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Market Wrap

Bin Laden Trade

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What is the biggest option trade you have ever witnessed? $10 million, $20 maybe even $50 million? That is chump change to what is being called the Bin Laden Trade in financial chat rooms all across the Internet. Try $6 billion in one open trade. Would that give you indigestion? It is giving traders from coast to coast indigestion today and it is not even their trade. More on this later.

Dow Chart - Daily

Nasdaq Chart - Daily

The final reading on Consumer Confidence came in at 105.0 for August, down from 112.6 in July. The present conditions component fell sharply to 130.3 from 138.3 and the expectations component fell to 88.2 from 94.4. Consumers also felt that jobs were increasingly harder to get with a -3 point drop in the "employment plentiful" component to 27.5. Every component showed deterioration and but ironically home buying interest rose. With mortgages becoming increasingly harder to get it appears the drop in home prices is peaking interest.

The new numbers out today from S&P/Case-Shiller showed that home prices fell -3.2% in Q2. Robert Shiller said there were no signs of slowing in the housing decline and if the numbers were seasonally adjusted they would be something in the -10% range. Analysts were surprised with the sharp decline in prices in what was normally the strongest quarter for the year. The -3.2% headline number was the biggest quarterly drop since the index began back in 1987. In order of decline severity Detroit homes lost -11%, Tampa -7.7%, San Diego -7.3%, Washington -7% and Phoenix -6.6%. Markets still doing well were Seattle +7.9%, Charlotte +6.8%, Portland +4.5%, Atlanta +1.6% and Dallas +1.6%. Those were the only metropolitan markets showing gains over the comparison quarter. The danger from rapidly falling home prices will be further caution in the credit markets. Loan appraisals are going to be overly cautious and loan to value calculations are going to widen.

The Richmond Fed Manufacturing Survey rose again to +7 for the third consecutive month in positive territory. The Q4/Q1 decline seems to have passed and manufacturing activity is improving. This would be a minor concern for those wanting the Fed to cut rates in September. Stronger economic conditions would cause them to stay on hold longer. There was a notable increase in shipments, which doubled from the +5 posted last month. Unfortunately the order backlogs fell sharply to only +2 from +10 in July.

Richmond Fed Table

The FOMC minutes from the August 7th meeting were released at 2:PM and the market was not happy. The Fed appeared no closer to a rate cut than at previous meetings and felt the economy was continuing to improve from a weak Q1. Inflation was slowing but remained a prime concern and the FOMC voted unanimously to keep the Fed funds rate at 5.25%. They discussed the potential that growth may have slowed in Q2 but were still pleased with the economy. The points the market keyed on were:

Headline inflation slowed due to falling gasoline prices.

Moderate expansion in coming quarters but increase in downside risks.

Demand for housing was restrained by interest rates and tightening credit conditions.

Mortgage and housing market developments could prove "deeper and more prolonged"

Further deterioration in financial conditions cannot be ruled out and "might" require a change in Fed policy.

Reading between the lines on all the minutes and it was evident the Fed was not ready to consider a rate cut. The Fed did change their view slightly in the press release for the discount rate cut where they said the economic risks had changed significantly and suggested inflation was no longer the prime concern. It appears from the market reaction traders were hoping for more indications they were concerned at the August meeting.

The markets were quick to price in a rate cut after the discount rate was changed two weeks ago. Now that rate cut does not appear as certain as traders thought. That means it must be subtracted from the market to return the market to a neutral position.

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Recession news is breaking out all over and pleas to the Fed to act quickly are coming from many high profile individuals. AutoNation (AN) CEO Mike Jackson said today that the U.S. economy is in danger of slipping into a recession unless the Fed moves aggressively to cut interest rates. Jackson said, I think we are at a tipping point and they have to realize the potential for a recession is increasing. "The Fed needs to cut rates not just once but several times."

Bill Zollars, CEO of YRC Worldwide (YRCW), the combination of Yellow Freight and Roadway several years ago, also gave a shout out to the Fed. He said, "I think the economy is softer than people are saying. The Fed needs to move quickly and make some kind of rate cut so that we can generate some kind of economic growth. The demand we were expecting has not materialized. Our customers are telling us the economic recovery has not shown up at this point." And, "Normally at this time of year we see business building toward a Christmas peak and that is not materializing this year. We don't foresee a normal seasonal peak, at least not yet." For any activity to occur the truck lines have to ship the products. If YRCW is seeing slowing shipments and facing layoffs it is time for the Fed to wake up.

