Nasdaq's Stinky Breadth, How We're Trading it

August 3, 2014 2:10 PM

This QQQ trade was discussed Friday on CNBC’s Options Action, watch here:

image

Nearly three weeks ago, when the QQQ was $94.35, just a tad below current levels, we bought the Aug 94 puts (below) as we thought the growing divergences between the Nasdaq 100′s leadership and rank and file components would eventually be too much to bare.   The NDX’s declining breadth has not improved, mentioning as recently as this am:

we have noted what appeared to be a dramatically narrowing rally in the technology stocks, where the 5 largest components (AAPL, MSFT, GOOG/L, INTC & FB) make up about 35% of the weight of the Nasdaq 100 (QQQ).  Last Friday Enis highlighted  the heavy-lifting of a few mega-caps  As of July 18th, the Nasdaq 100 had the fewest % of components making new highs with the index at all time highs  (from Dana Lyons):

Screen Shot 2014-07-25 at 10.55.10 AM

With results of most mega-cap tech stocks out of the way, I would suggest that the Nasdaq 100 could be one of the most crowded trades that exists in U.S. equities as its fate lies with the success of Apple’s iPhone 6 (13.5% of the index).

After such a sharp decline like yesterday, we think it is important to pick the right spot to add to the position, and/or roll.  The ytd chart below shows the near test this morning of the QQQ’s 50 day moving avg, a level that the SPX sliced through yesterday:

QQQ ytd from Bloomberg

QQQ ytd from Bloomberg

If the index can not rally here and breaks below the 50 day, we would expect a re-test of the prior break-out level from early June, back near $92.  If things were to really get going on the downside, a re-test of the the double bottom low near $84 from February and April could be in the cards.

Despite yesterday’s more than 2% decline, and the subsequent vol spike, implied volatility (the price of options) in the QQQ remains relatively low considering the pick up in realized vol (how much the underlying is moving).  If realized were to reach levels similar to April and May, implied vol at current levels would be a very attractive buy:

QQQ 2yr chart of 30 day at the money Implied Vol (blue) vs Realized Vol (white) from Bloomberg

QQQ 2yr chart of 30 day at the money Implied Vol (blue) vs Realized Vol (white) from Bloomberg

The puts that we are long are still down a little bit from the point of purchase as a result of time decay, and we will look for one more big down down to close them out, but in the mean time we want to roll out a bit to give the thesis more time to play out.

Trade:  QQQ ($94.75) Bought Oct 95/85 Put Spread for $2.40

-Buy 1 Oct 95 Put for 3.00

-Sell 1 Oct 85 Put at .60

Break-Even on Oct Expiration:

Profits: btwn 92.60 and 85 make up to 7.60, max profit of 7.60 below 85

Losses: up to 2.40 btwn 92.60 and 95, max loss of 2.40 or 2.3% above 95

Rationale:  While implied volatility has picked up, it is still only in the middle of the 1 year range, despite the yesterday’s move lower.  The October put spread offers a nearly 4 to 1 risk/reward, with more than 2 months until expiration, which looks attractive given that the March/April selloff in QQQ took about 6 weeks. The key pivot area to watch is the breakout area of $91-$92.

This post by Dan Nathan (@riskreversal) originally appeared on RiskReversal.com

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