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You Don't Have to Be an Economist to Know Things Ain't Good

February 17, 2009

Dear Fellow Options Traders,

We know it ain't good when the best of the best, Warren Buffett, suffers a 62% profit drop through his investment vehicle called Berkshire Hathaway Inc. (BRK), which owns a diverse mix of 60 different companies.

We know it ain't good when February non-farm payrolls, to be reported on Friday, are expected to fall by 640,000 jobs and analysts are looking for the unemployment rate to rise to 7.8%. In California, a place of innovation and economic leadership, the unemployment rate is at 10.1% and showing no signs of deceleration.

We know it ain't good when the picture below needs no words of explanation.



To see a down bar like Q4 2008, you would have to extend this chart back 28 years to Q1 1982.

You know it ain't good when stocks suffered their worst February since 1933 and we are just 2% away from where we can claim half of the 75 years' worth of appreciation in the Dow (DJI) from the 1932 low to the 2007 high has been erased.

We're from the Government and We're Here to Help

Sometimes poison can cure. Botulinum toxin (which retails as Botox), taken in small doses, can paralyze tissues to remove wrinkles. Chemotherapy targets cells that divide rapidly and kills them. As long as we follow the dosing recommendations on the label, the poison should help rather than hurt.

Government economic intervention appears to follow the same principle that dosing size really matters. Right now, "doctors" Barack Obama and Fed Chairman Ben Bernanke believe a heavy dose should do the trick. On top of the $9 trillion of existing government commitments made since the credit crisis began, in the past several days we've witnessed:

• The announcements of a $3.6 trillion budget plan.

• A federal deficit of $1.75 trillion (12.3% of GDP).

• A $25 billion bailout of Citigroup (C).

• A request by Fannie Mae (FNM) for $15.2 billion from the Treasury.

• An expected quarterly loss of $60 billion from American Insurance Group (AIG).

• A continued pleading from General Motors (GM) that billions are needed to avoid bankruptcy.

• A $787 billion stimulus plan.

• A $410 billion catch-all appropriation for the rest of fiscal 2009.

You don't have to be a doctor or an economist to know that overdosing can cause more harm than good.

Public investment crowds out private investment. Government borrowing crowds out future savings. Higher taxes diminish private investment. Replacing free enterprise with government economic planning led to economic comas in developing countries, like Russia, North Korea, Vietnam, Cuba and China.

To quantify that queasy feeling that government bailout dosing levels are reaching dangerous quantities, we took a look at the credit-default-swap pricing for insuring against default risk on the U.S. Treasury.

The cost to insure $10 billion in U.S. Treasuries for five years against risk of default is now $100,000. What was considered the "riskless" asset in finance textbooks now costs $100,000 to insure.

Default by the U.S. government would make what we have already experienced seem like the economic equivalent of a sneeze just before the onset of bubonic plague.

Worry is Elevated, Steady

The CBOE Volatility Index (VIX) closed on Friday at 46.35. Although it is high in historic terms, it seems too calm, given the pace of market deterioration. The major indices barely broke their November 2008 lows. From both sentiment and technical perspectives, it appears we should brace for further market declines.

Where Do We Want To Go?

We are hunting for the option opportunities that aren't likely to freefall with the rest of the market, trades where valuation and fundamentals are relatively attractive. Maybe, most importantly, we are avoiding the "crowded trade" and looking for spots where investors are yet to come, so that we can get in early and sell our positions to the Johnny-come-latelies for big profits!.

In our weekly trading landscape from Feb. 9, we talked about the crowded trade.

We said: "The funny thing about the bulls and bears is that they seem to be saying the same thing on the 'where do I put my money today' front. The bulls see solid fundamentals in healthcare and education stocks. The bears see recession-proof and counter-cycle plays in the healthcare and education stocks. Both bulls and bears like large-capitalization, blue-chip dividend-paying safety stocks."

Last week, the crowd rushed for the exits in these stock sectors partly because of investor concerns with some of the initiatives announced in the proposed federal budget. Conversely, we have seen surprising appreciation in the consumer discretionary sector, especially in the restaurant stocks and retail computers and electronics.

We are keeping a close eye on short interest levels. Nineteen of the last 20 trading sessions involved net shorting, with the past 12 sessions straight showing new short activity coming in above short-covering.

Our conversations with major stock lenders indicate that the duration and magnitude of short activity is greater now than it was from mid-October to mid-November 2008. It looks like the short trade is quickly becoming the new crowded trade.

