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UPDATE: All In

Dear Fellow Options Trader,

At the table of life in the high-stakes game of financial meltdown poker, the U.S. government has gone "all in."

Last week, the government announced it is injecting $20 billion into Citigroup (C), guaranteeing about $300 billion of its toxic assets and creating a new $800 billion program under the Term Asset-Backed Securities Loan Facility (TALF) in an effort to boost consumer credit and the mortgage-backed securities market.

The total relief package is now up to about $8.5 trillion. The entire U.S. debt at the end of 2007 was just above $9 trillion; $8.5 trillion is about 60% of the gross domestic product (GDP).

Here's a summary accounting of the $8.5 trillion:

• Federal Reserve: $5.5 trillion committed, $2.1 trillion used

• Federal Deposit Insurance Corp. (FDIC): $1.5 trillion committed, $149 billion used

• Treasury Department: $1.1 trillion committed, $597 billion used

• Federal Housing Administration (FHA): $300 billion committed, $300 billion used.

The $8.5 trillion chip stack is what the government pushed into the middle of the table. Not until the hand is played to the end will we know the fate of that bet. It is possible that this all-in bet could be a winner.

Following the Smart Money

For most, poker is a game of chance. For some, it is a game of skill. Winners play the odds of positive expected returns. They evaluate the cards in their hands, the possible cards in their opponents' hands and the pot odds.

In many ways, our options trading methodology is similar to playing a game of Texas Hold'em: We are always evaluating the odds of a hand being a winner and the chances of winning relative to how much money is in the pot.

The U.S. government has removed its sunglasses and is looking the world directly in the eye, as it has shoved this humongous chip stack into the pot. Staring right back is a cast of unsavory financial characters and negative economic forces. These are the same characters and market forces that have won every hand so far -- market forces that spell "deep recession" and financial speculators willing to purchase credit-default swaps and then short the equities into the ground.

Imagine making an "all-in" bet against the likes of "Teddy KGB" from the film Rounders (a 1998 movie distributed by Miramax Films about the world of underground high-stakes poker) -- pictured below:

Image Source: Miramax

Our chips are on this table. The question we have to ask ourselves is … who is the smart money?

Our Longer-Term View

The bet the government is making is to flood the troubled parts of our economy with support money to allow natural market forces to take effect in a controlled, gradual manner. Slowing the rate of economic deterioration may allow some healing economic forces to gain traction.

By placing a safety net under the falling economy, confidence and fresh private investing may begin to sprout and the credit-derivatives market will not be able to come due as "credit events" are averted.

Most of the bailout money is going into loans or loan guarantees, as well as asset purchases including preferred stock investments that potentially could see positive returns. Treasury borrowing costs are now down to 1% or less for a two-year term.

With corporate bond yields now at about 9%, the spread is at historically very high levels and leaves a lot of room for profit if the default rate does not become excessive.

In some sense, the government has rigged the game in its favor. It is capturing profitable spreads with one hand and using the other hand to keep the default rate under control through loan guarantees and direct liquidity injections.

Some of the most successful investors, including Carl Icahn and hedge fund manager John Paulson, believe debt is becoming attractive and they are starting to buy knowing that it is hard to pick the exact bottom. If this view becomes more widespread, the credit portion of our economic difficulties will begin to heal.

The next administration may be even more aggressive in playing this hand. With increasing confidence, the government is truly committed to an "all-in" bet, and the equity markets may finally be restored to pricing equities based on earnings expectations rather than guesses about the next exogenous shock.

Market Check

The CBOE Volatility Index (VIX) closed below the 50-day moving average (57.73) on Wednesday for the first time since Sep. 8. On Friday, it remained below the 50-day moving average with a close at 55.80. If the VIX is able to establish a downtrend, the market will have some opportunity to establish an intermediate-term bullish move rather than just another bear-market bounce.

The financials have moved upward very powerfully since the Citigroup bailout. From a low of $8.67 reached on Nov. 21, the Financial Select Sector SPDR Fund ETF (XLF) it is up more than 46% to $12.66. Citigroup hit a low of $3.05 and closed the week at $8.29, up about 172%. Ultimately, a strong banking sector implies a better lending environment.

Our broader-market option indicators are starting to turn bullish again. As we have said for the past several weeks, our confidence in these broader-market indicators is lower when the VIX is as elevated as it has been for the prior month.

