Sunday, November 22, 2009 8:51:59 AM EDT What might drive the market higher by Gregory Clay Click here to email Gregory Clay

Market Summary
Several market strategists have opined that the stock markets continued advance is being supported in part by the recent flurry of mergers and acquisitions. A lot of folks expected merger activity when the market bottomed because companies were pursuing undervalued assets. But equities have surged 60% above the March lows and some analyst are expecting M&A activity to accelerate. According to a report published by Ernst & Young, one in three businesses globally say they are "likely" or "highly likely" to acquire other companies within the next 12 months. Further, 25% expect to do an acquisition within six months.

One possible source of funds for the projected merger activity was mentioned in a report stating that "companies are bombarding the bond market with debt sales this month, pushing issuance above $40 billion, as they take advantage of low rates to build acquisition war chests, prepare to buy back stock and build up cash to finance growth. The recent surge of issuance comes as companies squeeze in new deals before trading activity winds down at year's end. The monthly total compares with $14.8 billion during the same part of November 2008." And of course there is the liquidity held by all the financial institutions - dollars that the central banks have printed up that they are not lending out to anyone. Eventually financial institutions might to decide to "relent" and move back aggressively into equities.

Position Update
Listed below is the status of our SPY Iron Condor trade as of Friday November 20th. This position has been open for 8 days:
The entire position is $970 in the black
SPY closed at $109.43
Both 30-day historical volatility and implied volatility numbers are stable - both volatility numbers are near 52 week lows, which is bullish
SPY is priced close to its current 14-day EMA (see SPY chart down below)
SPY is trading ABOVE its 20-day Bollinger Band SMA, and 50-day simple moving average (see SPY chart)
SPY is well ABOVE its 200-day simple moving average (see SPY chart)
Relative Strength Indicator (RSI) has turned neutral (See Spy chart)
Moving Average Convergence/Divergence (MACD) is beginning to turn down (See Spy chart)

Bear Call Spread
This spread is $730 in the black (see tables below)
$115 strike price short call delta is .1386 (86% probability this trade will be profitable)

Bull Put Spread
This spread is $240 in the black (see tables below)
$103 strike price short put delta is -.1882 (81% probability this trade will be profitable)

Risk Analysis
The SPY is having difficulty making a convincing break through the $111 level. If this index advances past $111, the 50% Fibonacci retracement level from the March 2009 low to the index all-time high will probably provide technical overhead resistance at $112. If there is a market correction, the most obvious SPY support level should be the 50-day SMA which is at approx. $107 (See Spy chart above) .

The November 13th Risk Analysis section of the Couch Potato suggested "...In the absence of a confirmed change in market direction we should presume the uptrend will continue. Our $115 short call strike price might be at risk if the market continues to trend upwards." At the very least the stock market's upward momentum has become more deliberate. And it appears that it might require an extraordinary market reaction to drive the SPY ETF to threaten our $115 short call prior to the December option expiration date. Since the beginning of October, the SPY has been trading within upper and lower bull channel trend lines. Our $103 short put is near the lower channel and as more analysts predict a market pullback, there is a higher probability that the short put will be encroached on (compared to the short call).

Exit Plan
We will follow the standard exit plan for our Iron Condor:

Anytime the market maker is willing to accept a limit price of less than .11 on one of our short strikes, buy back all the short contracts and sell the long positions on the same spread. However, if it is a few days prior to the expiration date, we may be able to hold out for a .05 bid.

If one of our short strikes is penetrated (closing price above our short call or below the short put) AND the delta rises to .65 we will look to close out this spread (buy the short contracts, sell the long) and roll it out to another short strike price. Unless this is option expiration week, do not panic and rush to close the trade, many times the market will reverse itself and remove the sense of urgency. If one of our short strikes has been violated and there is no price reversal, we cut our losses and live to fight another day.

We initiated the SPY Condor as one order with four legs. Exiting this position prior to expiration we will probably “leg out” of the trade by first unwinding either the bear call spread or the bull put spread; and close out the other side of the spread as a separate order. The timing of closing out each side of the Iron Condor is dependent on following our Exit Rules described above.

Final comment
If our Iron Condor were the type of person who becomes paranoid when things go to well, they probably would be going berserk right now. The current SPY price is virtually equidistant between our short strikes; volatility levels have diminished; and next week is a short trading week because of the thanksgiving holiday and should be relatively quiet considering many professional traders are taking time off. When traders return to work the first week of December our Iron Condor should have increased in value due to time decay (theta) related to the short strikes. Further, though certain technical indicators suggest the market is "overbought" the American Association of Individual Investors (AAII) numbers were flat this week – retail investors were 38.62 bullish and 38.62 bearish. This statistic might suggest that investors are either confused or hedging their positions.

Past Couch Potato commentary mentioned how market neutral trading strategies similar to the Iron Condor typical perform better and are easier to manage during orderly, deliberate market advances (or declines). We also discussed how the November to March market crash and subsequent rally accelerated volatility and put us on our toes related to managing our risks. Since the stock market has settled down over the past few months we should appreciate the opportunity to relax a little because eventually, sooner or later, the situation WILL change. But if and when volatility does erupt, we will continue to do what we have been doing to be successful - managing our risks, planning the next move, and honoring the exit rules.

Gregory Clay

Couch Potato Trader Disclaimer
All results reported in this section are hypothetical. While the numbers represented here may have been achieved or beaten by our readers, we make no representation that any individual investor achieved these exact results. The tracking for the plays listed in this section uses closing prices for the day the newsletter is published and it is not meant to imply that any reader actually received those prices (though many often do) or participated in these recommendations (even though many do). The portfolio represented here is hypothetical and for investment education purposes only. It is only an illustration of what type of gains a knowledgeable trader might receive utilizing these strategies. If you don't get close to these results, guess what. It isn't the fault of the strategies.