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In and Out of the Black Hole

January 12, 2009

Dear Fellow Options Traders,

The best way to describe the trading activity at the end of 2008 would be to say that the market went into a black hole in the fourth quarter.

For equities, a black hole is a market crash -- the panic-selling we experienced that led to a 20% market decline in both October and November. For options, it is the CBOE Volatility Index (VIX) rocketing above 40 and averaging nearly 60 for almost the entire fourth quarter.

Nothing close to this has ever happened before.

With stocks getting flattened and option pricing at many degrees of magnitude higher than anything ever experienced, intelligent option flow stopped. Panic option flow started. As many traders learned the hard way, making investments based on the signals generated by a herd of panicked investors generally gets you trampled.

Instead, we reduced our recommendation flow during this black-hole time, as there was a paucity of meaningful money-making signals. With the light trading volume in the broader markets and the weak trading signals in the options markets, we decided to wait it out and look toward January for the proverbial light at the end of the black-hole tunnel.

We'll talk more about the process of emerging from the black hole, but all signs point to the fact that we are. And that's great news for us, because the trading opportunities are developing in droves and our patience is being rewarded.

While we've stayed active by "selling to open" a number of trades, the stronger option signals that we're picking up also give us a clearer idea of what the big-money players are betting on. And that means more long put and call plays are in the works for us to play, as well!

So, strap on your seatbelt and keep some powder dry for new trade recommendations, because we've got an exciting ride ahead of us not just in the coming weeks, but also throughout 2009. We'll talk more about these opportunities later in this landscape.

It's All About Jobs

Last week, we mentioned that we are seeing glimmers of hope in the market. The indices closed out December on a positive note, the frozen credit market was thawing, and volatility as measured by the VIX was pulling back from extreme levels.

We also mentioned that the one of the keys to managing our way out of this recession is employment. First, the job losses have to decelerate, then stop, and then reverse to employment gains.

Last week, there were three "jobs" reports that made the headlines and moved the markets.

The first one, unexpected and not the one we were talking about, arrived last Monday morning, in the form of an update about Steve Jobs' health -- it was good for a 4% gain in Apple (AAPL) on the day.

Automatic Data Processing's (ADP) negative report on Wednesday and the government's December unemployment number of 7.2% (a 16-year high) released on Friday highlighted the underlying weakness in the U.S. economy. The 524,000 drop in payrolls was a little better than consensus, and certainly better than what people had feared.

However, the negative revisions to the prior two months and the aggregate hours worked indicate the weakness in the jobs market is still very bad and just got a little worse. We expect more job cuts to be announced with the earnings reports in the coming weeks.

The employment news or, rather, the lack of employment news, along with weak December retail reports, sent the VIX up 9% on the week, closing at 42.82. The S&P 500 (SPX) was down 4.5%. We hope the bulls were just blowing off a little steam. The bears will claim it was more-rational trading action, with stocks actually going down on bad news for a change.

Our broader market option signals point to a more-bullish direction, and we interpret last week's market action as a pullback. We just hope the calming feeling we are experiencing is the result of a market that is stabilizing and not the calm before another storm.

The Bigger Picture

When we entered October 2008, many investors believed the economy was deteriorating and the market had established a downtrend. Very few believed we were about to experience a market crash.

During June, July and August, options traders were establishing call positions on many stocks with expirations in November, December, January and February. Their call bets were made, in part, because they expected the market to experience its usual end-of-year rally and erase any October/November pullback losses.

From the November lows, the S&P 500 rallied as much as 20%. In plain English, the stocks tanked way below any level expected.

The unexpected market crash of October and November is the No. 1 reason why we experienced a few losses in some of our Options Trader recommendations.

December, especially during the final two weeks of the year, is a weird time for options trading. Many institutional money managers use options during this time to manage investment returns in a manner not seen during any other time of the year.

December 2008 was even weirder than normal, as it came on the heels of the black-hole period mentioned above. We started the month with an 8.9% drop in the market (S&P 500) and the VIX closing at 68.51.

A New Year

Although the VIX remains high (at 42.82) on a historical level, it is way down from its black-hole fourth-quarter level. We have seen a return of the intelligent option investor, as the panicked ones have all gone home to lick their wounds.

During the past 10 years, the VIX's average is just above 21. The volatility today says the fear and risk are twice average levels. We may have entered a brave new world with regard to market volatility and we will adapt accordingly.

The January options expiry is this Friday. Going forward, we expect the information and signals to be more meaningful, which will help us to navigate this difficult trading landscape.

In the review of open positions below, you will note a substantial increase in the number of option recommendations this past week. Expect that to continue. Our systems indicate it is open season again and time to capture a steady stream of options profits.

UPDATE ON RECENT RECOMMENDATIONS

This week, we recommended three new call positions, sold short two put positions and closed a call and a bull-call spread position. In sequential order, our trade recommendations for the week were:

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 $3.70.

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.

This is one of the positions that was damaged by the black-hole effect discussed above. The good news is that the stock has been steadily recovering and it is possible the Feb 25 Calls will go into-the-money. Given the more-optimistic outlook for this trade, we recommended removing the short Feb 35 Call portion of this trade for 5 cents, as it removes the upper-profitability cap from the trade at a very low price.

However, do not add new money to this trade, as the market dynamics have shifted substantially and have negated the original reasons for entering the position.

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 $1.05. We continue to like this trade.

Shaw Group (SGR) -- On Wednesday, Nov. 26 we recommended buying the SGR April 15-25 (SGRDC/SGRDE) bull-call spread for a net debit of $3.60 or less. On Jan. 8, the company reported robust earnings and the stock was up over 20%. We used this catalyst as an opportunity to recommend that you close the bull-call spread for $6.60 or better for an 83% profit.

Part of the original SGR trade included selling the April 12.50 Puts (SGRPV) for $2 or more. Given the current positive outlook for the stock and that time is on our side, we decided to let this piece of the original recommendation mature for at a few more days to capture even more profit, and we issued a sell alert earlier today to close 50% of the position.

Novellus Systems (NVLS) -- On Jan. 8, we recommended buying the NVLS Feb 15 Calls (NLQBC) for 75 cents or less. This position closed the week at 75 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 $1.14. We continue to like this trade.

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 60 cents and we continue to like this trade.

REVIEW OF OPEN POSITIONS

CBRL Group (CBRL) -- On Dec. 10, we recommended buying the CBRL March 20 Puts (CBQOD) up to $3.50. These options closed on Friday at $3. 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 $2.77. 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 $1.45. The company reported worse-than-expected earnings this past week, which led to a one day 10% stock sell-off. 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 21 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

The options world is a dynamic place. The pace of change in the options world is substantially faster than almost any other part of the investment community.

As we work to make money together, we are always eager to hear your thoughts. We encourage you to e-mail us at options@changewave.com to keep us apprised of your thoughts and questions.

Have a great week and a great year trading.

Nick Atkeson and Andrew Houghton

Editors

Options Trader