This Could be the Contrarian Play of the Year
Fri Apr 17 2015
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This Could be the Contrarian Play of the Year

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Two of the most important lessons I’ve learned in more than 20 years of professional analysis and trading are:

1. The market nearly always overreacts, and
2. Investors are blind to the writing on the wall when fundamentals turn.

And I’m glad this is the case, because betting against market overreactions is one of the best ways to make money in the market. It’s how I plan to make 67% with this week’s trade and how we recently closed a 69% winner in Trade of the Week.

Less than a month ago, I told you about an opportunity in Valero Energy (NYSE: VLO). Shares were trading at dirt-cheap valuations thanks in part to oil’s sell-off. The market was clearly overreacting by punishing all stocks in the sector, even if they didn’t deserve it.

“The real opportunity lies in the fact that Valero is now buying oil 50% cheaper than last year, but has only had to reduce its selling price by 35%. Incredibly, shares are actually lower than where they were last year, despite the cheaper costs, increased consumption and improved margin.”

Shares started moving higher almost immediately after I recommended the trade, and we were able to capture a 69% gain in only 10 days.

To understand why the market overreacts — and how it’s possible to generate double-digit gains in a matter of days — you have to understand groupthink. It’s a psychological phenomenon that causes people to tune out critical viewpoints and often leads to irrational decision making. As investors pile into the trade and the power of the herd pushes asset prices in one direction, the need for conformity becomes so strong that few question the trend even when macro forces change.

I spent a good portion of my career as an insider in these groups as a high-volume options trader in the trading pits of Philadelphia, New York and Chicago. Now I view the markets from the outside, watching as the collective mentality pushes a trade to its limit and waiting to make a contrarian bet.

From my vantage point outside the herd, I have a good grasp on when the market has taken a trade too far. That’s exactly what’s happened with the U.S. dollar, and I see an opportunity to make 67% in the coming months as the greenback falls.

While U.S. asset prices soared on the Federal Reserve’s loose monetary policy for more than half a decade, the market refused to believe in the U.S. economic recovery. I watched this play out until August, when I made a contrarian play on the PowerShares DB U.S. Dollar Bullish ETF (NYSE: UUP), a fund that tracks the value of the U.S. dollar versus six other major currencies including the euro, Japanese yen and the British pound. When the value of the dollar (relative to the other currencies) increases, so does UUP’s price.

Unlike the herd, I saw the deterioration in the global economy and relative strength in the United States as a trading opportunity and took a bullish position on the dollar.

As UUP crossed above its 200-day moving average to $ 21.72, I set up a trade to buy UUP Mar 21 Calls for a limit price of $ 0.87 each. On Aug. 11, my order was filled at $ 0.70, or $ 70 per contract. I set my target price at $ 1.17, which was hit just 25 days later. My calls sold for $ 1.20 each, or $ 120 per contract, for a 71.4% gain in less than a month.

But now the market has taken this uptrend too far, and groupthink mentality has made investors blind to changing fundamentals that could push the dollar — and UUP — lower.

Anticipation that the Fed will raise interest rates has resulted in an historic rise in the dollar. Higher rates attract demand for the dollar as foreign investors search for the last bastion of yield in the face of historically low global rates.

In fact, the dollar has seen its fastest rise in more than 40 years, with the dollar index up 25% from July through mid-March. This pushed UUP back toward its Great Recession heights. You know, back when the market was bracing for the imminent collapse of the entire global financial system.

But here’s the thing, I don’t expect interest rates to move much higher any time soon.

First of all, higher interest rates are usually employed to keep inflation in check. But inflation is nowhere in sight. In March, job growth slowed to a 15-month low, and many economists are revising their estimates for first-quarter GDP growth down to just 1%. Right now, it looks like the Federal Reserve is more intent on carrying out its other mandate of increasing employment.

Secondly, U.S. companies are increasingly blaming the stronger dollar for weaker earnings. FactSet reported expectations for first-quarter earnings have come down 8.2% since December, the worst slide since 2009. Companies in the S&P 500 are now expected to post a 4.6% decrease in year-over-year earnings in Q1. An increase in interest rates would likely exacerbate this issue.

The technical picture supports my analysis. UUP recently fell from its trend and will likely break through key support around $ 25.50 on the weak jobs report. This represents its 50-day moving average and a breach of its 20-day Bollinger Band. As this happens, the rest of the market could finally clue in to changing fundamentals and send sentiment plunging.

A retracement back to the $ 24 level is likely with an even deeper decline possible as the market overreacts to the downside.

I recommend buying UUP Sep 27 Puts with a limit price of $ 1.65 to reduce risk and amplify a 7% downside move in UUP into a potential 67% return in less than six months.

This call option has a delta of 73, which means it will move roughly $ 0.73 for every dollar that UUP moves, but it costs a fraction of the price of the stock.

The trade breaks even at $ 25.35 ($ 27 strike price minus $ 1.65 options premium), which is 3.1% below current prices.

If UUP hits my target around $ 24.25, the put options will be worth at least $ 2.75 ($ 27 strike price minus $ 24.25 share price). Once you enter the trade, place a good ’til cancelled (GTC) order to sell your puts at that price. With these options, we stand to make a 67% return in just over five months while shareholders lose 7%.

These are the type of trades I’m making each week in my Profit Amplifier service. In the six weeks since I started sending out my trades, we’ve already made a 90.5% profit in 15 days on a 12.6% stock move. And as of this week’s issue, we showed a 31% profit in 39 days on a 9.2% stock move, a 16.3% gain in 34 days on a 0.6% stock move, and a 9.4% profit in 19 days on a 0.3% stock move.

You simply can’t make profits like this from buying and selling stocks.

If you’re interested in receiving my top trades directly to your inbox each week, you can read a short fact sheet about Profit Amplifier here. This not a promotional video or anything like that; it’s a document that takes about three minutes to read and outlines everything you need to know about my unique options buying strategy. Follow this link to read it now.

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