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Now It's a Fight!

August 17, 2007

Dear Fellow Options Trader,

Three days ago, I was speaking on the phone with a notable financial journalist about market sentiment. I mentioned to this friend that we weren't seeing a fight from the bulls as the markets and the bears overwhelmed them.

My observation of the action was that the bulls had pulled back and none among them was stepping up to fight the trend, especially with the Dow (DJI) trading within 2% of a 10% correction. Every time they (the bulls) felt the pressure coming from the bears, they pulled their bids back and we hit a vacuum, or freefall.

At the time, I pounded the table, saying the bulls would not make a stand until we hit that 10%-down level -- that would be when we'd see a fight. Until then, the bears would prowl and growl and drive the market at their whim.

I said this because the bears had demonstrated clear dominance, spreading rumors of "this" homebuilder or "that" financial stock filing for bankruptcy. The Street was running with blood as the bears tore their way through Beazer Homes (BZH), Countrywide (CFC) and E*Trade (ETFC). But when we hit that down-10% level, a funny and very predictable thing happened: The bulls made a stand. The bears pushed and the bulls pushed back!

The result was the bears, who had become overconfident, were stunned that the bulls were making a stand. The S&P 500 (SPX) rallied, as did the Dow. And the Nasdaq-100 Trust (QQQQ) rallied dramatically, as the bulls turned an extremely bearish 2.7-to-1 put/call ratio around to finish with a 1.9-to-1 ratio.

Then, just as the bears were licking their wounds, Federal Reserve Chairman Ben Bernanke proved he truly understands the markets by making today's 50-basis-point cut in the discount rate (i.e., the rate at which the Fed lends money to banks), taking it from 6.25% to 5.75%.

This was ingenious for three reasons:

1) It left another 50 basis points (or, a half-point) on the table if he needs it for a future cut.
2) The Fed Funds rate is still in play and the powder here is still dry.
3) The timing of the cut hit the bears right in the solar plexus, or maybe just below that!

The timing was indeed key, because if the Fed had announced the cut at 3:30 p.m. (with a half-hour left in the trading day), the markets would have rallied and everyone would have talked about it all weekend. But coming as it did before the open, the cut in the discount rate crippled the bears, as their expiring August puts vaporized and short calls exploded.

This move cannot be oversold. The hit was not one that you can trade your way out of. The hit to those expiring August options was a crushing blow that changed sentiment.

What's the evidence of that, Doc? Take a look at the put/call ratio in the S&P 500 options right now. Today that same index is at 1.6-to-1, which represents how dramatically sentiment has changed.

This is not to say that the market turned bullish. Actually, the market turned neutral, but at least now it's becoming a fight!

HOW BAD DID THE BEARS GET BIT?

I did some rough numbers on the expiring August S&P 500 options, both calls and puts, and came up with some very interesting statistics:

There were 339,000 calls and upward of 1.2 million puts that expired on the opening print of the SPX this morning (as index options cease trading a day before equity options settle).

This doesn't include every single call and put with an August expiration date, but it encompasses the meaningful calls and puts that had both trading volume and some sort of value greater than a penny.

The calls increased in value dramatically, and the puts either lost value or were vaporized by the rally.

* The settlement for the SPX was 1,450.11.
* Last night's close was 1,411.26.
* Thus, the gap settlement was 38.84 points higher than the close of last night.

This simply means any in-the-money put option lost either all of its value, or up to $38.84, while the calls -- even those that were way, way out-of-the-money -- finished in-the-money.

OPEN POSITIONS UPDATE

As it is expiration Friday, our Marvell Tech Aug 17.50 Calls (UVMHW), AngloGold Aug 45 Calls (AUHI), Ryland Aug 40 Calls (RYLHH) and Rowan Aug 47.50 Calls (RDCHW) came off the board today. Although we were able to capture profits in half of our AngloGold position in mid-July, the rest of these bullish plays ratcheted down in the midsummer market meltdown and each of the underlying stocks closed substantially below our strike prices.

We get into our trades based on how the cash-flush institutional "smart money" is spending its dollars, but even they can't predict when the market is going to take a tumble and take down otherwise-solid positions as part of the carnage.

Because of this shaky environment, I've been holding off on making trading recommendations just for the sake of doing so. Although options let you trade regardless of whether a stock or index is going up or down, the challenge we've been facing with the market going consistently down is that put options have become very highly valued -- in fact, as volatility expands, premiums go up. And I don't want you to get into a trade that doesn't have the potential to make significant returns.

And with the market executing a veritable about-face today, as I wrote above, the S&P put options lost their value, and the same is true of a number of companies (especially the financials) across the board. Whether or not the market is going to stay up is anyone's guess, but as option premiums pull back to more-attractive levels, we'll take a look at the ones that will offer the biggest bang for the buck in the aftermath of the volatility that this month, and particularly this week, has brought.

So, today gives us a chance to wipe the slate clean and see how trading shakes out early next week so that we can establish new positions with confidence and not have to worry about the rug being pulled out from under us.


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader