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Equity Investors Shouldn’t Fear Quadruple Witching if They Understand It

Posted on by phoffman@channelchek.com

June Quad-Witching is the Friday Before a Three-Day Weekend

Double, triple, and quadruple witching hours are often characterized by increased stock market activity as traders manage expiring positions in the last hours of trading. Friday, June 16th is a quadruple witching which may demonstrate increased activity as it leads into a weekend where markets are closed on Monday.

The term “quadruple witching hour” is used to describe the simultaneous expiration of stock options, stock index futures, and stock index options and single stock futures contracts on the same day. This happens only four times a year on the third Friday just before a quarter end. The same expiration date of all three types of stock derivatives can cause unusual swings as expiring derivative positions can cause increased trading volume and unusual price action in the underlying assets as traders close, roll, or offset expiring derivative positions, particularly in the final hour of trading.

Options Expirations and Futures Contracts

Stock index options, and stock options, are financial instruments that grant the holder the contractual right, but not the obligation, to buy (call option), or sell (put option) a specific quantity of an underlying security or value of an underlying index at a predetermined price (strike price) within a specified period. The final day of the period is known as the option’s expiration date.

Stock index options are options based on the broad market indexes, such as the S&P 500 or the NASDAQ-100. These options give investors exposure to the overall market’s performance rather than individual stocks.

Stock options work similarly, but are based not on index values, but on stock price.

Stock index futures and single stock index futures are contracts that obligate (not optional) traders to buy or sell an index at a specific price or a single stocks at a specific price on a future date.

Expiration Fridays often witness heightened trading activity, as investors attempt to rebalance portfolios and positions. This can cause increased volume and produce significant price fluctuations in the underlying, impacting both individual stocks and the overall market.

Arbitrage Opportunities

Though much of the trading in closing, opening, and offsetting futures and options contracts during witching days is related to the squaring of positions, this increased, and at times, frantic activity can create price inefficiencies, this may provide short-term arbitrage opportunities for those skilled and quick enough.

The arbatrageurs would generate even more volume into the close on quadruple witching days as traders attempt to profit on small price imbalances with large trades that may execute a buy and sell in seconds.

Additional Reasons To Care About Triple Witching

As four types of derivatives, with related underlying indexes and securities expire, traders, especially before a long weekend, will often seek to close out all of their open positions well in advance of the close. This can lead to increased trading volume and intraday swings. Traders with large short positions are particularly exposed to price movements that could be more difficult to manage leading up to expiration. Arbitrageurs try to take advantage of abnormal price action, this actually serves to keep prices more in synch.

The higher trading volumes can be one-sided and potentially result in wider bid-ask spreads and greater slippage. Investors mindful of the potential one-sided liquidity challenges may decide to wait for the smoke to clear the following week, or see if they can benefit by feeding into demand if they can.  

Traders who are skilled at interpreting trends, and have great execution, may find quick opportunities to make money during these multiple expiration dates.

Take Away

Quadruple expiration dates, which happen four times a year, can have significant implications for traders and investors. It is best to, at a minimum, know the dates to understand unusual price moves. Understanding the intricacies of option expiration, and multiple witching hours helps investors navigate markets. Advanced traders may even find ways to capitalize on the moves intraday.

June 2023 is unusual in that the quadruple witching hour comes before a three-day weekend; this could push more volatility to earlier periods during the afternoon.

Paul Hoffman

Managing Editor, Channelchek

Which Stocks are Most Impacted by Changing Interest Rates?

Posted on by phoffman@channelchek.com

Why Interest Rates Impact Large and Small Company Profits Differently

Small-cap stocks are less sensitive to interest rate changes than large-cap stocks. Generally, when interest rates rise, it can create a bigger drag on larger companies for a number of reasons. Meanwhile, companies with small market caps are unaffected or less affected on average. While there are many factors that impact stock prices, interest rates are certainly on the list – depending on company size, rates will impact them differently.

Interest rates have moved quite a bit over the past 18 months, and they aren’t expected to stabilize now. Here are some of the stock market dynamics at play.

Revenues and Costs

Small-cap companies typically have less debt than large-cap companies. This means that they are less sensitive to changes in interest rates, as the cost of borrowing does not affect them as much as  big borrowers when rates rise.

The main reason for lower debt levels is they typically have less ability to borrow through the capital markets. Smaller or less established companies in general find the cost of issuing a public market note as being behigher than the benefits. And since rising interest rates, increase the cost of borrowing, small-cap companies are not rolling large amounts of debt at the new interest rate levels. Whereas debt is often a much larger part of big company’s overall strategy and cost of capital.

It also helps that small market-cap companies are often in industries that are less sensitive to the overall economy. If rates are rising, fears of a recession often creep into investor’s mindsets. For example, smaller technology and life sciences companies are, by comparison, less sensitive to economic cycles than cyclical industries such as large manufacturing and big oil. Put another way, many smaller companies are more focused on discovery, innovation and growth, these are not as dependent on economic conditions.

However, small-cap investors should be aware that small-caps are often more volatile than large-caps. So the investor can experience larger swings in price, both up and down. This can make this investment sector more attractive to investors who are looking for growth potential, but it can also make them more risky. If they have lower trade volume, there are fewer buyers and sellers, making it more likely for prices to move up or down.

Larger companies tend to be international in their business dealings, compared to domestic small-cap companies which more commonly transact within their home-base country. For the US, an increase in interest rates relative to other nations, is likely to lead to a stronger $US dollar. A stronger US dollar makes the cost of goods sold overseas more expensive to buyers. This could lower sales expectations as overseas buyers find other suppliers. Small companies operating domestically do not have to worry about foreign exchange rates and how they are impacted by interest rate movements.

It is important to note that interest rate changes can impact all stocks, regardless of their size. The impact of interest rate changes on a particular stock will depend on a number of factors, including the company’s debt load, its industry, and its overall financial health. Overall, small-cap stocks are less sensitive to interest rate changes than large-cap stocks, but investors can expect more volatility.

Market-cap Sector Rotation

Sector rotation is the process of money moving from one stock market sector to another, based on expectations of which sectors will perform better in the future. This could be industry, types of securities (ie: bonds, real estate), or market cap.

As it relates to market cap, an investor might sell large-cap stocks and buy small-cap stocks if they believe that small-cap stocks are undervalued and are poised to outperform large-cap stocks in the future.

It can help you to stay ahead of the market. By monitoring sector performance and making changes to your portfolio accordingly, you can stay ahead of the market and make sure that your money is invested in the sectors that are most likely to perform well.

Take Away

There are many different groupings of stocks (market-cap, industry, international, region, etc.) and factors that can impact the group. One factor that has historically played a part in price discovery of small versus large-cap stocks is interest rate movements. Interest rates impact the cost of doing business and also sales. Investors add this into the myriad of other factors they try to be aware of when selecting stocks.

Paul Hoffman

Managing Editor, Channelchek

Will 2023 Be the Summer of Small-Cap Stocks?

Posted on by phoffman@channelchek.com

The Mid-Year Sector Rotation is Benefitting Small-Cap Investors

“This time is different” is a saying often used in investing, usually just before the investor does something that they will soon regret. I say “regret” because, although the timing of patterns that have repeated themselves time and time again may change, well-entrenched investment rules very rarely change.

Over the past year, what I have perceived as undervalued stocks – coincidentally, all companies with a small market cap – have been prominently placed on my stocks watchlist.   While last year was a bad year for most of the market, these underperformed during that down market. So, they became even cheaper. I fully expected the stocks to eventually get investor attention and begin to move upwaard – in fact, I have had reason to believe this for a while of the small-cap sector in general.

While these watchlist stocks, in my mind, became even better values, I never told myself the market may have fundamentally changed, which would mean small caps will no longer be the relied-upon outperformers over time, as they have been historically. I did not think that “this time it might be different.”

Based on the two major small-cap indexes stellar performance so far this June, and a couple of my watchlist stock’s movements, my long wait may have been worthwhile and may soon be replaced by action.

Source: Koyfin

S&P 600 & Russell 2000 Indexes

Small-cap stocks have certainly turned up the heat so far in June. What’s more, is the larger indexes would seem to be losing steam as they have run so far for so long that, unless this time is different, they may be due for a retrenchment.

The renewed enthusiasm for the smaller and perhaps riskier stocks, over large caps, with businesses that tend to be more diversified, have deeper pockets, and more overall resources, is likely based on a number of normal factors. Smaller companies tend to operate leaner, so a higher percentage of revenue can flow to the bottom line in a growing economy. The two-week-old rally comes as many cyclical stocks, and industries that do best in a growing economy are springing to life, especially since the debt ceiling negotiations have been resolved, the banking system is seen as out of trouble, and the Fed has broken records in its tightening pace yet still unemployment is low.

The reduced clouds on the horizon and higher multiples of large-cap stocks seem to have given investors motivation to move to small cap stocks with lower multiples, and with less fear of the economy falling apart any time soon.

Investors are rotating into companies with lower market caps. Looking above at the two small-cap indexes, the S&P 600 (IJS as a proxy) is low in tech stocks that are heavily weighted in the worse-performing indexes. Financials and industrials make up 34% (tech is just 14%) of the S&P 600 Small-caps. The S&P 600 is up 8.87% so far in June compared to the large cap S&P 500 which only gained half as much. The Russell 2000 Small-cap Index is up 8.55% so far in June. This is also the month when investors watch the Russell Reconstitution, which is the rebalancing of the Russell 3000, Russell 1000, and Russell 2000 index based on remeasuring market-caps on the top 3000 stocks. There will be a great deal of attention to the reshuffling come the last Friday of the month.

Take Away

Is it different this time? Are small cap stocks going to play catch up as investors, hungry for value, and growing concerned that larger companies may be overvalued, and an overall increased comfort level that fewer dangers loom on the economic horizon, rotate some assets there? They have whetted their appetite, if the outperformance continues, I suspect they may go back for seconds, then others might join.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.economist.com/media/pdf/this-time-is-different-reinhart-e.pdf

https://www.barrons.com/articles/small-cap-stocks-apple-big-tech-9d3b5669

When Shorting a Stock Becomes Illegal

Posted on by phoffman@channelchek.com

Crossing the Line into Naked Short Selling

Shorting a stock by itself is not illegal and can even be thought of as helping the liquidity in the company’s shares as many more continuously change hands (volume). Brokers and institutional investors can also reap additional benefits. For all participating investors, it allows the opportunity for money to be made as long as the stock is moving up or down. However, among the legal shorts, there are illegal short positions being made. This has been the subject of controversy, Volkswagen in 2008, GameStop 2021, and AMC which has worked to end attempts of this kind of activity in its stock.

The Upside-Downside of Legal Short Selling

Selling a stock that you don’t own puts you, the seller at a greater risk than buying a stock. The reason is simple, stocks can theoretically go up by an infinite amount, however, they can only go down by their current value. If your shorts go up, you are losing value in your position. With this risk in mind, selling shares you don’t own, or a shorting strategy, certainly can work in your favor if your risk management short-circuits are in place and the stock’s value erodes.

A legal short position involves your broker borrowing shares on your behalf, perhaps from a large institutional holder, paying them a daily accrual rebate rate (interest) during the period that you hold the short position. The strategy is to buy them back at a lower price in the future than what you sold them at today.

Crossing the Line to Naked Short Selling

The word “naked” when it comes to most investments, suggests that you are without that which you are trading. If the same amount of shares has been borrowed on your behalf or by you as part of your short transaction, you are not naked in the position.

Naked shorting is the illegal practice of short selling shares that have not been affirmatively determined to exist. This can happen when there are so many market players thinking shares will decline in value that more shares are sold than obtainable to back up each trade.

Despite the SEC making this illegal after 2008 in response to some failing investment banks that had been sold beyond the number of shares in existence, naked shorting still goes on today.

One example still fresh in many self-directed investors’ minds is GameStop (GME) shares. In 2021, traders reportedly sold short around 140% of GME shares outstanding. This meant a substantial amount of shares of the company were sold that didn’t exist. What allowed these trades go through was something called ‘phantom’ sales, the tool of naked short selling.

