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UPDATE: Yes We Can ... Make Money in This Market

Dear Fellow Options Traders,

Congratulations to President-elect Barack Obama on his historic victory. We wish him courage, wisdom and some luck as he embarks as the leader of the free world over the next four years.

As cycles will have it, Obama is receiving the keys to the car with the gas tank empty, the tires blown out, the transmission broken and the battery dead. Hoping he can turn this wrecked car into a magical one -- like Mr. Caractacus Potts did with "Chitty Chitty Bang Bang" that flies -- is very, very wishful thinking. We would settle for it driving 55 mph at this point.

The long political battle sideshow was put to rest last week, but the markets continued their volatile grind.

For the week, the Dow (INDU) was down 4.09%, the S&P 500 (SPX) fell 3.92% and the Nasdaq (NASD) lost 4.27%. Not too bad considering last week had the two worst consecutive days since October 1987 -- the major indices fell by roughly 10% on Wednesday and Thursday.

Please do not take it personally, Mr. President-elect. The reasons for the sell-off were attributed to profit-taking, General Motors' (GM) liquidity crunch, very weak consumer data and the anticipation of a spike in the unemployment rate -- which hit 6.5% on Friday, a 14-year high.

Credit Continues to be Ground Zero

The credit markets collapsed in September and everyone is de-leveraging, whether they want to or not. Credit lines to most businesses have been cut dramatically just when they need it most. The redemptions from the credit funds and equity funds are putting additional pressure on the markets.

Despite TED rates improving, the things we look at in credit remain bad. (The TED rate is the difference between the rate for Treasury bills and the rate for Eurodollar bills.) Take a look at this picture (source iMoneynet and WJB Capital):

Several weeks ago, we used this chart to demonstrate the effective "run on the banks" when money market funds "broke the buck" after the Lehman bankruptcy. This led to the dramatic pullback in money market assets and the spike in Treasuries.

Now, five weeks later, the picture and situation continue to be bad. Don't get excited about the small increase in traditional money market funds, as money continues to flow into Treasuries. This isn't good.

As an article on CNNMoney.com noted, "Money market funds play an important role as a savings and investment vehicle for many Americans; they are also a fundamental source of financing for our capital markets and financial institutions.

"Although the government has effectively guaranteed money market funds, the fall of Lehman has caused a spike in some short-term interest and funding rates and significantly heightened volatility in exchange markets. Absent the provision of such financing, there is a substantial risk of further heightened global instability."

Speaking of risk, in the form of measuring investors' perception of it in the coming 30 days, the CBOE Volatility Index (VIX) was down almost 12% on Friday and down 6.3% on the week.

The VIX appears to be in a downtrend -- at 56.10, it is below the 10-day moving average and the 10-day has gone through the 21-day. With the VIX at 56, it implies that during the next month we could see a 16% move in the broader market.

Our broader option indicators continue to signal "buy," but we think we are, at best, range-bound because of the deterioration of the debt market.

Size Matters

As the U.S. government transfers impaired private-sector debt obligations to the U.S. taxpayer, we're seeing that size matters.

When the phone rings at the Federal Reserve, all they hear is "Sold to you!"

By propping up the debt markets, the Fed is preventing a wave of collapses in the short term. But as each week goes by, the debt load increases. When will the load be too heavy even for the U.S. government?

In our view, the reason the VIX is so persistently high and the credit markets are not improving in a meaningful way is because of the extraordinary size of the debt burden, which is increasingly being viewed as not payable, especially as asset values fall, as people lose their jobs and as companies go bankrupt.

Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion. Credit-default swaps quadrupled, from $14 trillion to $58 trillion.

The markets will not take a lasting positive course until either:

1. The government provides a clear plan for how we are going to reduce debt rather than shift debt from the private sector to the taxpayer, or

2. We see clear-cut signs that Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke are succeeding at their long-shot gamble of hanging on until the healing effects of time can solve the problem.

Credit derivates debt must be reduced, regulated and made transparent before we are forced to name the next 10 years "The Great Contraction."

It is interesting to note that the buyers of credit-default swaps (CDS) -- either naked short-selling of debt or a put contract on debt -- have moved from focusing on corporate and real-estate debt to sovereign debt.

Of the top 18 CDS contract amounts outstanding, Italian, Spanish, Brazilian, German, Russian, Turkish, Korean, French and Portuguese government debt is on the list. This helps explain the recent strength in the U.S. dollar. It also makes you wonder when we'll see the U.S. on this list.

Finally, the biggest part of the economy at roughly two-thirds, the U.S. consumer, has dug himself into a hole and is saying "Uncle. No mas!"

The most recent survey data by our affiliates at the ChangeWave Alliance research network signals a massive breakdown in U.S. consumer spending for the next 90 days. This outlook is even more pronounced than what was projected from the September survey. It sounds like Q4 earnings need to be reduced further.

REVIEW OF LAST WEEK'S ACTIONS

Last week, we recommended to open two trades and to close an existing position:

Intrepid Potash (IPI) -- On Nov. 3, we recommended you "sell to open" the IPI Nov 20 Puts (IPIWU) for $1.50 or better. These options closed the week at $1.90 and we are down roughly 27%. With implied volatility at 110%, we continue to like this trade. With the stock trading at $20.38, it would now have to fall below $18.50, more than 9%, by expiration on Nov. 21 for this position to be a loser. We like those odds.

Vasco Data Security International (VDSI) -- On Nov. 4, we recommended you buy the VDSI March 15 Calls (QFNCC) up to 95 cents. These options closed the week at 95 cents. This is a bet that the stock will move roughly 50% during the next four-and-a-half months. We continue to like this trade.

Dow Chemical Co. (DOW) -- On Nov. 5, we recommended you "buy to close" the DOW Nov 22.50 Puts (DOWWX) for 30 cents or better for a 70% profit. It's no secret that this market is volatile, and we want to book winners when we can.

REVIEW OF OTHER OPEN POSITIONS

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 buying and simultaneously selling volatility, we are canceling out some of the cost of the long position. The stock pulled back sharply last week, and the HAIN spread closed the week at $1.05. We continue to like this trade.

Superior Energy Services (SPN) -- On Oct. 30, we recommended selling the SPN Nov 17.50 Puts (SPNWW) for $1.20 or better. These options closed the week at 90 cents. We are sitting on a 25% gain. With the stock at $19.32, we hope to see the premium go to zero. If the markets and the stock sell off again prior to expiration, we would be sellers at $1.20 or better.

PARTING SHOT

Because of the conflicting signals from our options indicators and the credit markets, we believe the market is range-bound and will not break this range to the upside until there is some real improvement in the credit markets. And without an improvement in credit, we believe the market may eventually break it to the downside.

As we discussed last week, our strategy of following the big money players' actions has become a bit more challenging in an environment where nearly every move seems to be extraordinary one.

The smart money is being careful, but it is still active and we are tracking it and trading on it and crafting new recommendations for you based on the signals we are picking up.

Like a game of poker and in the game of life, there will be good streaks and bad ones. The trick is to play small when the cards go bad -- but to keep playing.

By keeping your money at work, your skills stay sharp and you're ready to bounce when opportunity knocks.

The market continues to be extremely volatile, but these extreme levels will not last forever. We will continue finding ways to win -- yes, we can.

Have a great week trading.

Nick Atkeson and Andrew Houghton