THIS ESSAY WAS ORIGINALLY
PUBLISHED NOVEMBER 11, 2016, IN STANSBERRY DIGEST
Don’t ignore this warning. In today’s Friday Digest, I’m going to show you exactly how to make a lot of money in the options market. This is a much longer (and more thorough) Friday Digest, and I hope you’ll excuse the intrusion. I know your time is valuable.
But what I’m trying to teach you below could rescue you financially over the next 12 to 36 months.
Investors who don’t know the facts, the history, the financial concepts, and the trading strategy I outline in today’s Digest have absolutely no chance of surviving the next few years without taking huge losses.
Even if you’ve never printed a Digest before, I’m going to urge you to print today’s. Pin it up on the wall next to where you monitor your portfolio or do your trading. Make sure your adviser or your spouse gets a copy, too. At the end of each quarter over the next few years, read this letter again. And ask yourself what you’re prepared to do now about these ideas.
Please. Don’t. Ignore. This. Warning.
You have to understand this… You can take the information I’ll give you below (for free) and make something between 10 and 20 times your money in the next year or two. Investors who don’t follow this strategy – or one like it – are going to suffer big losses.
That’s why this is so important. It’s not just an opportunity to make huge gains. It’s a chance to blow past the results that anyone who’s only invested on the long side could possibly achieve.
Our Big Trade strategy – to buy out-of-the-money, long-dated put options – is normally the hardest way to make money in the securities markets. The only reason to consider doing any of the things I will outline below is because you already have a successful investment strategy. You already have a good diversified portfolio. You are already meeting your investment goals.
And because, like me, you’re convinced that Obama’s legacy – the stunning amount of bad debt that has been underwritten over the past seven years – is going to cause certain industries and businesses big problems. Life-threatening problems.
I firmly believe that’s true. It’s only because of the truly historic size of the debt bubble Obama built that I would even consider this strategy.
Our Big Trade strategy is the absolute best way to hedge your financial assets from credit risk.
This isn’t just speculation. It’s also the best strategy to avoid big losses from what’s about to happen.
The debt-default cycle has already begun, and big losses for most investors are now inevitable.
The real key to understanding this opportunity is to realize the profound dichotomy between how much financial risk U.S. corporations currently have on their balance sheets (the most ever) and how little risk is being priced into the equity market today (among the least ever).
It’s this shocking "spread" between the real and obvious financial risks we face and the nearly record-low volatility in the stock market that the Big Trade is set up to exploit.
Let me show you how this all works in practice…
Between 2005 and 2015, U.S. corporations exploited artificially low interest rates to borrow unprecedented amounts of money (see the chart below).
But this chart isn’t even the important stuff. Sure, record amounts of debt have been underwritten. It’s the quality of that debt, however, that’s the real problem.
Before the mid-2000s, U.S. corporations had never borrowed more than $1 trillion in a year. They did so twice in 2006 and 2007. Maybe you remember those "boom" years. And maybe you’ll remember what happened next – a huge bust, the worst recession since the Great Depression. Of course, during that bust, the worst problems were in mortgage securities, where debt (and particularly subprime debt) had grown the most.
So what did Obama do to heal our economy from these wounds? He engineered an even bigger debt bubble that will cause even worse problems than the mortgage bust. What Obama did is simply unprecedented.
First, he doubled the amount of outstanding, freely trading U.S. Treasury debt (from $7 trillion to $14 trillion). He directly borrowed more money than all the other U.S. presidents ever borrowed before, combined. Worse, his economic team led the Federal Reserve to hold down interest rates to essentially zero. And what happened next will scar our economy for a decade, at least.
Every year between 2010 and 2015, U.S. corporations borrowed more than $1 trillion. In 2014 and 2015, they borrowed nearly $1.5 trillion.
As you know, our economy barely grew despite all of these new debts. Servicing these debts will prove impossible for many companies. The situation is even worse than these figures indicate. You see, the nature of these outstanding corporate obligations changed a great deal, too.
Just like subprime mortgages grew faster than prime mortgages during the housing bubble, over the last several years, high-yield bonds (aka "junk" bonds) have become a far larger part of the corporate-bond market.
Junk bonds had almost never made up more than 20% of corporate-bond issuance. The only time it had ever happened before (’97 and ’98), it led to disaster as billions in high-risk telecom and tech debt collapsed in 2001 and 2002.
But during the six-year "Obama debt boom" of 2010–2015, high-yield bonds made up more than 20% of issuance in every year except the last (2015).
We know this big change in the underlying soundness of the corporate-bond market guarantees that during the next credit-default cycle, losses are going to be far bigger and hit far more companies and investors than ever before. Defaults will be much larger than expected. Losses will be much more severe. (Recovery rates on corporate defaults have already fallen by more than half, from around $0.45 on the dollar to around $0.20.)