Phantom Sales?

The term “phantom sales” sounds even more nefarious than “naked shorts.” What it means, is that the naked short sellers deposited digital IOUs into buyers’ accounts, promising that they will locate shares and make good delivery to the buyer as soon as possible. Unfortunately, it can become impossible when more shares are sold than exist. That creates a failure to deliver or simply “FTD” which is used in a hashtag that most that follow AMC Theatres (AMC) are familiar with.

When a stock gets oversold to the point of more shares sold than exist, it can be very bullish for the holders. This is because the short sellers desperately need to make good on their IOUs held by buyers.

If buying demand picks up in the stocks, the short positions are considered to be getting “squeezed” –  a “short squeeze” is taking place.

In the case of GME, communication made better through social media channels and stock message boards allowed individual investors to loosely coordinate and heighten the squeeze on short sellers, including large institutional hedge funds that may have had naked short positions.

Naked Shorts Banned

Imagine the problems and stress that occurs when trades don’t settle on time due to naked short-selling delivery failures.

The SEC banned the practice of naked short-selling in the United States in 2008 after the financial crisis. The ban applies to naked shorting only and not to other short-selling activities. Prior to the ban, in 2007 the regulator amended a 2005 rule called Regulation SHO. The amendment limits possibilities for naked shorting by removing loopholes that existed for some broker-dealers in 2007. Regulation SHO requires lists to be published that track stocks with unusually high trends in failing to deliver (FTD) shares.

These lists are available to investors and often used to determine where activity may become frantic.

A variant that is not banned, or in violation of SEC is rules is an FTD where the shares were located, but there is a legitimate failure to deliver. That is the short seller contacted a holder (usually through a broker) and they both agreed to terms of the short-seller borrowing authentic shares of the company.

Take Away

Short selling is a normal function of trading and not frowned upon by the regulators. However you have to be in touch with shares that are available for you to borrow at an agreed-upon interest rate. Otherwise you may find you are naked selling because you don’t own the shares, and can not make delivery.  

These rules apply to stocks that trade on a national exchange. For those stocks not listed on a major securities exchange, the SEC may require more disclosure from the transacting broker.

Paul Hoffman

Managing Editor, Channelchek

Stocks 101: The Basics of Investing in the Stock Market

Posted on by phoffman@channelchek.com

Need-to-Know for Those Starting to Dip Their Dough into the Stock Market

Maybe you’ve saved a little and know you ought to invest, or maybe school is finally out and you have time and a few dollars to build your future, but you don’t think you know enough about the world of stock market investing. It’s easy to feel overwhelmed by the abundance of information? It’s a big decision with many mysteries and unknowns for both newcomers, and veterans. This article aims to remove much of the mystery for new investors so you can be more confident in building a portfolio that can enhance your life plans.

Whether you become interested in small-cap stocks, growth stocks, or even IPOs, understanding key concepts such as valuing a stock, risk tolerance, investment goals, investment style, risk management, and portfolio strategy is crucial. Let’s dive in!

Set Investment Goals

Clearly defining your investment goals is essential so you can make decisions after comparing them to those goals. Are you investing for retirement, saving for a down payment on a house, or aiming for short-term gains? Your goals will influence the investment strategies you use. For example, if you’re investing for retirement and have decades of working years left, it may mean to buy and mostly hold for a long period stocks that have more potential given a long time horizon. This wouldn’t totally exclude mature companies with large market capitalizations but may include far more small and microcap opportunities than someone that is just a few years from retirement. If you are closer to retirement and don’t have as long for the growth to play out, the strategy may be to invest in large companies with stable dividends. If they throw off enough income, then an allocation of more speculative growth opportunities may make sense. This portfolio portion can allow for further growth.

