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Market 'Labor' Pains Mean a Bottom was Born

August 30, 2007

Dear Fellow Options Trader,

Normally, politicians and government officials take it easy in the summer, but this year hasn't worked out that way -- at least, not for the Fed and Sen. Charles Schumer (D-N.Y.).

Last week, Sen. Schumer sent a letter to both Treasury Secretary Henry Paulson and Federal Reserve Board Chairman Ben Bernanke. The senator asked the two officials to lean on lenders to help victims of the subprime-lending crisis and said, "Mortgage firms should stop running deceptive advertising for subprime loans and provide assistance to homeowners who can afford to refinance."

Then Wednesday, we got word from Schumer that he heard back from Bernanke, who told him that he and the Federal Open Market Committee (FOMC) were "closely monitoring," and that they were ready to act as needed.

The disclosure of the message helped the Dow Jones Industrial Average (DJI) press another 90 points higher by midday, moving from 13,120 to 13, 210. That rally helped push the Chicago Board Options Exchange's Volatility Index (VIX) down to session lows. The surge was only stopped by the closing bell, as the rally continued into the close yesterday -- two of the three major indices took back their multi-percent losses of the previous session.

Monday, Merrill Lynch (MER) cut its estimates on Lehman Bros. (LEH), Bear Stearns (BSC) and Citibank (C) by 22%, 16% and 5% respectively. Today, Lehman followed suit, cutting Morgan Stanley (MS), Merrill, Goldman Sachs (GS) and Bear Stearns. Lehman cited Q3 earnings that will likely be "significantly impacted by the dislocation in the credit and asset-backed mortgage markets."

This is what Doug Kass, president of Seabreeze Partners Management, and I called for on CNBC's "Fast Money" recently, when we both agreed that the financials needed to get those estimate cuts before we'd know that the Aug. 16 bottom would hold. Looking around today, the Lehman downgrade hardly budged the stocks, and by noon, most had broken into positive territory.

Thus, I believe the bottom for Bear Stearns, Goldman, Lehman and the ilk will hold, and most of those names are 10% to 20% above that panic low.

TRADING INSIDE THE BOX

Since Aug. 22, I've been getting notes from financial journalists and subscribers about the "unusual put buying" in the SPX. The bottom line is that what some have incorrectly cited as "terrorism puts" are instead a very benign banking function that goes on throughout each and every day on the CBOE.

Many folks have been asking us about potentially unusual trading activity in the S&P 500 (SPX) September put options. The open interest in the $700 strike (SPZUT) has been pretty glaring (today it was at 49,805), especially when you consider that someone bought over 60,000 of the puts at the $700 strike on Aug. 22. On the surface, it looks like a $4.2 billion bet that the market drops 50% in four weeks.

But is it an investable opportunity? Not so much for the individual trader.

The issue of why someone would buy a put this far out-of-the-money (as the index closed at 1457.64 today) is not because they are looking for a 50% drop in the S&P 500 by September expiration. Instead this is part of a "box," or a four-way trade where there is a call spread "married" with a put spread, thus creating four sides of the so-called "box."

Here is how and why traders would do this:

Trader A wants to borrow money and negotiates a rate to borrow money from the crowd. They negotiate the rate and then put on a box in the S&P 500 options.

The trade in this example is the purchase of the SPX Sept 700 Calls (SPZIT) and the sale of the same number of SPX Sept 1,200 Calls (SZPIT). Next, the purchase of the SPX Sept 1,200 Puts (SZPUT) and the sale of the SPX Sept 700 Puts (SPZUT). This would be an example of a 500-point box spread.

Why the SPX options? Because these are European-style options, meaning there is no early exercise. Rather, the in-the-money calls and puts turn to cash on expiration day ONLY.

At expiration, this box will be worth $500, come hell or high water.

If the SPX is trading at 1,400, the 700 call will be worth $700. The short 1,200 call will be worth $200. The put spread will be worthless, thus that $500 price. At 1,000, the 700 call would be worth $300, and the 1,200 call will be worthless. The 1,200 put would be worth $200, and the 700 put would be worthless. Thus, at any price level of the SPX, the spread will be worth, and cash out at, $500.

Knowing this, the borrower sells this box for $498.50, a discount of $1.50. That discount is the interest the seller will earn over the next 23 days for taking the huge credit into his or her account. The lender(s) buy the box for $498.50, knowing that it will be worth $500 in 23 days and are effectively lending cash at the negotiated rate. The discount varies based on the negotiated rate and the time for which the money will be loaned.

So, when you see spreads going up on multi-hundred-dollar in-the-money calls or puts in the SPX, you can be the smart person at the cocktail party who knows that the reason the trade went up was simply a banking function.

'BOXING' OUR WAY OUT OF THE CURRENT CONDITIONS

On the floor of the CBOE, hundreds of millions of dollars' worth of such trades happen every day. Arguably, the CBOE is one of the largest banks in the world, and since all options on this or any of the other five U.S. options exchanges are cleared through the Options Clearing Corp. (OCC), there is no contra-party risk. The full faith and credit of Goldman Sachs, Lehman Brothers, Deutsche Bank (DB), UBS (UBS) and the like, backs each and every trade with full transparency.

Transparency -- or the lack of it, if you remember -- is what started this whole credit mess. No one really knew how much exposure each company had to the subprime strife, so the whole lot was taken out.

It's going to take some time for each good name to come back, but they will -- especially when liquidity comes from the seasonally strong time of the trading year, which is just around the corner.

That bit-by-bit plan also relates well to our portfolio. I'm sure most of you understand the lack of trading recently -- decent puts have been wildly overpriced and calls were simply too risky. You know it's slow-going for everyone when a quote from yours truly is syndicated on CattleNetwork.com!

For as exciting as the markets have been to watch, the activity has been lightning-fast but not necessarily telling of a true direction for individual stocks and options. Many a professional options trader has been longing for merger-and-acquisition activity or something, anything that has the makings of a solid trading opportunity.

But despite today's late-day decline, overall we're on the up-and-up. Yes, the financials will see weaker earnings in upcoming quarters, but they'll still be in the black. Don't spend your time worrying about that (or about the options market predicting an Osama Bin Laden attack). This weekend, worry about keeping the grill hot and the beer cold, because next week could very well bring a clean slate from which to start recovering from this crazy summer.

Once the holiday weekend passes, some amount of normalcy will be restored to the markets, and we can make trades with confidence that they have a real shot of working out, and overcome the extra level of caution we've had to exert. The summer's wild swings have taken place on low volume, and while we enjoy getting into trades ahead of the news, it seemed like this summer brought nothing but "news" and few, if any, sustainable opportunities. And I don't want you wasting money on "opportunities" that I don't have much faith in, so things have been quiet around here, but I expect that to change sooner rather than later.

Don't rule out a trade this week, but keep your eyes peeled next week, as the markets should benefit from full trading floors as traders make their way back from vacation. This increases the likelihood that HeatSeeker and Depth Charge, our exclusive systems that uncover the unusual options activity that makes us money, should start to register some significant -- and investable -- movement again.


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader


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