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UPDATE: As Global Recession Intensifies, Glimmers of Hope Appear

January 05, 2009

Dear Fellow Options Traders,

We are not saying that the coast is clear and let's begin partying like it's 1999, but maybe the worst has passed -- at least for now.

The CBOE Volatility Index (VIX), a measure of fear and risk, closed last week and 2009's first trading day at 39.19, down almost 10% on the week. This was also down 29% for the month of December, and the first close below 40 since Oct. 2.

Wow -- that is good news! A glimmer of hope.

What an incredibly volatile quarter we've just endured. It seems like just yesterday that the VIX was pushing 90 (it hit 89.53 on Oct. 24). But with the VIX's retreat, breathing just became a little easier.

The credit market is showing signs of thawing. It's perfect timing -- and ironic given that winter just started -- as January is the most important month for debt issuance.

A couple of weeks ago, the thawing in the credit market started with some short-covering and then followed with more buying mainly from traders -- and not long-term credit buyers. Surprisingly, the equity market didn't respond, and the thought is that the macro strategy funds buying credit were also shorting equity.

Is this a sign that the worst isn't over?

Much has been written in the media of the attractive yields on corporate bonds and, with the lack of visibility on growth, in hindsight these moves appear logical -- especially given that 10-year Treasuries are hovering just above 2%.

We believe it is important to watch credit, as it may continue to lead us as it did in 2008, but we must be careful not to get head-faked. And this is why we look toward the options markets for guidance, as it paints the most-realistic picture of where the markets are and where they're going.

2008 was a great year to be an options trader and, from the looks of things so far, 2009 is going to be even better!

Looking for a Fearless Leader

The No. 1 question in this recession is: What is going to lead us out?

Getting "in shape" is a favorite New Year's resolution -- this year it will have more than one meaning.

So, if credit is going to lead us out, then this would mean that balance sheets need to be in shape and the banks are ready to lend.

According to the Federal Reserve, debt held by U.S. households shrank in the third quarter for the first time since 1952. The Fed also reported that 74% of the market value is held in cash, bank deposits and money market funds -- the highest ratio since 1990. These are good signs, glimmers of hope.

Targeting appropriate debt/capital ratios will result in companies refinancing debt at manageable levels and raising sufficient capital.

But the questions remain: Will companies be able to reissue debt -- especially at levels where they can manage their businesses and generate a profit? And will they be able to raise capital without damaging the existing shareholders further?

Besides credit, will housing and financials -- the same culprits that got us into this mess -- lead the way out and up? Surely, housing must stabilize as further deterioration in home values will put more stress on individuals and financial institutions.

Home Again, Home Again

The leverage used in real estate is just too great and debilitating in a deflationary environment. The problem is that home values more than doubled from 2000 to mid-2006, fueled by cheap money and weak lending standards.

The long-term average for home value appreciation is a little better than inflation; let's say 4%, not the 10% per annum home values soared during this period. At a rate more consistent with long term averages, values should have been up around 32%, not 100% during those seven years. And further, they should be a little better than 42% today compared to up 58% based upon a year 2000 base.

Last Tuesday, the S&P/Case-Shiller Home Price Index for October was down 18% from the previous October for the 20 metropolitan composite areas, the greatest year-over-year decline in the history of the index. It's also down 23% from the peak.

The index is calculated monthly using a three-month moving average and is published with a two-month lag. When Dr. Robert Shiller, the Yale economics professor who co-created the housing index, was interviewed on CNBC, he said that in certain markets home prices are "not so overpriced anymore."

Wow, is that good news -- a glimmer of hope -- especially from the guy who called the top. However, Shiller added, "With confidence so bad, we may overshoot. Things are still risky."

A VIX at nearly 40 is confirming Dr. Shiller's concerns -- the market and options are still pricing in plenty of risk/fear. Money may again be cheap, but the lending standards are not. Let's hope they don't weaken again.

Besides time, the key to managing this recession is employment.

Friday, the Department of Labor will report the employment situation for the month of December. More weakness is expected from the November unemployment report of 6.7%. There were a number of layoffs announced before the holidays and we would expect more to be announced now that the holidays have passed.

Like housing, an improvement in the rate of decline will make investors more bullish. This will help us gauge what is priced into "the stock."

A Thaw in the Fog -- But the Icebergs are Still Out There

If the top question regarding this recession is what is going to lead us out, then the No. 1 question in investing remains: "Is all the news baked into the stock's price?"

How many times have you seen a company come out with great news and the stock sold off, or vice versa when there is horrible news and the stock bounces? "All the news is already in the share price" is the response we hear -- gee, thanks for the explanation.

Wouldn't it be great to have a news gauge that worked like a gas tank gauge?

The market mechanism takes all available information and prices stocks according to their intrinsic values, discounting future earnings. Lately, projecting future earnings has been extremely difficult.

In December 2007, market forecasters predicted the S&P 500 (SPX) to produce roughly $90 in earnings per share; in 2008, earnings will come in around $55 per share, maybe lower. For 2009, estimates are $65.

With more and more companies withdrawing guidance, as visibility remains a little past one's nose, it might seem very optimistic that earnings will grow 20%. But let's listen for the horn and look to options to guide us through the fog.

REVIEW OF 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 simultaneously buying and selling volatility, we are canceling out some of the cost of the long position. This position is clearly struggling and we don't recommend adding new money here.

The open trades that are active are:

CBRL Group Inc. (CBRL) -- On Dec. 10, we recommended buying the CBRL March 20 Puts (CBQOD) up to $3.50. These options closed on Friday at $2.45. We continue to like 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 $2.84. 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. We continue to like this trade.

Shaw Group (SGR) -- On Wednesday, Nov. 26 we recommend buying the SGR April 15-25 (SGRDC/SGRDE) bull-call spread for a net debit of $3.60 or less. We also recommended selling the April 12.50 Puts (SGRPV) for $2 or more. The total net debt of all three transactions was $1.60 or less.

This was a trade with many parts, all of which we like. By selling two options and buying one, we greatly reduced the cost of having upside exposure to SGR. Additionally, we believe if the stock were to go below $12.50 and it is put to us, it is an attractive stock holding. On Friday, the bull-call spread closed at $5.70 and the short SGR April 12.50 Puts closed at 54 cents.

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 50 cents. This position closed the week at 30 cents. Although the stock has pulled back, the original signal is still valid and we are staying with the trade.

PARTING SHOT

"You only learn who has been swimming naked when the tide goes out," said Warren Buffett. The Oracle of Omaha wasn't talking about nudist resorts, the fastest-growing segment of the travel industry, but rather falling house prices and the ensuing credit crunch that left many investors fully exposed in 2008.

In 2009, we expect the commercial credit problems to come to light. The No. 1 lesson in leverage is that it cuts two ways: It drastically increases returns and greatly amplifies potential losses. As option traders, we live and die by this two-edged sword.

Over the past few months, we have often said that we want to be sellers with high volatility and when options are priced dearly. With the VIX finally pulling back, pricing on options will become more attractive for buyers.

Historically, we find more information from buyers of options than sellers. We expect that, as the volatility continues to come down, more buyers will emerge and more trading ideas will flow. Stay tuned to your inboxes -- it's going to be a profitable and active year for us!

Happy New Year and all of our best to you and your families for a healthy, happy and prosperous 2009.

Have a great week and a great year trading.

Nick Atkeson and Andrew Houghton

Editors

Options Trader