The credit crunch has not eased despite a couple of high profile bond sales today. AT&T sold $2 billion in 30-year bonds and Capital One sold $1.5 billion in 10-year notes. Both went down at reasonably rates although higher than past sales. On the flip side State Street (STT), a bank that operates in 26 countries, confessed that it had as much as $29 billion at risk in subprime transactions. The London Times blew the whistle on them overnight and suggested they could be in trouble. Today the Boston Globe reported that one of their funds was down more than -37% in value in recent weeks. State Street issued a press release saying that the credit quality for their paper was very good in the AAA/AA class and they were monitoring the situation closely. If borrowers default the loans will come back on State Street and they will be liable for the debt. Banks around the world are starting to confess exposure to U.S. subprime mortgages and the list is growing rapidly. The subprime credit problem is also spreading to credit cards and probably why Capital One sold those notes. According to numbers released today credit card defaults are up +30% over 2006 and fully 4.6% of outstanding credit card debt is now considered uncollectible.

Map of Subprime Loans

The crunch continues to cause pain in the banker/broker community. Merrill Lynch downgraded the brokers again today cutting Lehman (LEH) and Bear Stearns (BSC) to neutral. They cut estimates for the rest of 2007 and drastically knocked down 2008 estimates. Merrill cut estimates on BSC by -16%, LEH -22%, JP Morgan (JPM) -5% and Citigroup (C) by -4%. Of all the brokers Merrill said Morgan Stanley (MS) and Goldman Sachs (GS) were the best positioned due to their diversification. The sharp downturn in deals and underwriting as well as debt sales was expected to hurt the entire sector. S&P was also active in the broker community cutting LEH to a sell and BSC to a strong sell. Both of those companies report earnings on Sept-13th. The big fear circulating among analysts is that these big banks will get stuck with non-performing paper held by hedge funds. Through their prime brokerage operations these banks/brokers loan money to hedge funds and take paper in return as collateral. Much of that paper is not currently trading and analysts fear some of these funds may not be around to redeem it. If the banks end up getting stuck with this paper, which many say could run into the hundreds of billions before the cycle is over, they could suffer some major losses. With earnings next week BSC and LEH will have to assign a value to the paper they hold as collateral and it could get ugly.

Have you heard about the Bin Laden Trade? There are currently several billion dollars in option bets that the global indexes will fall 15-35% in the next 24 days. These are not just any option bets or a total of all the puts in the option chain. These are specific bets of a magnitude never seen before. The existence of these bets has prompted chat rooms all over the Internet to label them the "Bin Laden Trade." The challenge is in the quantity and valuation of the trades. Normally somebody buying 10,000 out of the money puts 3-weeks before expiration is either a gambler speculating about a dip or a hedge fund trying to protect long positions. This time of year either of those scenarios are normally valid tactics.

Unfortunately the bets causing consternation on the Internet are much larger and more diverse than just a few thousand out of the money puts. For instance, last week somebody sold short 61,730 SPX 700 calls. Selling calls short has the same result as buying puts but a lot more dangerous. If the market goes down the call value shrinks and you buy them back to cover your shorts at a cheaper price. If the market goes up the value of your calls goes up and you lose money on the trade, sometimes a lot of money. Somebody shorting 61,730 deep in the money calls is taking a monstrous risk but this is not the end of the story.

Those calls are worth $768 per share, $76,800 per contract. Shorting 61,730 contracts produces premium income of $4.74 BILLION dollars. Yes, billion. 61,730 contract times $76,800 per contract equals $4,740,864,000 in premiums. This is not idle chump change and not a frivolous bet. Reportedly this transaction was coded as a spread trade so I went looking for the offsetting entry. Why anyone would want to go that deep in the money for any kind of spread is pure lunacy but stranger things have happened. I found the offset in the SPX 1700 puts where 61,740 contracts were purchased long according to various researchers into the transaction. At today's value of $230 x100 = $23,000 times 61,740 equals $1.42 billion in option premium. Now, if the assumptions are correct the trader has roughly $3.6 billion in premiums sitting in his account and he has a massive short position worth a huge amount of money if the market tanks. How many players are there that can risk $1.5 billion on an option trade?

SPX Calls/Puts

I tried to analyze this for the last two days and it makes me crazy thinking about it. Assuming the reports are wrong and he went long the calls the numbers are even more hysterical. That would have meant he put out $4.74 billion to bet on the market going higher. If he is long calls then is he short the puts? Shorting the puts raises +$1.42 billion to offset the long calls and has the same effect as being long. Market goes up and your short puts become worth less producing profit when you buy them back.

There is one other option. Suppose some major institution needed some cash really bad and they sold short both the calls and the puts and by doing so they raised $6.16 billion and their risk is actually minimal. Market goes down, calls go down and puts go up by an equal amount because they are so deep in the money. Same in the reverse if the market goes up. No real risk. This would be expensive money since it has to be unwound in 24 days and there will be bid ask spreads and commissions on both sides of 122,000 contracts but it did raise a lot of quick cash for about 4 weeks. If a big firm was in trouble and could not go to the debt markets this would be one way to raise short-term cash. The problem then becomes what if they can't pay it back? Do they repeat it in October options and just roll it forward? Eventually the details will come to light and the market would not like it that somebody was this desperate to raise cash. I view this scenario as only slightly less bearish than the directional trade being discussed in the chat rooms.

So comparing these scenarios, which do you think is most likely? Somebody forked over $3.6 billion to go long the market from 700 points in the money or somebody shorted the market and raised $3.6 billion in cash while doing so? Or did some bank/fund in trouble simply borrow $6 billion from the market for 4-weeks? Remember these are September options that expire in 24 days. No other combination of trade possibilities makes sense when the depth in the money on both sides of the trade is considered. Why go that deep just to be long or short. There is no benefit from being more than 100 points in the money on either side because there is no volatility in the premium 100 points away from the market. You would have to be expecting a very large move. It only makes sense if the trader is short the calls and long the puts as several institutional researchers claim.

If this is a directional trade it is a massive bet on a major market disaster but it gets even more complicated. Somebody, nobody knows who, bought 245,000 September puts on the 2,800 strike on the DJ Eurostoxx 50 on August 16th. This is only material because the index was at 4,100 at the time. That is a very long way from being in the money and it would take a nuclear attack to knock that index back -32% in the next couple of weeks. I don't have a dollar value on that position but I doubt it compares in value to the SPX trade.
http://www.financialnews-us.com/?page=ushome&contentid=2448565379

It gets worse. In the last two days somebody else bought 10,250 puts on the Nikkei 225 Index on the 11,500 strike. The Nikkei is currently at 16,300. Again, those puts were a lot cheaper than the SPX play but still a major bet that disaster will hit the index before their expiration on Sept-14th.
http://www.nippo.ose.or.jp/20070827/html/p_10_03.htm

On Monday CNBC reported that investors have purchased more than $500 million in out of the money put options on the S&P betting we will see a further decline of -5% to -11% before September expiration. Using terms like "doomsday scenario" various analysts feel it is more of a speculation bet than hedging existing positions. This is not normal expiration volume.

On Friday another trader sold 10,000 contracts on each of 12 strikes (120,000 contracts) of deep in the money SPY calls with an average price of $6500 each. That is $780 million in premium received and a huge risk if the market continues higher. The strikes were between $60-$95 with the SPY at $147. Again, very deep in the money calls that nobody would ever do in normal circumstances. Open interest on the strikes before the trade averaged only 265 contracts each. Why so deep in the money unless you expected a very large move?

SPY Calls

Mark Hulbert, author of the Hulbert Stock newsletter Sentiment Index (HSNSI), said bearish sentiment is rampant. The HSNSI closed Monday night at 5.5%, which means that on average the majority of stock newsletters Hulbert tracks are recommending investors only retain 5.5% in stocks and 94.5% in cash. Just 10 days ago that number was 11.3% in stocks. The Dow rallied +500 points but the index plunged to near historic lows. Lots of bearishness from the newsletter crowd but those editors are not making billion dollar bets.

