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UPDATE: Extreme of the Extreme

October 14, 2008

Dear Fellow Options Traders,

The Dow Industrials (INDU) and the S&P 500 (SPX) suffered their worst week ever in both points and percentage terms last week. Both indices were down 18% -- the DJI was down 1,874 and the SPX was down 200 -- and the market dropped more than 40% from the high.

Almost all measures of oversold have never reached their current levels -- this is the extreme of the extreme.

Some examples included the percentage of all NYSE stocks trading above their 200-day moving averages hit 0.6% on Friday. In 2002, this measure at its low was 5.6%.

On Friday, the CBOE Volatility Index (VIX) hit an all-time high of 76.94. Yesterday, the VIX touched 71.42 before pulling back to its current level in the high-50s. Normally, a VIX reading of 40 indicates extreme fear.

Money markets are still frozen. Friday may have been the worst day in modern credit history, with yields blowing out by 175 basis points. Junk bonds, which are normally 4% to 5% above Treasuries, are now at a spread of 17% -- in 1991 and 2002, junk spreads were 11% above Treasuries.

The three-month London Interbank Offered Rate (LIBOR) climbed 49 basis points to 4.82% even with a coordinated central bank rate cut that took our Fed Funds rate from 2% to 1.5%.

As we "mark-to-market" the current situation, we find an equity market that has never been this oversold on a short-term basis, recent massive government intervention has been entirely unproductive to date and a credit market that portends further, substantial deterioration in the economy and stock prices.

Is It Possible the World Has Changed?

Every time the United States faces a major economic challenge, one considers whether this time is going to be different.

In this case, we are confronted with the mother of all asset inflation bubbles in housing while almost all participants of the economy are vastly over-levered. We are seeing the destruction of institutions at an alarming rate. Iceland, an important European banking center like Switzerland and Morgan Stanley (MS) appear to be two of the most recent examples.

As is always the case when fear mounts and wealth is destroyed, we transition from waking up to the problem late to believing the problem will never go away. The pendulum has swung. On Friday, the Dow broke loose for 1,019 points from its intraday high and low.

Market experts have moved from talking about buying the market on valuation to explaining how the "credit supercycle" will take many years to unwind.

It is possible that the world has changed and this time is different. In many respects, it has already proven to be very different in terms of seeing the extreme of the extreme.

If you play the odds, however, this time may have different root causes but the market will respond as it has every time during the 12 recessionary periods since the Great Depression. If we use history as our guide -- rather than fear -- the market is currently extremely oversold.

Looking Ahead

The factors that will control trading this week are difficult to predict, as several major events are slated to occur:

• The G-7 leaders have gathered to formulate a new rescue measure. It appears they conceptually agree on working together but we hope to hear the specifics soon.

• The U.S. government may begin to take equity stakes in banks.

• The credit market indicates further stock collapse but the instant the credit market shows improvement, stocks should bounce.

• Our broader market option indicators are giving us bearish "sell" signals but from very extended levels.

• The VIX at 70-plus suggested that the market volatility will continue to be extreme. Options expiration this coming Friday may exacerbate these volatile conditions.

• Mutual funds and hedge funds are experiencing heavy redemptions. Forced selling may continue to pressure the market.

• Investors will begin to price in a Barack Obama presidential victory, which could lead to higher capital gains and other taxes and additional measures seen as negatives for the market.

• More earnings will be reported. Earnings and outlooks are expected to be weak but the market may already have discounted more bad news than what we might actually experience.

What to Do

We are in a financial hurricane. As with real hurricanes, investors are shortening their sails, battening down the hatches and trying to weather the conditions. We believe the eye of the storm is upon us now.

Generally, buying when the world is coming to an end is the right time. This is what we are doing.

You may also want to consider selling puts on the stocks or indices that you have always wanted to own and are comfortable owning if shares are "put" to you, should the prices drop below your strike prices.

Volatility is at all-time highs, and this is one way to benefit from it.

