Here’s an update of the chart:

The obvious story this picture tells is that AIG is above the 200-day moving average and that the 20- and 50-day have crossed positive. Both of these facts provide more encouragement for technical traders, and for portfolio managers who already like the stock fundamentally. And it doesn’t hurt that on the weekly chart, although the 20- and 50-week moving averages have crossed negative, the stock is above these active trend markers, which surround the $30 level.

A Big Sprawling Bull Call Spread for only $2.40

This morning we spotted an interesting bullish options play in AIG, where an investor bought 5,000 January 50/75 call spreads for about $2.40 each. The net cash outlay for this strategy is 5,000 x $2.40 x 100 shares per option contract = $1.2 million. The investor stands to gain potential profits of $22.60 per spread, or a total of $11.3 million, if AIG shares hit $75 or higher by January 2011 options expiration.

Talk about bullish. This option player is hoping for the stock to double in the next three quarters, but will begin to make profits even before then if the stock continues to climb toward $50. Not only did they give themselves time for this strategy to work, but they paid less for the farther-out options in terms of implied volatility, which tends to hover around 85-90% for near-term expirations but is only at 75% for the January series. For more details on this trade, see Karla Yeh’s report here.

What About the Business Fundamentals?

All this chart and options talk is fine, but if you’re going to risk money on this hobbled insurance giant who still owes big dough to U.S. taxpayers, you had better have some idea of what the company is actually going to do to make money for investors besides watch its stock price run up. When I want to know what potential a financial company has to earn profits and manage its risk, I listen to a few experts and one of my favorites is Christopher Whalen of Institutional Risk Analytics.

In an interview on March 1^st with Southern California Public Radio station KPCC, Whalen talked about the line that AIG walks when it succumbs to public pressure to repay the U.S. government by selling valuable assets:

“It’s a good thing, but these are some of the best assets that AIG has so I’m not sure we’re going to see anything like the proceeds that we need for the government to be paid back in full,” he said.

“Once you sell the Asian business, which, as I say, is one of the most attractive businesses they have, and you lose that cash flow you lose, that revenue what’s left is going to be worthless, by definition,” Whalen said.

And since AIG still hasn’t returned to profitability and may not for some time, what is it investors are buying? The company lost $9 billion in the fourth quarter of 2009 even as the financial system recovers and the housing market stabilizes. Without profitable business units that could generate revenue in the future, are investors merely banking on the nearly blank check of government life support to continue giving the company a long-term guarantee at future success?

Those are important questions and next week I will dig deeper to find out what some bullish financial analysts think about AIG to plot a course for how much higher the stock can go from here. Until then, the bulls appear in charge and all dips to $30 can be used as opportunities to accumulate shares or call options.

“Mind the Risk, Bank the Profits!”

Hightower spotted a near-term top in copper at $3.50 a month ago, but now sees that real industrial demand, not merely government stimulus programs, will likely keep the “PhD of metals” bid above $3.00 this year. He says that copper is referred to as having a PhD in Economics because its price is so sensitive to the underlying business cycle and it is therefore a great forecaster of expansion and contraction trends.

Yesterday, Goldman Sachs weighed in on another heavy metal—actually the source material for many industrial metals—iron ore. Raw ore mines can be full of lots of different important minerals and metals, but finished iron ore, in the form of fines, lumps, and pellets, is all about making steel. And the jump we saw in iron ore prices last December is seen to continue this year as China’s import demands grow.

For even as China is still in the middle stages of its industrial revolution that will lift hundreds of millions of citizens to middle-class status, the country produces so much steel that it remains a net exporter. But its natural deposits of the basic raw material, iron ore, are not accessible enough to justify the mining costs. It’s cheaper for them to continue importing from the biggest iron-ore producers in the world who have vastly greater economies of scale: Australia’s BHP Billiton (NYSE: BHP),  the UK’s Rio Tinto (NYSE: RTP), and Brazil’s Vale (NASDAQ: VALE).

Goldman’s Eye Always on Commodity Trends

In a Bloomberg.com story by Jesse Riseborough, Iron Ore Price to Gain 60% on China, Steel Output, Goldman Says, we are given a glimpse of the high-level pricing agreements that large miners and steel makers form a year in advance to set “benchmarks” for the exchange of iron ore. Steel makers want to lock in their costs for iron ore and will sign forward contracts for millions of tons to avoid the risk of rising prices. Obviously, iron ore producers have their own agenda and word is that this year they are gunning for record benchmark rates to fund new expansion.

Every year around this time, the two groups (and any relevant national governments, like China’s, that superimpose themselves on the process) get together and negotiate forward contract prices to mitigate demand-supply and price risks for the coming 12 months from April 1, the start of the financial year in Japan. Spot prices, which include freight and insurance, tend to be higher than contract prices and they are expected to also rise this year, as high as $113 a ton. The highest contract rate ever set was $90 a ton in 2008.

Goldman Sachs analysts in Australia, who wrote the research report the Bloomberg story is based on, are calling for the annual price of Australian fines, a benchmark for Asia ore pricing, to rise to $96 a metric ton from $60 a year earlier. These same analysts had just raised their forecast for contract prices to a 35% gain from 20% in January. And they are joined in their bullishness for the essential ingredient of steelmaking by Morgan Stanley, Nomura Holdings, and Royal Bank of Scotland who have all raised their forecasts for this year, according to Riseborough.

From Bloomberg.com:

“The seaborne trade in iron ore will increase 10 percent, a record annual gain, to 1.01 billion tons this year on growing Chinese imports, Goldman said in the report.

Gains in contract iron ore prices will boost profits for Brazil’s Vale SA, Rio Tinto Group and BHP Billiton Ltd., the three-biggest iron ore exporters. Goldman raised its 2010 earnings per share estimate for London-based Rio 19 percent on higher commodity prices. It raised BHP’s estimate 3.7 percent.”

To top it off, US-based Goldman analysts on Monday raised their rating on US Steel (X) from Hold to Buy with this rationale: “Raw material prices continue to move up with scrap now in the lead and likely soon to be followed by higher iron ore and coking coal prices, which could provide support for higher steel prices.”

Clearly, the raw material with an “undergrad” in economics is telling us that the base of the global recovery is on solid footing. In my MarketWatch article this month, Emerging Asia Opportunities I highlighted the iron ore producers for exactly these reasons.

What About China Inflation, Monetary Tightening, and the Coming Slowdown?

China has been slowly edging toward tighter monetary policy since December to prevent asset bubbles in its real estate and equity markets. Some economic observers would say that it’s too late; since I wrote the two articles below in February, we have received stronger GDP numbers from China (10.7% for the most recent quarter), significant rebounds in both exports and imports, and today brought higher than expected CPI, PPI, and industrial production statistics.

Chinese Stocks at a Crossroads: The FXI

Freeport-McMoran Options Action Betting on a Fall

So, all this would seem to spell a slowdown in the biggest emerging market’s engine of global growth, right? But that’s not what we’re seeing yet, as both Chinese stocks and materials names like Freeport-McMoRan (NYSE: FCX) continue to advance. China central bank policy is targeting 3% inflation this year and they are getting awfully close, with a high probability of overshooting.

But for a “command” economy like China’s that is also probably targeting double-digit GDP growth, they are not that worried about near-term spikes in inflation. In fact, they probably welcome them as they experiment with fueling domestic demand and tinker with alternatives to an export-driven economy.

China has a long-term view of economic policy and officials know that they the hold the biggest lever of all to control inflation—easing the renminbi currency peg. In the meantime, it’s easy economic math to see that turning their excess dollar reserves into commodities is a good bet. Why stockpile dollars when they can stockpile “stuff” that they can actually use to grow their economy? For now, it’s full steam ahead for growth.

To understand how U.S. industrial manufacturers plan their growth strategies around emerging markets, see the link below. Caterpillar (NYSE: CAT) is an especially interesting play because it (1) uses steel to make its machinery and engines, (2) makes the machines that make mining iron ore and copper possible, and (3) builds the roads, bridges, and other infrastructure that China needs. I recommended buying CAT below $30 a year ago, and again on last summer’s dip to $30, and I now like it on all pullbacks to $50.

Emerging Markets Drive Global Recovery: CAT & ETN

ABT won with a $27 per share cash offer, which far exceeded Biogen’s bids of $14.50, and then $17.50, since last September. Based on analyst interviews by Bloomberg reporters Meg Tirrell and Ellen Gibson, Abbott made a surprising power grab to lock up half of the worldwide rights to daclizumab. And they paid a 67% premium over FACT’s closing price yesterday to get it done, sending the shares up nearly $11.

Why would Biogen let its partner in a potential blockbuster MS drug go to a competitor like this? It’s possible they didn’t see it coming. After Biogen’s “best and final offer” of $17.50 late last year was called “inadequate” by Facet, Biogen management said it was “moving on,” according to the Bloomberg story. But Facet was still entertaining other suitors and this left the door wide open for a big-cap biopharma company like Abbott to sweep in.

From Bloomberg.com:

“’Abbott is a plotter and a planner, and they tend to make smart acquisitions,’ Philip Nalbone, an analyst with Wedbush Securities, said yesterday in a telephone interview. ‘This is right in their power alley — immunology and oncology. The pipeline makes sense.’”

Biotech Bull Train Steams On

I wrote last October about the incredible deal-making going on in biopharma in Biotech Bull Train Fueled by M&A. And today, in an Option Trading Alert for InterMune, I summed it up this way:

“The other important backdrop for InterMune is that they become a more likely acquisition target for partners like Roche and potential ones like Gilead, both of whom have interest in InterMune’s other drug pipeline for hepatitis drugs. The buyout frenzy continues in this space as confirmed by this morning’s news that Abbott Labs (ABT) is way outbidding Biogen Idec (BIIB) to scoop up Facet Biotech (FACT). The scramble to buy companies with promising drugs and research is clearly a case of demand exceeding supply and this long-term investment approach of big pharma with lots of cash will likely not be ending soon.”

Another great way to view biotech investing is through the lens of the best ETF vehicle for the job. See my other article today for more on that:

Biotech ETF Surges Again: The FBT and InterMune (ITMN)

InterMune shares have moved over $24 (165%) in the past few days on optimism that the FDA will approve their experimental drug pirfenidone, the only available treatment for a lethal lung scarring disease known as idiopathic pulmonary fibrosis (IPF). Today, let’s look at what the FBT gained with its roughly 5% equal-weighting in ITMN.

The chart above shows the dramatic gains the FBT made in July due to its holding of Human Genome Sciences (NASDAQ: HGSI), which I wrote about when I first discovered this biotech wonder ETF. Since ITMN’s 165% surge, which started Friday, the FBT is up over 9%. Not a bad return for the lower risk of an ETF holding 20 “aggressive” stocks and at the same time having what I call “mandatory exposure to the future of medicine.”

A Very Good Problem to Have

One of the consequences for the equal-weighted FBT of holding potentially explosive small-cap biotech stocks is that when the big move happens, suddenly a stock accounts for a bigger dollar portion of the fund. And this has happened quite frequently in the past year for the FBT. But it’s certainly a good problem to have.

To deal with this “bio-harvest” effect, the fund follows the rebalancing of the underlying NYSE Arca Biotechnology Index, which occurs on the third Friday in January, April, July, and October. The FBT basically had to take profits on HGSI twice in the past year and will soon get to do it for OSIP and ITMN. Until the next rebalancing in April, both of these names will account for larger portions of the ETF and move it accordingly.

For the most up-to-date holdings list, visit the OptionsHouse Research page. Here’s a snapshot from there showing the effects of the most recent rebalance when they had to knock HGSI down from a 20%+ position. This does not reflect the higher percentage position of ITMN, but OptionsHouse Research is showing a $45.4 million increase in assets (+59%) since the end of February, which clearly reflects the surges in OSIP and ITMN, in addition to new investment money pouring into the fund.

To learn more about the goals and structure of the FBT, check out the First Trust “Fact Sheet.” Here is a summary from the site:

Fund Objective

This exchange-traded fund seeks investment results that correspond generally to the price and yield (before the fund’s fees and expenses) of the NYSE Arca Biotechnology IndexSM.

• The NYSE Arca Biotechnology IndexSM is an equal dollar weighted index designed to measure the performance of a cross section of companies in the biotechnology industry that are primarily involved in the use of biological processes to develop products or provide services.

• Such processes include, but are not limited to, recombinant DNA technology, molecular biology, genetic engineering, monoclonal antibody-based technology, lipid/liposome technology, and genomics.

• The index is rebalanced quarterly based on closing prices on the third Friday in January, April, July & October to ensure that each component stock continues to represent approximately equal weight in the index.

1. Biotechnology

2. Alternative Energy

3. Agriculture

4. Mobile Communications

5. Materials and Commodities

For long-term investors, I wouldn’t take biotech out of the first spot, but I am considering I might have to move alternative energy down a notch—or three. I wrote about the struggles of the “numero uno” sun stock two weeks ago when I asked FSLR: A Buy Here? 

Today, J.P. Morgan (NYSE: JPM) has “weighed in” on the name, tipping the scales with a downgrade from “neutral” to “underweight” and clipping their FSLR price target from $140 to $85. They also took down Energy Conversion (NASDAQ: ENER) from “neutral” to “underweight” and Evergreen Solar (ESLR) from ”overweight” to “neutral.”

In their Alternative Energy research report published this morning, JPM analysts Christopher Blansett and Brian K. Lee say “don’t try to catch a falling knife” in this space because “oversupply” will be the theme for the second half of 2010.

As discussed in my FSLR piece from February, German government subsidies for wide-spread solar development have been a great boon for the companies in the space but that this was beginning to decline. And as the JPM boys point out, more subsidy cuts are “right around the corner.” They expect Germany to withdraw more of that taxpayer juice in January of 2011 and this will only continue to impact margins for solar manufacturers.

Blansett and Lee acknowledge the rash of negativity around FSLR, but they still think that investors overall are too comfortable with 2010 EPS of $6. They see little room for error in the estimates, leaving the stock open to downward revisions in guidance and analyst projections.

How’s the Weather Today for Sun Worshippers?

Here’s how these names are holding up under the dark clouds, with the solar ETF TAN included for an overall sector view:

It looks to me like the space is not taking it that hard, based on percentage losses and volume shares traded. I expected two weeks ago for FSLR to make a visit below the $100-level, and it did briefly puncture the century mark two days after my write up. But I will likely still be a buyer at $90 if I get the chance.

Alternatives to Solar

JPM analysts also highlighted where they believe alternative energy investors should put money instead of solar this year: LED through names like Cree Inc. (NASDAQ: CREE) and Veeco Instruments (NASDAQ: VECO), and Wind through Broadwind Energy (NASDAQ: BWEN), which they just initiated coverage on today with a $6.50 price target. See my recent bullish play on CREE here in our Idea Generating Platform trading ideas.

Today, I want to address what the FDA designations “Fast Track” and “Priority Review” mean for ITMN’s pirfenidone and how they have been affecting recent stock price action. And we’ll also look at what analysts who have been following the company’s drug R&D for a while think about the potential of today’s decision.

The FDA meeting that is probably still going on this morning as you read this, of the Pulmonary-Allergy Drugs Advisory Committee (PADAC), was scheduled to review the New Drug Application (NDA) for pirfenidone. This committee is usually composed of independent physicians and medical researchers who are not employed by the FDA, but who have been involved in advising the FDA on the new drug’s trial data and ultimate efficacy. After ITMN’s NDA was submitted on November 4, 2009, the FDA granted Orphan Drug and Fast Track designation to pirfenidone. On January 4, 2010, FDA granted Priority Review status to the drug.

Why the Hurry?

The primary motivations for the FDA’s actions revolve around their philosophy of making experimental drugs with some promise to treat previously untreatable diseases get the quickest path to market where they could potentially begin saving lives or reduce suffering and/or progression. Below are the short definitions for these designations, taken directly from the FDA’s guide page, which gives details of the approaches and statistics on approval times. Even the agency admits there is much confusion about these terms because they all imply some form of “speed.”

• Fast track is a process designed to facilitate the development, and expedite the review of drugs to treat serious diseases and fill an unmet medical need. The purpose is to get important new drugs to the patient earlier. Fast Track addresses a broad range of serious diseases.

• When studying a new drug, it can take a long time – sometimes many years – to learn whether a drug actually provides real improvement for patients – such as living longer or feeling better. This real improvement is known as a “clinical outcome.” Mindful of the fact that obtaining data on clinical outcomes can take a long time, in 1992 FDA instituted the Accelerated Approval regulation, allowing earlier approval of drugs to treat serious diseases, and that fill an unmet medical need based on a surrogate endpoint.

• A Priority Review designation is given to drugs that offer major advances in treatment, or provide a treatment where no adequate therapy exists. A Priority Review means that the time it takes FDA to review a new drug application is reduced. The goal for completing a Priority Review is six months.

From the above FDA designations, it’s clear that once ITMN’s pirfenidone received Priority Review status in early January, the stock was poised for imminent action. We noticed right away in our daily options scans that the implied volatility “curve” for ITMN options was uniquely structured to anticipate a big event in March, which was then known to be the likely month for an FDA review meeting. The February options traded at a mild 50% implied volatility, while the April options had vaulted to over 150%.

But the FDA walks a tightrope on these approval processes. On the one hand, they want to get new drugs to market that might help terminally ill or greatly suffering patients. On the other, they need to stand for good science and public safety. Pirfenidone had two completed research studies, only one of which gave the positive result of improved breathing.

Thus the caution by investors since the FDA usually likes to see two positive studies. Overall though, data from the two studies seemed to confirm that fewer people died who received the drug versus those who got only a placebo, and that news had investors much more positive last Friday after the FDA posted its pre-review briefing documents. See my article yesterday for a fascinating look at recent placebo research.

Where the ITMN Analysts Stand

In a Bloomberg.com article by Catherine Larkin on March 5, the day the FDA posted PADAC review documents which were seen as less critical of pirfenidone research results, a couple of InterMune analysts were quoted and they will give us a starting point for gauging today or tomorrow’s possible stock reaction.
From Bloomberg.com:

Annual sales of pirfenidone may reach $666.5 million in 2014, according to the average estimate of four analysts surveyed by Bloomberg. A positive FDA panel review would make InterMune an attractive acquisition target for Gilead Sciences (GILD) of Foster City, California, or Roche Holding AG, of Basel, Switzerland, said Brian Abrahams, an analyst of Oppenheimer & Co. in New York.

“InterMune works with Roche on their other product,” an experimental treatment for hepatitis, he said. “Gilead is a company that is building out a respiratory franchise as well as a hepatitis C franchise.”

Abrahams anticipates that InterMune shares will continue to rise if the panel recommends approval of pirfenidone. He raised his 12-month price target on the shares today to $33 from $25. Oppenheimer makes a market in the securities of InterMune.

The Oppenheimer analyst mentioned had just recently raised his price target on ITMN on January 25 from $20 to $25. But he is not alone in his bullishness.

My sources spoke last Friday with an analyst from Wedbush Morgan, who had an Outperform rating on ITMN shares in October 2009 with a $23 price target. Wedbush’s equity valuation with an FDA approval of pirfenidone would probably put the name at $32, and initially they expect the stock to hit a range of $27 to $33 on a positive PADAC decision. Others I am hearing have targets in the $35 to $37 range on approval, while a negative vote would suggest something around $8-12.

Keep in mind that we might not get the whole move higher this week even with a positive PADAC outcome because, as I mentioned yesterday, the final FDA decision is not due until May 4th and there have been instances where they did not follow the recommendations of an Advisory panel. That said, the potential for InterMune becoming an acquisition target by its larger biopharma brothers is still high enough to make the stock worthy of serious consideration by biotech investors.

And for biotech investors who don’t want that kind of volatility, remember the First Trust NYSE Arca Biotechnology ETF (NYSE: FBT) as my favorite, safest, and “mandatory” way to invest in the future of medicine. Tomorrow, I will look at the recent gains in the FBT off of its exposure to small biotech “gems in waiting” like ITMN.

Last week, I decided to write—for the next 20 weeks—about all 20 stocks in my favorite biotech ETF, the FBT. This week was made for ITMN, one of the top-ten holdings, with its scheduled FDA review date of March 9^th and stock-moving news posted Friday in briefing documents on the FDA website. The optimism expressed in ITMN’s rally is built around speculation that the FDA analysis of pirfenidone’s Phase 3 clinical trials may be more favorable than previously expected.

The final word of approval from the FDA for pirfenidone is not due until May 4^th, but the company and investors may be hanging their fortunes on the fact that the findings of Advisory Committee meetings, like tomorrow’s, are often the direction the agency is headed. In other words, while the FDA is not held to judgments by its advisory panels, it usually follows them. Before we look at how options traders might be playing the event, let’s review some of the key facts about InterMune and pirfenidone.

Key Facts on ITMN

• InterMune, Inc. is a biotechnology company focused on developing and commercializing innovative therapies in pulmonology and hepatology. Their only drug approved in the U.S. currently is Actimmune, which treats both CGD and severe, malignant osteopetrosis, two rare congenital disorders
• Pirfenidone is the only drug designed to treat idiopathic pulmonary fibrosis (IPF), an unexplained inflammation and scarring of the lungs, which hinders the ability to process oxygen and causes shortness of breath. A progressive disease, symptoms increase in severity and usually result in death within two to five years of diagnosis.
• 200,000 people are affected by IPF in US and Europe; there are an estimated 30,000 new cases each year
• Pirfenidone is approved and marketed in Japan as Pirespa
• FDA granted Fast Track/Priority Review status for the US New Drug Application (NDA) on January 4, 2010
• On Friday March 5, FDA posted a March 9 Review briefings document, signaling that prior criticisms of ITMN research may be alleviating
• Proposed U.S. name for pirfenidone is Esbriet

Neutral and Bearish Strategies

For investors and traders who believe that we won’t know enough after tomorrow to take ITMN’s stock above $30 or below $15, this short iron condor offers significantly high implied volatility to temper the risk. We recommended this play in our Trading Ideas section on Friday when it was garnering only $2.50 in total premium. With implied volatility climbing yet again today to over 300%, this iron condor could now collect more than $3.00.

And for those who think that a severe disappointment and pullback is likely after tomorrow, in our OTA Portfolio we looked at a bear ratio put strategy where you could buy a March 17.5 put and sell two 12.5 puts for nearly even money. With essentially zero cash outlay, and a max profit potential of $5.00, this play doesn’t begin to lose money unless the stock falls below $7.50. (The chart below was created with a virtual trading account, something I recommend especially for anyone who wants to experiment with new option strategies).

All of these March strikes have seen significant trading today with the March 30/35 call spread trading over 10,000 by noon and now edging closer to 20,000 contracts each as the day winds down. On the put side, the March 12.5 and 15 puts have seen more than 12,000 contracts trade in each, while the 17.50, 10, and 7.50 strikes all have close to 5,000 contracts. All of these volumes are well above normal and indicate many players positioning for any possible news tomorrow.

Short Interest and Insider Buying

Also worth noting about ITMN shares is that since the early January announcement about FDA’s track for approval of pirfenidone, short interest in the stock climbed significantly from around 11% of float to near 16%. This may explain much of the move we saw Friday that vaulted the shares from below $15 to above $25 at one point.

And late January saw significant buying by insiders, with Director Jonathan Leff buying 2.1 million shares at $14.10 and Director James Healy exercising 5,000 options at $4.50 per share.

Placebo Effect

Finally, one of the most important components of any scientific study is the control. And one of the primary tools is the placebo. I heard an interesting story on NPR this morning about the study of placebos and whether their evolving impacts are affecting drug and medical research and their results.

Caterpillar (CAT) Bulldozes the Recession, Excavates the Boom

CAT and the Emerging Markets’ Middle Class

Yesterday, I saw another CEO of a diversified industrial manufacturer talking about the same themes of Emerging Markets development in places like Brazil, India, and China (the “BICs” after kicking out the “R”) driving their business growth. Sandy Cutler of Eaton Corp (NYSE: ETN) was on Cramer’s Mad Money discussing his company’s recent solid quarterly report and why he thinks we are still in “year one” of a four-to-five year cyclical expansion built on the industrial revolutions occurring in those countries and dozens of others in Asia, South America, and Africa.

Eaton’s core businesses are power management and electrical control systems, hydraulic and pneumatic systems for trucks and military equipment, and automotive drivetrain/powertrain systems. On Wednesday, Bank of America upgraded ETN from neutral to buy, raising its 2010 EPS estimate for the company to $4.17 and its price target to $90, with a focus on improving margins and demand. And this after shares have already rallied 75% since last July.

Clearly, BofA analysts believe that Eaton can support a 20+ P/E multiple in this environment of global growth. What this also means is that materials stocks will do well; because if industrial manufacturers like CAT and ETN are doing well and expanding operations around the world, their demand for raw materials like iron ore, steel, copper, and aluminum will only grow.

To get further ideas about these Emerging Markets trends and how they will play out, particularly in agriculture, see my article in this month’s Trading Strategies section of MarketWatch.com:  Emerging Asia Opportunities.

Their total bill for the battle came to $618,616, of which they only had to pay $9,468 out of pocket. But both husband and wife struggled with the idea of the incredible costs, and her piece today is a cathartic look at what price we put on life—and if any of it made the right differences anyway for her, her husband, and their two children.

I wrote the widowed author, Amanda Bennett, to thank her for sharing her family’s story. It affected me in many ways, thinking about my own family’s potential struggle if I were to get sick. It also made me question my own ignorance of medicine, cancer, and the health steps I should follow to prevent illness.

What Do I Know About Medicine? Not Much, But There’s Hope

Amanda’s story hasn’t motivated me to learn more about the healthcare debate and I’ll explain why in a moment. But it has inspired me to recommit to my own health and to learn more about the biotech companies I so love to write about. I’ve decided to write an article a week for the next few months on each of the 20 companies in my favorite biotech ETF, the First Trust NYSE Arca Biotechnology ETF (NYSE: FBT).

I will not only offer a look at the fundamental business prospects for each company, but also collect key facts about their research and development on innovative drugs, therapies, and treatments. Plus, I want to share what far more knowledgeable bio-medical analysts think about a company’s chances for conquering hurdles like the FDA, marketing and delivery of its solutions, and winning the hearts and minds of doctors.

Up to now, I have written about biotech and biopharma stocks frequently, even though I can’t begin to explain the science behind a tiny fraction of what these companies do. As a fan of science in general, and brain science in particular, I just trust in the fact that thousands of devoted researchers and “bio-preneurs” are putting their life’s energy into discovering cures for our worst illnesses, and better treatments for those we just have to live with. I have bet my money on their drive and commitment and intelligence. Now I want to know more and share more about the science and patents and potential of that intelligence.

Where I’m Starting From As An Ignorant Investor

As an investor who knew nothing about medicine, I decided years ago that I wanted to have exposure to the future of medicine and the explosive new technologies that advanced bio-medical research companies were creating. As a market analyst, I try to find solid biotech investment opportunities for investors and traders, and at the minimum I want people to “own the future” through biotech ETFs like the FBT and the iShares NASDAQ Biotechnology Index (NASDAQ: IBB). Here are some of my recent articles on these topics.

Biotech Singles and Homeruns: The FBT vs. OSI Pharmaceuticals (OSIP)

Smart Biotech Investing Means Picking the Right ETF

Biotech Bull Train Fueled by M&A

Finally, I will continue to stay out of the healthcare debate for two reasons. First, the politics and bureaucracy of healthcare reform are mind-numbing. I can’t afford to waste any more of my brain cells trying to understand our byzantine legal system and how it might actually come up with a plan that works for everybody.

Second, trying to pick the investment winners in the aftermath of the debate are too nebulous, if not downright boring. United Healthcare (UNH) vs. WellPoint (WLP) or Aetna (AET) vs. Aflac (AFL) are not as compelling to me as Amgen (AMGN) vs. Amylin (AMLN) or Gilead (GILD) vs. Genzyme (GENZ) or Celgene (CELG) vs. Cephalon (CEPH).

Maybe I have just liked biotech stocks because the companies are exciting to invest in. They hold more mystery, more hope for miracle cures, and more opportunity for lottery-ticket-type windfalls. But now I like them even more because I am committed to doing the hard work of understanding their business and their science. I hope I have piqued your curiosity as well, and that you come back to see what I have discovered.

This issue is whether or not trading firms colluded or conspired to devalue the euro in some collective scheme. But if you look at the copy of the event agenda, which has 23 other themes including sell ideas for other assets, a title like “Short the Euro” isn’t exactly a secret conspiracy. It’s what FX analysts like me have been doing for decades – sharing information, ideas, research, and opinions in an attempt to get headlines, win new client business, sound important, or just “be right.”

I’ve been saying to “short the euro” for months and speculators big and small just like me always talk to each other and exchange ideas. So why are the regulators all over this trade? In addition to the fact that we are still in the early stages of the regulation backlash since Wall Street nearly broke the economy in 2008, there is a new thinking among the international regulatory community that speculators shouldn’t profit from the pain of others.

This DOJ action follows Tuesday’s announcement by the European Commission that they are investigating trades in sovereign credit-default swaps in the wake of the Greek crisis. So, now the U.S. Feds need to puff out their chests and look busy investigating something.

From Bloomberg’s story by Katherine Burton and David Scheer:

Aaron Cowne, an executive at SAC Capital Advisors LP, David Einhorn, head of Greenlight Capital LLC, and Don Morgan, who runs Brigade Capital Management LLC, attended the dinner, as did a representative from Soros Fund Management LLC, the Wall Street Journal said Feb. 25.

FX vs. CDS

While the complexities of credit-default swaps are unique and the academic-financial jury is not yet in on how destructive these unregulated derivatives can be, the beginning of a conversation about the dangers of FX – the biggest, most liquid free market in the world – is a bad omen for smaller free markets everywhere.

George Soros made a fortune off of shorting the British pound in 1992 when he saw that the UK must soon exit the European Exchange Rate Mechanism (ERM) and stop supporting an unrealistic value for the currency near $2.00. He was a big speculator who was right and who profited greatly from the strategy, as the pound dropped 45 cents, more than 22%, in two months. But he didn’t bring down the pound single-handedly.

Soros was, of course, joined by many other much more quiet (and humble) traders. And the academic economists who have evaluated the situation since seem to agree that he probably helped take the pound off of its unsustainable pedestal, if not altogether putting it where it needed to be. In essence, his speculation served a purpose.

The Liquidity of Speculation = Price Discovery and Risk Transfer

I got my “economic training” on the frontlines of capitalism – the trading pits of the Chicago Mercantile Exchange. There I learned the economic purposes of speculative markets like agricultural, interest rate, stock index, and currency futures. And I left the floor to become a currency market maker in FX futures, providing liquidity to the rest of the world at the fairest prices, in the most liquid and safest markets for currency traders, whether hedger or speculator.

The CME blazed a trail in the early 1970s to make currency markets a more stable and predictable place for corporations and banks after the fall of the fixed exchange rate system known as Bretton Woods. To read the fantastic story of how visionaries like Milton Friedman and Leo Melamed built the world’s first futures market for financial assets, see this PDF on the CMEGroup.com website

The economic principles and purposes of futures markets are at their core contained in two functions: Price Discovery and Risk Transfer. Hedgers—those with price risk—come to futures markets to get rid of their risk. If there are not liquid bid/ask quotes from many participants, they don’t feel they can get in and out of their positions at fair prices.

Speculators—those who take on risk—provide the liquidity that hedgers need. And the risks they take on often hurt them as often as anyone else. That is the nature of economic risk. Someone, somewhere must pay the top and sell the bottom. And there is a price for letting go of risk, as well as taking it on.

Thus, for every fortune made in speculation, there is a field littered with the bodies of broken, busted, and blown accounts due to the irresponsible use of leverage. But that is what makes these free markets work—that individuals are free to hedge and speculate on their own fortunes with their own money.

For an excellent summary of why futures market have the best model for price discovery and risk transfer, see some of my articles from a series I wrote in January on “The Secrets of Wall Street.” Here’s a link to the most relevant for today’s theme of the regulatory pendulum swinging too far:

Wall Street vs. LaSalle Street: Where Mark-to-Market Works

But that day proved to be the reversal day as the world edged closer to resolution of the Greek/Eurozone debt crisis and risk appetite in equities and commodities resumed. Here’s what the “price map” looks like now.

So it looks like we have a breakout on our hands and the price action has definitely been fueled by technically-oriented commodity and hedge funds that had buy-stop levels at $1,105 and the much bigger $1,120-$1,130 area. The next key upside level is the swing high of $1,167, achieved on January 11^th.

Now, instead of looking for opportunities to sell $105-strike puts in the GLD, we may shift higher to the $110 strike. A pullback to $1,120 and bounce there would give me confirmation of the breakout and that the lows are in for the year. To help you equate the GLD to spot gold or gold futures, my article from last week, “Gold Buying Opportunity Around the Corner” does a good job of explaining why the GLD trades at a discount to its 1/10^th tracking value of gold.

And for a review of the longer-term forces I see driving the price of gold much higher from here, see the following article I wrote on December 4^th:

Gold Opportunity: 5 Bullish Forces Mean “Buy the Dips”

“Mind the Risk, Bank the Profits!”

Why are small biotech companies so attractive, yet so hard to spot for their winning drugs or technology? That’s the nature of a business built on complex science like molecular biology and complex drug development/approval processes like that of the FDA. I wrote about these theme in two articles from the fourth quarter of 2009:

Biotech Bull Train Fueled by M&A

Smart Biotech Investing Means Picking the Right ETF

In the second piece on biotech ETFs, I introduced my new favorite such instrument, the First Trust NYSE/ARCA Biotechnology Index ETF (NYSE: FBT). There I explained why owning this ETF gave biotech investors decent exposure to small-cap names such as Human Genome Sciences (NASDAQ: HGSI) that vaulted last year on takeover speculation.

Investors who took my advice and planted some money in FBT for what I call “essential” exposure to the future of medicine were also rewarded today, just not as dramatically as owning OSIP shares outright. Since FBT is an equal-weighted fund, its 5% holding of OSIP gave it over a 5.5% boost as of 1:00 pm ET.

From the OptionsHouse Research Tab, below is a table of just half of FBT’s biotech “gems in waiting.” Among the names in the other half (it only holds about 20 stocks with its equal-weighted structure of about 5% per stock) are Sequenom Inc. (SQNM), Life Technologies Corp (LIFE), Celera Corporation (CRA), Alexion Pharmaceuticals (ALXN), and Vertex Pharmaceuticals (VRTX). 

I’m not positive if the FBT still holds HGSI, but I’m guessing it does and just recently rebalanced in the first quarter as the stock grew out of its 5% box into a 7.6% weighting by December 30th. And that would not be the first time the FBT had to rebalance, as HGSI grew to be 21% of the fund in the second quarter of 2009 and had to be chopped down quite a bit. I go over these details in my article “Smart Biotech Investing Means Picking the Right ETF.”

Lately, we’ve been looking at short-term bullish option strategies in InterMune Inc. (NASDAQ: ITMN) as it approaches some FDA milestones for its lung drug.  But if you don’t want that kind of volatility in your biotech portfolio, the FBT offers the best way to get exposure to a good handful of small “future-building” names.

IBB Biotech Bull Train Steams On

And if staying invested in the big biotech names is still a part of your approach, then my second-favorite way to own the future is the iShares Nasdaq Biotech Index ETF (NYSE: IBB), a capitalization-weighted fund that will by design concentrate more assets in Amgen (AMGN), Teva (TEVA),  and Gilead (GILD). As the IBB breaks out above $86 today, I am looking at selling some June 90 calls for at least $2.00 as a way to hedge and/or take profits on long positions here.

I’m not afraid of selling covered calls on these core investments because these biotech ETFs won’t run away from you. They tend to trade back and forth as they grind higher, swinging within $5 trading ranges and giving you plenty of opportunity to take profits and get back in as you wish, even selling cash-secured puts to do so at a discount. And these strategies have worked very well for the past year. See my article Biotech Bull Train Fueled By M&A for examples of the “covered short strangles” I use with the IBB.

“Mind the Risk, Bank the Profits!”

Below is a one-year price chart of TOL with 20, 50, and 200-day moving averages. I’ve also drawn trendlines that highlight the juicy triangle consolidation crunching 30-day historical volatility down in this name to its 52-week lows near 30%.

The other interesting story this chart tells is with the “coiling” moving averages. The 50- and 200-day are wrapped around one another just above $19, and this is completely expected of a stock trading in such a six-month consolidation triangle where the price action has gotten more narrow every month.

And chart traders get excited about things like this because their expectations turn toward eyeing the impending breakout that they feel must soon resolve this much-too-quiet stalemate. Let’s look at the risk/reward profile of the short straddle trade we saw to get an idea of what this trader was thinking. I built the graph below using the OptionsHouse Profit & Loss Calculator and it shows the risk/reward dynamics of this strategy at June expiration.

Based on the choice of strike for this strategy, the trader is looking for TOL to “breakout” only slightly—and to the downside. By selling both the 18 put and the 18 call, they are saying they believe they can make money as TOL trades around $18.

Based on the price chart, which clearly shows the stock trading below both its 50- and 200-day moving averages and threatening the lower trendline of the triangle, this is not a bad play. And by collecting $3.10 for this short straddle, the trader is getting paid to take the risk on a bet the stock stays close to $18 and definitely between $15 and $21.

That’s another interesting place to look at the chart as well since the stock found significant support at the $15 level in July and launched from there to reach its 52-week highs of $23.62 in August on housing recovery optimism. Clearly, this trader has given this strategy a lot of forethought in the aftermath of TOL’s “better than expect losses” reported Wednesday, and today was the day they decided to deploy it.

Practicing and Rehearsing Strategies

Before you try selling any straddles yourself, be sure you understand all their risk/reward dynamics. And I actually recommend looking first at iron condor strategies, which also allow you to sell options around a trading range using strangles—but with much less outright risk.

One of the best ways to get familiar and comfortable with these essential option strategies is through practicing with the Trading Tools at OptionsHouse. You can get free, unlimited access to the P&L Calculator above and more than half a dozen other Trading Tools, including a Probability Calculator and Volatility Charts.

Plus, you get to use the new Research Tab, which has key metrics, ratios, financial estimates, and even a look at technical trend indicators. Go there today and sign up for a free, no-obligation virtual trading account … I swear by these tools for education purposes alone, so I swear you won’t regret using them!

“Mind the Risk, Bank the Profits!”

That correction is still in progress, if not in lock-step with the corresponding move in equities. To say that gold and the S&P 500 Index are highly correlated in the past six months is an enormous understatement, since on any given day you could mistakenly quote one for the other as they both pivot around the 1,100 mark.

The support levels I identified in December for the gold correction took us all the way down to $1,050, where I believed strong buying would surface among hedge funds, hard currency fund managers, and central banks. In late December, we bounced off of the $1,075 area back up above $1,150, but the correction wasn’t over as equities began their “sovereign debt”-inspired slide.

Then February gave us a bounce off of $1.044.50 in the current lead month April futures contract—eerily identical to where the S&P 500 found support! The chart below highlights the descending channel gold has been in since the short-term top. And I think one more trip down near the bottom of that channel and the 200-day moving average (marked blue) at $1,033 will prove to be the bottom this year.

GLD Option Opportunities

We have been taking advantage of the dips and rallies in gold through selling GLD puts either as spreads or as cash-secured puts . But for a really good opportunity, investors may want to wait until gold trades down near the support areas identified on the chart. Be sure to check back here in the next few weeks to see what opportunities we are eying.

The caveat here for using the GLD is that it doesn’t trade at the same level as spot gold, or gold futures, even though it is designed to represent 1/10^th of their price. The discrepancy is due to the expense charges of the ETF (about 0.4% per year) that have made the GLD trade at a steadily increasing discount for the past five years.

For instance, as I write this morning, spot gold and April futures are trading around $1,096 and the GLD is at $107.35. If we multiplied the GLD by ten, we’d get $1,073.50. That’s almost a $23 difference.

Know the ETF Beast You Trade

Clearly, it’s important to know the nature of the product you are dealing with and what you can expect from its performance. ETFs on other commodity products like crude oil (USO), natural gas (UNG), and grains (DBA) have had their performance problems because of the way they use and roll futures contracts. The good news with GLD is that they buy actual physical gold (for the most part) to build the fund.

Another reason to wait on put sales is for a spike in implied volatility of the options. The volatility chart below, courtesy of OptionsHouse Trading Tools, shows how implied volatility (black line) and 30-day historical volatility (green line) have converged at the 20% level.

Though this relatively “cheap” vol may provide opportunities for call buyers, we need a big fear-driven push lower that will provide better GLD price levels and higher implied volatility (i.e., option premiums) before we jump in to more aggressive put-selling strategies. To see GLD option quotes and use all the OptionsHouse Trading Tools, go there now and sign up for a free virtual trading account.

That means it’s time to shift some focus from broad index and sector opportunities to quality names with deep franchises and global footprints. One name I always come back to is IBM (NYSE: IBM), for its leadership in technology and its ability to create key solutions. And one IBM growth area I am especially excited about is the company’s “smart grid” energy IT infrastructure initiative. If you want to learn more, see this short slide presentation on the web.

But the chart below is telling you that IBM share price is struggling along with the broad market. No longer a growth stock, the slow and steady big blue has as much power to lead the market lower as higher, as both IBM and the S&P 500 try to hang on to 5% gains for the past six months. And both have rallied back up to their 50-day moving averages and been rejected.

My bet is that IBM outperforms the broad market for the next few years. This is based on several assumptions:

1) IBM revenues are spread across the enterprise technology and services spectrum and so not dependent on “corporate IT upgrade cycles.” That said, the company was tops in the server market in 2009.

2) IBM is not dependent on a still-contracting U.S. consumer.

3) IBM contracts for “smart grid” energy IT infrastructure will come from national and municipal governments with big budgets for Intelligent Utility Network projects. They also design and deploy traffic management, carbon emission management, and advanced water management systems that are all about extreme efficiency and environmental protection. In these business areas, IBM has a strong European presence with major contracts signed or in the works in Italy, Germany, and Denmark.

4) IBM is projected to earn about $11 per share in 2010 and should continue to support a 12+ P/E multiple.  A $150 price target this year is not unreasonable for this blue chip dividend payer.

To do your own homework on IBM, I have to recommend one of the greatest new features among the OptionsHouse Trading Tools—the Research Tab. It gives you snapshots of key metrics, ratios, and news on every company as well as detailed financials and analyst earnings projections.

Here are a few screen captures of some of this must-have info (they have a much clearer visual resolution on the OptionsHouse site as I had to shrink them a bit for this article):

To see and use these research tools, in addition to all the OptionsHouse Trading Tools, be sure to sign up for a free virtual trading account. I have always recommended this for both experienced  and novice traders because the option tools are excellent for building trading ideas, simulating positions, and for better understanding the risk/reward dynamics of options. Now I can recommend the OH virtual account as a starting point for fundamental research as well. The “priceless practice” of OptionsHouse Trading Tools just got even better.

In November, I was a buyer of the stock and the call options, looking for a rebound to fill the vicious gap down from $150 to $130 on its disappointing third-quarter report. FSLR made it from $120 to $140 by mid-December, but it double-topped there in January and commenced a steep slide down to $107.

The price action of February alone is even more disturbing as it climbed back to $127 on low volume and then got smacked down again to $110 on heavy volume. The one-year chart below tells the story, with the 50-day moving average a clear lid on the last rally and the 200-day all the way up at $144.

Why Do They Hate Solar?

One of the big backdrops for solar stocks in the past few months has been concern that Germany, a country that has traditionally provided large government subsidies for solar investment, may roll back some of the gravy train soon. Even though the official word that came on Monday was less bleak—with cuts of only 15 percent of funding for “solar parks” versus expectations of as much as 25%—the sector as measured by the Claymore/MAC Global Solar Energy Index ETF (NYSE: TAN) is clearly not dancing in the sun on the news.

Below is a chart of TAN, also subdued by its 50- and 200-day moving averages, and barely a threat to its 52-week high of $11.67 achieved last June. FSLR is the top holding of TAN, which also includes Suntech Power Holdings (STP), Chinese company Trina Solar (TSL), and MEMC Electronic Materials (WFR).

The Nuclear Option

Another blow to sun power worshippers came after President Obama’s State of the Union Address when he kept a promise and earmarked $8 billion in loan guarantees for nuclear power as his new favorite source of clean energy. And in First Solar’s home state, Arizona Republicans are delighted to be redefining “renewable” to include nuclear power and thus include it under the umbrella of the Renewable Energy Standard (RES).

The Arizona RES requires utilities to generate 15% of their electricity from renewable sources by 2025. The muscling in of nuclear into the “clean and renewable” space will likely be bad for solar companies as they will attract less capital by default, further pushing out the dreams of environmentalists and alternative energy investors.

What’s Wrong With FSLR?

First Solar manufactures solar modules with an advanced thin film semiconductor process that significantly lowers solar electricity costs. On February 18^th, FSLR reported earnings per share of $1.65, which actually beat the consensus by 16 cents, and still gives the company stock a very attractive 15 P/E trailing multiple. But the earnings conference call that followed possibly held more negatives on balance for investors than they were hoping for. Here are some excerpts from comments by Rob Gillette, CEO of FSLR:

Our forecast from ‘09 to ‘12 is a 35% CAGR, so we expect the German market to decline over time as the FiT (feed-in-tariff) changes will start to make the market itself less financially attractive and the economics there in terms of sunlight and other things making it less sustainable over time.

The transitioned markets we’re focused on are U.S., China, France and Italy, will continue to grow and probably overtake Germany as a market. The economics I think will provide long-term growth for our business, especially, as electricity prices start to grow.

Comparing those two markets, subsidized and transition market economics, the subsidies really are designed to create markets and they have. We can see that in Europe and especially, in Germany, and growing now in Italy and France. The FiT decline over time to fossil fuel competitive levels may result in declining economics, as we said.

So the first half is very strong demand, orders look very strong. The second half, we’ll have to see. We believe Italy will start to accelerate in growth with a lot of development that has taken place. And we believe that some of the challenges that may exist in Germany, we’ve more than offset by a lot of the pipeline that we mentioned during the presentation. So we feel really good about the outlook for growth and demand.

Here Come the Downgrades

Courtesy of Thomson-Reuters news services…

February 19^th: Merriman downgrades to Neutral from Buy and ThinkEquity downgrades to Hold from Buy.

February 23^rd: Wunderlich initiates with a Sell rating and price target of $90, saying they believe 2010 revenue and EPS estimates are at risk of downward revisions, particularly in the second half. These estimates are predicated on a 40% increase in worldwide photovoltaic (PV) demand and relatively stable module prices. They believe PV demand will fall short of forecast and module prices will fall 10%-20%. Firm expects FSLR’s response to a less expansive market will be to cut prices as it attempts to keep its factories running at 100% capacity, thus causing a decline in gross margins. They believe the stock’s premium valuation will continue to erode.

February 23^rd: Wedbush Morgan downgrades to Underperform from Neutral and lowers their target to $90 from $110 due to expected margin contraction, pricing pressure, project development risks, and potential feed-in-tariff changes in 2010.

Here Come the Opportunities

All in all, it sounds bad, but it doesn’t sound like awful news for FSLR. If they can capitalize on the “transition” markets they speak of in China, Italy, and France, they should be able to turn things around later this year. Until then, the stock has some hard rows to hoe and if earnings drop significantly, it may get “re-priced” below $100. The comments above from Wunderlich on over-optimistic growth targets getting revised downward are the real linchpins for this company and its stock this year.

My bet is that this is a name you want to own for the future. So I am thinking long-term when I see the possibility of buying it at $100 or slightly lower. The alternatives to FSLR are buying Trina Solar (NYSE: TSL) below $25 and a 20 P/E multiple, or taking almost no risk in the space and just buying the TAN ETF. Any way you slice it, buying the future of alternative energy should deliver reward commensurate with risk.

But the recent concerns about Chinese asset bubbles in real estate, equities, and commodity prices prompted the central bank to start a gradual tightening process. The chart below of the iShares FTSE/Xinhua China 25 Index ETF (NYSE: FXI) shows the last bubble in Chinese equities in 2007. The FXI top-ten holdings are heavily concentrated in financial stocks and the largest holding is China Mobile (NYSE: CHL), comprising 9.4% of the fund.

What stands out about this chart is the recent pullback to some critical support areas. After selling off with U.S. equities early this year, the FXI never quite recovered. But it did bounce off its 200-week moving average above $37.50. And it is also climbing back to hang on to its 50-week moving average at $39.

While the S&P 500 remains nearly stationary at the 1,100 mark for the past few months, investors in China may be waiting to see how severe the tightening will become. As a bull on the global economic recovery—and on China as one of the primary engines—I would be a buyer of the FXI here and down to $35. Next time, I’ll look at the much broader Hang Seng index which is trying to hang on to the 20,000 level.

The market’s reaction is telling you exactly what you should expect—the Fed exit from quantitative easing will be a slow, steady, and well-telegraphed process that rarely surprises the investment community. I have written about this theme in several articles over the past six months:

Don’t Fight Inflation—Buy It! Asset re-flation has been in full force since early this year, and it’s not over yet.

Inflation and Higher Interest Rates Coming? Still Not Yet The yield curve sees inside the Fed’s mind.

Bernanke’s Bet, Bernanke’s Trim Tab Fed Chairman stays the course, adjusts gradually

And finally, in late November, I called Big Ben the Maestro of Transparency a month before he was nominated as Time magazine’s “Person of the Year” for 2009.

To Fight, or Not to Fight…

Despite this unprecedented financial crisis bringing about “extraordinary” and equally unprecedented emergency liquidity measures from the world’s most important bank, it still helps to look at history to see what might happen. Past is rarely prologue, but the old adage “don’t fight the Fed” needs intelligent interpretation, not blind allegiance.

