🗞 Confession: I Messed Up

WHILE YOU POUR THE JOE… ☕️
Once In a Decade

This is David Tepper. He manages up to $5 trillion in his Appaloosa fund 💵, which is one of the best-performing funds on Wall Street today. He went live last week on CNBC to say he’s buying “Everything” related to China.

And he’s not wrong. We’ve been calling for Chinese stocks for over two years now, but we only made it public through this newsletter and our Twitter account recently.

In China, we’re most bullish on Alibaba, which is why we bought up to 700 shares below $80 two years ago. After all this waiting, things are finally looking up.

But there’s a problem.

I messed up big time. Remember the Alibaba bull calendar spread that we pitched a few posts ago? It’s been paying nicely until I got greedy and thought I was being smart when I adjusted that position.

Before we get to that, here’s how else you can avoid mistakes in the market; let’s get on with today’s email 📧…

AGAINST ALL ADVICE
You Never Go Full Macro

When you’re fresh off the economics and finance books, you feel like you have a crystal ball in your hands, and following all the indicators and data can give you a glimpse of what could happen next. 🔮 

The thing is, if that was truly what paid in the stock market, economists would be the real billionaires, and they barely break 200k a year at the top end.

So, what do we mean by all this?

Never go full macro.

Using indicators like GDP, money supply, PMI indexes, and housing data, you can get a very powerful idea of what is happening underneath the hood of the S&P 500.

Yet, you can be wrong 90% of the time when making a bet or investment with these conclusions. We have been bearish on the market since July of last year, yet the market has been making new high after new high.

We’ve played the long end of things, hedging with some shorts in what we believe could come down, and have done very well.

Things are changing now, though. When markets are not trending hard, that means correlations are high, and you can make a lot of money employing long/short equity strategies, but that’s about to be over.

We will either trend high in a big way or down in a big way, so our portfolios need to be ready.

This is the manufacturing PMI index, which has been contracting for 22 consecutive months. This is bad news for the economy and the S&P 500. 📉 

Yet, the normal divergences are from 12-18 months, so betting with this data would’ve given you nearly two years of losses.

Don’t go full macro.

Now, here’s another reliable indicator:

The yield curve, which has been negative for as long as the PMI has been contracting, 100% of the time means a recession and a stock market crash, especially when it returns to positive territory.

Yet, nothing has happened.

If that’s not enough, let’s take a look at inflation and unemployment, which impact the Services sector (80% of the US economy now):

Inflation is down and unemployment is up. This can only mean bad news for cyclical stocks dealing with consumers and businesses right?

So, why in the hell is the S&P 500 still going up after all this bad data coming for two years now? 👀 

The answer is, nobody knows, and if you try to make sense of it you will be bankrupt. This is exactly where being a good trader comes in handy.

We are not expecting the market to crash tomorrow, but we have to realize that the odds of being short are better compared to the odds of being long, all based on growth potential vs current valuations.

So, as long as the market wants to go up, we’ll let it go up and keep buying it, but when it decides to come down, we can also be ready and ride that wave hard.

This is by no means an end all be all analysis, but that channel in the red lines represents a regression line, keeping volatility and price action in mind, we are at a significant upside deviation.

Again, the odds of being short are better than being long.

But, we need investor confirmation in this case, so we checked volume to gauge how people feel about today’s prices:

Volume has trended lower since we got closer to that deviation level, and just like any other market, lower participation at higher prices means that people are just not interested (they think it’s too expensive).

One last check to bring it all home, what are the big institutional dealers (commercials) doing? This is where the commitment of traders reports comes in handy:

The red line represents the commercial side, banks, and other dealers for S&P 500 futures inventory. Notice that they are as short the market as they were during the financial crisis and COVID-19. 📉 

At the same time, the green line representing institutional managers and other funds is as long as it has been during those two historical periods.

You must understand that commercials shorten this market when they need to hedge their positions, but that doesn’t necessarily mean a view of the market itself.

On the other hand, when fund managers get this long, they typically do so when chasing momentum, and the fact they are tapped out to the long side tells me this could become a pain trade.

** Quick tip 💡: A pain trade is when the view is so heavy in one direction that if the view is proven wrong, all hell could break loose.

This can mean the market rallies hard to new highs, or it can mean the market has run out of buyers, and any buyers coming in today are late to the party and will be shaken off just as quickly.

Here’s a bonus: Equity risk premiums, seen through the yield on corporate bonds, are on the rise.

