Sponsored By:

The Bigger They Are, the Harder They Fall

August 23, 2007

Dear Fellow Options Trader,

Since I received so many e-mails regarding my observation last week about the lack of fight in the bulls during the recent market downturn, I thought I'd expand that conversation today.

Specifically, the bulls were looking pretty spent after multiple runs to 14,000 in the Dow (DJI). The bad news kept stacking up, and the bears sensed their opportunity wouldn't get much better than it was at a market high. So, they pressed forward. And for the first time since the global market meltdown kicked off on Feb. 27, the bulls failed to answer the challenge.

The bears' push came in late July, but rather than pushing back, the bulls backed off each time the selling pressure came. Since I love all manner of sports analogies, I would say that it seemed like a boxing match -- one in which a boxer had nearly exhausted himself in trying to knock out the other. And when the knockout didn't come, the survivor, sensing the weakened opponent, went on the attack!

Being a big fan of the sweet science of boxing, and having attended dozens of championship matches, I had seen this scenario play out many times. Any fan of pugilism knows what happens next: The boxer who had extended himself covers up, backs up and focuses on surviving the match. He waits to see whether his training and experience will save him. This is where all that sweat in the gym and on the road at 5 a.m. pays off, but he needs to backpedal, stay covered up and wait for his strength to return.

If you watched the action of the past four weeks, you saw the same situation play out in the stock market. The bulls were covering up and trying to dance away from the bears. The bears were throwing haymakers right and left, the subprime contagion was spreading to all credit markets, the yen carry trade was unwinding and hedge funds were being liquidated. Did I leave anything out?

AND THE WINNER IS: BENEVOLENT BEN

But as I said last week, a predictable thing happened when the bears drove the bulls to the brink, and the Dow finally made that 10% correction: The bulls gathered themselves and fought back. It turned on a dime -- or rather, several trillion dollars -- as the Dow fought back from a 346-point decline at mid-session on Thursday, Aug. 16, to finish flat on the session. For a change, the bears were on their heels.

But smart bears had seen that move before, and knew that the fight back had cost their opponent nearly as much as it had cost them. Both fighters were short of breath, with their chests heaving and arms aching. But the bears went for the knockout blow and loaded up on the short side for August expiration.

Their strategy was clear, as put options in the S&P 500 (SPX) had open interests that were four-times larger than the calls -- a very clear indication that the bears were playing for a quick, lethal shot on expiration that would push the market beyond a correction and into a bear market. The bears were licking their chops!

And that's why I say Ben Bernanke earned his street (i.e., Wall Street) credibility on expiration Friday. The Fed chairman knew how markets worked and how psychology moves them.

If the bears won the day after the bulls made their stand, trading psychology would have continued to be very negative, and the bears would have maintained their dominance. But, if a strategic strike was dealt -- one that left the Fed room to use its heavy artillery, but one that gave clear notice that they were off the sidelines -- then sentiment could swing to neutral.

STOCK-MARKET SMACKDOWN

That move by Bernanke and a unanimous Federal Open Market Committee, delivered a little more than an hour before the opening bell on Friday, Aug. 17, meant there would be no saving the bears. As I mentioned in last week's newsletter, the Fed's calculated move (in which it cut the discount rate at which it lends money to banks) was a positive one not just for the lending sector, but for the broader market as well. And this was the crippling blow that hit the bears in the gut, or perhaps even a little lower than that!

The consequence was non-negotiable and non-recoverable, because those short positions in August S&P options would price on the first print of Google (GOOG), Microsoft (MSFT), IBM (IBM), eBay (EBAY) -- basically, of every single one of the stocks in the S&P 500.

That settlement price was nearly 39 points above the previous close of the SPX. And since the bears were feasting on the 5.4% sell-off of Japan's Nikkei 225, the S&P futures were down more than 20 points prior to Bernanke's haymaker.

Add that 20-point pre-market sell off to the 39-point settlement, and you get the idea of how powerful the punch was. That 60-point turnaround, from that potential windfall profit of 20 points or more to a staggering loss for the bears, was one of the most deadly blows ever delivered by the Fed.

BULLS: 1, BEARS: 0

Here is just one of the hundreds of ugly examples of how much pain was dealt by this move: The SPX Aug 1,450 Puts (SXZTJ) closed at $33 per contract prior to Benevolent Ben's pre-market announcement. Someone had sold a large number just prior to the close, and these puts closed nearly $6 under parity.

Since the SPX cash index on Thursday closed at roughly 1,411, those puts -- or, the right to sell at 1,450 -- would be worth $39. But because that large seller came in near the close and these are European-style exercise options, they only can be exercised for their cash value on expiration Friday. (With American-style options (for example, equities), you can exercise them on any day during the life of the trade.)

With the futures trading down 20 points an hour and a half prior to the open this past Friday, the owners of these puts were looking for the SPX to settle at roughly 1,391 (1,411 - 20 = 1,391). At that settlement level, those puts would be worth $59 (1,450 puts grant the right to sell at 1,450. Subtract the anticipated SPX settlement of 1,391 from that and you get $59). Instead, however, these puts priced out at ZERO, as the right to sell at 1,450 is worthless given the 1,450.11 settlement!

When you multiply the open interest of 110,000 contracts by 100 (each SPX option carries that 100 multiple, just like a regular option contract that you're used to trading) by that $59, you see a swing of more than $649 million! Now, consider that every put registered losses and every call option up to that 1,450 strike finished in-the-money, and you understand why I say this move by the Fed cost the bears dearly.

Is it over? Do we go back to a bull run? I can't say yet, but I can say that the bears' month of ruling the markets has finally been challenged and what we're seeing now is truly a fair fight!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader