The almost 6% rally U.S. stock markets enjoyed Monday and Tuesday this week was based on the belief that the Fed would soon have to “pivot,” stop raising rates and start lowering them.

Pivot talk worked its magic on stocks this time because investors believed the Fed could not ignore scary cracks in global bond markets as harbingers of what could happen to financial systems if they keep raising rates.

Investors saw those serious cracks and figured every central bank in the world saw them too. And given that if those cracks widen enough, whole financial systems could fall into them, it would naturally follow that the Fed and other central banks would have to pivot.

At least, that was the prevailing narrative pushing stocks higher earlier this week.

But it’s all just wishful thinking. What happened in the U.S. and in the U.K. recently were indeed indicative of serious cracks in bond markets, but they were contained, and central banks went right back to their hawkish rhetoric about raising rates to tamp down unacceptably high inflation.

Because the mainstream media isn’t covering this to any great degree, I’m going to do it for them.

Let me explain what was so scary, how it was contained, and what it’s telling us about global bond markets. I’ll also go over why the Fed will keep raising rates and keep them higher for longer, what that will do to stocks, and how to make money on falling equities and know when the real pivot’s going to happen.

Fault Lines in the Global Bond Market

The first crack, which happened in the U.S. mortgage-backed securities (MBS) market in September, wasn’t widely seen or heard, but enough institutional investors and smart operators understood it for what it was – a crack in one of the country’s biggest markets.

This story goes back to the end of May when the Fed announced it would start quantitative tightening, or QT, in June, by letting $17.5 billion of MBS and $30 billion of treasuries runoff its balance sheet every month. Runoff means maturing bonds within the Fed’s balance sheet wouldn’t be replaced. In other words, the Fed wouldn’t be in the market buying bonds to maintain its $9 trillion balance sheet.

The May announcement declared that starting in September, the allowable runoff in MBS would be upped to $30 billion a month and to $60 billion a month in treasuries.

But in September, instead of letting mortgage-backed securities runoff the balance sheet, the Fed bought them instead, contradicting their announcement.

That mini pivot was necessary to arrest fast falling prices of mortgage securities, which were dragging down fixed income and bond portfolios around the country.

The hits were a matter of “duration.”

If you own any MBS or a portfolio of MBS, or are Freddie Mac or Fannie Mae, you know what duration is. It’s the average maturity of your MBS holdings.

When interest rates come down, mortgage holders refinance, meaning they borrow at a lower interest rate and pay off their higher cost mortgages. If you own MBS and higher interest 30-year mortgages within your securities package are paid off, the duration or average maturity of your remaining mortgages will almost always be less or shorter.

The opposite happens when rates rise. There’s no incentive for mortgage holders to refinance at higher rates, and because rates are rising, the actuarial calculations that determine average duration or maturity of a securities package increases the average maturity of the remaining MBS.

Now, when rates rise more, longer maturity bonds (and MBS duration is getting even longer) get hit harder.

That’s a double whammy for MBS holders, leading to what happened in September.

The Fed stepping in to buy MBS and support falling prices was a sign of a serious crack. If they had let billions of dollars’ worth of MBS runoff their balance sheet, those securities would have to be bought by other investors. But those investors weren’t about to buy more MBS, as their duration was lengthening and their prices were falling. The Fed had to intervene to keep the market from bottoming out.

Then last week, the Bank of England had to step in and buy 30-year gilts (gilts, as in gilt edged, are what the British call their treasury bonds) to plaster over a scary crack in the country’s pension systems, or “schemes” as the Brits call their pension plans.

The short story here is that in a low yielding environment, which lasted for more than 15 years, pension plans amped up their returns by trading derivatives in particular swaps. Using the 30-year maturity gilts they held in their portfolios as collateral, pension managers and trustees bought long dated fixed rate bonds and essentially shorted adjustable-rate notes as part of their interest rate swaps.

When rates on shorter maturity notes adjusted higher, pensions got margin calls or were closed out of their positions, and then had the collateral they posted, 30-year gilts, sold out. That selling of collateral tanked 30-year gilt prices.

That’s why the BoE announced in the midst of QT that they’d be buying 30-year gilts and only 30-year gilts.

That selloff was indicative of a serious crack in the UK’s bond market and pension schemes.

Unfortunately, however, even though these evident cracks are probably the tip of the iceberg of monumentally leveraged securities, bonds, positions and institutions that could turn into the next LTCM (Long Term Capital Management, the currency and credit hedge fund that famously blew up in 1998 and almost took down several money center banks), the Fed is hellbent on proving its credibility and sticking with higher rates for longer to tame inflation.

This is going to send stocks lower as real-world implications work their way through earnings and necessitate re-rating and re-pricing securities in every portfolio out there.

The way to make money on falling stocks is by targeting stocks that you know are going to fall because rising rates will cost them exponentially more to refinance their mounting debts. If they don’t make any profits and have to keep rolling over their bigger and bigger piles of debts, eventually they’ll collapse.

That’s what we’re doing in my subscriber service, and we’re raking in huge gains, by the way. I suggest you do the same.

Meantime, I’ve no doubt the Fed will raise rates too high and keep them there too long and more than a few cracks will widen into multiple financial crises.

That’s when there’ll be a pivot. I’ll let you know exactly what to do when that happens.

The Fed is trying to send a message to the markets. The Wall Street Journal reported that Chairman Powell’s Jackson Hole speech was directed at traders. Powell had prepared a traditional central banker speech that was heavy on policy. But stocks still rallied because traders expected the Fed to reverse course and start cutting rates this year.

Powell decided to clearly explain the Fed would do what it takes to tackle inflation, even if that fight caused pain for millions of families.

His speech had the desired impact, if the reports are to be believed. The stock market has been selling off since then.

Powell seems to be focused on expectations. After this week’s meeting, he indicated the Fed would use inflation expectations to determine when rates could be cut. That means we could see long-term rates ease within the next few months. This should have a large impact on mortgages.

That’s the trade. iShares MBS ETF (MBB) tracks mortgage securities. Downside risks are relatively low since rates are already over 6%. Upside potential is significant since rates are likely to come down. The exchange-traded fund (ETF) offers a small dividend, about 1.2%, that pays investors to wait for the turnaround. If the Fed succeeds in lowering inflation, MBB might be the fixed income trade of the year.

We man the scanners. Watching each signal that comes through, and giving blessings to only the best.

Meanwhile, paying the role of trading coach. I ensure that everyone who joins the room is getting the education they need to manage a portfolio like a professional.

For example: we’ve spent numerous sessions in the Trade Room recently covering position management techniques. Specifically, managing multiple options positions at once to hedge your risk.

Most traders never bother to learn these concepts. They go on an options buying spree, not really understanding what they’re doing, and wind up blowing up their account.

Today, I’m going to share just a taste of how you can manage your positions effectively, so you can avoid that.

But before I do, know that if you’re a member of Wealth Whispers and you missed any of my coaching sessions live, you can find all the recordings here.

If you’re not a member, there’s no better place to learn trading education in real time.

And if I were you, I’d learn all I can to be positioned correctly once this market starts to rally. Click here to learn more.

UNDERSTANDING “EFFECTIVE LEVERAGE”

One key concept to understanding how a position will behave is what I call “effective leverage.” 

Now, we all should know that an option contract controls 100 shares of the underlying stock. So, on the surface, an option position can be considered levered 100:1 to the price move of the stock. 

However, in practice — especially over differing times to expiry of option contracts — that leverage will vary significantly. 

This should be top of mind when choosing positions to add to a portfolio that includes hedges.

Let’s Illustrate this by comparing a couple MSFT options with different expirations. First, here’s the 2 DTE (days to expiry) MSFT ATM (at the money) call:

Last week we talked about using delta to decide which option to buy.

Delta tells us how “fast” an option will move relative to the underlying stock.

This week, I want to continue the conversation — but this time, we’re talking about “delta per dollar.”

Basically, this lets us see how much bang we’re getting for our option-buying buck.

A position with higher delta per dollar will be more volatile than a position with lower delta per dollar. This means profits and losses will accumulate faster.

So, higher delta per dollar might be better for a day trade, while lower delta per dollar could work well for a longer-term swing trade.

Let’s dive right in:

Take a look at the WBA August 26 $37.50 call option above.

To determine how much delta we’re getting per dollar of capital committed, we first look at the delta and mid-price of the option.

In this case, it’s a .48 delta for $0.45 per contract.

The closest to a dollar we can get is two contracts, for a total of $0.90 and a .96 delta.

Let’s compare that to another WBA option, this time expiring in a few weeks.

Are you seeing the market action today?

It’s a whole lot of chop, chop, chop…

And that action is slicing up traders committed to a single direction in this market.

If you’re reading this, I’ll go out on a limb and say you’ve heard of a hedge fund. Hedge funds are made up of the smartest traders in the world.

But they call themselves hedge funds because they, well, HEDGE.

That means protecting yourself from the move you don’t see coming… and making sure that you’re set to profit in multiple scenarios.

Setting up a hedge is something every trader should know. Many folks think it’s complicated because of its hedge fund pedigree, but it doesn’t have to be.

Today, I’ll show you just how easy it is…

For this, I’m going to be using November 4, 2022 expiry options for the following two instruments: Carnival Corp (CCL) for my upside play, and the VIX ETF (UVXY) for my downside play.

Why these two?

Well, CCL was down almost 30% in a single week… so that screams “play the bounce” to me. If stocks rally, CCL should rally even harder.

And we’re hedging with UVXY because it’ll rise if the broad market continues to fall.

Plus, there are some technical reasons I chose these two tickers which I’ll get into shortly.

I’m shooting for the simplest possible hedge I can set up… So, to start, I’ll explain why I’m choosing November 4 expiry options.

As we all know, option contracts have theta decay (AKA time decay) when we buy them.

Theta decay becomes a major component of loss in an option contract about 8 days to expiry, so for this example, I’m picking contracts with 23 days to expiry to avoid theta decay.

I would hold this position about 13 days, and then close it no matter what, and if I wish to keep the position on I can just buy later-dated option — this is called “rolling” an option.

For the next step, I’d like the two instruments to be as similar in dimensions as possible: In particular, I want similar ATRs (Average True Range, or Average Trading Range) and I want similar deltas for each option (for a refresher on delta and how to use it, check out my piece from a few weeks ago).

In this case, I’m going to keep it simple and use the At-The-Money options for both the upside and downside play here.

So, let’s take a look:

CCL has an ATR of 0.68, and UVXY has an ATR of 0.87, relatively close. (On thinkorswim, you can get ATR on your watchlist by clicking the small gear icon in the upper right of the watchlist header, choosing “Customize” and then typing ATR in the search box of the menu that pops up, then click “Add”).

Now that I have two tickers with similar ATR, the next thing I want to look at are the delta of each instrument:

CCL:

I wrote in July about the Coinbase (COIN) put-sell trade I put on. I got paid $650 a contract selling the January 2024, $22.50 strike.

Coinbase shares were trading for about $50… already more than 80% off their $381 initial public offering (IPO) price. And I reckoned I’d be willing to buy shares at $22.50… which would require a further 50% drop.

And the yield was just too juicy to pass up: 29% on the full cash-secured $2,250 potential purchase price, and 74% on the $875 initial margin requirement.

Since selling those contracts, a January 2025 series has come on the board. Here’s a trade I like on those: Sell to Open the January 17, 2025, $35-strike puts for $15 or higher.

The last trade was at $13.10, so I suggest setting a limit order at $15 and waiting patiently.

You’re risking $2,000 per contract if COIN shares go to zero… and making $1,500 if the stock is above $35 come January 2025.

$1,500 on the full cash-secured purchase price gives you a total yield of 42.9%, or a little over 17% annual.

17%!

Sure, COIN shares could continue to get hammered by the bear market.

But I don’t see them going that low.

The stock has already fallen more than 80% from its IPO price. The company holds about $27.50 in cash per share.

And they have 73 million users… with more than 6 million of them making at least one transaction a month. Worst-case scenario: One of the traditional online brokers buys them out for their customers.

17% annual yield may not be as much as some DeFi projects paid before the music stopped. But Coinbase is an exchange-listed stock, and your option sales will most definitely be cleared through the OCC.

Inflation is likely to remain high through the end of next year before dropping back to 2% by the end of 2025. At least that’s what the Fed believes. At this week’s meeting, Federal Reserve members updated their economic projections. Consensus is for short-term interest rates to be at 2.9% in three years. The Fed is clearly admitting it will take months to fight inflation.

This seems to be at odds with what many market participants are saying. ARK’s Cathie Wood expects inflation to fall quickly as recession reduces demand in Europe and the U.S. Elon Musk agrees with her. We are likely to see a recession, but inflation and recession can coexist. We can glance at economic data from the 1970s to see that.

We do share some similarities with the 70s. Oil prices spiked and created economic hardship. Policymakers flooded the economy with money. Confidence in political institutions fell to new lows. All of that happened then, and it’s happening again now. With history as a guide, it could be time to buy gold.

FT Cboe Vest Gold Target Income ETF (IGLD) offers exposure to gold and income. The ETF offers a 3.2% yield, and income is one of its primary objectives. Tracking the price of gold is the second objective. Income should hold steady so the yield should drop as gold rises. This is a small ETF with just $40 million in assets, just 0.07% as big as the more popular SPDR Gold Shares (GLD). But IGLD is liquid and could be the better choice for those wanting gold and income.

The “Option Greeks” are an obscure group of letters and symbols that most traders tend to ignore.

But those of us who understand how they work? We can make the money that others lose.

You’ve probably heard of some of them.

Delta, theta, gamma, and the lesser used: rho and vega. 

Most of these terms apply to the options contract itself.

However, there is another Greek that’s just as important to be aware of that I don’t see many educators talking about.

And that is Beta.

A stock’s beta measures how the price of the individual stock moves compared to the price of the S&P 500. 

In short, it’s a volatility score.

Beta is expressed as a decimal ratio, such as a beta of 1.5 versus a beta of 0.8. 

The stock with a beta of 1.5 will, on average, move 1.5% for each single percent the S&P 500 moves. Meanwhile, the stock with a beta of 0.8 will move 0.8%. 

This tells us something critically important when setting up an option trade: How volatile the price action is of the stock we’re buying an option on. 

A higher beta corresponds to more drastic price movement up and down, while a lower beta corresponds to less drastic price movement as the market ebbs and flows.

Now, the simplest and most effective way to use this in our option trading is a strategy like this… 

Using higher beta stocks for day trades — in order to get bigger relative moves on the stock itself, and using the lower beta stock for longer term swing trades or position trades — where we have more time to expiry and less drastic volatility, meaning we are more likely to avoid being stopped out of the trade.

Here’s an example of my ThinkOrSwim setup where I have beta at the bottom of all my stock charts: