After a very volatile week is the worst over? Over the prior twelve days the Dow lost -975 points, rebounded +380, declined -315 and finished only about 175 points off its two-week lows. Just on Friday alone the Dow gapped open +75, fell to -40, spiked to +105, returned to -55 and rebounded to close at +66. Welcome to option expiration volatility! The week was punctuated by the end of the earnings cycle, the return of inflation, a rate warning by Fed heads and the expiration of the 45-day clock for hedge fund investors. All that happened in an option expiration week. It is a wonder the overall damage was not worse.
Dow Chart - Daily
Nasdaq Composite Chart - Daily
Economics on Friday were headlined by a major drop in Industrial Production for October. The headline number fell -0.5% following a +0.2% rise in September. That was the biggest drop in several years. As you can see by the chart the monthly numbers are very volatile and we could easily see the October number revised higher but the longer-term trend is still down. The headline number was dragged lower by a -1% drop in auto production, -0.6% in mining production and -1.6% in utility output primarily due to lower production of natural gas. Capacity utilization also fell to 81.7% from 82.2%. While the internal numbers can be confusing the key point is a decline in industrial production and by inference a decline in economic activity.
Industrial Production Chart
Friday's Industrial Production number is not the problem despite being the worst drop in several years. The problem is the return of inflation in the Consumer Price Index that we saw on Thursday. I charted both the headline number including food and energy and the core CPI number that excludes those factors. The government and analysts continue to point to the core CPI, as proof inflation is tame. Relatively speaking it is after returning to hold just over 2% and a level that is just over the Fed's comfort zone but tolerable. The Core CPI chart is the one that allows the government to brag that inflation is not a problem. The headline CPI chart is the one currently giving the Fed indigestion and the chart that suggests there will not be any further Fed rate cuts. Headline CPI has returned to nearly the recent highs seen in 2005-2006 and a level that the Fed can't ignore regardless of how bad they want to brag on the core numbers. The rising price of energy is filtering through into everything we consume. For the Fed to tell us there is no inflation is similar to the fable about the king and his clothes. The tailor can convince the king he is wearing a fabulous suit of the finest cloth but the population sees the truth the emperor is wearing no clothes. The Fed is telling us there is no inflation but the population can see by the rise in their expenses inflation is returning if not already rampant. A survey out on Friday said the cost of the traditional Thanksgiving dinner rose +11% this year for the biggest jump in price in 17 years. Milk prices were up +32% over the last 12 months.
Core CPI Chart - Two-years
Headline CPI Chart - Two-years
The Fed may be facing up to the problem as evidenced by comments by Fed Governor Randal Kroszner and St Louis Fed President William Poole on Friday. Kroszner said the rates are already low enough to get the economy through this rough patch. That is Fedspeak for don't bet on a rate cut. Poole told Dow Jones the Fed is unlikely to change its current policy stance (4.5%) unless the economy slows more than expected. Just as the Fed was trapped into a rate cut at the last meeting because they had not changed their bias from easing and there was no Fedspeak to the contrary, the current round of Fed heads taking to the microphones have gone on the offensive in trying to telegraph to the markets there will be no further rate cuts in December. Since they very rarely make any policy changes in December anyway this should not be a market-moving event.
However, the market is keying on the sudden drop in economic signs that are pointing to an accelerating decline in the economy. In the ISM chart below the economy was heading for a recession back in Q1 but somehow pulled out of that dive to rebound in Q2. That bounce is now failing and the odds are very good that the next ISM will be back in contraction territory under 50. There is simply too much evidence that the economy is slowing.
ISM Chart - Two-years
I am rehashing these economics to refresh your memory on how we got to Friday's events. There were several confirming events that suggest the Fed may be between a rock and a hard place in wanting to hold off on future rate cuts. To start the list FedEx (FDX) announced it was cutting earnings estimates for the quarter by 15-20 cents due to lower shipments and higher fuel prices. The CEO said truck shipments remained weak and fuel prices were rising faster than their dynamic fuel surcharges could adjust. Fuel costs for the quarter had risen $85 million or +8% over the prior quarter. He said FedEx was reviewing their capital expenditure plans for reductions to keep pace with the weaker traffic. FDX lost -4.57 for the day to $96 and a level not seen since Dec-2005.
Not to be outdone Yellow Roadway, now YRC Worldwide (YRCW) said the shipping market was continuing to deteriorate with weakness in manufacturing, retail and housing sectors and had still not reached a bottom. CEO Bill Zollars said conditions were worsening month by month. YRCW tracks factors like shipment size and quantity to determine when a bottom has been reached and Zollars said we are not there yet. They quit giving guidance earlier this year when conditions began to get worse. YRCW fell -2.52 to $17.59.
YRC Worldwide Chart - Daily
Kohl's (KSS) reported a 13% drop in income Thursday and cut its earnings forecast for the holidays and for the full year. They said seasonal clothing was showing significant weakness. Kohl's had previously warned on Q3 earnings but this announcement shows the trend is continuing. Retailers in general have been warning in droves. Others warning last week included JC Penny (JCP), Macy's (M) and Ann Taylor (ANN) to name a few. JCP made headlines when they said they were seeing a "dramatic weakening" in consumer spending. Analysts and traders alike were shocked when Wal-Mart did not warn lower when they reported earnings earlier in the week. Higher gas prices and very few home equity loans were putting a real drag on consumers.
Want real proof the economy is slowing? Starbucks reported earnings on Thursday and also reported its first ever drop in store traffic. Sales were up due to higher prices as they tried to recover the higher costs of dairy components but traffic was down. The consumer is being pressured by higher fuel prices to the extent they are forgoing that $3 cup of specialty coffee. SBUX fell intraday to $21.77 and a level not seen since Sep-2004. True believers bought the dip to produce a close at $23.18 but tougher times are still ahead.
Next week is a holiday-shortened week and there are no inflation reports on tap. In a cruel twist the Fed is releasing the most important report for the week at 2:PM on Wednesday afternoon. That is the FOMC minutes for the last Fed meeting in October. On a very light volume day this highly anticipated report is sure to cause volatility. This report will be scrutinized for clues for the December 11th meeting three weeks from now. The Fed funds futures are calling for more than a 25-point rate cut but the Fed speakers are doing their best to squash that idea. Since there was a dissenter to the last cut these minutes will be critical for rate forecasting.
Goldman Sachs rocked the credit markets again on Friday by saying the cost of the subprime induced credit crunch could top $2 trillion in reduced lending and actual losses. That included $400 billion in losses tied directly to mortgages. You may remember last July Bernanke put the risk at $50-$100 billion on those same mortgages. The Goldman analyst said this $2 trillion included a pull back on lending and cancellation of deals that could not be funded. "Even if this occurs gradually, and even if there are some offsets from reduced credit demand and increased lending by other sectors, the drag on economic activity could be substantial" according to the Goldman analyst, Jan Hatzius. The credit crunch was thought to be over a couple months ago after the Fed cut rates and encouraged the use of the discount window. Recently it has returned and last week alone we saw the cancellation of $5.6 billion in expected fundings including $2.55B for United Rentals and $2 billion for Alltel. Countrywide warned again last week that their ability to raise capital was again in jeopardy. The Fed will have to balance this return to a locked up credit market and dramatic slowdown in consumer spending with the rise in inflation we are seeing in the various reports.
Master them with Hotstix QQQ Trader. We'll show you exactly when to buy and sell the QQQQ and turn you into a master trader who knows how to cut your losses, nail short term gains and rack up some incredible profits.
30-Day FREE Trial:
John Bogle, founder of the Vanguard funds was on CNBC on Thursday saying there is currently a 70% chance of a recession. He is not the only major player singing the same tune. On Friday Merrill Lynch Chief Economist, David Rosenberg, laid out his reasons why he thinks the economy is already in a recession or very close to it. When questioned about the strong global economy keeping the U.S. afloat he quickly rattled off the conditions in each of the countries we export to and 60% had already peaked and were heading lower. The countries doing very well including China, India, etc, are countries we import from not export to so their strength is not directly beneficial to us. He pointed out that much of the S&P earnings are derived from global sources from multinational companies like GE, MMM, MCD, KO, CSCO, etc. Much of those earnings are profits from currency conversion back to dollars. Every major company has warned in their guidance that U.S. earnings were weak but their international business was strong. That trend for companies that don't export to India and China is weakening. David pointed out that it is no longer just a housing crunch. It has spread to retail, autos, banking and nearly every other sector except tourism. That sector is booming because world travelers are coming to the U.S. to take advantage of the 50% off sale on our products due to the weaker dollar. It was not a pretty picture and David had the facts to back up his position.
Rosenberg Recession Worries
Wal-Mart (WMT) was the last major company to report earnings for the Q3 cycle. We are now moving into the pre-warning stage of the cycle for Q4. This is too soon for most companies to warn and gives us about three weeks respite from earnings challenges. That has not stopped analysts from cutting estimates. In just the last two weeks Q4 estimates for the S&P-500 have fallen from 11.5% to only 3% growth. That is a monster revision and we are still a long way from hearing that first confession in January. Consumer discretionary earnings have fallen from 22% growth to estimates of 15% but that is likely to fall even further as the quarter progresses. The financial sector is the biggest drag on the S&P with estimates falling from growth of +1% to a loss of -20% just over the last three weeks. The outlook is grim. Bonuses in the financial sector could be cut by 50% or more in some areas. Obviously employees in the fixed income field are expecting some significant cuts especially in the mortgage divisions. Goldman Sachs is the exception since they largely escaped damage from the subprime contagion. Bonuses at Goldman are expected to total nearly $20 billion. The breaks down with the movers and shakers getting the biggest checks but first year associates are still expected to take home an extra $250K. I faxed in my resume for any available position early this morning. (big grin)
There are big changes in the wind over at the NYSE and I don't mean the musical chairs in the CEO position. The specialist arm of Bear Stearns, Bear Wagner, is one of only five specialist firms left at the NYSE and handles 381 NYSE listed companies. Bear said in a memo on Friday that they were losing money in their current specialist role and looking at leaving the NYSE soon. After the news broke Bear Stearns immediately responded that they were working with the NYSE and they were committed to their listed companies. The challenge is the dramatic drop in manual trading on the NYSE. Over 85% of the trades are now handled electronically and that percentage is rising. If you look behind the reporters on CNBC when they are on the floor it is a ghost town behind them. It is a far cry from the same reporter spots back in 2000 where there were so many traders you had to stand against a wall to avoid being run down. The NYSE went to hybrid trading in 2005 and merged with the Archipelago electronic exchange in 2006. This accelerated the move to an electronic model and hastened the death of the floor specialists. It probably hastened the exit of John Thain last week to head up Merrill Lynch. The floor is doomed and everybody knows it. The offer gave Thain a graceful exit. In his short three-year tenure he has presided over some major changes including the Euronext deal and the NSYE IPO.
Cisco announced on Friday it intends to buy back another $10 billion in stock. That brings the total authorized to $62 billion with $46.2 billion already bought. Cisco bought back 1.2 billion shares from 2001 to present but employees exercised options on 1.15 billion to put that many back into circulation. When an employee exercises options that increases the shares in circulation and Cisco has been an avid grantor of options over the years. Cisco's share price has risen from $14 when the current buyback program began to $30 today adding around $80 billion in market cap.
Cisco Chart - Daily
Garmin Chart - Daily
Well played! Garmin (GRMN) dropped its bid to acquire Tele Atlas and announced a new long term mapping agreement with Navteq. The new deal with Navteq extends to 2015 with an option to extend it again to 2019. Nokia stole the mapping plum from right under Garmin's nose several weeks ago when it announced a deal to acquire Navteq, Garmin's primary map provider. TomTom, Garmin's biggest competitor, was already under contract to acquire the other major mapmaker Tele Atlas. Garmin was forced to consider its options. In a major show of strength and determination it made a higher offer for Tele Atlas knowing that for TomTom to increase its offer to match or beat would put undue hardship on TomTom. Meanwhile Navteq was watching its biggest client potentially heading to another vendor. Because Garmin was willing to raise the stakes on Tele Atlas it put a little fear into Navteq and allowed Garmin to sign a favorable long-term contract that protected them from Noika's GPS dreams. Now with a 12-year deal in their pocket Garmin kissed Tele Atlas goodbye and everybody leaves the boardroom happy with the possible exception of Tele Atlas who thought they might score some additional bucks in a bidding war. Garmin spiked +$13 on the news and will probably resume its upward trajectory when the market decides to cooperate.
December crude futures rose to close and expire at $95.10 on Friday. Thus ends a very volatile contract that set new records on both price and volatility. The January contract (CL08F) became front month and gained +1.77 to close at $93.81. OPEC has adamantly refused to even discuss production levels at this weekend's meeting and gasoline demand has fallen through the floor given the high prices. Gasoline demand fell to 9,187,000 bpd for the week ended 11/09 and that is the lowest demand since mid May with the exception of a possible accounting blip showing one week in September at 9,120,000 bpd. Last week's demand was nearly 200,000 bpd below the prior week. At the same time gas prices rose +10 cents to an average of $3.11 per gallon. Gasoline demand is expected to pickup again next week and continue through the holidays but demand destruction due to high prices is readily apparent. Oil prices are likely to cool as we approach year-end with tensions cooling against Iran and the storm season over for 2007.
U.S. Gas Prices - Source EIA
January Crude Oil Chart - Daily
The markets escaped option expiration and the Nov-15th hedge fund withdrawal window only slightly bruised. Support is still intact and the internals were showing signs of dip buyers as we approached the weekend. The Dow volatility as I described in the opening paragraph was extreme as the various events wound their way to Friday's close. The Dow never retested Monday's dip to 13000 and the internals were not that bad considering it was OpEx Friday. I said on Tuesday night I thought the lows for the week were behind us and it appears to have been true. Initial support on the Dow is 13000 followed by a long drop to 12500 if that support actually breaks. Initial resistance is 13350 followed by stronger resistance at 13500. It is definitely a strong recipe for some range bound trading.
The Nasdaq Composite is holding over 2600 and the 200-day average but it is looking progressively weaker. The selling in the big cap techs has not ended although it has slowed. The Nasdaq-100 big cap index is holding above 2000 and actually showed a little more bullishness on Friday gaining +24 points. The NDX gained +14 points for the week compared to only +9 on the composite. If I were going to buy next week I would still focus on the big caps rather than the smaller stocks.
Nasdaq 100 (NDX) Chart - Daily
Russell-2000 Chart - Daily
Confirming this view was another weekly drop in the Russell-2000 to set a new 2-month low in that index at 759 on Friday morning. This is initial support followed by 740 but there is a genuine fear of small caps right now. Fund managers are still avoiding them like last Sunday's veggie tray. All the good stuff has been picked out and the leftovers have turned brown. I would avoid anything to do with small caps, tech or otherwise. This is a dish of negative sentiment that is stinking up the entire refrigerator.
The NYSE Composite is also projecting a negative sentiment of its own. The index contains a broad range of stocks from small to giant and the big caps have been unable to drag the small caps higher. On Tuesday the outlook was promising but the index faded back to 9600 and is in danger of a breakdown. 9600 is decent support and would be a good launching pad for a rebound but I am not seeing it in the internals. There were 28 new highs on the NYSE on Friday and 285 new lows or roughly 10% of the index setting new lows and only 1% new highs. I could not spin that bullish if I tried. The S&P-500 is trying to use 1450 as support with backup at 1425-1430 but I would not count on it holding. There is risk on the S&P to 1385 if conditions don't improve very quickly.
NYSE Composite Chart - Daily
This is normally a bullish week as holiday cheer begins to form and visions of a year-end rally dance in their heads. Unfortunately the long-term view is starting to cloud up. With all the recession bears coming out to play we could easily find ourselves clawing for traction as November ends instead of climbing a wall of worry back to the old highs. The risk to the market is continued tightness in the credit markets and more bad news hitting the wires. With earnings already falling to only 3% growth for Q4 the odds are very good they are going negative and the market will not like it.
Monday and Tuesday have only housing reports and that bad news just keeps
getting worse. Any glimmer of increased buying activity would be very good
medicine for the markets but I would not hold my breath. Wednesday is loaded
with reports but the key one will be the FOMC minutes. Volume will be very light
so expect some whipsaws when they are released at 2:PM. Friday is a throwaway
day but should be positive if the FOMC minutes did not spoil the party or some
news event didn't further
energize the recession bears. This is normally a
bullish week but these are not bullish times. I would buy the dips to Dow 13000,
SPX 1440, NDX 2000 and NYSE 9600 but should we break below those levels I would
be a strong short.
Canadian Pacific - CP - cls: 64.29 change: +0.69 stop: 66.26
Why We Like It:
BUY PUT DEC 65.00 CP-XM open interest=484 current ask $3.00
Picked on November xx at $ xx.xx <-- see TRIGGER
ESSEX Property - ESS - close: 104.17 change: -2.63 stop: 107.31
Why We Like It:
BUY PUT DEC 105 ESS-XA open interest= 0 current ask $5.20
BUY PUT JAN 100 ESS-MT open interest=13 current ask $4.50
Picked on November xx at $ xx.xx <-- see TRIGGER
J.B.Hunt - JBHT - close: 25.78 change: -0.69 stop: 27.05
Why We Like It:
BUY PUT DEC 25.00 JHQ-XE open interest=583 current ask $1.10
BUY PUT JAN 25.00 JHQ-ME open interest=5266 current ask $1.55
Picked on November xx at $ xx.xx <-- see TRIGGER
Regency Centers - REG - cls: 67.56 chg: -1.50 stop: 72.01
Why We Like It:
BUY PUT DEC 70.00 REG-XN open interest= 0 current ask $4.40
BUY PUT JAN 70.00 REG-MN open interest=17 current ask $5.10
Picked on November 18 at $ 67.56
Express Scripts - ESRX - close: 65.38 chg: +0.56 stop: 61.14
Shares of ESRX are still showing relative strength. The stock is inching closer to a bullish breakout over resistance near $66.00. Short-term technical indicators continue to improve. While we are cautious on the market as a whole we would still consider new call positions in ESRX. Readers can choose to buy a dip in the $64.00-64.75 region or wait for a new relative high over $66.00, which might be the safer entry point just to confirm the bullish momentum. The P&F chart is bullish with a $97 target. Our short-term target is the $69.50-70.00 range.
Picked on November 13 at $ 64.67
Gilead Sciences - GILD - cls: 44.64 change: +0.99 stop: 41.74
GILD is another stock that continues to show some relative strength. The stock added 2.2% on Friday after traders bought the early dip near $43.50. We remain wary of the wider markets but readers may want to gamble on GILD managing to buck the trend and continue higher. Our target is the $47.00-48.00 range. There might be some resistance its 10-dma near $45.00.
Picked on November 13 at $ 43.11
Goodrich Corp. - GR - close: 71.93 change: +0.12 stop: 67.90
GR garnered some positive analyst comments from Friedman, Billings and Ramsey on Friday. The analyst firm also raised their price target on GR from $69 to $83. This gave GR an early morning spike higher but shares consolidated sideways most of the day. The larger trend in GR is still bullish and the defense-sector stocks should be somewhat insulated from the broader-market and economic weakness. We would still consider new bullish call positions here or on a dip near the $70.00 level. More conservative traders might want to ratchet up their stop loss toward to 50-dma near $68.65. We have two targets. Our conservative target is the $74.90-75.00 range. Our more aggressive target is the $78.00-80.00 range. The P&F chart is bullish and points to a $99 target. FYI: GR is due to present at the Aerospace and Defense conference on Thursday, November 29th, 2007 at 11:30 a.m. ET.
BUY CALL DEC 70.00 GR-LN open interest=228 current ask $3.80
BUY CALL FEB 70.00 GR-BN open interest=5324 current ask $5.90
Picked on November 05 at $ 71.05
L-3 Comm. - LLL - cls: 111.50 chg: +0.30 stop: 107.99
Some of LLL's short-term technicals have turned negative during the recent two-week sideways consolidation. Overall the trend in LLL remains bullish and traders have been buying dips in the $109-110 region. Friday's late day bounce looks like a potential entry point for new call positions although readers might want to consider a tighter stop loss near $109 around last week's low. The current consolidation looks similar to the bull flag pattern in mid October. If you don't want to buy calls here then wait for a new rally through the short-term trend of lower highs. LLL has already hit our first target in the $114-115 range. Our second, more aggressive target is the $118.00-120.00 range. FYI: The P&F chart's bullish target has risen from $133 to $139 and now to $145.
Picked on October 29 at $108.10
Las Vegas Sands - LVS - cls: 118.76 chg: +4.21 stop: 109.90 *new*
Traders continue to buy the dip in LVS. The stock rose more than 3.6% on Friday albeit on relatively low volume. Technical indicators are mixed and not much help but the stock's relative strength is encouraging. Shares look poised to breakout over resistance near $120 soon. We suspect that LVS may continue to see buying interest as we near its December 20th opening of the Palazzo Hotel and Casino in Vegas. The place is supposed to rival the most glamorous destinations in Vegas. LVS has already hit our initial target near $117. Our secondary, aggressive target is the $121.00-122.50 zone. We are actually considering a third, higher target in the $127-130 zone. Please note that we're adjusting the stop loss to $109.90. Some of our more conservative readers might want to place their stop near $111.75 under last week's low.
Picked on November 08 at $111.60
ExxonMobil - XOM - close: 85.10 chg: +0.61 stop: 82.99
The tug-of-war in XOM continues as the stock traded sideways Friday above support at its rising 200-dma. Shares are in a multi-week bearish trend but XOM is looking a little oversold and investors have a consistent trend of buying dips at the 200-dma. XOM tested its 200-dma last week and the first test did see a bounce. Unfortunately, bulls have encountered stiff resistance and Friday's rise in crude oil was not enough to launch a new breakout rally in XOM. We would still consider bullish positions in the $84-86 zone but readers might want to wait for a breakout over its 10-dma before initiating anything. Currently the 10-dma is near $86.85. Our target is the $92.50-95.00 range. More conservative traders may want to lock in some gains near $90.00.
Picked on November 13 at $ 86.75
PACCAR - PCAR - close: 47.07 change: -0.60 stop: 50.81
PCAR continued to sell-off. The stock broke down under the $47.00 level and hit our suggested trigger to buy puts at $46.99. Volume on the session was really strong at almost three times the norm. Now that the play is open our target is the $42.50-42.00 range. The Point & Figure chart is forecasting at $38 target. If PCAR bounces look for short-term resistance near $48.00 and then again near $50.00 and its 10-dma.
BUY PUT DEC 45.00 PAQ-XI open interest=461 current ask $2.15
BUY PUT JAN 45.00 PAQ-MI open interest=291 current ask $3.30
Picked on November 16 at $ 46.99 *triggered
Northrop Gruman - NOC - cls: 80.45 chg: -1.31 stop: 79.99
NOC continued to see profit taking on Friday. The stock broke down under short-term support near $81.75, near $80.80, at its 50-dma and again at the $80.00 mark. Volume was pretty strong on the sell-off, which is bearish. The intraday low was $79.76 so NOC hit our stop at $79.99 late Friday afternoon.
Picked on November 06 at $ 84.48
Borg Warner - BWA - cls: 99.15 change: -0.83 stop: n/a
Friday failed to see any fireworks in shares of BWA. The stock closed near the $100 level probably due to options expiration. Our strangle has expired. The options we suggested for a strangle were the November $100 calls (BWA-KT) and the November $90 puts (BWA-WR). Our estimated cost was $4.50.
Picked on October 23 at $ 95.67
Express Scripts - ESRX - cls: 65.38 chg: +0.56 stop: n/a
ESRX closed near the $65.00 strike price most likely due to option expiration. It's common practice to see stocks gravitate toward a strike price as option expiration week ends and a listless market just makes it easier. Our strangle on ESRX has expired. The options we suggested for a strangle were the November $65 calls (XTQ-KM) and the November $55 puts (XTQ-WK). Our estimated cost was $1.95.
Picked on October 21 at $ 59.65
Monster Worldwide - MNST - cls: 36.42 chg: -0.38 stop: n/a
In spite of all the post-earnings volatility shares of MNST closed almost unchanged from our entry price. This strangle has expired. The options we suggested for our strangle were the November $40 calls (BSQ-KH) and the November $35 puts (BSQ-WG). Our estimated cost was $1.75.
