the same stock or ETF traded together:

1 long put (purchase)
1 short put (sale)

When both of these trades are done at the same time with the same expiration, it’s called a bear put spread.

Here’s what you need to know about them:

1. Bear put spreads cost money because you always purchase a long put that has a higher strike price (more expensive) than the put you sell.

2. You will always trade the same number of long and short puts — if you buy one, you sell one.

3. The most the trade can be worth is the difference in the strikes.

4. The most you can lose is what you pay to initiate the trade.

5. The goal is for the stock to stay below the short put strike. As long as the stock is below that level on expiration, the maximum profit is achieved.

Let’s walk through an example of a recent trade I recommended.

On June 17, I made a bearish call on online travel company TripAdvisor (NASDAQ: TRIP):

The ticket breaks down like this:

We’re purchasing the TRIP Jul 75 Put.
We’re selling the TRIP Jul 70 Put.
The most this spread can be worth is $5 ($500 per contract).
The most we’re going to pay for this spread is $4 ($400 per contract).

The maximum profit we stand to make on this trade is $1 ($5 spread – $4 net debit). But I typically like to set a target slightly below the spread’s maximum value, placing a good ’til cancelled (GTC) sell limit order at that price to automate my exit. In this case, I set a GTC sell order at $4.80.

So, as long as TRIP stayed below $70 (the strike price of the short put), we’d at least hit our target price and generate a 20% gain in 29 days, or 252% annualized.

When we entered this trade on June 17, TRIP was trading around $63. This meant shares could go down, stay flat or even rally to $70, and we’d still achieve our profit target with only $400 at risk.

And down they went, and even quicker than I anticipated thanks to the Brexit panic. Our automatic exit was triggered just five days later. This meant that 20% gain translated into an amazing 1,460% annualized return.

Trading spreads like the bear put requires a little more effort, but the payoff is well worth the learning curve.

– Jared Levy

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Source: Profitable Trading