There are multiple scenarios making the round as to why anyone with deep pockets would make such a monstrous directional bet. If it is directional and not a cash crunch spread it has to be deep and I mean very deep pockets. The account size and credit worthiness of the trader would have to be unbelievably huge to be able to margin a $5 billion naked option trade where you are going short index calls. The margin would be huge. The trader would have to be credible and have multiple levels of management, including the market maker, approve the trade. Hold that thought. I can just picture that market makers face when he first saw the potential order. Short $4.72 billion in calls? Not on my watch! But it did happen. How much credit does a market maker have to have to cover a trade like that? Sheesh!

Scenario one has the most followers and that is the Bin Laden Trade. People think Al Qaeda will take the seven-year anniversary of 9/11 to hit the US again with another monster attack. 9/11 is on Tuesday again this year as it was in 2001. Rumors have been circulating for months that Al Qaeda was targeting seven US cities for some sort of nuclear attack. (Los Angeles, Las Vegas, New York, Boston, Washington D.C., Houston and Miami. All port cities with the exception of Vegas. Easy to sneak a weapon in by boat.) This is the lunatic fringe but documents captured in the past couple of years have substantiated this plan. Whether Osama can pull it off in my lifetime is doubtful but still a possibility. He did get permission to kill 10 million Americans from his religious leader two years ago. The only way he could do that is with a nuclear weapon(s) or a bacteriological attack. Since 3 known Al Qaeda associates have died from radiation poisoning in the last 3 years, including one in the U.S., I would bet on the nuclear option even if it is only a dirty bomb. You may remember Al Qaeda posted a video on the Internet back in early August showing President Bush standing in a burning White House with the headline "Big surprise coming soon." However, whoever placed that billion-dollar bet would have a tough time collecting if a major terror strike occurred. The SEC and Homeland Defense would have everyone in that trade chain locked up or buried in rubble within days of the event if it appeared to be a prior knowledge trade. Remember, the trader had to be credible to place the trade. Somehow credible with a multibillion dollar account and terror suspect don't seem to fit in the same sentence. However, the 1st Battalion 265 Air Defense Artillery mobilized on Friday under presidential order to deploy to Washington, after a stop at Fort Dix, to provide high tech weapon systems against any potential air threat.

Scenario two has a major financial institution imploding in a very visible way over the next two weeks. If somebody like Bear Stearns or Lehman Brothers were forced to file bankruptcy because of the subprime exposure it would be lights out for the market. That would be a doomsday scenario for the financial sector. Nobody would trust any bank or broker for several quarters to come. The debt wreck from early August would look like a fender bender compared to the global train wreck a major bankruptcy would cause. Since that kind of financial sickness would be hard to contain the odds are good somebody with deep pockets would find out before it was made public. By shorting the indexes with these monster positions they would avoid any specific scrutiny from zealous regulators. "Heck sir, we just thought the market was looking weak and got lucky I guess." It has even been suggested that whichever bank/brokerage is in trouble placed the bet themselves to profit from the beating their stock will take when the truth comes out. Coincidentally BSC and LEH both report earnings on Sept-13th. Is that a clue?

Scenario three has Bernanke and the gang holding fast to the inflation story and not cutting rates on the 18th. Personally I think this would cause another market dip but nothing as potentially dangerous as the first two scenarios. Definitely not enough of a drop to justify $5 billion in risk in one trade.

Scenario four would be a cash strapped bank or fund shorting both sides to raise cash they hope they can pay back in 3-weeks. If they could not pay when those options expire that would be another massive problem for the markets to digest.

Whoever made that trade is looking at something around $1 million in transaction costs not counting any increased premiums from increased volatility surrounding any event. They could easily be looking at $2-$5 million in shrinkage regardless of how the trade turns out. If it was a directional trade and the market goes against them it could easily cost $100 million or so just to exit. Of course what is $100 million when you can afford to wager $5 billion?

I have no clue as to the motive for the trade or even if the facts circulating around the trading desks regarding the trade are true. I can look at an option chain and that open interest still exists on those strikes so somebody is still in the game, somebody with a lot riding on SPX options. Somebody that might just be able to stimulate that crash by a few well-placed program trades to speed things on their way. I look at it this way. This is a perfect chance to follow the money. There is a monster bet on the table and every scenario is bearish to some extent regardless of which one is true. I am going to move my few meager chips to their side of the table on the very good chance they probably know a lot more than we do about future events.