These are profound changes to the underlying risk in America’s corporate balance sheets. Unfortunately, they may not be the biggest or most important risks. Most leveraged financial firms aren’t allowed to buy "junk" bonds. Big banks and insurance companies generally are only allowed to hold investment-grade debt. Whether because of explicit rules or capital requirements, just about every important financial firm avoids holding "junk" bonds.
Therefore, most investors don’t worry too much about the junk-bond default rate. Those losses don’t trigger problems in "systemically important" financial firms. But… what if investment-grade debt has suffered the same kind of quality impairment?
It’s not just junk bonds that have seen a material decrease in credit quality. Investment-grade debt has, too.
Over the past decade, the lowest-quality tranche of investment-grade debt, debt rated "BBB," has grown from around 10% of total investment-grade issuance to more than 30%. While I don’t think BBB debt will default at anything like junk-bond rates, I’m certain that during the next credit-default cycle, the annual default rate on the lowest rung of investment-grade debt will be at least triple its former peak (1% in 2002).
If we see three or four years of default rates at this level (say 3%), you’re going to see big losses at major financial institutions. These losses will be more than enough to cause the collapse of at least one or two big firms. We’re talking about $200 billion–$500 billion in investment-grade-bond defaults. This will send a wave of panic through the markets, which, combined with junk-bond losses, will dwarf the losses caused by bad mortgages.
Artificially low interest rates didn’t just cause the corporate-bond market to grow and decrease in quality. It also promoted a huge boom in subprime auto lending.
We’ve covered this topic in incredible detail, first during the boom in 2014 (when we warned about GM’s lending practices) and then again in 2015 (when we profitably recommended shorting auto lender Santander Consumer USA).
I’d urge you to go and reread the Santander piece because we predicted accurately the rising default rates on U.S. junk bonds and so much of what has occurred this year in subprime auto finance.
We are in the early stages of a great debt default – the largest in U.S. history… Default rates on "speculative" bonds are normally less than 5%. That means less than 5% of non-investment-grade U.S. corporate debt defaults in a year. But when the rate breaks above that threshold, it goes through a three- to four-year period of rising, peaking, and then normalizing defaults. This is the normal credit cycle…
At the end of 2014, only 1.42% of speculative corporate debt had gone into default for the year – near a record low. The only better year for speculative corporate debt in recent history was the top of the mortgage-debt boom in 2006. As you know, two years later, disaster struck. A new low for defaults in 2014 points to 2016 as the year when corporate debt will begin a new default cycle.
As you may know, the default rate on high-yield U.S. corporate bonds broke through the critical 5% threshold in August, just as we predicted it would. That kicked off a new credit-default cycle. We believe default rates will come close to 10% next year before rising to more than 15% in 2018.
The impact of these rising defaults will be widespread and impossible to totally predict. But at least two things are sure to happen. First, you can count on volatility rising in the stock market as bankruptcy becomes more than a remote possibility for hundreds of companies. And second, the issuance of subprime debts – mortgages, cars, and junk bonds – will completely shut down.
Subprime lending only exists when interest rates are low enough to finance the large and inevitable losses that occur when you make loans to people who can’t afford to pay them back.
There are enormous costs involved in subprime auto lending.
For Santander’s most recent loan securitizations (where it sells its subprime loans to investors), the company had to provide 65% of the loan value in "credit enhancements" to entice investors to buy the loans. That means these securitizations won’t default even if loan losses reach 65% of the total amount of the loans. A few years ago, those enhancements were in the 25% range. In other words, as the default risk increases, making subprime loans becomes more expensive.
If interest rates go up at all, the subprime lending market will shut down completely. Even though Santander charges more than 20% annual interest rates on its subprime car loans, if interest rates go back up to 3% or 4%, its profits will disappear because its costs of underwriting and insuring these loans is so high.
Demand for cars has been wildly inflated by both fleet sales to rental companies (which, as you’ve seen, are now falling apart) and by subprime auto lending. During most of the last credit boom, subprime auto lending was generating more than 80% of General Motors’ non-fleet sales. The figures are similar across the industry. And that means, as subprime lending goes, so goes demand for cars.
Therefore, Santander’s results tell us a lot about what’s coming next for the automakers. The company’s most recent quarterly conference call paints a dire picture.
"Santander’s retail installment contract net charge-off ratio increased to 8.7% up 50 basis points year over year," CEO Jason Kulas said on the call with analysts.
That means the bad subprime loans Santander made in 2014 and 2015 are going bad at an increasing rate. These rising defaults explain why it has become so difficult for Santander to gain access to additional capital. The rating agencies reported last month that losses on subprime auto securitizations jumped 20% last month – a big move that surprised the market. (It didn’t surprise us at all.)
Big increases in repos and big sales from rental fleets are significantly reducing used-car prices. Most investors won’t see these important declines in collateral values because they’re watching the Manheim Used Vehicle Value Index. The price index maintained by the wholesale car-auction firm Manheim remains strong… But the key index to watch is the National Automobile Dealers Association (NADA) index. It tracks the market for older cars and records, and it isn’t seasonally adjusted.
The NADA index of used-car prices just "broke down," falling 3.6% in a month. Prices are falling down past levels they’ve been above since 2011. This tells us that much lower prices for used cars are coming. And that’s going to put even more pressure on both automakers and subprime auto lenders.
"Auto originations during the quarter totaled $5.2 billion, down 31% from the prior year quarter," Kulas said on the analyst call. "Originations with FICO scores below 640 in our core and Chrysler Capital channels decreased 29% and 38% versus the prior year quarter…" [Editor’s Note: emphasis added.]
Santander’s total volume of auto lending fell an astounding 31% in a year. That’s a Great Depression-like decline. In the subprime lending it did for Chrysler, loan value fell 38%.
We made 50% when we shorted the stock in 2015. For us to see bigger declines in Santander, we’d need to see some of its securitized loans blow up – something that has never happened before to securitized auto-loan securities. While I believe that will happen, it’s not likely to happen soon (within the next year).
To profit from the collapse in subprime lending, I’d rather target the automakers themselves, whose big debts and razor-thin margins put them at big risk from any decrease in sales value. We’ve already seen sales volumes falling (down about 8%) and moves to further reduce supplies. (GM is closing two plants and laying off 2,000 employees.) I’m certain we’ll see more of both moves over the next year.
Both Ford and GM have long-dated, out-of-the-money put options that trade frequently and have lots of volume. In plain English, that means you have a highly leveraged and liquid way to bet against the share prices of these companies.
Looking at the options that expire in January 2018, you’ll find two out-the-money strike prices with plenty of volume. With Ford shares trading around $12, the $7.75-strike-price put options have more than 27,000 open contracts. With each contract representing 100 shares of stock, that’s 2.7 million shares of liquidity – that’s a lot.
This option has been trading around $0.30 for the last month. Today, it would cost you $0.32 per share to buy, or $32 for a contract covering 100 shares. With this contract, you’d have the right (but not the obligation) to sell 100 shares of Ford’s stock at $7.75 at any time until January 19, 2018.
For you to make money with this position, you’d have to expect that Ford’s shares would fall 38% between now and then. Given Santander’s enormous reduction in lending, I’m pretty sure that’s a safe bet.
Your real upside here, though, comes in if investors begin to doubt Ford’s ability to refinance half of its $137 billion in outstanding debt over the next five years. So, let’s imagine that Ford’s sales do decline by more than 20% next year, and its earnings disappear, and its losses mount. And investors (rightly) begin to fear that Ford might finally follow GM and Chrysler through bankruptcy. Let’s say Ford’s share price falls sharply, back down to its 2009 lows ($2).
With these $7.75 puts, you’d have to the right to sell the stock at $7.75, not $2. Thus, you’d earn $5.75 on each share covered by your put contracts. Your $0.32 investment would now be worth $5.75. You’d make almost 18 times your money.
Only you can answer how valuable this opportunity is to you. Is it worth nothing? Maybe. If you think Ford can weather the virtual collapse of the subprime-lending market and the auto-rental companies without any reduction in profitability or financial security… then you won’t want to make this bet.
But if, like me, you believe that far, far too much money has been loaned to deadbeat car buyers, then this bet is probably worth something. In my mind, it’s certainly worth 2.7% of Ford’s share price. (That’s the value of the option compared with the price of the stock.)
I also believe it’s worth putting some capital into it – as a hedge against these risks, if nothing else. If you have a reasonable chance to make 18 times your money, you don’t need to risk much. Putting up $1,000 now would allow you to reasonably hedge a $200,000 portfolio. (Earning $17,000 in profits on this trade would provide 8.5% of downside protection against the entire portfolio.)
But… is there an even better way?
With GM, traders have congregated around the $18 January 2018 put. There are more than 16,000 open contracts, and there’s plenty of daily volume. Today, the puts are down 20%. With GM shares trading for around $33, you can buy the puts now for $0.45. That’s only 1.4% of the share price, so in terms of nominal price, these options are definitely the better value. But are they really?
Let’s ignore for the moment that Ford is a riskier credit than GM. The Ford puts require the stock to fall by 38% for you to be "in the money" on your options. This GM put, even though it’s cheaper in terms of nominal price, has a strike price that’s further out of the money. You’d have to see the share price fall 47% to be in the black on this position. That’s a big difference.
So which option is the better value? Well, answering that question requires a lot of math. There’s something called the Black-Scholes formula that can give us the answer. It measures the different variables – the price of the option and the strike price – to give us something called the "implied volatility." Think of it as how volatile the stock has to be, on average, during the life of your contract for you to have a shot at making money. (That’s not really what it means, but it’s a reasonable shorthand.)
The implied volatility of the GM option is 42%. The implied volatility of the Ford option is 38%. Those are small differences in price, and they’re probably not meaningful. But sometimes you’ll find very large differences in implied volatility. And you should always check the implied volatility to compare different options.
Doc Eifrig, who has traded options for longer than anyone I know (including on the proprietary trading desk of Goldman Sachs), warns me that the Black-Scholes formula isn’t meaningful beyond about a year in duration. The math just doesn’t work as the time frame extends further than that. So once we begin trading the January 2019 options, we’ll have to rely on other measures of value, too. But for these 2018 options, just looking at implied volatility is close enough.
Well, any time you buy an option contract, there’s a chance you’ll lose 100% of your initial investment. Most of the long-dated, out-of-the-money put-option contracts expire worthless. That’s a fact, and normally, it’s very difficult to beat those odds. But it’s also not normal to see corporate debt at these levels, and it’s not normal to see volatility so low. Volatility is a key factor in options prices. When the Volatility Index (the "VIX") goes to 25 or 30, you’ll see options prices soar – sometimes by more than 100%, even when the underlying share price doesn’t move much.
To be successful with this strategy, you have to be very patient. You want to buy these kinds of put options when the VIX falls to below 14 or 13… or even lower. Remember, the VIX gauges the price of options investors use to protect the value of their stock investments. When the VIX falls, options prices are down.
The VIX rarely drops to those levels. But it has been happening a lot lately. If it continues, you’ll want to put on a few of these positions. Then, one of two things will happen.
First, if the company doesn’t see its earnings collapse, or if its bonds begin to trade at big discounts (like we expect they will eventually), you can hold these puts for two or three months and then "roll" them forward into a longer-dated option contract. That will, of course, cost you some money. You’ll see losses before you see gains. For most investors, that’s hard to stomach. So you’ve got to be really committed to the strategy and the companies you’re trading against.
Second, something happens to send volatility higher. It could be something like the "Brexit" vote, which caused the VIX to spike higher… or the collapse of a big subprime securitization… or the collapse of a high-yield bond fund, like we saw last fall.
There are so many debt potholes out there for the market to step in, I can’t predict which one it will be… But I know it will be one of them.
When that happens, you’ll see the value of your put portfolio leap – 20%, 30%, or maybe even 50%. If the situation is just a general rise in volatility, take profits. With this strategy, you’ll do a lot better trading around these positions than just holding on to them. Remember, they’re likely to expire worthless. So if you get a chance to make a good profit, take it. You will have plenty of time to buy another contract, perhaps for an even later date, soon enough.
Just catching a few of these volatility spikes will allow you to see profitable results without any big winners. But what you’re really waiting for is the day when the market’s pothole comes from one of your covered sectors… or even better, from one of your put-portfolio companies. Just imagine if you’d bought puts on Hertz before it fell 50%. You’d probably see the value of your puts increase tenfold.
And it will only take a few of those big winners to make your entire campaign a big success. That’s why you’ve got to diversify. And you’ve got to be patient. If you’re not… if you don’t have the emotional discipline… you’re sure to fail. But if you can manage your emotions, I’m sure that following our lead into this incredible opportunity will make you a lot of money during the next three years – more money than you’ve ever made before.
Anyone who tells you that making money in "naked" options is easy is lying. We’re going to be tracking 30 different companies in our "Dirty Thirty" list. We will probably have two dozen or more different open positions over the next 18 months. That’s a lot of trading – and a lot of positions to watch.
We will, of course, do everything we can to keep you fully informed. You won’t ever have to wonder what we’re recommending. But… I can’t stress enough… these individual positions will be volatile and risky. Unless you really understand the importance of being patient and being disciplined, I don’t recommend this strategy.
I do, however, recommend this strategy to anyone who is genuinely concerned about the credit bubble that’s stalking our economy. I recommend this strategy to everyone with more than $100,000 in stocks. This is a fantastic way to hedge your portfolio with even small amounts of money. Ten put contracts on Ford will cost you $320… but they could easily make you more than $3,000. In other words, this isn’t only for the super rich.
Editor’s note: Porter says his new strategy is “nearly foolproof” and could be the single best way to make 10–20 times your money as the credit collapse unfolds. Based on his track record, it’d be difficult to argue.
The best part is that anyone with a regular brokerage account can participate. That’s why he strongly recommends that you at least learn how to make these trades yourself.
So if you want to know how you can profit from the great American credit collapse that Bill has been warning about, go here now for details.