That white bar chart is the difference between corporate bond prices and treasury bond prices; it’s down, which means markets are seeing stocks as more risky today than bonds. 🫢 

So again, the odds are better for being bearish today than for being bullish. Don’t go full macro; wait for confirmation. ⏰ 

MISTAKE OF THE WEEK
I Messed Up Big Time

Yep, I took on that bull calendar spread on Alibaba when we posted about it, but I made one critical rookie mistake.

A bull calendar spread means you buy call options 📈 for a later date (November in this case) and sell short call options 📉 for a sooner date (October in this case), with the idea of being relatively risk-neutral and having a lot of time on your side to make a killing.

Well, last week, I decided to close my long call position to roll into a higher price and expiration date, thinking, “What could go wrong in 24 hours?”.

Well, everything did go wrong in less than that:

Alibaba shot up by over 17 points in less than a week. 🔥 

Sure, my 700 shares are at a nice profit of roughly $20,000, but the short calls I had left open quickly caused me a paper loss of $10,800.

What. The. Hell. Do. I. Do. Now..?

Honestly, I’m asking the Universe and ChatGPT at this point because two years of waiting were erased in 3 days of parabolic price action, and it hurts.

But the show goes on, so here’s what I figured out:

1. I can close the option and take that $10,800 loss (ouch), but then I get to keep my 700 shares, ride it higher to my valuation target of $220 🎯, and potentially open new bull calendar spreads to recover.

2. I can let the options expire, but then I would be forced to sell my 700 shares at $90 and pray to God that the stock comes back down to a nice enough price where I can buy again (unlikely).

3. I can roll the option to simultaneously close the losing position and sell another set of call options at a higher price or a further out date, ideally at a credit 🫰.

Whichever way you look at it, I’m in a pickle. Given my liquidity requirements for my daily S&P 500 trading algorithm, I cannot see myself losing the $10,800 out of my liquidity pool for high-frequency trading.

By the way, here’s how the algorithm performed in the last two weeks of September using a 10 ATM options lot on $SPY.

When adjusted for that frequency, there are 90 trades, 84.4% win frequency, and a 5.4x win/loss ratio 🖥️.

It’s still a little rough around the edges, as some of the losing trades are much bigger than the average winning ones, but that winning frequency keeps it alive. We’ll work on that.

It was a $4,400 high watermark and finished the 2 weeks at a $3,400 profit.

Anyway, let’s continue with Alibaba…

I am honestly leaning toward letting my shares go, then buying them back on the next big pullback and initiating more bull calendar spreads to make up for the 17-point difference I left on the table.

If in 18 days 📆 (when my options expire) that doesn’t look as good an opportunity, I can roll out by maybe a month or so and try to get a credit by going to the $105 strike price.

Here’s what I’ll need to see to make my decision by the end of expiration:

First of all, the new prices need to be accepted, particularly above $105, as the volume has decreased since the start of 2023.

Historically, there has been no interest in trading in this area, but of course, today’s narrative is different.

If we do get some acceptance here, a potential pullback to $100 or even down to $90 📉 might be warranted, as the stock makes a new volume profile for the quarter.

While this is unlikely, or at least within 19 days until my expiration date, it doesn’t look like I can wait for a pullback in time.

So, I might have to end up rolling to the $105 strike and adding another month to this trade to buy back some time. For that scenario, I need to see volatility at a historical high so that the contraction will work in my favor and significantly devalue the options I’d be short on.

Here’s what volatility for Alibaba looks like right now:

In short, it's popping above the five-year highs, meaning we might soon experience a contraction 📉.

This is the perfect scenario for me to roll out and potentially make back the loss from the previous contract on this volatility contraction, just as long as Alibaba doesn't go on a crazy rally again.

So, considering that this pullback might be here after all, I think I'll monitor volatility and volume in Alibaba stock to time this rollout in options as best I can.

Don't make my mistake; when you have a trade idea, just stick to it and don't try to be too smart.

We'll update this situation on our Twitter account. Let it be a lesson for you, and avoid getting yourself into something similar.

NOW GO AND MAKE IT HAPPEN
Keep a Margin

The way I should have gone about this Alibaba trade management is with a philosophy I learned through today’s book recommendation 📖, a concept made famous by Warren Buffett himself.

Always invest with a margin of safety, so in case you are wrong, you come out losing only a fraction of what you would stand to gain instead.

To your success,

G. 🥃