Picked on October 23 at $ 37.22
This weekend, Michael Cavanaugh agreed to answer those questions many traders want answered. Michael is an Independent Registered Representative with Brokersxpress, Investment Advisor representative and partner in Clinton Street Capital Inc., and former floor trader at the CBOT. As a floor trader, he worked at one of the busiest institutional execution desks in the futures/commodities industries. He holds licenses in NFA series 3 and FINRA series 7, 63 and 65. In addition, he has written daily analysis and has been recognized by quoted and published leaders in the industry.
Michael also happens to be the broker that many Option Investor and CPTI subscribers trust with their accounts. Michael notes that his location in Chicago allows him to visit each exchange numerous times a year. He speaks frequently with market makers, former and present, and understands the CBOE market maker position as well as that he held as a floor trader at the CBOT.
Question: Michael, a webinar participant once asked a former market maker whether market makers sometimes forgot orders. The person asking the question said that his broker had told him that the market maker "had probably stuffed it in his pocket and forgotten about it." In this day of hybridization and electronic orders, is that even possible?
Answer: A couple of different terms that get confused and lost in the mix
are the actual names of positions for the people on the floor.
Question: Some traders express confusion about how options prices are
set. What part does the Market Maker have in setting prices and what part does
Question: How does the market maker or specialist make money?
Question: Some assume that the market maker relishes running stops before reversing the market. Is this true, as some retail traders presume?
Answer: I would put this in the category of "urban myth." In order for this to happen, a market maker would have to be privied to the placements of the stops. The only way this could happen is if someone were to share this information with the market maker, which is a severe rules violation and would more than likely end up with thousands of dollars in fines and suspensions to all involved. This has happened, although the only occurrence I heard of was in the soybean pit in 1988, when a market maker and a floor broker were in cahoots. Several people were handed very large fines and lifetime suspensions from the exchange. The exchanges have safeguards in place to protect the integrity of the exchanges and to prevent this sort of manipulation from occurring. Each exchange has its version of internal affairs and investigators that investigate suspicious activity. The investigations are swift and painful if you are doing something unethical. Upon receiving a membership, floor brokers and market makers are required to take hours of ethics training to ensure they understand the ethics of business in the marketplace, and it is made clear that there is no gray area. It is black and white when it comes to ethics.
Furthermore, most online retail brokerages do not place stops in the marketplace. The stops are held in the brokerage firms queue until the trigger price is elected. Once elected the stop is sent to the exchange. So there is no way to know what and where the stops are until elected. Hypothetically, market makers who have a keen sense of technical analysis could logically guess where stops from retail traders are placed and attempt to "run stops" where they think they would be. They would be stepping out of their traditional role as liquidity provider and into speculator at this point, and the statistics of market makers show that the ones who speculate are not around as long as the ones who are there to do the job of a market maker, in providing liquidity and profiting from the quick edges they receive for making the markets.
Question: Most market makers seem much more concerned about neutralizing risk than the average retail trader. Is a market maker most concerned about delta and gamma (price movement), theta (time decay), vega (volatility risk) or even rho (interest rate changes), which might assume special importance in the time near FOMC decisions?
Answer: A market maker takes into consideration all the Greek aspects of an options price. The primary being vega, the measure of the option's volatility. The volatility of the option is what market makers use most to decide the price points of the trades they take the other side of. Market makers use volatility skew charts to influence their decisions. They buy low and sell high in terms of volatility. An interest rate decision would affect a market maker's inventory, as a change in interest would affect the cost of carry and may influence the decision of a market maker to hold an inventory or liquidate portions that are negatively affected by a rate decision.
Question: Does the primary concern change according to market conditions, or does the market maker try to neutralize as many of these risks as possible in one setup?
Answer: A market maker looks to hedge risk and take in the small increments of "edge" as soon as possible. They tend to not want to speculate in any situation. The decisions a market maker makes are most influenced by the volatility aspect of an options price, and determines how and how often the market maker takes the other side of the trade.
Question: What would the market maker like the retail trader to know?
Answer: I think the market maker would like the retail trader to know
that they are not there to screw anyone. They go to work to perform the task of
providing liquidity to the marketplace that allows us, the retail trader, to
make the speculative trades that we make. They take the short term risk to allow
you to be in the position you desire.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by the Option Investor staff.
Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.
Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report and website should be independently verified.
To ensure you continue to receive email from Option Investor please add "email@example.com"
Option Investor Inc