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Even Star Performer Stumble Sometimes

July 27, 2007

Dear Fellow Options Trader,

To say it's been quite the week would be as big an understatement as saying Lindsay Lohan has a slight drinking problem. Ms. Lohan clearly has some major demons she's trying to kill, and likewise, the stock market has some major demons trying to destroy it.

Strangely, both seem to be struggling with success -- and, specifically, too much success, too fast -- as the catalyst for their problems.

Maybe the old saying that you can never be too rich or too thin needs to be expanded to include the concept of being too successful, too quickly.

Time will tell whether she can recover from the downward spiral she's in, but if she doesn't sober up, dry out and get her life together, Ms. Lohan will go down the same path as Danny Bonaduce, Cory Haim and nearly countless others who never were able to truly deal with the fortune that smiled so brightly upon them.

The stock market's predicament mirrors that of Ms. Lohan's. Despite the fact that it has been around considerably longer, it's also true that the stock market has also achieved a great deal of success in a very short amount of time. And, thus, it has drawn the wrath of those who resent the strong performance.

Rather than embracing the double-digit advance of all three major indices in the first six months of this year, the bears use this very success as the reason why the market "must" fall.

But as we examine the similarities between the pressure of success on a young star and the outperfomance of the stock market, we must also consider the differences.

INTO THE SWING OF THINGS

Ms. Lohan's success brought fame, and fame brought paparazzi, who then chronicled the starlet's every move. The notoriety from the tabloids brought more fame and endorsements. If she wore a scarf as a belt, and one picture of the outfit made it onto the pages of People or Us Magazine, stores couldn't keep that scarf on the shelves.

That brought even more attention to Ms. Lohan, but made it nearly impossible for her to go out in public. The isolation of fame must have amplified the loneliness, which seems to have accelerated her need to escape through drugs and alcohol.

The market, on the other hand, was only guilty of doing too well. If the Dow or S&P 500 posted 9% gains in a single quarter, it must be a sign of what our former Fed Chairman Alan Greenspan referred to as "irrational exuberance." No matter how many stocks posted 30%, 50% or even 100% better sales and/or net profits year-over-year, the market must have gotten ahead of itself and was ready for a fall.

If too many deals were being done, the money must be too cheap. If the money was too cheap, it was because the Fed was ignoring inflation. If consumers weren't tapped out, it must be because they were over-leveraged on credit cards. If the credit card debt was being met, then the consumer must be using his or her home as a piggy bank.

Expanding that analogy, then, if consumers were using their mortgage like an ATM, then they were probably subprime borrowers. If they were subprime borrowers, they were probably borrowing money to buy stocks as well. As any market-watcher and trader knows, the ball rolls faster downhill than uphill.

Translation: Markets go down faster than they go up. And this explains why the Dow can close up 50 points one day and then drop 311.5 points like it did yesterday. This is typical of the market's "summer swing," when volatility heats up as buying volume from the institutional investors (or what I like to call "smart money") cools.

The swings are particularly fierce after the most-anticipated third-quarter earnings start to dry up, leaving only the "disappointing dog" reports, which run off the few investors who haven't already begged out for summer vacations.

But, at the risk of sounding like a broken record, let me reiterate that traders and investors have short memories. How quickly we seem to have forgotten that, just two weeks ago, the Dow shot up more than 283 points in one day -- its best run in four years -- and traders were dancing in the streets.

Now, it's simply time for the "summer swing dance."

THOUGHTS ON VOLATILITY AND THE MARKETS

I’m in San Francisco with the rest of the ChangeWave gang at the Money Show, and it seems ironic that the Dow would sell off twice in the same week that we're meeting traders and investors to talk about the stocks and sectors that we think are going to do well in the coming weeks and months. On the other hand, this gives us a great forum to show folks that there are ways to make money no matter what the broader market is doing.

That's what I love about trading options. Although I'm generally bullish on the markets and trade a lot of calls because those are a great way to leverage pending upward moves on the part of the underlying stocks, we've got an equally powerful instrument on the bullish side with put options. And while buy-and-hold investors are hitting the exits or covering their eyes until the latest bout of selling abates, we can make money on those stocks as they're falling.

My brother and trading partner Pete and I spoke of this and I'm confident you will not read the following words anywhere else, that is until after they read it here!

The volatility for the S&P 500, expressed as the Volatility Index (VIX), and the risk for the Nasdaq, expressed as the Nasdaq Volatility Index (VXN), move in concert. However, as you might expect, the perceived risk in big-capitalized, multinational stocks in the S&P carry lower risk premiums than those that make up the go-go high-tech stocks in the Nasdaq.

That was what you'd expect, but it is at odds with what we saw yesterday, as the VIX hit a high of 23.36, while the VXN peaked nearly a full point lower! At the close, the VIX was still up 20%, trading at 20.74 while the VXN was up about 10% to 19.50.

The crossing of the VIX over the VXN is, I believe, unsustainable, but the opaqueness of who has what as far as credit risk is most certainly more-directly focused on the financial stocks, and there are a plethora of those in the S&P 500.

The fact is, we've been calling for increased volatility for weeks. I'm not at all surprised, and as I wrote last week, volatility only opens up additional trading opportunities for us. Depending on how things unfold, HeatSeeker, our system that uncovers unusual call-buying activity, may join the institutional guys and gals for a little vacation as Depth Charge, our system for tapping into unusual put-trading activity, takes the helm. That's the secret behind options trading -- we're ready to profit in any market.

As bad as yesterday was, I doubt it will stay that way for very long. In fact, I'm pretty confident that our future in the options markets currently looks a whole lot brighter than Ms. Lohan's!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader