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Two Ways to Win

March 16, 2009

Dear Fellow Options Traders,

The S&P 500 (SPX) rallied almost 12% off of its 12-year lows last week. It feels good.

But there is much banter about what this market rally represents. Is it just a bear market bounce that will play out like the previous bounces of this recession averaging 17% up and then a dive to new lows or have we seen the bottom?

Our advice is to enjoy the restoration of some net worth but don't get too caught up in contemplating the meaning of the market. Instead, focus on the CBOE Volatility Index (VIX). The VIX dropped on an intraday basis last week by about 20% from 50 to 40. Having the VIX pull back spells opportunity.

As options traders, we are buying both direction and volatility. As a result, we have two ways to win.

For much of February, while the VIX was toward the upper end of its three-month trading range, we sold volatility and used the proceeds to give ourselves upside exposure to a market bounce. Our double-win opportunity comes from collecting premium up front by selling puts and possibly collecting even bigger gains on the back-end with long call positions.

This strategy has worked well in our Yahoo (YHOO), Alcon (ACL), Perrigo (PRGO) and Ivanhoe Mines (IVN) trades. We think it will work out very well for Novell (NOVL), B/E Aerospace (BEAV) and Schlumberger (SLB). We encourage you to add SLB to your portfolios if you did not take advantage of it last week.

The VIX is now at the lower end of the three-month trading range, and we anticipate the institutional money will start going long options and we will follow. With the VIX down, we win when we buy a call if the VIX trades up, and we win if the stock moves above our strike price. We have our eye on a number of new opportunities that should emerge this week.

Big Money 1st-Quarter Review

Big institutional money got off to a rough start in 2009. The institutional market came charging into 2009 getting long calls. These calls have not performed, as the market first went sideways for about six weeks and then collapsed about 20%. March expiration is likely to come too early for many of these positions to recover.

But the institutional market got smart. In early February, its trading pattern stopped fighting the high volatility and started using it to its advantage. We followed these signals and have had success, starting with our Wal-Mart (WMT) trade.

We have been following big money institutional trading flows for years. One fact is certain: The institutional options trading market does not get off-track for long, and it is becoming evident they have found their groove again.

The Life Cycle of a Market Economy -- Spring Buds Emerge

Just as a plant has a natural life cycle, so does an economy.

An economy starts with factors of production being applied to produce goods and services that satisfy consumer needs. We have growth. With growth, inventories build. At the peak of a cycle, production capacity and inventory levels have run well ahead of demand, especially if a financial crisis emerges and consumer demand begins to pull back after many years of levered expansion.

People lose jobs and companies shut down. Fewer goods and services are produced and inventories shrink. At some point, there is too little productive capacity in the economy relative to base level demand and prices start to rise. With rising prices, profits improve and new productive capacity is added. People are hired and companies are expanded and/or created. We have growth again.

While fear is high and governments go through incredible gyrations to rectify problems, the natural life cycle of the economy rolls on. In many parts of the economy, inventories are now so low, sales levels are running ahead of what these inventories will be able to supply.

The Commerce Department reported Thursday that businesses reduced their inventories for the fifth-consecutive month in January by 1.1%. Retail sales dropped 0.1% in January, which was better than the expected 0.5%.

It is interesting to note that temporary hiring, often considered a leading indicator, has fallen steadily since December 2006 and appears to be stabilizing in the first two months of this year. We may be setting up for production to bottom out in the second quarter and rise in the third.

Why Oil Prices Matter

We care about oil because lower prices are helping us all manage through this economy, and we have direct exposure in our XLE and Schlumberger trades.

If you think our economy is bad, imagine an economy that relies virtually on one product (oil) and has seen the price of that commodity drop from close to $150 to $30. OPEC governments are feeling the stress.

No wonder OPEC is committed to keeping the price per barrel between $40 and $50. Every OPEC member country is abiding by the cuts agreed to in December, which is almost unheard of.

This past week, we learned from the International Energy Agency (IEA) that OPEC's tight quota discipline has caused January oil inventories to be smaller than expected -- 9 million barrels versus a five-year average of 26 million barrels.

Institutional option traders and traders like us are positioned to profit from oil price stability near-term by being short the XLE March 40 strike puts that expire on the last day of the month and through our SLB trade whereby we are short the SLB April 35 Puts and long the SLB April 50 Calls. SLB has not traded below $35 a share during any point of this bear market. We continue to like both of these trades.

The Week Ahead

The Fed ends its two-day meeting on Wednesday and is expected to make no changes to interest rates. Last night, Bernanke appeared on "60 Minutes" and it is clear the Fed is in full-on restore confidence mode.

From Tuesday through Thursday, we will hear about the February Producer Price Index (PPI), the Consumer Price Index (CPI) and the Leading Economic Indicators. Given the subdued state of expectations, these reports are likely to have a mild positive impact on the market if they are in-line to less bad than expected.

Friday is March options expiration. With the market turmoil of the past month, anything is possible. We will be watching our March positions closely, looking for all opportunities to close the positions profitably.

REVIEW OF OPEN POSITIONS

We closed and rolled one trade forward, opened two new positions and closed part of a 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. During the market pull back over the past several weeks, the CSIQ July 10 Calls dropped to about 10 cents. On March 12, we recommended you buy to cover the CSIQ July 10 Calls for an 80%-plus gain and remove the upside limiter from this trade.

Yahoo! (YHOO) -- On Feb. 24, we recommended you "buy to open" the YHOO March 16 Calls (YHQCQ) for 13 cents or less and, using a spread order, simultaneously "sell to open" an equal number of the YHOO March 10 Puts (YHQOB) for 14 cents or more for a net credit of at least 1 cent. On March 12, we recommended you roll this trade forward and up by closing the March options and open a similar position in the April options one strike higher. We recommended you "sell to open" the YHOO April 11 Puts (YHQPK) for 32 cents or more, and "buy to open" the YHOO April 17 Calls (YHQDR) for 22 cents or less

Schlumberger Ltd. (SLB) -- On March 12, we recommended you "buy to open" the SLB April 50 Calls (SLBDJ) for 40 cents or less, and "sell to open" the SLB April 35 Puts (SLBPG) for $1.35 or more for a net credit of 95 cents or more. We have seen institutional options flow in the SLB March, April and May 40, 45 and 55 calls. After a long sideways drift since late 2008, it appears option investors expect this stock to go well north of $45 per share, and we can position ourselves to profit from that move with this trade.

GigaMedia Ltd. (GIGM) -- On March 13, we recommended you buy the GIGM Oct 7.50 Calls (GBUJU) for 80 cents or better. After selling off in the early trading hours, the stock rallied driving the options up to about $1. Look to add this position to your portfolio on any pullbacks.

The remainder of our open trades are:

Ivanhoe Mines Ltd. (IVN) -- On March 3, we recommended you buy shares of IVN for $4.45 and "sell to open" the June 5 Calls (IVNFA) for $1.20 or more, effectively making your entry price $3.25. We saw more unusual call buying activity in IVN on Friday. We continue to like this trade.

Alcon Inc. (ACL) -- On March 4, we recommended you sell to open the ACL May 70 Puts (NOZQN) for $3.10 and buy the ACL May 105 Calls (ACLEA) for 45 cents. With this trade, you collect premium while we wait to see whether Novartis AG (NVS) acquires the company for north of $105 per share. ACL is a high-quality company selling at a very discounted price that may see rapid appreciation in the near term. ACL closed on Friday at $88.23. We continue to like this trade.

Perrigo Co. (PRGO) -- On March 6, we recommended you "sell to open" the PRGO May 17.50 Puts (IQPQW) for $1 or more and "buy to open" the PRGO May 25 Calls (IQPEE) for 35 or less for a net credit of 65 cents or more. This is another opportunity that we're getting paid to see if we capture incredible upside profits on a company exposed to secular growth of "store" labels over branded products. PRGO had a good week and closed on Friday at $22. We continue to like this trade.

Energy Select Sector SPDR Exchange-Traded Fund (XLE) -- On Feb. 26, we recommended you "sell to open" the XLE March 40 Puts (JSKON) for $1.26 or more. All indications are for the price of oil to stabilize and many of the XLE component stocks have started to rise. On Friday, the XLE closed at $41.50. We continue to like this trade.

Novell Inc. (NOVL) -- On Jan. 19, we recommended using a spread order to simultaneously "buy to open" the NOVL Jan 5 Calls (WNNAA) for 50 cents or better and "sell to open" an equal number of the NOVL Jan 2.50 Puts (WNNMZ) for 25 cents or more, for a net debit of 25 cents. NOVL closed the week at $3.67. We continue to like this trade.

United Parcel Service (UPS) -- On Jan. 18, we recommended "selling to open" the UPS March 40 Puts (UPSOH) for $1.40 or more. We would rather go long options rather than sell puts or calls to open, but in this market, many great companies are being sold down to incredible valuations. By selling the puts, we collect premium and, in the worst case, take ownership of a great stock at a great price. These puts closed on Friday at 25 cents. As expiration is on Friday and we have captured most of the value of this trade, we would not add to the position.

Research In Motion (RIMM) -- On Feb. 11, we recommended selling the RIMM June 25 Puts (RUPRE) for 95 cents or better. These puts closed the week at $1.02. We like this trade as we believe RIMM at $25 per share represents good value.

B/E Aerospace (BEAV) -- On Feb. 12, we recommended that you use a risk/reversal order to "buy to open" the BEAV April 15 Calls (BQVDC) for 40 cents or less, and simultaneously "sell to open" an equal number of the BEAV April 7.50 Puts (BQVPU) for 25 cents for more, for a net credit of at least 15 cents. Last week, the company reiterated its earnings guidance for the year of $2. Although this news sparked a small rally in the stock, the rally was surprisingly small given the earnings of the company.

The credit on this trade now stands at 90 cents. We continue to like this trade. If you would like to add to the position, you could substitute the BEAV April 10 Calls (BQVDB) in place of the April 15 Calls and you should continue to collect a credit. However, we will continue tracking the $15 strike calls on our Open Positions list.

Ametek Inc. (AME) -- On Feb. 6, we recommended buying the AME March 35 Calls (AMECG) for $1 or less. Our option position closed the week at 10 cents. AME appears to be a casualty of the market decline that is unlikely to have sufficient time to recover before expiration on Friday. Do not add new money to this position.

Red Hat (RHT) -- On Jan. 28, we recommended buying the RHT March 17.50 Calls (RHTCW) for 45 cents or better. This position closed on Friday at 5 cents. Although RHT outperformed the market during the sell-off, it did not appreciate and it appears will not have time to recover by Friday.

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 50 cents 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. This past week, we cleared the July 10 portion of the trade and we are now long the CSIQ July 5 Calls only.

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 $4.90. On Friday, the stock closed at $20.72. This trade becomes breakeven if the stock reaches $22.25 by Friday. We are watching this position closely but are prepared to take ownership of the stock as we believe it is undervalued and will trade above the $22.75 level at some point in the near term.

Rackable Systems (RACK) -- On Jan. 8, we recommended you buy the RACK June 5 Calls (RQOFA) for 95 cents or less. These options last closed at 10 cents. We continue to like this trade, given the company's $5.88 per share in cash, no debt and June expiration.

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 last closed at 5 cents. Do not add new money to this trade, as it has already moved substantially in our favor already.

Cadence Design Systems (CDNS) -- On Jan. 9, we recommended buying the CDNS May 5 Calls (CDNEA) for 60 cents or less. This position closed Friday at 21 cents. We 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 Friday at 45 cents. At the beginning of the week, they traded at $2. A while ago, we wrote "never say never" when it comes to options. MXB might fit this category of trade. MXB, after going to $12 and change, ran straight up last week to close at $14.95. As the options expire on Friday, we will be looking for opportune times this week to close the 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 5 cents. This once-high-flying stock has slammed into the wall called recession and is really struggling. We would not add new money to this position.

PARTING SHOT

This week started early with Bernanke's "60 Minutes" interview last night. The highlights were:

• Overall, "60 Minutes" casts a very favorable picture of Bernanke and his economic stabilization efforts.
• Bernanke believes the recession will end this year and we will see recovery in 2010.
• The key to the turnaround is our financial system. He believes all of the big banks are solvent. There may come a time when they are required to sell pieces to repay the government for the bailout money.
• During the second week of October 2008, the crisis hit its peak. We were close to moving into a second depression. The Dow fell 18% that week, its worst week in history.
• The Fed's powerful and rapid response saved us from depression.

Bernanke's "60 Minutes" comments suggest we will hear more stabilization and recovery remarks from the Fed chairman on Wednesday. With Citigroup, Bank of America and JPMorgan Chase all reporting that they are now profitable, we may continue to move away from the most negative investor sentiment ever recorded just two weeks ago to a more-optimistic outlook. With valuations still at very oversold levels, this bounce may have legs.

Have a great week and a great year trading.

Nick Atkeson and Andrew Houghton

Editors

Options Trader