If We Were Boss

We are currently experiencing a run on stocks because they are one of the few places where there is liquidity (i.e., active buyers and sellers).

Today, we'll briefly lay out how we would fix the credit crisis now.

The guts of the problem are:

• There's too much leverage. As a reminder, total corporate debt in America is about $3.7 trillion. Credit-default swap (CDS) "insurance" contracts on that debt are $53 trillion.

• There's no visibility regarding who owes what because of the off-balance-sheet nature of CDS contracts. (Think Enron.)

• There's no confidence in banks, insurance companies and other financial market participants because no one knows who will be next to blow up overnight based on huge amounts of CDS contracts that might come due.

• With too much leverage, no visibility and no confidence, there is no commercial paper market because market participants have to hoard cash in case of unexpected CDS calls -- because if they lend cash, even on an overnight basis, it may not be returned.

If we were boss, we would:

• Immediately terminate the CDS market and call all existing contracts null and void. We would do this under the authority of national security/emergency powers.

• Immediately start a regulated debt insurance market for those lenders or owners of debt who wish to buy debt-default protection. As a regulated insurance market, $1 of debt could only have $1 of insurance written on it instead of $14, as is currently the case.

Who would be helped?

• The U.S. economy and "Main Street." With the time-bomb of CDS liability removed, counter-party risk between lending parties would be vastly reduced.

• The commercial-paper markets would almost instantly un-freeze. Regular operating companies could once again access cash to continue normal business activities.

• The Dow would soar as much as 6,000 points in the next several weeks.

• The U.S. economy would de-lever by $53 trillion.

• No taxpayer dollars would be at risk.

Who would be hurt?

• Those who bought CDS contracts would have paid premium and receive nothing for it. Premiums could be re-paid by the underwriters of CDS contracts to alleviate this problem.

• Bondholders who are concerned about remaining insured would have to buy replacement insurance possibly at higher prices.

The bottom line is that most of the current CDS obligations will never be paid because the amount owed is many times beyond the capacity of the underwriters to pay. Writing off the CDS market now is calling a spade a spade and removing the pressures that are driving our institutions out of business and raising economic uncertainty to historic levels.

REVIEW OF LAST WEEK'S ACTIONS

Last week, we bought one position, and closed three. Remember, volatility is near all-time highs, and the key is to sell high.

We closed some of the put positions early, which meant we missed out on some profits. But in this unpredictable environment, it's prudent to bank gains and limit losses when possible.

True Religion Apparel (TRLG) -- On Oct. 6, we closed the TRLG Oct 25 Puts (ZJQVE) for $3.30. On Aug. 27, we opened the position for $2.20.

Shanda Interactive (SNDA) -- On Sept. 10, we opened the SNDA Oct 35 Calls (QKUJG) for 35 cents. On Sept. 24, we closed 50% of the position for 70 cents. With volatility spiking, a very short time to expiration and the big gap between the stock price and the strike price, we thought it was best to take our lumps and closed the trade Oct. 7.

FedEx Corp. (FDX) -- On July 31, we opened the FDX Oct 75 Puts (FDXVO) for $3.90. With the tremendous market downdraft, these puts soared substantially above $5.30. We were pleased to come out of this trade with a 50%-plus profit after having been in a losing position for most of the life of the trade.

PowerShares WilderHill Clean Energy ETF (PBW) -- On Oct. 9, we opened the PBW March 10 Calls (PBWCJ) for $2.45. These options closed the week at $2. This was one of the few cases we saw all last week where option volatility appeared to be reasonably priced. With the index pulled down to an all-time low and with strong secular and political tailwinds, we believe this option buy presents an exciting profit opportunity.

PARTING SHOT

Last week was very difficult, and it is important to remember that the "crash phase" is typically of short duration. We continue to believe that, in the weeks ahead, the market will find its equilibrium and we will all be in a better position to make more-predictable, money-making trades.

Have a great week trading.

Nick Atkeson and Andrew Houghton