Don't worry, though -- we've got quite a few tricks left up our sleeves. Our goal is to stay a few steps ahead of the herd, and to keep you ahead of the crowd as well. Let's take a look at how we're doing just that.

REVIEW OF OPEN POSITIONS

With the idea of staying in front of the crowd and/or investing in areas where huge crowd shifts have already occurred, we added two new trades this past week seeking to capture value and minimize risk. Additionally, we exited a trade where, unfortunately, the crowd went against us.

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. There is growing speculation that Microsoft (MSFT) will re-approach YHOO in the near term to either acquire the company or form a substantive working alliance. The catalyst for this friendlier relationship is the change of CEO at Yahoo! just three weeks ago.

We believe our recommended YHOO trade provides you with a low-risk way to gain exposure to potentially significant upside between now and March expiration. Although it is unclear how one should calculate returns on a position where you were paid to put it on and paid more later, we show the trade up 900% as of the close on Friday.

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.

Last year, we saw the crowd push into energy prior to the Beijing Olympics when oil prices nearly reached $150 per barrel. As consumers weakened and reduced their energy consumption at a surprising rate, we saw the crowd rush out of energy and drive the price per barrel down to about $30.

The energy trading room looks fairly quiet right now. But what has captured our attention is the $40 XLE support line whether the price per barrel is $30 or $45. The 52-week low is $38.84.



Many ETF options have two separate expiration dates at the end of each quarter. One set of options expire on regular expiration day (the third Friday of the month) and a second set expires on the last day of the month.

We recommended the XLE option set that expires on the last day of the month (with the ticker JSKON) as we felt the extra premium collected made up for the additional time risk exposure. However, at this time, the same trade could be made using the regular option that expires on March 20 (ticker XLEON). We will continue to track JSKON on our Open Positions list.

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 company reported better-than-expected earnings and the stock began to run on the morning of Feb. 24. We recommended closing out the position for $1.60 or better that morning.

The remainder of our open trades are:

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 posted earnings this past week and sold off with the market. You can now establish this position and collect a credit. We like the trade even more and strongly reiterate our recommendation.

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 company at a great price. These puts closed on Friday at $1.35.

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 $1.20. We like this trade even more, 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. The credit on this trade now stands at 75 cents. We continue to like this trade. If you would like to add to the position, you could substitute the 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. Like most stocks last week, AME declined sharply. Our option position closed the week at 10 cents. Although the original option signals are still in place, we're going to take a wait-and-see approach before adding to this position given current market conditions and the distance developing between the stock and strike price. Hold this position.

Red Hat Inc. (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. We continue to like this trade as the original option signals are still in place, but it is unlikely this will be a winner unless the market makes a move upward. Hold positions if you have them, but do not add new money here.

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 35 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. The spread position closed Friday at 45 cents. We continue to like this trade. CSIQ is an incredibly volatile stock and we have lots of time till expiration.

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 $3.60. 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 last closed at 25 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 20 cents. Do not add new money to this trade, as it has 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 40 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 80 cents. A while ago, we wrote "never say never" when it comes to options. MXB might fit this category of trade. The company posted missed earnings about a month ago and sold off 10% on the announcement. Since the report, the stock has been amazingly robust until this past week. MXB is finally headed back in the right direction, so hold on to this position if you're in it, but don't add new money.

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

Mike Tyson was the youngest man to win the heavyweight title at just 20 years old. He won his first 19 professional bouts by knockout, with 12 taking place in the first round.

In the ring, he was not a subtle boxer. He would approach directly from the front and proceed to hit with tremendous power. Toward the end, he even resorted to biting.

This economy and overall market are like Mike. They have all lost their subtlety.

With every news flash, it delivers a strong blow. In a single day last week, we clipped the following headlines: Continuing unemployment claims jumped to a record 5.1 million. New home sales fell 10% to a record low annual pace of 309,000. The median price fell 13.5%, while supply rose to 13.3 months' worth. Durable goods orders were down 5.2% in January -- more than twice the forecast.

Standing in front of the onslaught in long equity has been painful. When we enter the ring, we know we have to fight smarter to win. We have to structure trades so that we win if there is upside and we win if there is no upside.

The best, most recent example of this type of trade is the YHOO trade we put on last week. If nothing happens, we can collect premium. If something does happen, we can collect ridiculous profits.

Take that, "Market Mike." Carefully structured options trades can overcome brute force any day.

Have a great week trading.

Nick Atkeson and Andrew Houghton

Editors

Options Trader