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Burning, Churning Leads to Market Indigestion

February 02, 2009

Dear Fellow Big Money Traders,

January 2009 was a replay of the first two weeks of last year (as 2008 was the worst January on record until the surprise 75-basis-point rate cut in mid-month), and it sets us up for another year of intense investment cross-currents.

This week, we describe the deterioration of the market and economy as a burn, but it is the churn under the surface that really has caught our attention.

Burn

Across the globe and throughout the financial publishing industry, the message is the same. The market's fundamentals are weakening and investors are losing faith that government intervention will ever work.

Ninety percent of the world's economies are in recession. The Dow (INDU), down 8.84% on the month, had its worst January in 113 years. The S&P 500 (SPX), down 8.57%, was not much better.

Unemployment, currently at 7.2%, is expected to be revised up to 7.5% when the latest figure is announced on Friday. Virtually all of us are experiencing contracting income and savings, and 92.8% of us are wondering whether we might lose our job.

GDP declined at a 3.8% rate last quarter, which was better-than-expected because inventories rose 1.3%. Increased inventories suggest worse GDP statistics going forward, as those inventories must now be worked off.

However, such negative consensus of our current economic state is not of much use to us as options traders. We remain focused on the market mechanics at this moment so we fully understand the optimum way to continue making money with our option investments. Read on to learn more about where we're focusing our attention.

Churn

Simply put, what's impacting our option investing isn't being reported in the negative headlines.

Although the markets appear to be in a state of collapse, the recent declines are concentrated in the financial sector. Whether measured by the New York Stock Exchange or by the Nasdaq (NASD), the financials are down in excess of 20% year-to-date.

Much of the rest of the market appears to be in a state of churn, especially growth stocks, which typically have less debt and should provide greater reward to the investor willing to accept some degree of "risk."

(Evaluating what the real risks to stock valuations today is a shifting landscape, as much of what determines stock value is not associated with fundamentals but more with speculation on how the company will handle its next debt financing event.)

In the Russell Index, the growth segment is down about half the amount of the overall market year-to-date at 4.87%. From the November low, the largest 100 stocks are up just 9%, while the mid-cap stocks are up 23%.

Churn is the enemy of option profits. It keeps the price of options high (the volatility band you are required to buy is wide). As the stock bounces inside the range of volatility that was priced into the option, time passes causing erosion of the option premium.

For example, let's look at Cracker Barrel Old Country Store Inc. (CBRL). We are long the March 20 Puts (CBQOD).

In January, the stock traded in a range of about $22 per share to $15.44 per share. It moved in either direction as much as 30%. One might imagine that 30% swing volatility would be sufficient to make serious money. Unfortunately, this type of volatility has been priced into the option.

Although we did manage to capture a 40% profit on half of the position during the month, we would like to see this churn end and the stock revisit its November lows to capture big money.

While we are in a churn mode, we will have to be very quick to take profits when our positions hit the edges of their trading ranges. Additionally, we will look to enter call positions when the underlying stocks are down and put positions when the underlying stocks are elevated.

In Super Bowl language, we will be throwing deep strikes (longer-dated expirations) down the sidelines (edges of the trading range) to prevent getting hit in the middle of the field with the clock expiring.

Some Banks Toast -- The Rest in Triage

The market's conclusion that the financial sector equity value is going to be in the hurt locker for some time to come is likely correct.

Six banks failed during January. Last month, the FDIC approved a budget for the coming year that almost doubles spending to $2.2 billion from 2008 levels to hire staff for handling bank closures. As much as $1 billion was allotted to manage failed banks. As of the latest report, the FDIC classifies 171 banks as "a problem" -- up 46% year-over-year.

Unlike the falling bank sector, the rest of the market is churning inside a wide trading range. Investors have yet to decide if government intervention will overcome economic deterioration sometime late this year or early 2010. As they continue evaluating the current state of affairs, their appetite for riskier asset classes may just now be emerging.

