How To Profit If ARKK Stays In The $50-$80 Range (NYSEARCA:ARKK)

Thesis

The ARK Innovation ETF (ARKK) price has started to stabilize as of late. The current rally is the result of oversold technical levels rather than a change in fortune for the underlying companies composing ARKK. We thus believe that an intermediate top for ARKK has been established at a price point of $80 and we are not expecting a V-shaped recovery in high P/E stocks this year. Since the beginning of the year interest rates expectations have increased with Goldman moving to the five hikes in 2022 camp.

There are also increased discussions regarding a 50 bps rate hike in March, with Nomura being the flag bearer for this call. While investor flows out of ARKK have normalized, and enormous profits have been already made from shorting ARKK we do not believe a full bottom is in for the ETF and the current technical correction of an oversold condition will give way to a renewed downward pressure in the vehicle with a potential move down to the $60s and a bottom at the 100% Fibonacci retracement of $50/share.

The best way to trade ARKK now is via a short strangle position with $50 as the lower bound and $80 as the upper bound in price, a trade which can net you a 19% annualized return given the proposed June 2022 maturity date. This strategy allows you to monetize a larger range macro view on ARKK rather than anticipate distinct long or short moves from the current spot level.

Oversold Set-up

In our January 23rd piece we argued it was time to move from Sell to Hold on ARKK given oversold technical conditions:

We showed readers how our reasoning behind closing a short position at the time rested with oversold technical conditions as outlined by RSI indicators:

If we look at historical occurrences in the past year where we get significant technical oversold conditions we will notice a certain pattern:

We can see from the above table that oversold conditions in ARKK are followed by dead cat bounces where the upswing in price lasts for around a week, with the upwards move in a +10% to +20% range. What we are seeing today in the ARKK price move fits nicely with historic patterns.

The RSI is finally normalizing indicating a neutral technical set-up:

We can see that in the past year each time selling pressure put the RSI below a 30 level the oversold technical condition corrected itself via an upwards price bounce that also saw the RSI normalize in the middle of the range. Each such occurrence of a dead cat bounce, or an upswing in a historic downward trend was subsequently followed by more weakness in price and a resumption in the downward historic trend line.

Fibonacci Retracement

We firmly believe we are in a downward trend in ARKK driven by fundamental factors where we can use technical indicators as useful goal posts:

The stock entered oversold territory and bounced off its 78% Fibonacci retracement. The bottom is not in yet, and historical performance shows us that a firm support level lies with a price point around $50/share, which would see a full 100% Fibonacci retracement occur in this speculative vehicle. An informed reader should keep in mind that nothing goes down in a straight line, but in waves, and oversold technical conditions are always to be followed by short rallies after which fundamentals take over again and the trend resumes. Here we have a historic downtrend which is set to take over again as we move to a neutral technical set-up.

What is the best trade now

Given the re-rating in the discount factors associated with the portfolio companies in ARKK, we do not believe there will be a V-shaped recovery this year. We feel that an intermediate multi-year top has been established at an $80/share price point. While on the downside we feel there is still a bit to go, the timing is unclear, but we have a specific floor in mind, namely $50/share.

The best trade to take advantage of this view is a short strangle position:

We are proposing a June 2022 short strangle trade that involves selling a call at an $80 strike for a premium of 6.63 and also concurrently selling a put at $50.22 for a premium of 1.98.

If in the next 127 days the ARKK price stays bound by the $50 and $80 strikes an investor can end up with a net premium of $861 for 1 ARKK contract, or better said a 19% annualized yield as calculated on a theoretical cash out at the strike level.

The proposed trade will only incur losses if on maturity date the ARKK stock price is below $41.61/share (premium factored in) and above $88.61 on the upside (premium factored in). A violent rally in ARKK is the main risk.

Factors

The factors that led to the initial short call on ARKK have not changed substantially:

The Fed

Rates have not achieved liftoff yet, let alone a plateau. We need rates to normalize and stop rising before we can see a bottom in ARKK. Given their high duration and speculative nature, the ARKK components are very sensitive to rates moves and any valuation normalization has to be accompanied by a stable interest rate environment.

In effect, since our last article we have seen the opposite happen, namely a hawkish revision in market participants’ views on rates, with Nomura being the flag bearer:

Nomura stands out because it is actually looking for a 50bps rise in rates in March, a very aggressive take on the Fed policy. An aggressive Fed is bad for ARKK given the valuation compression that is going to occur. Ultimately the ARKK stock price is driven by fundamentals and high P/E companies do not benefit from a monetary tightening environment, especially a hawkish Fed.

Flows

Enormous amounts have been made by shorting ARKK in 2022 – almost $1 billion by an estimate. Outflows seem to have ebbed a bit after the carnage, with a statistic seeing an inflow in the past week into the ARKK vehicle. Do not let yourself be lured by the siren song of easy money. The bubble era of low interest rates is behind us, and while outflows might have been accelerated by year-end selling we do not believe the same setup as in 2020 is here today.

Speculative assets have seen a tremendous cut in valuation that is set to continue as investors have other options given the increase in rates. While outflows will not be as radical as we have seen at the end of 2021 we do not predict a resumption of the 2020 “belief” trade where easy money was constantly thrown at ARKK.

Conclusion

ARKK has seen a violent correction in price as we entered 2022. Nothing goes down in a straight line and oversold technical conditions have led to a “dead cat” bounce in the stock. While technical conditions were overstretched, fundamentals have not moved in ARKK’s favor, with the Fed being on a tightening path in 2022. The best way to trade ARKK now is via a short strangle position with $50 as the lower bound and $80 as the upper bound in the stock price, a trade which can net you a 19% annualized return given the proposed June 2022 maturity date. This strategy allows you to monetize a larger range macro view on ARKK rather than anticipate distinct long or short moves from the current spot level.