The period from July 2004 to July 2006 saw 17 quarter-point rate hikes. Below is a 10-year chart of Fed Funds, courtesy of the St. Louis Fed website, and below that, a 10-year chart of the S&P 500. Note the calm trading range and steady march higher in the broad market as the Fed did its work. It wasn’t a time to sell stocks, it was a time to accumulate quality names and position for the recovery in growth—even if that growth was partially fueled by excessive easy credit from the previous two years.

During this period highlighted on the S&P chart, the index moved from below 1,100 after the first rate hike to over 1,300 in that two year stretch. That 200 point 18% move was slow, steady, and easy to stay in for most investors who followed a strategy of buying the dips.

I am looking for this same kind of investment climate for the next two years as we are still in the early innings of this cyclical recovery and the Fed’s real rate hikes—that will also come slow, steady, and predictable—haven’t even begun yet.

To not “fight the Fed” means knowing which side of the economy they are on. Since they are still clearly in the corner of growth, and not worried about inflation, they are a tailwind for this economy. And despite the China slowdown, all signs appear to be “go” for a further steady climb in stocks as emerging markets help propel corporate profits.

The only caveat I would add is that since the market has shifted to such a low volatility environment, my thesis of the past six months about The Bull Train You Can’t Catch is becoming less true by half. It is easy for you to catch it now as the S&P 500 has sat at 1,100 for 3 months. But, you still can’t buy the dips very well as they don’t last long. You have to be fast, as evidenced by our last mini-correction to the 1,040 level.

If and when we do get an event with more impact than the Eurozone debt problems to spike some fear into this market, use the chart here as your roadmap of where buyers will come in. They came in right where I expected on the first panic push down, but didn’t even try the 1,020-1,030 area that I highlight, which is also the site of the 200-day moving average. Thus, it’s still my thesis that the S&P will not go below 1,000 this year. Check out the chart and my logic to see if you agree.

Here’s a look at that strategy that I built using the OptionsHouse Profit/Loss Calculator:

Then yesterday, we saw another investor take up a similar bullish theme in the manufacturer of essential soil nutrients. In this play, the trade was buying the March 125 call 2,000 times and selling 4,000 135 calls for a net debit of about $0.67 per share. With only 30 days to March expiration, this trader is looking for another strong push higher from POT.

“Potash” the substance is the common name for potassium carbonate and other mined or manufactured salts that contain the element potassium in water-soluble form. The company, Potash Corporation of Saskatchewan, is an integrated provider of fertilizer and related industrial and feed products. In addition to owning large mining deposits of naturally occurring potash in Canada, POT produces two other essential fertilizer ingredients: phosphates and nitrogen.

I think POT is a good long-term investment because of the global trend of higher living standards driving increased and more sophisticated food demand. Their fertilizer products will be key components of the agricultural revolution happening in places that will feed the world, like Brazil. I wrote about these themes in two articles from December:

Food is Fundamental: Ag Stocks for the Next Decade

MOO ETF Conservative Way to Buy Agriculture Stocks

POT earnings for 2009 were $3.25 per share, which gives it a trailing P/E multiple of 35 at a price of $115. That sounds expensive, but is probably about average for high-growth cyclical and commodity stocks. Worth noting is that 2009 saw a 20-year low for potash production. This likely means the company will have stronger 2010 with the global recovery apparently on solid ground.

Investment or Trade?

So that leaves the question of whether you just buy the stock and look to hold for several years into this global secular trend, as opposed to the short-term option plays highlighted above. Well, the June 100/115 ratio I did was a play with stock that assumed you were an investor. The second strategy that we saw in the March series is a very short-term trade.

I think there is a place for using options for both trades and investments in your favorite stocks. You just have to decide on your overall investment thesis by answering questions about your timeframe, risk tolerance, objectives and available capital. For a name I really want to own anyway, I might only use short-term front month strategies with short put spreads or cash-secured puts.

For anything involving long calls, the ratio spread with stock may offer a flexible risk/reward mix that lets you invest and trade around a core long position. To practice building these strategies, sign up for a free virtual trading account that allows you to use all the OptionsHouse Trading Tools and execute trades in real-time. Simulating complex positions before you try them with real money allows you to learn the strategy more fully and get comfortable with how they play out. I call this “priceless practice.”

Below is a snapshot of the trade’s risk/reward dynamics that I built using the OptionsHouse Proft&Loss Calculator. (Build your own with a free virtual trading account.)

The cash-secured put is a strategy that many investors like to use for stocks they want to buy at a discount. I say “at a discount” because the strategy usually involves selling an out-of-the-money put. If the stock does move lower through that strike by expiration, you will face assignment of the short put and end up buying the shares at the strike price—but you also have the additional income you received for selling the put.

When we looked at the WFMI February 29 put, the stock was trading around $29.60. Selling the put for $1.10 gave us an effective cost to buy the stock of $27.90 if it went below $29 by expiration and we were assigned. For the risk of this position, our broker required that we have sufficient funds in our account to buy the stock, in this case 100 shares x $29.00 – $1.10 = $2,790. This is why the strategy is called “cash-secured.”

In this trade, we didn’t get to buy the stock because it will likely stay above the $29 level through February expiration. But we did generate income off a name we were fond of. That’s why this strategy is a nice alternative to buying stock and selling covered calls, even though the two strategies have identical risk/reward dynamics.

To practice building strategies like cash-secured puts and dozens of other option trade ideas, be sure to try the free virtual tools at OptionsHouse. You can even implement the trade strategy in a practice account to simulate its dynamics in real time and make sure you are comfortable with it before you deploy real money. It’s the perfect “test drive” for all your investment ideas.

When I called for a sell-off in the euro in early December, the catalysts were the following:

1. Euro reaching $1.50 was a target I had set in mid-2009, but I also believed it would not be able to sustain above that level because the Europeans didn’t want a strong currency any more than the next hobbled economy.

2. Euro was always the weak follower of risk appetite, more along for the ride with Aussie and Canada who led the charge into all higher-yielders, including emerging markets currencies. This carry trade would not last long with Eurozone fragility and sovereign debt issues finally front-page headlines.

3. Breaking down through the 10- and 20-week moving averages was a sure sign of weakness. I called for a bounce off of the 200-day (40-week) moving average and that’s exactly what we got from mid-December to mid-January where you could have sold the euro as it touched the rapidly falling 10-week.

Now, let’s look at the chart and see what damage has been done to determine where we go next…

The cold hard facts are…

1. The break of the 200-week at $1.3875 two weeks ago is terrible as a “supply/demand” picture. The euro now has risk to $1.31, which was a key breakout level last March. Falling through that puts $1.25 in the cards.

2. A relief rally bounce is likely here as the euro consolidates and FX players await further clarity on the Greek bailout. My strategy would be to sell $1.42 calls on the rally, on a high-probability bet it will not get through that level, and likely not above $1.40.

3.  A year ago, the PIGS (Portugal, Ireland, Italy, Greece, and Spain) were an institutional concern, but it never materialized as the Fed liquidity made all carry trades too easy. Now, the Eurozone is being evaluated for its fundamental viability, a concern we haven’t heard mentioned since its debut 10 years ago.

“Mind the Risk, Bank the Profits!”

You’ve no doubt noticed how relatively quiet the broad market has been, with the S&P 500 Index (SPX) sticking either side of 1,100 for 2.5 months—just like I predicted in mid-November for both fundamental and technical reasons. But even I’m surprised it’s been sooo “sticky” at 1,100.

The chart below shows the relative performance of the index vs. the CBOE Market Volatility Index (VIX) for the past six months, with SPX the black line and VIX the blue-green. On a relative % basis, the swings in the VIX look dramatic, while the stock market hovers around a 5% gain for six months. And there is another interesting force at work here that most stock investors aren’t familiar with.

Just as high volatility begets higher volatility in a rapidly declining market, so too it can work in the opposite direction and it has to do with the natural behavior of option market makers when buy-side institutional investors tend to be premium sellers.

Delta-Neutrality Encourages Gamma Scalping

As you probably know, option market makers try to trade delta-neutral as much as they can, preferring to trade volatility instead of having directional risk. This means that when investors sell them puts, they have to buy stock to hedge. When the market goes up, market makers adjust their newly increased delta by selling stock.

Conversely, when investors sell them calls, market makers sell stock to hedge and when the market drops and their delta position subsequently falls, they buy stock to adjust. This process tends to keep stocks in an increasingly narrow range.

Why do option market makers’ positions gain (lose) delta when the market rises (falls) just because they are long options? It has to do with the relationship of delta and gamma. As an underlying market moves higher, all option deltas move higher, with calls becoming more in-the-money (ITM) and puts moving further away toward zero. As an underlying market moves lower, all option deltas move lower, with puts becoming more ITM and calls moving further away toward zero.

And this delta build can happen at a faster rate because of the stochastic nature of gamma. So option market makers get to take advantage of this when they are long options (thus, long gamma)—they get to sell stock they are long at higher levels, and buy stock they are short at lower levels. Option market makers can actually make a significant portion of their profits from “gamma scalping,” as this is called.

To learn more about delta and gamma, see my awesome education articles:

Delta and Gamma: How Options Move With Stock

Gamma: The Gears of Options Leverage

This cycle where “lower vol begets lower vol” can persist for some time, until investors become bigger buyers of options. This may happen soon enough if we get a spike down in the market on fear, which causes a scramble for put protection, and a resulting bounce, which sees a rush for calls.

But even then, there is relatively little fear in the market considering the problems in the Eurozone with sovereign debt risk, and after this equity correction is over (see my Correction in Progress, Proceed with Caution piece), we should continue to see the S&P march higher while the VIX slips back below 20 in 2010 and the calm resumes.

The fate of AIG for many analysts has rested for the past year on if and how soon they could revive from their government-assisted life support. Key issues revolved around dead assets on the books for the company 80% owned by the U.S. and whether selling those assets too soon just to raise cash to repay the loans would severely discount any future earnings power, essentially locking in the losses now at lower valuations.

And the big picture for investors who own the other 20% of AIG was that asset sales to repay government debt would leave common equity holders with little or nothing. Here’s what Standard & Poor’s Equity Research had to say in February 2009:

AIG confirmed it was in talks with the U.S. government to get additional funds. AIG has already received $150 billion of aid late last year. While we believe the dilution from the expected conversion of the N.Y. Fed’s 79.9% interest in AIG may already be priced into the shares, we think additional dilution is likely. We are cutting our target price to $0.50, our lowest available target price, from $1.50.

Reports of My Death…

Despite numerous eulogies for AIG’s anticipated demise, including several downgrades from major houses like Wells Fargo and Credit Suisse back in September when the stock had recently vaulted from $10 up to $55, the stock was given a boost Wednesday by news that its planned Asia IPO would see much more support from money center/investment banks.

From Briefing.com:

In what first looked like a roughly $5 bln IPO, the size of the listing of one of Asia’s largest insurers is growing in price and scale. One of the sources expected A.I.A. plans to raise $10 bln to $15 bln while another source said it could raise at least $20 bln.

This “upside” uncertainty is what’s driving the surge in AIG shares this week, in addition to word that MetLife Inc. (NYSE: MET) might use $8 billion in stock and $7 billion in cash for its planned purchase of AIG’s life insurance unit. The planned price for Alico exceeds the sum of more than 20 earlier asset sales since AIG’s bailout in 2008.

Concern that this deal might not get done was alleviated on both sides, with (1) MET rumored to secure a bridge loan of $5 billion for the deal from JPMorgan Chase, Bank of America, Deutsche Bank, and Credit Suisse, and (2) AIG seen as flexible enough to come to terms.

From Bloomberg.com:

“It shows AIG needs to get a deal done, and they’d be willing to accept MetLife stock even though they’d probably prefer all cash,” said Robert Haines, an analyst at CreditSights Inc. in New York. “What AIG can’t have is a complete blow-up of this deal; that would be viewed extremely negatively by the market and public.”

Other lesser factors that may be contributing are a cessation of sovereign debt worries in the Eurozone—which is really a contagion theme that could affect lots of financial companies—and the company’s announcement about revisions to its compensation structures that should put to rest the furor over retention bonuses.

A View from the Chart

The stock is currently breaking out of its downtrend since October, crossing up through both 20 and 50 day moving averages. The descending 200-day is up at $31 and so there will likely be sellers up there. But as we watch the fundamental story unfold, the $20 level may be turn out to be support where investors are willing to gamble on AIG.

Wells Fargo and Credit Suisse analysts, in their downgrade notes from September, put their price targets for AIG below $20. Any sentiment change there among the hard-core financial company number crunchers could put a bottom in here as “sell” ratings turn “neutral” or better.

But one other element of sentiment we have to consider is short interest. At the end of December, short interest was about 27 million shares, 22.5% of the 120 million float. Last month, those figures had risen to 30.2 million shares and 25.9% of float. Remember that when AIG made that moon-shot last summer from $10 to $55 in less than two months, a lot of the action was short-covering as those who thought the company was doomed got stopped out — and probably shorted again higher, only to be driven out again.

Wednesday’s and today’s moves most likely have some elements of short-covering driving the price action. Be sure to check out the “frenzied” options action we saw this morning in the February 29 calls in our Sidewinder Update. With only 6 trading days left in the February options, someboday paid up for 8,300 of these calls that may never see the light of day — and it was quite possibly someone with a big short position scrambling for protection.

The King of Volatility in 2009 May Resume the Throne in 2010

The bottom line with this stock is that its uncertainty is balanced by its government crutch. This makes it hard to invest in, but possibly ripe for trading opportunities. So while I’m not recommending the stock as an investment, I am watching it closely for short-term volatility trades where I can get paid for the risks.

The slow grind lower in the past five months from $50 to $22 had little of the volatility we saw in late 2008 and early 2009. But those price moves could come back as both fundamental and technical players make their bets about the fate of the hobbled giant.

In the volatility chart below (part of the Trading Tools available from OptionsHouse), you can see the incredible moves in both the stock and its options for the past year. The green line represents 30-day historical volatility (the realized, or actual, volatility of the stock’s moves), while the black line is an average of the at-the-money implied volatility of near-term options. We may not be headed up toward 200% volatility again, but my guess is that we’ve seen the lows in both the stock and its volatility for a while and that good opportunities will abound for savvy stock and options traders.

In my March iron “fly” I have tightened the trading range by buying a strangle closer to my straddle. This means I am taking half as much absolute dollar risk ($22 vs. $44), but still achieving the same maximum potential return on risk of 127% as in the June version. If you compare the two versions side-by-side, you will also notice that for chopping the trading range in half from $200 to $100 wide, I also cut the credit received by half.

In the graph below, I show the risk/reward dynamics of the strategy at expiration. And I’ve described it in both of its common forms: as selling two vertical spreads that share the middle strike and as the short straddle/long strangle combo. This graph was created using the OptionsHouse Profit&Loss Calculator.

As you can see, you can collect about $28 for the entire four-legged strategy, depending on bid/ask spreads. Broken up, the 530 straddle is priced around $34.50 and the 480/580 strangle is about $6.50, thus $28.

The maximum profit for the iron butterfly is achieved if GOOG shares are at $530 come March expiration. Anywhere higher or lower than that and you will give back some of that $28 as you have simultaneous long and short obligations from $530.

The breakeven prices here are $558 on the upside and $502 on the downside. These are simply found by adding or subtracting the initial $28 credit to or from $530. Above $558 or below $502, the strategy will begin to incur losses all the way to the strikes of the long 480/580 strangle, with the maximum loss being $22 ($50-wide spreads minus the initial credit of $28 = $22).

Even if you think you will never employ an iron butterfly strategy because you don’t like the risk/reward characteristics, learning to build the strategy on the OptionsHouse Trading Tools is a great way to build understanding of many essential dynamics of options trading. I encourage all my students to sign up for a free, no obligation virtual account and begin strategizing right away.

Biogen Idec Inc. (NASDAQ: BIIB) announced earnings of $1.20 per share this morning, which beat estimates by 15 cents a share. The company also issued upside guidance for the year, which sent the stock up 86 cents, or 1.6%, to $53.70 during the first 30 minutes of trading. We saw heavy strangle action out of the gate, as an investor sold the March 50-55 strangle and simultaneously bought the March 45-60 strangle. The investor collected a net premium of $1.50 for the package.

This pattern of strikes bought and sold, equally spaced and one-for-one, is a classic option strategy known as an iron condor. The iron condor is a great way to bet on a stock or ETF staying within a certain range. You sell option spreads with your choice of strikes and expirations and profit if your view of that range is correct. Here’s a look — using the OptionsHouse Trading Tools — at the risk/reward dynamics of this BIIB trade and the potential profit/loss at expiration.