Define Your Risk Tolerance

Before swimming in the deep end of investing, it’s important to assess your risk tolerance. Ask yourself how comfortable you are with potential fluctuations in stock prices. Small-cap stocks and microcaps, which represent companies with smaller market value, often offer greater growth potential, but they also come with increased volatility. Growth stocks, however, are known for their potential high returns over time, of course this could come with the cost of more volatility (sharp price moves) than established “blue-chip” stocks. Knowing your risk tolerance, or uneasiness with losing, or riding out drawdowns, versus gaining more than the potential loss (risk/reward tolerance) will help you make investment decisions aligned with your comfort level.

Determine Your Investment Style

After assessing your risk tolerance and setting goals, determine your investment style. Some investors prefer a more hands-on approach, engaging in frequent trading and closely monitoring stock market trends and evaluating stocks through websites like Channelchek. Others may prefer a more passive approach, investing in broad-based index funds or exchange-traded funds (ETFs) that provide diversification across various stocks. Understanding your investment style will help shape your overall investment strategy.

Minimizing Risk

Investing inherently involves risk, but there are strategies to help minimize potential losses. One approach is to conduct thorough research on companies you’re considering for investment. This includes analyzing company-sponsored research, equity research reports, and equity analysis provided by reputable sources. Understanding the financial health, competitive advantages, and growth prospects of a company can help you make informed investment decisions.

Developing an Investment Portfolio Strategy

Diversification is considered key when it comes to building an investment portfolio. Investing in a variety of stocks across different sectors and market capitalizations, including small-cap stocks and growth stocks, can help spread risk and potentially increase returns. Consider allocating a portion of your portfolio to IPOs if you have a higher risk appetite. However, it’s important to exercise caution as IPOs can be volatile shortly after their public debut.

Stay Informed

Keeping up with investment news is vital for any investor. Stay updated on market trends, company announcements, and economic indicators that may impact the stock market. Many financial news outlets provide lists of “stocks to watch” or provide insights into market trends. Regularly reviewing investment news and equity research can help you stay informed, make timely investment decisions, and expose you to opportunities you may not have discovered otherwise.

Take Away

Knowing it is time to start building an investment portfolio is a good first step. Now may be the when you should implement, especially if you have a long road ahead of you and financial security is important. It will require careful consideration of your risk tolerance, investment goals, investment style, risk management techniques, and portfolio strategy. Be prepared to conduct research, analyze equity reports, and stay informed about market developments. Investing is ordinarily long-term, patience, discipline, and a well-structured portfolio are key to achieving your financial objectives.

Paul Hoffman

Managing Editor, Channelchek

US Treasury Bonds: A Safe Haven Investment in Times of Economic Uncertainty

Posted on by phoffman@channelchek.com
Image Credit: US Dept. of Treasury

Are Treasuries the Safe Bet Investors Think They Are?

Are US Treasury bonds worth owning? US Treasury debt is considered one of the safest investments in the world. The securities are issued by the US government and are backed by the full faith and credit of the US Treasury – guaranteed at the same level as the dollar bills in your wallet. These bonds are a popular investment choice for individuals, institutions, and governments in times of economic uncertainty. But, as with other investments, they are market priced by the combined wisdom of the marketplace. So the return, or what is sometimes referred to as “the risk-free rate,” may not measure up to the potential that stock market investors expect.

Why Allocate to Treasuries

US Treasury bonds are considered a safe haven investment because they are perceived to have a low risk of default. This is because the US government has never defaulted on its debt, and it has the ability to raise taxes and print money to meet its obligations. In addition, the US dollar remains the world’s reserve currency, this makes US Treasury bonds highly liquid and easily tradable.

Image: Fmr. Fed Chairman Greenspan, Meet the Press interview, August 2011

During periods of low economic clarity, investors that are not required to invest in low-risk investments will weigh US Treasury returns against expected returns in other markets. As interest rates approach or exceed expected inflation US Treasuries become more attractive to investors, both individual and institutional. This is because they provide a reliable source of income (semiannual interest payments) at times of market volatility, and at maturity, owners know exactly what they will receive (face value plus the last interest payment). For example, during the global financial crisis of 2008-2009, investors flocked to the safety of US Treasury bills, notes, and bonds as a safe haven. This drove down yields and pushed up bond prices.

There are three main Treasury Securities, TIPS are not included below, they are T-Notes and have unique risks, so, therefore, deserve a separate presentation.

Treasury Bills:

Maturity: Typically less than one year (usually 4, 8, 13, 26, or 52 weeks)

Yield: Discounted yield, historically lower than T-notes and T-bonds

Size: Available in denominations of $1,000 or more

Treasury Notes:

Maturity: 2 to 10 years

Yield: Par plus interest historically higher than T-bills and lower than T-bonds

Size: Avaialable in denominations of $1,000 or more

Treasury Bonds:

Maturity: 10 to 30 years

Yield: Normally higher than T-bills and T-notes

Size: Avaialable in denominations of $1,000 or more

Overall, the main difference between these securities is their maturity. T-bills have the shortest maturity and are discounted at purchase to provide the yield, while T-bonds have the longest. T-notes fall in between. Additionally, their yields are calculated on an actual number of days held over the actual number of days in the year. The US Treasury yield curve, above which other bonds are priced, depends on market conditions and economic expectations.  

Can Not Avoid Risk

Despite their reputation for safety, US Treasury bonds are not without risk. In December of 2021, the 10 year US Treasury note had a market yield of 1.70%. Just ten months later the same bond sold at a yield of 4.21%. This represents an actual loss over the ten month period for those selling the bond then. For those holding until maturity, when they will receive full face value, investors would have to hold more than eight years during which they will be earning a measly 1.7%. This is interest rate risk, the time period used to explain was a recent extreme example of how Treasuries still have very real risk. This is why a good bank investment portfolio manager will do stress tests and scenario analysis of the banks portfolio using extreme conditions.

Another risk is credit rating. In 2011, for example, the credit rating agency Standard & Poor’s downgraded the US government’s credit from AAA to AA+. This was the first time and continues to be the only time the US government has been downgraded. The downgrade was based on concerns about the government’s ability to address its long-term fiscal challenges, including high levels of debt and political gridlock.

Similar conditions may be playing out now as the debt ceiling has been raised quite a bit since 2009, and large buyers such as China are seeking alternative investments for their reserve balances.

Inflation is another risk that is quite real. As in the earlier example of the USTN 10-year yielding 1.7% in December 2021, during the following year, CPI rose 6.5%. this is another recent example of how investing in a low-rate environments can erode the purchasing power of the interest income and principal payments from US Treasury bonds. If the rate of inflation exceeds the yield on the bonds, investors can actually experience a negative real return.

If the government is seen as possibly not being able to pay interest on maturing securities, as is the case during debt ceiling standoffs, US Treasuries coming due may experience illiquidity problems as bids for maturing debt that may not get paid on time will be weak.

Although US Treasury bonds are highly liquid and easily tradable, there may be periods when the market for the bonds becomes illiquid. This can make it difficult for investors to sell their bonds at a fair price, especially during times of market stress or uncertainty.

How to Invest in Treasuries

Investors can buy US Treasury bonds directly from the US government (treasurydirect.gov) or through a broker. The bonds are issued and market priced at auctions on a regular schedule. Individual investors typically will bid to own securities at the average auction price. Savvy institutions and individuals may contact their broker and bid at the auction and hope to win an allotment.

Investors can also invest in US Treasury bonds through mutual funds or exchange-traded funds (ETFs). These funds don’t offer the benefit of holding to maturity or some of the tax planning strategies that can benefit those holding a security and not a fund.

Take Away

US Treasury bonds are considered a safe haven investment in times of economic uncertainty. They are backed by the full faith and credit of the US government and are considered one of the safest investments in the world. While they are not without risk, they remain a popular choice for investors seeking a reliable source of income and capital preservation. The US government’s credit rating was downgraded once, but investors continue to have confidence in US Treasury bonds due to the idea that they may not be safe, but they are likely the safest place to store savings.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.realclearpolitics.com/video/2011/08/07/greenspan_us_can_pay_any_debt_it_has_because_we_can_always_print_money.html

https://www.bls.gov/opub/ted/2023/consumer-price-index-2022-in-review.htm