The credit markets continue to suffer as credit buyers are willing to only buy government-guaranteed debt. The flow into Treasury funds is historic, with the 10-year yield at 2.86%. This flight to safety comes at the expense of all other non-government-guaranteed debt.

In other words, corporate America continues to be debt-starved. When they do borrow, it is at rates that will smother future earnings power.

The news media are likely to devote substantial time to discussing shopping trends over the Thanksgiving extended weekend. On Thursday, many retailers will report same-store sales for November. Retailing trends are expected to be weak.

On Friday of this week, non-farm payrolls for November will be released, as well as the unemployment rate. Unemployment is expected to rise from 6.5% to 6.8%. With both unemployment and retailing trends, the critical market question is how much has already been priced in.

REVIEW OF OPEN POSITIONS

We were active during the short trading week with the Thanksgiving holiday on Thursday and the shortened trading hours on Friday. We used the curtailed trading hours to our advantage in selling short a couple of options to profit from time decay.

Dow Chemical (DOW) -- On Monday, Nov 24, we recommend selling the DOW Dec 17.50 Puts (DOWXW) for $1.10 or better. As expected, time decay helped reduce the price of these options to 70 cents by Friday. The weekend should erode this option further and we will be watching for an attractive exit point if the opportunity arises.

Tekelec (TKLC) -- On Tuesday, Nov. 25, we recommend buying the TKLC Jan 10 Calls (KQAB) for $1.85 or better. These options immediately jumped up and our entry price was $1.90. They closed on Friday at $2.60.

Superior Energy Services (SPN) -- On Wednesday, Nov. 26, we recommended selling SPN for $16.30 or higher. At this price and above, you will have recovered any loss from the sale of the SPN Nov 17.50 Puts. On Oct. 30, we initiated this position by selling the puts and collected $1.20. Although there was some stress involved in taking ownership of the stock for three days, we believed the stock would quickly recover as it is a sound company at an attractive valuation.

Intrepid Potash (IPI) -- On Wednesday, Nov. 26, we recommended you sell IPI for $18.50 or higher. At this price and above, you will have recovered any loss from the sale of the IPI Nov 20 Puts. We recommended shorting the IPI Nov 20 Puts on Nov. 3 for $1.50 or better. As with our SPN trade, although there was some stress involved in taking ownership of the stock for three days, we believed the stock would quickly recover as it is a sound company at an attractive valuation.

Shaw Group (SGR) -- On Wednesday, Nov. 26 we recommend buying the SGR April 15-25 (SGRDC/SGRDE) bull-call spread for a net debit of $3.60 or less. We also recommended selling the April 12.50 Puts (SGRPV) for $2 or more. The total net debt of all three transactions was $1.60 or less.

This was a trade with many parts, all of which we like. By selling two options and buying one, we greatly reduced the cost of having upside exposure to SGR. Additionally, we believe if the stock were to go below $12.50 and it is put to us, it is an attractive stock holding. On Friday, the bull-call spread closed at $3.85 and the short SGR April 12.50 Puts closed at $1.65, all money-makers.

Other Open Trades

Pitney Bowes (PBI) -- On Nov. 12, we recommend buying the PBI Dec 22.50 Puts (PBIXX) up to $1.45. On Friday, these options closed the week at 65 cents.

Vasco Data Security International (VDSI) -- On Nov. 4, we recommended buying the VDSI March 15 Calls (QFNCC) for 95 cents or better. This position closed the week at 75 cents. Although the stock has pulled back, the original signal is still valid and we are staying with the trade.

Hain Celestial Group (HAIN) -- On Oct. 21, we recommended you buy HAIN Feb 25 Calls (QQHBE) and simultaneously sell an equal number of the Feb 35 Calls (QQHBG) against them for a net debit of $3.05 or less. By simultaneously buying and selling volatility, we are canceling out some of the cost of the long position. This position is clearly struggling and we don't recommend adding new money here.

PARTING SHOT

October and November have been two of the most difficult trading months we have ever experienced. We are entering December with a troubled fundamental economic forecast but increased certainty that the government will pull out all the stops in addressing the financial crisis.

Equity valuations are arguably low and option premiums remain high, but we will continue following the smart money to profit from these circumstances in trades like VDSI, TKLC, SGR and DOW, and in many others to come.

Have a great week trading.

Nick Atkeson and Andrew Houghton