I labeled this Proft/Loss diagram as the two different spreads that make up the iron condor — one out-of-the-money (OTM) put spread and one OTM call spread. But you can also speak of this trade as selling an inside strangle and buying an outside strangle to hedge. The investor collects $1.50 for the four-legged strategy and retains the maximum amount of this potential profit if BIIB stays between the short strikes (in this case, the 50 put and 55 call). Outside of these strikes, the profit begins to gradually evaporate.

What I didn’t label were the breakeven points where profits turn into losses. On the downside, just like any short put spread, you subtract the credit received from the short strike. $50 minus $1.50 gives you $48.50, and below this level the losses begin with the maximum potential loss equal to the width of the spread minus the credit received, or $5 – $1.50 = $3.50.

On the upside, you add the credit received to the short call strike, so $55 plus $1.50 gives you $56.50. Above this level the losses accumulate, again, to a maximum of $3.50 since this is also a $5 wide spread. These breakevens of $48.50 and $56.50 create an $8-wide trading range in which the investor can be profitable. And beyond the long strikes at $45 and $60, the losses stabilize as you would expect with any short-spread strategy.

Customizing Your View of Volatility

The great benefit of iron condor strategies is that if you are confident about an expected trading range for a stock, you can get paid for taking the risk. Since the stock at expiration cannot finish through both of your short strikes, you only have risk on one side of the trade. Your stock may even have substantial volatility, bouncing between both of your spreads, and you can still realize profits as long as it finishes between them before you want to exit.

The above trade we saw today in BIIB was a conventional iron condor in the sense that the investor used evenly-spaced strikes and spreads and identical quantities. But you can build iron condors — and plain vanilla all-call or all-put condors — with any strikes and spread widths you choose to completely customize your risk/reward preferences. To check out a very unique — and sizable — condor we spotted in Goldman Sachs two weeks ago, see my article GS Put Condor, With a Twist.

And to practice building these strategies with absolutely no risk, sign up for a free virtual trading account at OptionsHouse. There you will have access to all the trading tools, including the Profit/Loss Calculator I used above, and you will be able to execute the strategy in your virtual account so you can experience the risk/reward dynamics over time, including “Greeks” analysis. As I always say, this kind of practice is priceless when it comes to options trading.

Here’s a look at the current chart and then a few reasons why this correction ain’t over.

In addition to the three “fulcrums” I outlined in last week’s article: China Slowdown, Sovereign Debt, and Perfect Future (stocks priced for best case 2010 earnings), here are two more things to keep in mind:

4) Bearish Sentiment. By this I don’t mean we’ve seen an excess of it. I mean it has only just begun. A little fear in this market is in order with all the uncertainty in the first three themes. In short (pardon the pun), the sellers have the upper hand right here and portfolio managers will “wait and see” how bad it gets before they put too much of their cash to work. A test of last week’s low is a high-probability bet, and a touch of my support levels on the chart in the 1,020-1,030 band is a “50 delta” (50% chance).

5) The Flush. This market will turn and go higher after a fear-driven exit from risk assets peaks and takes out the weak hands. That could be accompanied by a VIX spike above 30, and continued pressure on crude oil, gold, and the euro currency. Maybe that takes us down to S&P 1,000, or even the 50-week moving average at 985. But it will likely happen in one day and the violent bullish reversal won’t give you a chance to think about it, let alone to buy a close down there.

The overall strategy then for this market correction is to have at hand your watch list of favorite stocks you want to buy on sale, and then be ready with low-ball limit orders. Whatever your criteria, oversold momentum/growth/sector leaders  or attractive forward multiples, you won’t get a second chance to buy those names at 20-40% off their highs in the next month.

Bottom line: Be cautious about the broad market now, and be ready to pull the trigger on growth and value leaders on the flush. And, as always, be sure to…

“Mind the Risk, Bank the Profits!”

This “wide-angle” view that Hightower gave us spoke volumes about the “V” recovery because the jobs data have had such a nice inverse correlation to the economy and equities. What also stood out to me was the possibility that this rapid rebound in employment was due to pause and even revert back to a middle ground for the worst recession in generations.

Sure enough, Thursday’s Weekly Claims came in at 480,000 vs. market expectations of only 455,000 while the Continuing number hung in around 4.6 million.

Then, this morning’s NFP and employment report gave us a fuller idea of the surprises Hightower was looking for, with January declining by 20,000 versus expectations of a 15,000 gain, a swing about 35,000 jobs to the downside, and December revised to -150,000 from -85,000, a swing of 65,000 further in the hole. His breakdown of the forces creating the potential for a negative snapback were as follows:

• Jobs Recovery Slows Down. Just as firms over-reacted in 2008 slashing workforces, the expectations for less cuts/more hiring may have gotten ahead of themselves on the rebound. Remember, even the NFP number is a survey number of the corporate landscape, just like the unemployment rate is a survey of 60,000 households. Hence, we aren’t dealing with exact numbers of people hired and fired as most people think.

• Obama’s Megaphone. Hightower notes how well the President gets the message out in advance of a good (or bad) jobs number. He’s on top of the situation, at least from a PR standpoint, and tries to appear at the helm in the deeply partisan political environment he finds himself in.

• V-Recovery Unicorn. The myth and legend of this economic resurgence will be marveled at for some time. Many fortunes were made on the dramatic upswing that equities “ran ahead” and priced in. Now, we have to wonder if all of the best earnings scenarios for 2010 are already baked into this risk asset cake. Hightower spoke of “market jitters” and on Monday, I called for a correction, based sufficiently on the S&P 500 chart if nothing else.

• Commodities as Canary? The other half of the risk/reflation trade, as seen in areas like oil, copper, and the dollar, had also been showing some signs of a near-term top, especially with China on the path to pro-actively prick any possible asset bubbles there. My talk with Hightower the week before gave us a strong thesis for selling copper and stocks like Freeport-McMoRan (FCX). 

Check out the full interview where we discuss these themes.

The Earliest Call for Job Creation

As another example of Hightower’s spot-on analysis of the trends in employment data, last November he was the first to predict the strong possibility of job losses turning the corner into job creation as early as December. He showed us the chart below of Continuing Claims on Nov. 16, and revisited the theme on Nov. 30 ahead of December’s NFP/unemployment report which did indeed stun the market with a loss of 11,000 versus expectations of -125,000 and October revised from -190,000 to -111,000.

The trend that Hightower saw of Weekly Claims slipping below 500,000, and Continuing Claims below 5 million, was realized quickly. And even though December’s NFP fell by 85,000 versus expectations for zero losses, the November number was revised from -11,000 to plus 4,000!

A Double Dip in Our Future?

With today’s disappointing two-steps-back, many are going to start to conjecture about job market weakness and if it predicts something more ominous for the economy. Certainly, the annualized GDP growth rate we got this month, won’t be as dramatic in Q2. But, the real story probably lies in a “muddle through” scenario, where unemployment hovers around 10% and claims are sticky at 450,000 Weekly and sub-5 million Continuing.

Credit for businesses is still the troublesome linchpin of economic expansion and job creation. And worries about sovereign debt aren’t helping right now.

John Mauldin, money manager and author of Bull’s Eye Investing, used this “muddle through” description for the post-tech bubble, post-9/11 economy. That recovery turned out to be more robust than he imagined and we now know fully why as we live out the consequences of the bubble in credit and housing that followed those calamities.

So that I don’t have to wonder about any of this too much, or try to crunch and interpret the data myself, I am going to keep reading and talking to the guy who has it nailed so far. David Hightower doesn’t just look at government statistics or commodity trends and charts. He’s talking to the big producers and consumers of the economy at all levels, globally. For a free trial of the Hightower Report or their other research, visit www.Futures-Research.com and sign up.

And keep tuning into to ONN every week for my video chats with David. I usually know what charts and analysis he’s going to bring on Monday because I get the Hightower Report on Friday. But many Mondays, he surprises me with a look at some commodity or data trend I didn’t see coming. It’s always worth my time to find out what he’s watching and why.

The key support levels I am watching for the S&P are between 1,020 and 1,030.  The 1,015-mark was a key area of congestion and support in August through early October. Then the late-October/early-November pullback found support in the 1,025-1,030 area. Also, the 200-day moving average comes in around 1,020, a level not breached since the July lows. I think equity bulls will come in above here and buy the market when valuations are irresistible again.

As I outlined in a series of articles last year, The Bull Train You Can’t Catch, we are still in the early innings of this cyclical recovery and equity portfolio managers have to buy stocks at this stage to earn their keep. In early November, I summarized what would drive the S&P back above 1,100 to new highs and gave the Bull Case—5 Reasons to Buy.

So, if I’m still longer-term bullish, what else besides the technical picture above gave me a sell signal a week ago?

Three Fulcrums

1) China Slowdown. Concerned about asset bubbles, the Chinese government has been taking steps to cool things down. This has puts the brakes on many facets of the risk/reflation trade and a global recovery built on the back of emerging market leaders, like the Chinese economy.

2) Sovereign Debt. I began recommending short positions in the euro currency back in early December after Greece was first downgraded. The PIGS were finally coming home to “root” and with that much uncertainty, it’s definitely “sell first, ask questions later.” This fear will certainly spill over into other emerging markets in Asia, Latin America, and Africa.

3) Perfect Future. Stocks have rushed in the past nine months to price in the most optimistic recovery, and in a race where trillions of dollars are chasing a few thousand stocks, the money caught its prey. Now, all those money managers in aggregate get to watch Q4 earnings meet and beat most expectations, and they aren’t disappointed overall. But they might be concerned how sustainable growth rates are into an uncertain first half, especially with pressure on interest rates to rise before employment has rebounded.

How Low Can It Go?

We need a correction. The stock market cannot hang out at 1,100 for three months, and we are not going higher in February. That leaves the correction scenario into March. The fall in June-July of last year was the steepest pullback we’ve had and at only 9%, hardly worthy of the title “correction.”

A good washout to the low 1,000’s on the S&P would give this market the internal structure to rally strongly again and make new highs by summer. And from peak-to-trough (roughly 1,150 to 1,000) would be a 13% correction. I don’t think it will be that severe. Money managers will come in before then to buy the market at 1,040 for the first bounce. Anything below that will be bargains, as long as no other cracks in the global recovery surface.

“Mind the Risk, Bank the Profits!”

The stock opened up $1.67 at $73.24, but when it slipped quickly back below $72 within the first 30 minutes of trading, more than 10,000 of the March 70 puts were apparently purchased for around $3.85. At first, it looked like a seller to me since the delta change in the puts seemed in line with such a trade, but my trading sources tell me it was definitely a buyer.

Additionally, by noon ET, about 9,500 of the February 75 calls had accumulated, with many of these reportedly sellers — which is not surprising considering expiration is right around the corner. And by the close, a total of 18,800 of the March 70 puts had traded vs. open interest of only 7,000. I thought these positions were worth mentioning in light of three dynamics affecting this stock:

1) The S&P 500 Index (SPX) is fighting back to reach its magnetic 1,100 level during the past two days, despite what looked like a larger potential correction brewing. Meanwhile, the FCX chart is looking weak and the stock is going to have trouble even recovering the $75 level, a full 20% lower than its 52-week high above $90.

2) While gold marks time around $1,100 an ounce (as we thought it would in the first quarter), copper is seen by many as quite near a short-term top since more inventory-stockpiling has been driving prices than real industrial demand. For more on this, see my interview two weeks ago with David Hightower.

3) China slowing down is a big question mark on every investor’s growth radar. Up to now, we have depended on the secular growth drivers out of China to dig Western economies out of this recession. Since the Chinese seem very concerned about asset bubbles in real estate and stocks, likely caused by government over-stimulus, we have to wonder if industrial stocks are pricing in too much perfection in demand and earnings.

For the bullish case on FCX, here are two notes from Citigroup’s call:

• Citigroup analysts raise their copper forecasts to $3.34/lb in 2010 and $3.47/lb in 2011

• Citigroup analysts note that even with the bounce today, FCX shares are still trailing the S&P by 8% this year, and they think the stock is attractively valued at 9.5 times their 2010 estimate of $7.50 and 8.8 times their 2011 estimate of $8.15.

It’s definitely worth keeping an eye on this “king of copper” that has also served as a key barometer of the commodity reflation trade. And ONN.tv will continue to watch the options action every day to let you know what the “smart money” might be up to.

Who presses on the gas pedal the hardest? At-the-money (ATM) options do. They are the most fickle and the most unstable — in a sense, the most unsure of themselves about whether they are going to be in-the-money (ITM) or out-of-the-money (OTM). Thus, their deltas change quickly to reflect this identity crisis and hair-trigger jumpiness, as they constantly flip back and forth around a 50% chance of being worth something or nothing by expiration. Indicative of this “volatility of identity,” ATM options have the highest gamma.

ITM and OTM options, conversely, are the most quiet and relaxed and have the lowest gammas. They don’t feel like going anywhere fast. Their speed changes little and slowly and this is reflected in their low gammas, whether deep ITM, with deltas near +1.00 or -1.00, or deep OTM with deltas closer to zero.

Below is a hypothetical view of gamma’s rise or fall (y-axis) across a wide range of stock prices, or strikes (x-axis). I’ve also shown how time impacts gamma, actually making options slightly more “schizophrenic” the closer they get to expiration.

Notice how the strikes farther away from the current stock price of $85 have very low gammas relative to the ATM options. Both the deep ITM 60-strike calls and the deep OTM 60-strike puts share very low gamma readings. As well, the deep ITM 110 puts and deep OTM 110 calls have low gammas. Incidentally, options of the same strike and expiration will have nearly identical gamma readings.

Next, see how with less time to expiration (the red bell curve), gamma increases for ATM options and decreases even faster for OTM and ITM options. The speed of delta change for OTM and ITM options has dropped considerably with less time to go because there is even less chance of their deltas changing course from what appears to be their destiny— either nearly a full 100 deltas like the underlying, or worthless and thus zero deltas.

Finally, if you can picture a tent pole holding gamma up around the ATM strike, you can imagine that as the underlying stock price moves that pole, the “tent” of gamma will move with it. This dynamic action would add gamma value to ATM strikes and take it away from newly ITM and OTM strikes, thus continuously changing the speed of their deltas.

Based on our first discussion about gamma, where I included quotes by famous options instructor Sheldon Natenberg, this explains why gamma is so important – it shows us now how fast our position delta will change as the market price of the underlying asset changes.

Identity and Stability, Destiny and Anxiety

If we knew where a stock was really going in the future, we would have certainty about whether to buy the ATM call or the ATM put. That’s why, all else being equal, the fate of an ATM option lies with the flip of a coin, and it’s 50% delta. As stock movement throws these ATM options back and forth, the speed of their fate is much more dramatic than any others. This is reflected in a high gamma reading.

Deep ITM or deep OTM options have small gammas and thus slow-moving deltas. This means their deltas are stable and change very little compared to ATM options. We have relatively more certainty about the destiny of these options. Not perfect certainty, but on a probability basis, we have a better chance of winning a bet that they will remain ITM or OTM.

Since ATM options have the highest gammas, this makes their deltas the most sensitive to fast price changes in the underlying stock. Option pros would call ATM deltas “unstable” because of their high gamma, with underlying price moves up (down) quickly adding (subtracting) more delta points faster.

You could liken this instability to my analogy of a driver who is frequently heavy-footed on the gas pedal, and even prone to give you whiplash if you’re a passenger with their on-again/off-again pedal pumping.

And that instability increases the closer we get to expiration, as options become slightly “jumpier” about their destiny. I shouldn’t call them schizophrenic, though. It might make them even more anxious.

Next time, we’ll look at how volatility affects delta and gamma.

Delta gives pro option traders an instant reference to hedge their positions so that they can trade “delta neutral,” which is simply their attempt to trade implied volatility and avoid the risks of directional movement in the stock. But delta is not static— it also changes as underlying stock moves.

Thus, the way that delta changes is very important to option traders and must be monitored at all times, especially for large, complex positions. The primary tool to measure delta movement, and thus directional risk, is gamma.

Gamma is the sensitivity of an option’s delta to price changes in the underlying stock. While delta tells you how much an option price should change for every $1 move in the underlying stock, gamma tells you how much the delta should change for that same move. In this way, as delta is the rate of change of the option price, gamma is the rate of change of the delta. Let’s look at an example of the mechanics of this, that you will be able to see on any quote chain, before we get into any more theory about what gamma is.

Let’s say we are looking at a quote chain for Amazon.com Inc. (NASDAQ: AMZN) options, with the stock currently trading around its previous day’s closing price of $129.78. Today, if the AMZN February 130 at-the-money (ATM) call has a delta of 0.470, this means that for every one dollar move up (down) in the stock, the call option will gain (lose) 47 cents.

If AMZN stock drops $10, the option could lose as much as $10 x .47, or $4.70. But if the stock falls $10 to around $120, the 130 call won’t have a delta of 0.470 anymore either. Actually, on the way down, the delta was also changing. So, all else being equal, the call option wouldn’t lose as much as $4.70.

On the way down to $120, and as the option price was losing value by virtue of that 0.470 delta, the delta was also changing, albeit by a much smaller magnitude. With the 130 call now about $10 out-of-the-money (OTM), the option may have lost over $4.50 worth of value and the delta was also reduced to, say, 0.170. This change in the delta means the option is now even less equivalent to the underlying stock, and has less probability of becoming more like stock–about a 17% chance from this moment’s vantage point.

So, how did the option price change – but less than a 0.47 delta would have indicated it should — and how did the delta change, and what’s the relationship between the two?

Gamma is expressed in delta points gained or lost per one point change in the underlying. This “big” 0.30 drop in the delta was brought about by its tiny gamma of 0.03, multiplied by the $10 stock move. Gamma is always represented by a positive number and it is a straightforward application to the delta — up moves in the stock are added to both call and put deltas, and down moves subtracted from both.

Learning Greek, One Letter at a Time

If it isn’t obvious yet, you have to understand delta to grasp gamma. You could probably go on to learn about the other two important “greeks,” theta and vega. But you can’t really “get gamma” unless you know delta. So if any of this is the least bit confusing so far, make sure you go and read The Option Delta Code before you proceed.

In the above example, a $10 move meant that the gamma of 0.03 was multiplied by 10 to yield 0.30. Hence, 0.30 was subtracted from the 130 call delta. But, this was actually occuring on the way down in real time. So, for every dollar point drop from $130 to $120, the 130 call delta was losing approximately 0.03 of value and thus the option was losing value in its premium at a slightly slower and gradually decreasing rate as the stock price dropped. Think of a boy going down a slide, with a slowdown in speed as he gets near the bottom and you get the idea.

Conversely, the 130 put would have gained about -0.30 delta points, likely going from around -0.50 (since it was ATM before the $10 drop) to around -0.80, pushing this put deeper in-the-money (ITM). Since put deltas are always negative, the subtraction or addition of gamma makes them move either deeper ITM (toward -1.00) or deeper OTM (toward ZERO).

You may have noticed I said that the put “gained” -0.30 delta points. How can a negative be a gain? Well, if you’re a put, it’s what you want to be when you grow up — more like a real, live underlying short position with a -1.00 delta! So, keep in mind that a mathematical loss of -0.30, taking you from -0.50 to -0.80, is actually a gain in the put’s delta value. The diagram below should help you visualize this.

To summarize, gamma tells you how much delta changes relative to stock. When stock rises $1, delta increases mathematically by the amount of gamma. When stock falls $1, delta decreases mathematically by the amount of gamma.

Remember, since gamma is always a positive number — added or subtracted to delta depending on stock rise or stock fall, respectively — put deltas will increase mathematically toward zero on stock rise and decrease mathematically toward -1.00 on stock fall. But, again, mathematical “losses” for put deltas are actually moving them more in-the-money, closer to -1.00, where their value increases.

In our AMZN example, if stock rose $10 to $140, the ATM 130 put would have probably “lost” about -0.30 delta points as 0.30 was added mathematically to a delta of -0.50, resulting in a new delta of -0.20. The ATM put would have lost delta points because the stock’s rise caused it to lose “moneyness,” decreasing its value.

One of the best options instructors in Chicago is Sheldon Natenberg, author of the option trader’s bible, Option Volatility and Pricing. Most of the other great options teachers work at PEAK6 I think, but I digress. Anyway, Shelly had a great and simple way of explaining many market concepts, and his quote below got me thinking years ago about how to see the logic of delta and gamma, without thinking about the math.

“This corresponds to our intuition that as the underlying price rises, ATM calls move into-the-money and ATM puts move out-of-the-money.”

Thus, my homemade graphic above. I am working to build this into an animated and interactive tool soon. It only took me 30 minutes to turn my idea from 3 years ago into this slide, so don’t hold your breath.

More Options Intuition

Underlying stock has a delta of either +1.00 or -1.00, depending on whether our position is long or short. So, what’s the gamma of underlying stock? Zero. It has no rate of change in its delta. Likewise, deep ITM options and deep OTM options have small gammas because their “moneyness” (i.e., their delta) shouldn’t fluctuate very much on moves in the stock.

Deep ITM options are more like stock, with a delta very close to +1.00 or -1.00 that doesn’t change very fast. And deep OTM options are closer to worthless, with a delta very close to zero that also doesn’t change very fast. In this way, you can think of gamma as the speed of the delta.

Deep ITM or deep OTM options have small gammas and thus slow-moving deltas. This means their deltas are stable and change very little compared to ATM options, whose gammas are the highest, thus giving them fast-changing deltas.

Natenberg, again, says it best…

“The gamma is a measure of how fast an option changes its directional characteristics, acting more or less like an actual underlying position. Since directional risk is always important, the gamma is [a very] important risk measurement. Indeed, an option position can change its directional risk dramatically, even if a trader takes no action in the marketplace.”

Since gamma is always a positive number for both calls and puts, buying options gives you a positive gamma position. You are long gamma and can benefit from big and quick price movement in your delta direction, whether you are net long delta, or net short delta. When you sell options, you are short gamma and can suffer because of big, quick moves against your delta position.

This may not mean much for single option positions, but for large complex positions, the gamma number becomes a vital single reference for risk evaluation, much like a barometer can instantly tell you something meaningful and useful about complex weather conditions. Gamma describes a trader’s exposure to leverage so that they will know how quickly their position could morph into a nightmare. You could think of gamma as the “gears” of leverage because they can ratchet up your delta exposure quickly on a big move.

For instance, think of a trader being short many deep OTM puts. The options have a low delta and thus a low probability of getting near the money. But the trader, in aggregate, has a short gamma position that can grow in size if those options move closer to the money, since gamma increases for ATM options. If the market makes a swift move lower, this position will “gear” up and cause large potential losses for this trader. This is what happened to hedge funds of Victor Neiderhoffer, on two occassions I believe.

Natenberg on the “bottom line” of gamma:

“A large gamma number, whether positive or negative, indicates a high degree of risk. A low gamma number indicates a low degree of risk. Every option trader learns to look carefully not only at current directional risk (the delta), but also at how that directional risk will change if the underlying market begins to move (the gamma).”

Natenberg says that a large gamma number can hurt you and that fits with my trader example above where a guy who thought he had the market outsmarted sold “too many” puts. But how can it hurt to have a large positive gamma? Well, this just means you are long a lot of options and a move away from the money for those options means you have increased your chances of losing a good chunk of that money. It’s something pro option traders take very seriously and they don’t want to be long too much premium any more than they want to be short too much. 

Curvature and Acceleration

Gamma is one of the option trader’s most important risk management tools. The only second-order derivative of the option pricing model, it tells traders how sensitive their positions are to directional movement. Since most option pros tend to carry what we call “delta neutral” positions, it seems at first glance that they should not be worried about the market moving in either direction.

But since delta changes ever so slightly with moves in stock, option traders are forced to continuously adjust the hedges on their positions when those changes add up because of position size or big percentage stock moves. They do this by either buying or selling the underlying stock to get the delta position back to neutral. This is often called “gamma scalping” because in a relatively stable market, with no surprises like a big change in volatility, it is a profitable adjunct to the option trader’s primary goal of volatility arbitrage.

There’s a lot to learn about gamma that I cannot begin to explain here. We haven’t even touched on how time and volatility figure into determining both delta and gamma, or how gamma changes. But I will close with some simple descriptions that have helped me picture their power and usefulness as concepts and tools.

Delta is often called the “slope” of an option. And gamma is sometimes described as the “curvature” of the option because as the underlying price changes, the option delta changes too in a non-linear way–sort of the way I used the “gearing” analogy. You engineers and other quantitative types should readily understand this stuff.

For us non-quant types, I like the way Natenberg once explained it to us in class at the CME in the mid-90s. He said you can think of delta as the “speed” of the option and gamma as its “acceleration.” That I can relate to.

To hear me discuss all this and break it down with an option pro, join me Wednesday February 3rd for a complimentary ONN webinar “Introduction to Gamma.” You don’t want to miss this, so go to the webinar sign-up page now before the registration fills up. I’ll be sitting down with ONN.tv’s Chief Investment Strategist Jud Pyle to go over the theory and the practical ins and outs of this essential barometer of options risk.

The call ratio “1 x 2” spread, where you sell more call options than you buy, offers an opportunity to leverage any such bounce at a minimal cost. Essentially, you are buying a bullish vertical call spread and selling one more call at the short strike simultaneously. The extra short call is considered “covered” if traded in the same account where you hold the underlying stock. So, if things go as you think they might, you will make money on the long vertical call spread and have your shares called away by the covered call at the strike of your choosing.

By selling twice as many of the higher-strike calls, you effectively lower the purchase price of the long call. And you potentially double your gains on your long stock if you get the pop you were hoping for. Here’s a look at the strategy on a recent high-flyer, Potash (NYSE: POT), whose stock has fallen dramatically in the past three weeks, from new 52-week highs of $126.47 hit on January 11^th to a low of $101 this morning after the company reported better-than-expected earnings per share but gave subdued forward guidance.

With POT trading around $103.50, I found I could buy the June 100/115 call ratio for a small debit of 25 cents. Sometimes you can build such ratios for even money. But with the risk of long stock, and the bet being on a big 15% move back up into the teens, 25 cents per share is nothing to quibble about.

Keep in mind that you would only do a “1 x 2” like this for every 100 shares you owned so that the extra sold call was covered. And also note that this so-called “stock repair” strategy doesn’t remove the risk of being long stock.

Now let’s look at some possible scenarios and how you might adjust or exit this position to best capitalize on them.

Scenario #1: POT keeps going lower into February. In this case, your stock-repair strategy still has some time to work, but the risk of the position has continued to hurt you. This is where you need to have a stop-loss target in mind for the stock, regardless of any ideas about a bounce. Do you still hold the stock on a fundamental or technical basis at $90? At $80? Can you still sell the 1:1 100/115 call vertical portion of the ratio for anything? Always know your worst-case and have your exit strategy in mind before you make any long-term investment or short-term trade.

Scenario #2: POT only crawls higher and trades in an agonizingly quiet range between $100 and $110 for the next three months through April. In this case, you still have time for a pop higher to $120 before June and maybe this consolidation in the stock is encouraging. The value of the June 100/115 call spread—which you could sell by itself at any time, leaving you with a covered call position via the other short 115 call—has probably slipped some on time decay and lower volatility, but still trades with some parity in the 100 call. You could sell the spread if you think the chances of a rally have dwindled.

Scenario #3: POT rallies over the next month to $113 and the 100/115 call spread is trading around $10. You could sell the spread and keep the covered call, or close everything and call it a small winner on the repair strategy. In that case, if what you pay to buy back the ratio, say $6, is less than your gains on the stock from $103.50, you win something you didn’t have before ($9.50- $6 = $3.50 gain) as you gave your repair strategy time to work and now decide “time’s up.” If you don’t take some profits here on either the spread or your stock, you could end up with no gains and all the risk.

Scenario #4: POT rallies to $120 before June and, amid global expansion and upgrades, the stock looks poised to make new highs in 2010. Depending on how close to June we are, the value of the 100/115 call spread is getting closer to full parity of $15. If you have revised your outlook to more positive as well and want to stay in the stock, you could close the ratio or just sell the 1:1 spread and decide if and when you want to buy back the other 115 call so your shares don’t get called away.

Scenario #5: POT rallies through short 115 strike in June and you just let everything expire ITM, accepting full profits on the strategy. If you bought POT at some point in the past and it’s a losing position, you have to evaluate if this “stock repair” strategy is worth the risk for your situation. If you think the probability is high for a rally, then the reward might justify the risk for you.

Rehearsing Strategies and Scenarios

I have covered five different scenarios, but these are not the only things that could happen. I just did this exercise to get you thinking in advance about how you would feel and what type of plan you want to have in place beforehand. And clearly, you have the choice of strikes and expirations to tailor the risk/reward and timing to your needs.

Another important note about the profit and loss potential of this strategy displayed on the graph above: this is what things look like at expiration and before then, when options still have time and volatility value, the dynamics are not so linear. Option values, and consequently their spreads, will have more or less value depending on these factors of probability and risk.

One of the best ways to get a handle on all the possibilities is to practice building these strategies on an options-friendly broker platform. The above Profit & Loss profile was built using the OptionsHouse Trading Tools. If you don’t have an account there, I encourage you to sign up for a free virtual account, which will give you full access to all the tools and allow you to simulate these positions so you can learn the most from their risk/reward dynamics.

For more on POT:

Potash Down Nearly 5.5%, Beats Q4 Estimates But Sees Q1 and FY EPS Below Expectations

A Potash (NYSE: POT) Iron Condor

Potash (POT) Trading Idea: Bull Put Spread

With QCOM stock trading near unchanged at the open around $46.90, here were the put contracts that went across the tape:

• March 43 puts traded 10,000 for $0.90
• March 47 puts traded 5,000 for $2.25
• Net debit for 1 x 2 spread: $0.45

This could be a speculative play on QCOM where the trader is betting on a moderate move lower, with profits achieved if the stock falls anywhere between 2% and 15% and the max gain is earned with the shares at $43, an 8.5% haircut from current levels.

Or the investor may also own actual QCOM shares and be buying protection against a moderate drop in the stock after the company’s earnings report tonight. Here’s a look at the risk/reward of this put ratio 1 x 2 without underlying stock as part of the position:

Just for fun, let’s look at the actual dollars and cents potential of this trade based on the big size the investor did: 5,000 of the March 47 puts vs. 10,000 of the March 43 puts:

• QCOM finishes above $47: 5,000 contracts x $45 per contract = Loss of $225,000
• QCOM finishes between upper breakeven of $46.55 and $43: Profits increase 1:1 with stock drop because of long 47-strike puts
• QCOM finishes at $43: 5,000 contracts x $355 = $1.775 million max potential profit
• QCOM finishes between $43 and lower breakeven of $39.45: Profits decline 1:1 with stock drop because of naked short 43 puts
• QCOM finishes below $39.45: Losses are potentially unlimited down to zero, e.g. at $36 the loss would be 5,000 x $345 = $1.725 million

Ratio spreads like this, where you sell more options than you buy, are usually precision option plays and should not be entered into lightly. The reward can be relatively high, but not without commensurate risk. The flip side of this spread is often called a “backspread” with the basic idea being to buy more options than you sell. This avoids the unlimited risk of naked short option positions, but also requires more directional movement in your favor to realize a profit.

All ratio spreads can be done in-, at-, or out-of-the-money and this affects whether you pay a debit or receive a credit to initiate them. Tomorrow, we’ll look at a ratio spread used with a long stock position that eliminates the risk of naked options and gives you an opportunity to either pinpoint a range on a stock or merely leverage some repair profits from a wounded position.

For more on QCOM:

Bearishness in Qualcomm, Berkshire Hathaway, Tyson

Earnings Preview: Qualcomm to report 1Q results

Today, I want to break down the details of that trade because it illustrates the versatility of options in building strategies with “customized” risk and reward. Here’s what we saw just after 10:00 AM ET on Monday:

• July 135 put: 13,600 contracts trading for $5.52
• July 145 put: 13,600 contracts trading for $8.75
• July 160 put: 13,600 contracts trading for $15.20
• July 165 put: 13,600 contracts trading for $18.20

These puts all traded simultaneously as one spread, and at first glance it looks like a condor where the investor is selling the out-of-the-money (OTM) 135/145 put spread for $3.23 and buying the in-the-money (ITM) 160/165 put spread for $3.00. This put condor thus traded for a net credit of $0.23, which is not what we usually expect of a conventional all-call or all-put condor where the strikes are equidistant and we have to pay a debit.

And also note that this is not the “iron” condor that we are so fond of here at ONN, where you sell an OTM call spread and an OTM put spread and always expect to collect a credit that you will retain if the stock stays in a range between the short strikes. For an example and dissection of the iron condor strategy, see this trade on I recommended on the SPDR Gold Trust (NYSE: GLD) with a diagram, or this one on the S&P 500 Index (SPX), which is attempting to profit from a 165-point range on the S&P 500, between 1,020 and 1,185, up to February expiration.

Below is a Profit & Loss graph of this unique GS put condor at expiration, built using the OptionsHouse Trading Tools.

This put condor is still designed to capture profits if the stock trades in a range.  In this case, maximum gains are achieved if GS shares are between $145 and $160 come July expiration. That’s when the ITM 160/165 put spread will achieve full parity value of $5.00 — this plus the $0.23 credit collected initially will equal profits of $5.23 per share, or $523 per option contract. Remember, even though the trade only collects $0.23 up front, an ITM put spread was purchased that the investor hopes will stay ITM and mature to parity, thus adding $5.00 to their haul.

