Option Investor
Market Wrap

A Day Away

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[Image 1] A Day Away

In my opinion, much of today's volatility to the downside is attributed to the market pricing in tomorrow's earnings reports from Goldman Sachs (GS) and Best Buy (BBY) as well as the FOMC meeting on Tuesday. We are really a day way from most of this week's exciting news. Too bad I don't get to cover tomorrow's Wrap. Other than a few analyst updates, there wasn't a lot of new news. While on the subject of analysts, Schlumberger (SLB) was upgraded to an outperform by RBC. BB&T Capital upgraded Covenant Transport (CVTI) and Knight Transportation (KNX) to Hold and Buy, respectively. RBC Capital downgraded Noble (NE) and Flotek Industries (FTK). The news on the automakers is that there is no news. The White House commented that a more thorough relief plan was on the way but not immanent.

In today's economic release, November industrial production was about in line with expectations, but slipped 0.6%. The decline reflects the underlying weak economic trend. Manufacturing output fell a sharp 1.4% in November.

Telecom Stocks were down mostly from a downgrade of AT&T by Goldman Sachs. Generally, the sector outperforms due to its relative strength and defensive nature. The Financial Sector was weak from JP Morgan (JPM) and Bank of America (BAC) being downgraded to under perform by analysts at Merrill Lynch. That's funny; the analysts at Mother Merrill downgrading their company's acquirer.

Looking above, you can see that the internals were weak on both the NYSE and NASDAQ Composite. There were 3 to decliners on both exchanges. More specifically, 760 stocks advanced while 2281 declined on the NYSE. The NASDAQ Comp had 727 declining stocks and 2137 advancing. Volume was somewhat subdued on both exchanges. The NYSE had 1.2 Billion shares while the NASDAQ had 1.68 Billion.

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We get to see the CPI for November tomorrow morning. The Market expects a decline of 1.5% from the CPI and a flat reading from the Core CPI. As would be expected, Housing Starts continue to decline. The market expects 725K starts versus October's 791K. But the big news is the FOMC Policy statement due at 2:15 PM. The Fed Funds futures are predicting a 66% chance for a decline to 0.25% from 1.0% and a 34% chance of a 0.50% cut.

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As mentioned earlier, Goldman Sachs and Best Buy report earnings before the market opens tomorrow. Morgan Stanley (MS) reports on Wednesday morning. I looked at the BBY EPS trade but it didn't provide the desired level of risk/reward for the December strike prices. Looking onto the next day, MS December 11 Puts are trading at $0.30/contract and the 16 Calls are at $0.25/contract. The total credit is at $0.55 with an initial margin of $140 per contract. The front month Implied Volatility is at 216% versus April 09’s 152%. I expect MS to move on its earnings, so going wider is better. If you want to sell farther strikes, there is a 25% difference between the January and April Implied Volatility. Selling the JAN 7.5/19 Put/Call Strangle yields a $0.82 initial premium and a $94 initial margin per contract. The assumed profit on a 25% decline in the Implied Volatility is about $40 per contract. Therefore, if you sold 10 contracts, the Delta is -23 with an initial margin of $940. The assumed profit on Wednesday morning with MS opening within 2 points of today's close is about $400 on 10 contracts. Earnings season is coming in another four weeks. I love these trades because it is simple in structure and concept; Sell high/Buy low. Plus, it is a quick trade.

The S&P 500 (SPX) fell 11 points to 868.57. At one point today, the SPX was down 23 points or 2.6%. The SPX had a 26.91 range versus the 21 day Average True Range (ATR) of 43 points. Something to note is the ATR is the actual average volatility of the index. The CBOE Volatility Index or VIX is the Implied Volatility of 30 day at the money options. Mind you, this is a simplistic explanation, but the VIX is at 56.76 while the actual volatility is at 43. A lot of times, these two correlate nicely within only a few points. Basically, option traders expect more volatility to come versus what we have been experiencing.

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The daily chart above shows the 50, 89 and 200 day Simple Moving Averages (SMA). Now that the 50 day SMA (blue) is within reach, it is now providing additional upside resistance. After the 905 resistance, the November 14th and December 8th highs at around 917 provide some decent resistance. As for support, there is some at around 814 and Friday's test of the uptrend line. However, it appears as though the SPX closed just below that uptrend line. At 50.42, the Money Flow Index is declining toward distribution levels while the SPX is consolidating. The ADX is still confirming no trend. A new trend will be established once the ADX begins upward. According to the above brackets, you might short at the 50 day SMA and setting a stop on a close above the upper bracket. Otherwise, go long at a test of the 814 levels and set a stop if the SPX closes below the lower line.

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Unfortunately, the Bollinger Band chart isn't providing a defined pattern either. The 8 day Exponential Moving Average (EMA) has slipped below the 21 day EMA. But the two have been crisscrossing one another for a week. The RSI is declining and would signal further weakness if it breaks below the December 1st low around 40. However, the Slow Stochastics is slowing its decent and looking like it may begin to curl upward. While neither oscillator is in oversold territory, they are both declining which supports a continued sell off. There isn't really any trend other than the long term down trend. But that may soon be averted if the market finds itself in a Santa Claus rally. It is difficult to determine a directional trade with the information provided. That is the beautiful thing about options. We can sell premium at support and resistance levels and get paid on a non-directional trade. The NDX chart resembles the SPX chart in that they both have upside resistance and are still on downtrends.

Gold Futures Glitter. The February contract gained 19.5 points to close the day at $839.50. The chart below is the daily gold futures chart. The 8 day EMA is spreading away from the 21 day EMA which confirms the uptrend. Gold broke above the 833 resistance level. RSI is still advancing with a shallow slope. Sharp increases in an oscillator represent quickly overbought conditions while shallow ascents provide the market to uptrend while becoming overbought for a longer duration.

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If the risks to the economy persist, gold may rise back up to the previous highs seen on the chart. Why is gold moving upward? I believe that it is becoming a safe haven investment for those that do not want to buy into an overbought Treasury bond market. I also believe that the risks of deflation aren't as high as the risks of higher inflation as the cost of money declines to nearly nothing. As of the close, the 10 Year Treasury Yield (TNX) is at 2.533%. The inflation play is not ready yet, but other asset classes such as the Metal, Energy and Agricultural commodities are beginning to show signs of support. We might see a similar situation to earlier this year when equity and fixed income asset investments declined and commodity prices increased as interest left traditional investment classes into real assets (alternative investments). If you agree, then adding exposure to gold via ETFs, futures or the commodity itself may be done on pull backs to the 8 EMA. If you choose to use ETFs, you can use the SPDR Gold Shares (GLD) for a non-leveraged approach, the Deutch Banc-DB Gold Double Long (ETN) Exchange Traded Note (symbol: DGP) or the Proshares Ultra Long Gold (UGL). While I think gold still has some legs, I believe it may be time for some profit taking. Be patient and try to buy around the 8 day EMA.

Crude Oil isn't pretty like gold, but it still has some relative price movement in relation to the weakening dollar. The Crude chart below is of the 2 hour NYMEX Mini Contract. I placed a Heikin-Ashi bar as the style to reflect trend tendencies. After the strong open all the way up to $52.525, the January contract fell down to about $47.50 by the close on news that OPECs reduction in production was no longer speculation but the news. This was a classic case of buy the rumor sell the news! Jim Brown is the oil expert at OptionInvestor.com. But I will try my best to do it justice. Ever since the TARP was revealed, I have been calling for a weaker dollar. Usually, a weaker dollar translates to higher commodity prices. Inflation hits from two places, an oversupply of the currency and the increased demand for commodities at reduced dollar denominated prices. Actually, the US economy can benefit a little from a weaker dollar because it spurs foreign investments and consumption. As long as the US Dollar remains weaker, the chance for Oil to run up to the low 70s remains high. I see the dip down an opportunity to buy the commodity for a trade.

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As with gold, we can look to the futures contract, options on the futures, or ETFs to trade the directional tendencies. For instance, last month we sold the DEC puts on the US Oil Fund (Symbol: USO) with a 35 strike. Unfortunately, oil declined further than I calculated and the position was stopped out. However, I was able to sell the DIG Puts and roll down the USO puts to a lower strike price so that upside on Oil from the low 40s could be enjoyed. Selling Short DIG Puts represents the affects of the commodity on the Oil and Gas Sector rather than oil prices directly. Therefore, if I see the market bouncing at the same time that Oil is moving upward, I sell the DIG Puts to benefit from the upside of both markets. But DIG can decline while the commodity price declines. So choose your weapon accordingly.

Currency Trading with options on ETFs can be done by selling puts and calls on the CurrencyShares. For instance, if you believe the Dollar will regain its strength versus the Japanese Yen you can sell the FXY Calls. As the chart below shows, the Yen has had the Dollar in a stronghold for the last three months. For instance, you can sell the FXY January 115 Calls about $1.45 per contract. Because the underlying asset is the ETF, you would just be short FXY at 115 rather than the dollar itself.

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This week should be filled with increased volatility due to option and futures expiration. Therefore, the increased implied volatility could be pricing in this assumed increased daily price range. Be patient with entries and quick to exit bad positions. It may take three or more tries at a position entry before getting the right parameters set to trade the next trend. Have a nice week!

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