Water is to Fire as Liquidity is to Recession

Fed Chairman Ben Bernanke, through his writings over the past decade, has made clear that a government facing the type of crisis we are currently in can "essentially never go too far in dumping money into the system, penalizing risk aversion and, ultimately, raising prices and asset values."

From the chart below, you can see the consistency between what Bernanke says and what he does.

http://www.bigmoneyoptions.investorplace.com/images/charts/2-2-09-monetary-base.gif

Source: The Federal Reserve Bank of St. Louis

The contrarian trade right now is to bet government intervention finally works. What is interesting about this view today is that government stimulus generally impacts the economy in a lagged way.

Liquidity and bailout programs are much more likely to have an effect now than when they were first announced last year. This delayed impact might be coming just at the time when market participants have finally lost hope that any government action will have lasting positive value.

Here We Go Again -- Government to the Rescue

Obama and his team believe in bold action and a time for change. Our new Treasury Secretary, Mr. Tim Geithner, would like to present a "comprehensive" bank bailout bill that will command market confidence.

Details are being finalized but are likely to include an overhaul of the TARP, the creation of a taxpayer-owned "bad bank" and insurance-style guarantees for problem assets remaining on bank balance sheets. We could also see anti-foreclosure provisions that involve the write-down or subsidization of many home mortgages and an attempt to revitalize the securitization markets.

The Senate is expected to vote on the $819 billion stimulus bill while the market endures another week of distressed earnings outlooks and declining economic data like personal income and consumption, the January Institute for Supply Management (ISM) Index, fourth-quarter productivity and December factory orders.

REVIEW OF OPEN POSITIONS

This past week was filled with mixed signals. We closed a position and a half during the week and kept a watchful eye on several emerging opportunities.

Shaw Group (SGR) -- On Nov. 26 we recommended selling the April 12.50 Puts (SGRPV) for $2 or more. On Jan. 12, we recommended closing half of this position for 30 cents or better but the option ran away from our limit price. We reissued the close half recommendation on NTY) -- On Jan. 14, we recommended buying the NTY Feb 15 Puts (NTYNC) for $1.15 or better. The company reported better revenues but lower earnings on Jan. 29, which clearly was a case of bad, but not as bad as the shorts had expected. There was a sharp rally in the stock and we decided to clear the position for 15 cents or better. This was a disappointment, as the original option signals were strong. The option investors got the fundamentals right but misjudged the market reaction.

The remainder of our trades are:

Phase Forward (PFWD) -- On Jan. 21, we recommended you buy a half position in the PFWD Feb 15 Calls (UTOBC) for $1.30 or less because we believe option investors are making a directional bet based on the company's Feb. 5 earnings announcement. We normally do not like buying in front of earnings announcements, as these trades contain less proprietary information (as it is public information the company will report on Feb. 5) than other generally unknown catalysts. But, we made an exception in this case because of the persistence and magnitude of the option signals. We are hedging our bet here by recommending only a half-position. This trade closed the week at 65 cents.

Grupo Televisa SA (TV) -- On Jan. 23, we recommended buying the TV April 15 Calls (TVDC) for $2 or less. They closed the week at $1.20 and we continue to like this trade.

Canadian Solar (CSIQ) -- On Jan. 15, we recommended using a spread order to buy the CSIQ July 5 Calls (GQAGA) for approximately $1.85 and simultaneously sell an equal number of the CSIQ July 10 Calls (GQAGB) for approximately 60 cents, for a net debit of $1.25 or less. The spread position closed the week at $1.10. We continue to like this trade.

CBRL Group (CBRL) -- On Dec. 10, we recommended buying the CBRL March 20 Puts (CBQOD) up to $3.50. We closed half the position on Jan. 14 for $4.80. The stock reached a point of technical support, which we expect it will eventually break. However, prudence dictated that we take some money off the table. These options closed the week at $3.60.

Supertex (SUPX) -- On Jan. 6, we recommended selling to open the SUPX March 25 Puts (SQOOE) for $2.75 or more. These puts closed the week at $2.95. We continue to like this trade.

Rackable Systems (RACK) -- On Jan. 8, we recommended you buy the RACK June 5 Calls (RQOFA) for 95 cents or less. These options closed on Friday at 35 cents, as the stock was hurt by a negative earnings pre-announcement. We continue to like this trade given the company's $5.88 per share in cash and no debt.

Shaw Group (SGR) -- On Nov. 26 we recommended selling the April 12.50 Puts (SGRPV) for $2 or more. We covered half the position on Jan. 29 for 25 cents or better. Given the continued strength of the stock, we feel there is no rush to clear the entire position. This position closed the week at 25 cents.

Novellus Systems (NVLS) -- On Jan. 8, we recommended buying the NVLS Feb 15 Calls (NLQBC) for 75 cents or less. During the week, NVLS traded up just through $15 per share. It is showing tremendous volatility which we hope will eventually work in our favor. This position closed the week at 40 cents and we continue to like this trade.

Wal-Mart Stores (WMT) -- On Jan. 8, we recommended selling the WMT Feb 47.50 Puts (WMTNW) for $1.45 or more. These puts ended the week at $1.90. We continue to like the trade, as we would not mind taking ownership of WMT in the mid-$40s if required to do so upon expiration.

Cadence Design Systems (CDNS) -- On Jan. 9, we recommended buying the CDNS May 5 Calls (CDNEA) for 60 cents or less. This position closed at the end of the week at 30 cents and we continue to like this trade.

Hain Celestial Group (HAIN) -- On Oct. 21, we recommended you buy the HAIN Feb 25 Calls (QQHBE) as part of a bull-call spread for $3.40. HAIN was badly damaged by the market crash. We are hopeful to recover more than the current 10 cents from this position but we do not recommend adding new money to this trade.

Pool Corp. (POOL) -- On Dec. 10, we recommended buying the POOL April 17.50 Puts (QCLPW) for $3.80 or less. These options closed on Friday at $3. We continue to like this trade.

MSCI Inc. (MXB) -- On Dec. 11, we recommended you buy the MXB March 15 Puts (MXBOC) up to $2.50. These puts closed the week at $1.25. With the financial sector melting down, we wonder how much longer MXB will defy the trend. We continue to like this trade.

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 10 cents. Unfortunately, the company had a negative earnings pre-announcement that halted the positive upward trend the stock was in the process of establishing. Although the stock has pulled back, the original signal is still valid and we are staying with the trade. However, we would not add new money to this position.

PARTING SHOT

Obama is aiming to fire a double-barreled shot of stimulus and bank bailout into our economy. Market prognosticators and credit analysts are relentlessly calling for the market to bottom out somewhere near 600 on the S&P 500. With the market caught in the middle, it may make up its mind and move in a more-definite trendline as February progresses.

What would be ideal for Options Trader is to see many of the mid-cap stocks we have based our options trades on breaking out from their current trading ranges.

Fasten your seatbelts, as we expect the market to move in a dramatic fashion when and if the majority of investors come closer to an "invisible hand" agreement on what our economic prospects are likely to entail.

Later this week, we will be attending the World Money Show in Orlando. We hope to see you there.

Have a great week trading.

Nick Atkeson and Andrew Houghton

Editors

Options Trader

P.S.You're Invited to Attend Toby Smith's Book Signing for 'Billion Dollar Green'

We would like to invite you to join our friend Toby Smith at the World Money Show on Saturday, Feb. 7, 2009, at 11:45 a.m. at the ChangeWave/InvestorPlace Media booth, where he'll be signing copies of his new book: "Billion Dollar Green."

"Billion Dollar Green" is your "How-To" guidebook to capturing life-changing profits from the green wave. You can purchase a copy of the book at the show or bring your own and he'll sign it for you.

Read a free excerpt of "Harnessing the Profit Power of Solar" by visiting this link.

If you're not going to be at the show you can still attend a few of our sessions by watching the live webcast. Sign up today here.