In this “broken” or “skip-strike” condor, the investor built a wider downside put spread to sell so he or she could collect more for it. Sacrificing protection by moving down to the 135 strike (vs. the 140) likely also means the investor is confident that GS shares will stay above $145, even if they are moderately bearish and believe they will stay below $160 through July.

You may also hear option traders use lingo like “unbalanced” or “lopsided” to describe unique variations of condors where quantities can also be different between strikes. Thankfully for our study here today, this one was done 1:1 with 13,600 in each strike.

The investor or institutional trader who implemented this strategy obviously had a very precise view of GS as a stock for the next six months. Let’s look specifically at the profit potential, the risks, and the breakevens they had in mind, with the stock trading around $158 when they made this bet:

GS stock finishes above $165: Gain limited to $23 collected initially as the long 160/165 put spread expires worthless. 13,600 contracts x $23 = $312,800

GS stock finishes between $160 and $165: Gain = $23 plus amount by which the 165 put is in the money

GS stock finishes between $145 and $160: Max profit achieved of $523 per contract x 13,600 = $7,112,800

GS stock finishes between $135 and $145: Max profit erodes point-for-point from the max gain of $523 to the max loss of $477. This is the value of the short 135/145 put spread ($1,000 per contract). Below the breakeven of $139.77, this trade begins to incur this loss.

GS stock finishes below $135: Max loss incurred of $477 per contract x 13,600 = $6,487,200

Buying ITM Spreads = Selling OTM Spreads

In option spread trading, the goal is to capture profits by either trading volatility or directional movement, or both. Iron condors collect their max profit potential up front in the form of the total credit received for selling two OTM spreads, one call and one put. The iron condor intends to profit from these spreads expiring worthless, or at least from time decay and/or declining volatility since the iron condor can be bought back before expiration for a profit as well.

Plain vanilla condors (all call or all put) also intend to profit by pegging a trading range in a stock, but with one of the spreads being ITM; we want this leg of the trade to expire at full parity value. In other words, we want the ITM spread to mature to full value, not expire worthless. This idea of selling an OTM spread you want to expire worthless vs. buying an ITM spread you want to expire at its full worth is really about equivalent strategies that the simple mechanics of put-call parity allow.

As the pros like to say, “calls are puts, and puts are calls, but buys are not sells.” To get a better understanding of this concept, see my article “Why Buy Calls When You Can Sell Puts?”

The President’s apparent lack of understanding about what causes systemic banking risk is barely concealed by his zeal to appear to be doing something regulatory, and the consequences for markets could be ugly–and not just in the short run. This was all very predictable.

After the collapse of Bear Stearns in March of 2008, I started writing about the inevitable regulatory backlash that would surface to punish Wall Street excesses and the systemic risks they wrought. Clearly, Washington politicians would have to respond with lots of finger-waving indignation and calls for reform to please their constituents and voters, even if they didn’t understand their own complicity in the great housing bubble.

In October of 2008, I used a speech by Alan Greenspan to highlight the age-old problem of tools and weapons in the wrong hands . We all know guns don’t kill, and in Chicago where futures and options are the tools of choice, you learn quickly that they can be used to build or destroy. Where Wall Street took a wrong turn was in believing that quantitative models were flawless money-making machines with scalable (as opposed to geometric) downside risk.

In January of 2009, I wrote a piece for Greenfaucet.com called “Ponzi and Usury” in which I quoted London Business School founder Charles Handy about how banks and other mortgage players—including GSE’s Fannie and Freddie—built the bubble with unregulated derivatives, leveraged to the hilt.

In March of 2009, I conjectured that despite the calls for heads and reform on Wall Street, the market wasn’t afraid of the coming backlash. This was when they were merely speculating about hedge fund restrictions and possibly making them disclose their positions publicly. Here’s an excerpt from that piece:

The danger, as always, would be of politicians going too far, swinging the pendulum so hard that a host of new, unintended consequences would be born. I am not sure what regulations make sense for hedge funds. But what I am still sure about is how Washington will get the “R” stuff wrong, whether it’s for hedge funds or derivatives. Don’t get me wrong-I don’t like how Wall Street excesses with leverage and a convenience store approach to packaging and marketing junk (in the form of securitized, structured investment products) broke the economy. Even though the horses are long gone from the barn, people should be punished and the house of cards should be studied for lessons learned.

But the over-regulation of financial markets that’s coming will likely do more harm than good. In general, markets operate on freedom and risk-taking, not restriction and fear. Limiting yours and my ability to raise money from other private investors to invest in whatever we want (the hedge fund model) will hurt markets. Period.

Okay, so what should Washington do? What would I tell my Congressman? Four things for starters: (1) Don’t rush because there’s no fire anymore and the horses are long gone; (2) Do some studies on what might happen if you make hedge funds disclose their positions on a regular basis. Don’t assume this is automatically a good thing without great unknowns; (3) Speaking of unknowns, don’t assume anything. Black swans are just waiting in the dark wings (or fat tails) and no amount of regulation will prevent them. That you can bank on; (4) Look at how mark-to-market works in futures and options. It prevents large systemic risk in highly-liquid markets. Heck, it works so well, it prevents huge domino-type losses in illiquid markets too because no one is allowed to take on risk that they can’t pay for and collateralize every day.

I’m not saying we have to enforce the mark-to-market accounting rules explicitly and continuously. The banks clearly need whatever relief we can think of right now. And that’s a complicated debate for the FASB experts, who need to be advising Congress, who needs to be thinking in terms of the principles of freedom above all else (because there are worse things than a temporary economic collapse, like no free market at all). What I am saying is that we use the logic of liquid markets thriving under mark-to-market and preventing systemic risk as a basis for deciding what kinds of structured products and securities banks can invent. If you can’t trade a security, maybe you shouldn’t be allowed to sell it. I’m no authority here, this is just trader talk.

Gridlock is Still Good

So while Obama and Company debate the virtues and victims of killing proprietary trading at big banks, I hope that classic Washington gridlock takes hold and prevents overzealous politics from taking over. Punish, reform, and rein in all you want. But don’t rush, don’t assume you know the causes from the effects, and don’t pretend you can predict the future. Look at real causes of risk and at models that work to control it. To that end, read my piece from last week on “Where Mark-to-Market Works.”

From iron condors, that try to make a small return by capturing a big trading range, to iron butterflies that earn greater returns versus risk if you can be more precise, these strategies are more concerned with trading volatility than betting on a big delta move one way or the other.

The run-up in implied volatility in GOOG options in January was built on news-driven price action, like the reaction to Nexus phones and China search censorship. But it was also anticipation about GOOG earnings released yesterday. Below is a snapshot of that boost in implied vol, taken from the OptionsHouse trading tools.

Adam Warner wrote a great pre-earnings analysis of the potential move in GOOG shares based on options implied volatility. He uses a chart similar to the one above and explains his quick way of figuring out if you could make money buying a strangle even if this bid-up implied vol falls after the event.

Warner is an options pro and he knows you can make money quite often selling relatively high implied vol before an earnings release, but when you’re wrong, it really hurts. So he likes to know what kind of move options are pricing in and if he could still make money buying volatility, or if the options are priced so close to the expected move that you’d be lucky to break even.

His analysis found that you’d need about a 40-point move, or nearly 7%, to break even on buying the 25-delta strangle. That seemed expensive to me, so I looked at the opportunities to sell 35% implied volatility and profit from less than a 7% move in GOOG shares. I looked at several butterfly strategies and settled on this Feb iron butterfly, with a view of its profit/loss potential at expiration.

This iron butterfly was slightly profitable today with the sub-4% move in the stock and the drop in at-the-money (ATM) vol to 27%. Selling the iron fly yesterday for $30, I could buy it back this morning for $26.50. Had I taken more risk and moved my strangle hedge out further, to say the 530/630 strikes, I could have made more. I also have the option of holding this strategy for a few weeks on the bet that GOOG stock rallies back toward $580 and volatility declines further, allowing me to capture more of this premium, especially as time decay picks up.

The bottom line is that most options pros have access to the historical earnings moves of the stocks they follow. And some average of this data gets built into implied volatility, with greater or lesser risk premiums based on company news or general market sentiment. As Warner says,

“Most names move less than the options imply. Shorting options over and over again into earnings bid-ups is a zero expected gains strategy, as the moves beyond the implied range produce greater and open-ended losses. In fact, I’d suspect it mirrors volatility in general such that about two-thirds of earnings moves are within the range.”

Before you attempt these types of volatility strategies, I highly recommend practicing with them on the virtual trading platform at OptionsHouse. The Volatility Charts and P&L Calculator featured above are among more than half a dozen great tools that can build your understanding of volatility spreads and their risk/reward dynamics. And you can put the trades on in your virtual account and see what would happen real-time in the markets.

This iron condor would be profitable if GOOG stock stays between $540 and $630, a $90-wide trading range. The ONN Idea Generation Platform (IGP for short) selects strategies like this based on volatility and probability. We want to sell relatively high implied volatility and have a margin of safety that still allows for large movements in the stock until expiration.

As with all iron condors, the maximum risk in this trade was limited to the width of the spreads minus the credit received, in this case, $10 – $3.90 = $6.10. Since GOOG stock can’t be both above $630 and below $540 at expiration, you can’t lose on both spreads. I’m reviewing the risk/reward mechanics of iron condors so that we can look at another way to capture option profits with even less risk, and much greater potential reward—if we can be precise about a stock’s trading range, instead of betting on a wide one.

Precision Spreads: Betting on Accuracy to Boost Return

The option butterfly strategy sells one vertical spread and buys another (all calls or all puts), with the short legs of both sharing the same strike. Below is an example of a GOOG put butterfly I recommended last week, with the graph representing the potential risk/reward profile at expiration. The idea behind this play was to benefit from the possibility that GOOG shares would continue to be weak after lukewarm reception to the Nexus phone and concerns about its future in China, but that the stock would gravitate around the $570 mark.

The butterfly strategy is often described as “selling two at-the-money (ATM) options, buying one in-the-money (ITM) option, and buying one OTM option, all equidistant from one another.” But it’s just as correct to think of it as buying a vertical spread and selling a vertical spread, where the “ATM” short strike is common to both but it can be anywhere you want and doesn’t necessarily have to be “at-the-money.”

And in its simplest form, you can think of this put butterfly as a way of buying the 590 put at a very affordable cost if your view is that the downside is limited to around the $570 mark.

If GOOG is at $590 (or $550), my goal here is for it to move down (or up) towards $570 for me to achieve maximum profits. I paid about $2.50 and my max potential gain is the width of the strikes minus my debit, or $20 – $2.50 = $17.50 per share ($1,750 per option contract). We did an OTM “bullish” call butterfly in GOOG in November with Dan Keegan of TheChicagoSchoolofTrading that was highly profitable as GOOG made the move from $570 up to $600 where our short strikes and max profit awaited.

Keep in mind that the above graph is of the spread’s potential at expiration. Like any vertical spread, we don’t get the max profit until expiration, but we can always realize a profit before then, especially if implied volatility falls and the stock moves toward and remains “sticky” near our short strike. And still, in a relatively wide trading range from $552.50 to $587.50, this long put butterfly can make some money between these break-even points.

Selling Straddles, Hedging with Strangles

The other type of butterfly we want to look at is the “iron” fly. I also recommended this one last week when GOOG was trading around $590. Here, we are selling both spreads, one call vertical and one put vertical. Another way of describing this trade is that we are selling a straddle and buying a strangle around it. Notice how the March iron butterfly below is designed to capture max profits at the short strike, in this case the $580.

This species of the butterfly has an interesting twist compared to the conventional variety. The iron fly gets to collect all the premium, and thus the max potential profit, up front. So instead of paying about $2.50 to win $17.50 on a bet of GOOG staying at a certain strike, we are collecting the $17.50 up front and risking only $2.50. In both cases, our potential return on risk is about 700%. Except for the fact I used different strikes, these are equivalent strategies. And even though we speak of “buying” call or put butterflies and “selling” iron butterflies, the goal is the same—to nail a very narrow trading range for the stock by expiration.

Versatility Defined: Calls = Puts, and Puts = Calls

The last point about these two butterflies being equivalent in terms of risk/reward is very important because it emphasizes how completely “interchangeable” options can be. As the option pros say, “calls are puts and puts are calls, but buys are not sells.” This handy rule sums up how the pros think about options because, to them, calls and puts are truly interchangeable building blocks for constructing market views that buy or sell risk. (Risk, to options traders who hedge their delta positions continuously, is also known as implied volatility).

Options are so interchangeable, in fact, that pro option traders quickly recognize mis-pricings where they are able to lock in risk-free arbitrage profits with synthetic positions (simply, where combinations of calls and puts and their underlying stock can replicate each other). You have probably heard of some of these trades, like conversions, reversals, and boxes.

This interchangeability of puts and calls is often referred to as put-call parity, and this concept is central to the “fair value” pricing of options. It’s not about “fairness” among traders–it’s about what something is worth (all things being equal, like volatility and time) and how traders compete to capture the best price the market will bear, without violating the “law of one price” (i.e., that identical instruments should not trade for two different prices).

What does this have to do with butterflies? If a trader can buy the 550/570/590 put butterfly and simultaneously sell the same call butterfly for more, or vice versa, they will conduct an arbitrage trade, knocking prices back to the law of one price and locking in a risk-free profit. Even with the low transaction costs that pros enjoy, arbitrage profits like this are rare these days, especially with computer algorithms designed to watch prices and grab such opportunties. But it helps to know that this is the structure of options markets that keep prices in line and “fair” for everybody.

Because of the interchangeable nature of calls and puts, you can construct butterflies anywhere you like, all with similar risk/reward dynamics. Instead of buying an OTM put butterfly, betting on a move lower to a certain strike, say $540, you can buy an ITM call butterfly that will achieve the same thing.  For either of the 520/540/560 call or put butterflies, you will pay around $2 and achieve max profits of $18 if GOOG settles at $540 by expiration.

These “flys” are cheap because their probability of becoming profitable is currently considered so low. Obviously, spreads wider than $20 will cost more. And selling iron butterflies has the same goal of precision, so you can achieve the same results by selling the 520/540/560 iron fly for $18. Where it gets really interesting is when you begin building “broken wing” or “skip strike” flys, or make them “unbalanced” with ratios as Dan Keegan did in the December call fly.

Practice Building Flys

One of the best ways to get familiar with all the “species” of butterflies you can build is to use a trading tool like the Profit/Loss Calculator on the OptionsHouse platform. This tool lets you click on option bid/asks right off of an option chain and it automatically plugs them into the P/L graph. Once you have your fly built in the graph, you can fast forward in time and see how the risk/reward changes over time, based on today’s volatility—which you can also adjust.

Remember, the P/L graphs above are just the profile at expiration, so it’s important to understand how long it takes for these spreads to “mature” and achieve full profitability as option premiums experience time decay. Clearly, you can still be somewhat profitable in a fly strategy before expiration if the stock is close enough to your center strike.

If you don’t have an OptionsHouse trading account, you can sign up for a free virtual account that allows you unlimited testing and use of all the tools. Then as you practice building butterflies, you will greatly enhance your options knowledge and intuition as you begin to see the patterns of probability and versatility, even if you are never inclined to trade one. As far as I’m concerned, option butterfly strategies are simply some of the best option teaching tools around.

For more on GOOG:

Betting on a short-term range in Google (GOOG)?

Google (NASDAQ: GOOG): The bullish case

Google (NASDAQ: GOOG): The bearish case

On Dec. 14, I was on CNBC’s PowerLunch and called for a further drop in the euro from $1.46 to at least $1.44, with likely support at the 200-day moving average near $1.42. We got that move in two days and a bounce off of $1.42 gave the euro some mild interest that enabled it to claw its way back above $1.45 throughout the next three weeks.

Yesterday in an interview on ForexTV, I said the euro was poised to fall through $1.43 and was targeting $1.4090. Today we got that 200 pip move, as EUR/USD fell through its 200-day moving average (which had risen to $1.4280) like it was a trap door.

Today with the euro breaking below the 200-day, as hopeful long holders finally capitulate, and stocks selling off on general concerns over China’s efforts to slow the advance of a possible credit bubble, it helps to break down the two forces driving the dollar: interest rates and sovereign debt worries.

Euro (and its PIGS), the Weak Follower of Risk Appetite

In 2008, FX traders first began to get headlines with talk of the euro “PIGS.” This was the quick and dirty acronym to represent the most troubled economies of the Eurozone: Portugal, Italy, Ireland, Greece and Spain. These weak links in the single currency for 16 nations, combined with a slower-than-the-U.S. recovery outlook and concerns about some $4 trillion in Eastern European debt, made the euro considerably less attractive than other currency trades.