Volume on Monday at 4.0B shares was the lightest since July 3rd. Volume today was 5.2B and it was 13:1 in favor of decliners. Up volume was only 355 million shares across all markets. To say it was ugly would be an understatement. In the internals table below you should note that the up volume column is in millions and the down volume column is in billions with the exception of the Russell. Today was technically a 90% down day and would normally qualify as a washout. However, the volume was so light it would be tough to make a case for a rebound based on the technicals.

Internals Table

As several analysts and traders pointed out this afternoon a cardinal rule was broken today. There is an unofficial rule on Wall Street that nobody moves the market in the last week of August. This is vacation week for the street and everyone is supposed to respect it and not take advantage of the large number of traders away from the market. There will be some large long distance bills this week as institutional traders try to decide what to do with this mess. It was not that there were such a large number of sellers but there were simply no buyers. The volume was steady but increasing after the FOMC minutes and the volatility did not really pick up until after 3:PM. It was as if nobody believed the decline and just expected it to quit until the stop losses started getting hit.

Tomorrow we are going to have a return of an old problem. Margin loans increased last week as traders tried to double up on positions as the rebound broke out on Friday. Now all those long on margin will be getting the dreaded margin call and they will have to clean house tomorrow. With the rapidly deteriorating sentiment heading into the 9/11 anniversary I would be very surprised if they rushed to buy the dip again.

Even though the volume was light the damage was severe. Major losers were the Chinese stocks and miners including RTP -12, FXI -12, BIDU -12, CEO -10, PTR -10, LFC -9, YCZ -8, SHI -8 and SNP -8. A noted fund manager said they were reducing Asian holdings in the wake of the recent revelations of subprime exposure reaching into Asian banks. U.S. stocks were also hit with GS -7, BLK -7, BEN -6, PCP -6, WINN -6, FLR -6, CMI -6, NILE -5, GRMN -5, AZO -5, APPL -5, etc. Overall it was just another case of the winners being sold to capture profits while the lesser performers escaped relatively unscathed.

The economic calendar picks up again late in the week with GDP, NAPM, PMI and Factory Orders. The main economic indicator will be Ben Bernanke's speech at Jackson Hole on Friday. The topic is monetary policy and housing. It will definitely be a must listen for the street. There is sure to be some concern going in that he will try to play down the chances for a cut while traders will want him to play up the chances. This will be a critical event for traders and I think it is scheduled for 10:AM ET.

The Dow retraced -350 points from Monday's high at 13386 to today's low at 13034. There was no appreciable rebound into the close suggesting tomorrow's market could also see weakness. The Dow has initial support at 13000 but a break there almost guarantees a return to 12500 and the August low. A retest of the low would actually be a good thing for the markets and could be bought on strong volume assuming the financials can shake off the current gloom. It would also help if Bernanke threw the markets a bone on Friday.

The Nasdaq halted its dive at 2500 but was unable to produce even the slightest rebound at the close. It was a dead stop with zero bounce. That is decent support but I think it is just a pause point on the way back to 2400 for a retest of the lows. Apple, the heaviest weighted Nasdaq stock lost -5.43.

The S&P-500 sank to initial support at 1430 and like the other indexes failed to show any buying at the close. With the uncertainty over those $6 billion worth of unusual options it may remain weak. The financial sector is not likely to recover before the BCS and LEH earnings next week and the financials are the biggest sector in the S&P. Odds are good the S&P will have trouble moving higher until then.

S&P-500 Chart - Daily

Russell 2000 Chart - Daily

The Russell-2000 was the largest percentage loser for the day at -2.9% as support at 790 failed at the open. This is a clear sign the fund managers are NOT yet moving into the market in hopes of a normal Q4 rally. This sentiment indicator is definitely flashing a warning. In Sunday's newsletter I suggested going long on a breakout over 800 and short on a break of 790 after a weeklong failure to move higher. If you followed my suggestion you should be in good shape today. I am looking for a retest of the 740-750 lows on the Russell that were made on Aug-16th. I would be cautious about buying a dip to that level until the BSC/LEH earnings are released.
 

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