But when equity markets bottomed in early 2009, and central bank quantitative easing campaigns were clearly in force, the euro broke above a key level I had been watching around $1.31. With the European Central Bank (ECB) apparently on hold at 1% short rates, a new “reflation” trade was on where cheap and abundant dollars could be used to fund trades on a virtually unlimited menu of risk appetite. Concerns about the US debt picture, with trillions in new issuance on the horizon, didn’t help the dollar’s outlook either.

Equities, oil, gold and currencies across the globe were bought in this reflation trade. And when a new forceful trend trade is in motion, you don’t fade it. I found it hard to imagine the euro getting much stronger than $1.50 in 2009 and I said so on CNBC and Bloomberg appearances. But, as long as “the dollar carry trade” was in play, you were able to easily ride the trend much the same as the unstoppable bull run in equities. I also tried to explain the dynamics of the dollar carry trade that was suddenly on the lips of every business TV reporter.

In articles like The FX Carry Trade and Currency Carry = Interest Arbitrage, I made the point that success in a currency carry trade depended on two things: (1) a stable or widening interest rate differential and (2) a strong trend in the higher yielding currency, usually driven by fundamental forces and technical price momentum. Case in point, the stable 3% difference in rates between the U.S. and Australia was a key driver of the Aussie’s appreciation from 64 cents to 94 cents in 2009, in addition to the Australian economy thriving on strong natural resource demand from China.

This is important because just as trends are persistent beyond reason or belief, they can reverse brutally when key drivers change. And the interest rate differential is the key driver that, once believed to be reversing, can cause a brutal shift out of carry trades.

We are currently witnessing the strongest carry trade currency, the Australian dollar, having trouble getting above 93 cents again. If you look at the chart, Friday probably gave a sell signal to many technical FX funds. Another point worth noting is that the Aussie is not included in the U.S. Dollar Index that we see quoted on TV. For a breakdown of that index, see my What’s in the Dollar Index? article.

The Canadian dollar, the other “commodity currency,” is another interesting story here. It comprises 9% of the dollar index and its strength on energy and metals demand has kept the dollar down, while the Aussie strength is not reflected in DXY weakness. The recent double bottom in USD/CAD at 102 will only add to dollar strength now.

Who’s Debt Matters More?

While the world worries about the buildup of U.S. debt, the strongest, most dynamic economy in the world looks better when compared to scarier alternatives, like Europe (I’ll discuss, in another post, the specific issues with the UK and the Bank of Enland’s possible early exit from quantitative easing that have the British pound showing some surprising strength in early 2010). This week we learned the ECB was actually preparing legal documents to deal with any country that tried to leave the Eurozone and the common currency. Greece has reassured that they have no intention of doing so.

But markets have a way of voting and weighing regardless of what you do and, right now, big FX players are saying the risks of the euro outweigh the benefits. To be a member of the this Eurozone “club of 16,” you are supposed to maintain national deficits below 3% of GDP. The current average for the 16 nations during this recovery from the financial crisis is over 5%, so the whole club has some fiscally responsible work to do.

In the end, this crisis and the extraordinary monetary and fiscal measures enacted to fix it will be viewed for decades as pivotal moves where we fell in love with government debt to make up for the sins of private and corporate debt. And it’s giving investors now who know how to read a balance sheet great opportunities to put their money behind companies and countries who know how to manage their capital.

“Mind the Risk, Bank the Profits!”

A smaller (but no less beautiful) irony was that the day I wrote that piece was the premiere of the new documentary film about Chicago’s trading pits, Floored. Ever since the financial crisis began to unfold in 2007, the world got a ringside seat for a debate about a concept and practice known as mark-to-market — and how two different types of market places treated the risk of highly levered derivatives.

Commodity futures trading in Chicago is more than 150 years old, beginning with the pre-Civil War grain markets that evolved into organized exchanges. For farmers, food producers, and speculators to come together and negotiate prices on wheat and corn contracts every day, a system had to be built to control the risks of any trading counterpart defaulting on his half of the deal.

That system used “good faith deposits,” which were only worth a fraction of the total value of the grain contracts. In essence, a trader had to deposit a certain sum with the exchange officials to be allowed to trade each futures contract. And at the end of the day, all positions were “marked to market” so that the losers had to pay the winners, moving money from one account to another. If a trader couldn’t meet his obligations, his trading deposit was seized and his trading privileges revoked.

Speculators—Not Necessary for Delivery, But Vital for Liquidity

When people are first introduced to the world of commodity futures, they often question whether or not it’s “all just gambling.” This perception is usually born of the observation that hundreds of traders in the pits are frantically trading in and out of positions for short-term gain, without any fundamental interest in the underlying commodity itself.

While it is true that speculators do not have direct business interest in corn, wheat, gold, or oil that would motivate them to make or take delivery of the commodities themselves, they provide a vital function without which futures markets could not function: liquidity. Speculators come into the futures markets and provide constant buying and selling prices that allow other bigger players, especially hedgers, to get their larger transactions done.

Without this liquidity, futures markets could not fulfill their two primary economic purposes: risk transfer and price discovery.

As Chicago’s futures markets for grains and other agricultural products grew, the role of speculators became ever-more important. And the mark-to-market systems had to grow to handle the exploding volume of transactions. This evolution was not without its challenges, as speculative trading of grain futures contracts sometimes far exceeded the actual amount of grain harvested in a year and scandals occasionally erupted.

But one thing about mark-to-market that held constant in the face of these challenges is that the exchange “clearing houses” at the Chicago Board of Trade and the Chicago Mercantile Exchange could virtually guarantee that no trader or customer lost money because of the losing trades of another customer or trader. We’ll see in a moment if this has held true with the modern onslaught of financial futures products since the 1970s.

As long as commodity futures markets provided an economic purpose that benefited the buyers and sellers of grains, bonds, and currencies, speculators could come and go, losing their own money and no one else’s, all the while providing the vital function of liquidity. If you can still call that a casino atmosphere, then maybe we need to compare it to a place where risky bets did take down more than the house—they nearly took down the whole country.

Derivatives Leverage and Systemic Risk

In 2008, the phrase “mark-to-market” was newly on the lips of business TV journalists almost every day because this was the accounting issue that was causing so much pain for the big banks on Wall Street and beyond. The debate was about how portfolios full of toxic mortgage assets should be treated. If the assets were marked at their current market value, the banks would have to realize devastating losses.

Some people went so far as to blame the accounting practice itself for banks having their capital and share prices destroyed. Many others recognized that if an asset declined in value, it represented a potential loss that should be acknowledged in some way in a company’s wealth, or lack of it.

The reasons that mark-to-market became so painful for the banks are at least two-fold:

1) They weren’t accustomed to doing it in a real way that meant anything. I am not an accountant and so can’t tell you what differences bad assets made on which side of the balance sheet, but the point is that perception by investors and shareholders was 9/10ths of the law here. If banks could paint the picture of “assets with potential to recover,” then maybe the market would believe them and not require harsh accounting, whether directly on the balance sheet or indirectly in the form of a flight of capital from the bank.

In futures trading conversely, every day the mark-to-market process moves money from account to account according to realized gains and losses. There’s no maybe, kinda, or sort of about it. A loss is a loss, and a gain is a gain. There’s no “potential to recover” either. Profitable positions get paid and losing ones do the paying in a dispassionate zero-sum game.

2) The structure of these bad mortgage derivatives was convoluted and mysterious. And no two alphabet-soup funds were alike. So not only wasn’t there a liquid market where they could be priced and traded at anything near the fair value the banks believed they were worth, this also meant they were likely sewn with much more leverage than any sensible futures trading firm would allow.

The world of futures is built on transparency and fungibility. You know exactly what you are trading, and what the terms of the contract are. And because the instruments are standardized, they are liquid minute by minute. The failure of Wall Street with derivatives—that ended up creating systemic risk for the entire economy—is that they built dark time bombs of unknown leverage, and unpredictable detonations.

Performance Bond is Volatility-Based, Conservative Leverage

The leverage question is especially informative here. In equity markets, we use margin to trade, which is just the opportunity to take a loan of up to 50% of the value of securities. The good-faith deposit in futures markets evolved in the last century to become known as performance bond.

The performance bond for every futures contract is based on the volatility of that contract and its underlying instrument. The volatility analysis is continuously evaluated, with changes often made at least once per quarter. And remember, this is a one-to-one requirement; for every futures contract you want to have a position in, you have to post the minimum performance bond. Again, the idea behind this is that the money is there to cover your losses.

Since each futures contract has a known size and a known performance bond, the leverage ratio is clearly known. For instance, to hold one S&P 500 E-mini futures contract, the performance bond is about $5,625 vs. a contract value of about $57,000. This creates leverage of about 10 to 1. To hold a Euro FX futures position, the performance bond is about $4,050 vs. a contract value of about $180,000, for leverage of around 45:1. The leverage is higher for FX products than stock indexes because the volatility is lower. In essence, you are allowed greater leverage where there is less risk.

The “teeth” in this system is that the exchange Clearing House assumes the authority to strictly supervise Clearing Member Firms and make sure money moves where it’s supposed to, when it’s supposed to, all in CFTC-regulated and properly segregated accounts. No one can trade unless they have a relationship with a Clearing Member Firm to hold their account funds. If the firm doesn’t put the proper money in or take the proper money out of your account according to your positions’ profits and losses, the firm will be sanctioned and probably fined. Trading privileges can also be affected immediately.

Because the Clearing Member Firms must have on deposit more than enough money to cover the single day losses of all of their trading accounts, the system has built in financial safeguards that protect all traders. In fact, in the entire history of the Chicago exchanges, no customer has ever lost money due to the failure of a counter party. Individual traders and even some big firms might blow themselves up (see my SFO magazine piece on famously huge blow ups), but all their obligations have always been accounted for and those with money coming to them got paid.

So, the next time you hear someone say that mark-to-market caused all sorts of problems for big banks on Wall Street, know the difference and explain it to them if you can: mark-to-market is a responsible accounting practice that prevents massive losses and systemic risk and makes futures and options derivatives markets an integral part of the global economy. Without the risk transfer and liquidity functions that futures markets provide so well across all asset classes, Wall Street might not work at all.

As the dust settles on the sub-prime mortgage crisis, maybe most of us now accept that risk management isn’t a science. But we’re not better off today than one year ago because Wall Street somehow totally revamped its models. Things are stable and growing again because Washington provided a “get out of jail free” card, and some pocket money, to Wall Street.

So, why does it matter that “risk management isn’t a science?” Because those who act like it is can get in lots of trouble with their capital, and yours. And we had lots of warnings before 2007 that this was true. The best example was 1998’s blow up of quantitative hedge fund Long Term Capital Management (LTCM for short).

Myron Scholes, Nobel prize-winning financial theorist, was a partner in LTCM. With his equally-quantitative partners, he made sizable leveraged bets on interest rates in the late 1990s that got creamed when Russia defaulted on some debt and devalued the ruble, sending shockwaves through global markets.

The Federal Reserve decided to bail them out to the tune of about $3.5 billion because they believed that not paying LTCM’s derivatives obligations would create “big” losses for too many Wall Street firms. How ironic that the phrase “too big to fail” may have originated with this now tiny fund collapse. Roger Lowenstein’s 2000 book on LTCM, When Genius Failed, chronicles the missteps in strategy and risk management that brought the fund to its knees.

Black-Scholes and Black Swans

Scholes was one of the geniuses behind the landmark options pricing model that bears his name. His and Fisher Black’s work, published in 1973 and built on theories from the 1950s and 1960s (Modern Portfolio Theory and the Capital Asset Pricing Model), opened the flood gates for financial innovation and engineering in the following three decades. Some would say they also let a wicked genie out of the bottle.

Another observer of the irony—i.e., quantitative PhDs building beautiful mathematical models designed to pick up nickels in front of steam rollers—was Nassim Nicholas Taleb in his books Fooled By Randomness (2001) and The Black Swan (2007). Taleb’s TBS is a winding journey through history, literature, and finance, but if you get through it, you are rewarded with a key insight about how Wall Street treats risk—or fails to.

In a nutshell, financial modeling uses old fashioned probability and statistics to measure risk. But the tools of this trade, like standard deviation, were invented to quantify the variation in physical phenomena. Markets are social beasts with virtually unlimited complexity and variability.

This means that the way Wall Street talks about and measures risk in financial markets is fundamentally flawed from the start because the volatility of returns (the markets term for standard deviation) is not dependent on averages that have anything close to the constancy of human height and weight or the behavior of gases and plants. When anything can happen, standard deviation can’t help you define the average—and thus the risk of deviation from it—very well.

Here’s an excerpt from my 2008 book review of The Black Swan in SFO Magazine:

Taleb’s issue is that these quantitative models are simultaneously sold to investors by the financial industry as air-tight risk analysis for all sorts of long-term investments that cannot be accurately or sufficiently described by the models.

The central problem with the models is that they assume rare events—statistical outliers—have a drastically lower probability than reality would indicate to anyone who can read a newspaper. Standard deviation and its correlations do not accurately reflect randomness in complex and chaotic social realms (markets) because they were created for measuring and evaluating the dispersion of data in gravity-dependent physical domains.

In short, the bell curve is a measuring device that ignores its own “fat tails”—what statisticians call the portion of a bell-curve distribution that indicates a higher probability of extreme events—when it comes to human inventions like income, portfolio returns or book sales.

Volatility—Its Uses and Abuses

How was standard deviation misused in the buildup of toxic assets leading to the subprime housing crisis? Very simply, banks packaged mortgages in all types of “structured products” (from basic MBS to complex CDOs) and then assigned an expected risk or volatility measure to the “securities.”

The problem was that their volatility numbers were too conservative and couldn’t take into account the unexpected, like the wildly unpredictable possibility of housing prices actually going down in 2006. Whether or not Wall Street models could handle the input variable of a declining real estate market, they definitely got the risk management wrong by ever assuming their models could save them even if they had the correct inputs.

Would they have used less leverage with more conservative assumptions? Probably not. The PhD quants who built the models said everything was going to be all right. If you’re a banker, and it’s not really your money, just listen to the Doctor, right?

One of the responses of a banker that shocked me most in 2007 as this crisis began to unravel was from David Viniar, then CFO of Goldman Sachs. On Portfolio.com, Felix Salmon had a question for the leader of quants and risk managers about what exactly he meant in the aftermath of market gyrations when Bear Stearns first announced the collapse of its two subprime-focused hedge funds that summer.

As some of Goldman’s quant funds began losing money, Viniar is reported to have said, “We were seeing things that were 25-standard deviation moves, several days in a row. There have been issues in some of the other quantitative spaces. But nothing like what we saw last week.”

Viniar’s statement reveals a fundamental misunderstanding of standard deviation and volatility. A 25-standard deviation move doesn’t happen very often, let alone “several days in a row.” If this was a veiled attempt at obfuscation, to appease (read patronize) investors and the media that the losses were quite a surprise to the bank as well, it probably worked. Who knows when black swans can surface… it’s not our fault, right?

Where Volatility Is a Necessary Power Tool

Before anyone thinks I am completely discrediting volatility as a risk management and trading tool, let me clarify where it is useful and powerful. In options trading, you need a baseline for comparing the perceived risk of positions. It works for options because you are dealing with two elements where the variability of inputs is strictly limited.

First, you are valuing options and their risk on one security. Second, you are doing so to a specific forward date, usually less than one year. Mortgage-backed securities were infinitely more complex than this. By reducing the complexity of your risk analysis, you quickly make volatility a more useful measure.

But option traders don’t pretend they are doing science here. They know it’s still all about probability and that conditions change constantly. They go beyond recognizing that today’s implied volatility number is still only a 68% chance guess at what is likely to happen. And they know that this is not a poker game with finite outcomes. When a company or market event explodes the risk measurement (implied volatility) by two-fold in one day, they take it in stride because they never promised themselves or others with massive bets that it couldn’t happen.

There’s hope for Wall Street to learn to use financial modeling and quantitative strategies for good. As long as we learn from our mistakes and don’t let ourselves become seduced by the latest equation from a math whiz promising great returns with low risk. Probably the best teachers here will not be the universities, but the firms who survived the crisis with better, more robust models that took all the money from the illusionists and fools.

5 Secrets of Wall Street: Profiting from How Stuff Works

Secret One: They Have to Buy Stocks

Secret Two: They Don’t Have to Sell

Secret Three: Sector Rotation

Secret Four: Liquidity, Information, and Speed Rule

But I quickly recognized that there were lots of different types of traders, some who didn’t really have their own ideas about markets and who simply made their living off of the order flow of unsuspecting customers. The traders I admired were the ones who had a method—be it fundamental, technical, or some blend—and did their homework every day because they loved the game, the creative challenge of a three-dimensional, 24-hour global chess match.

When I moved from the trading pits to an interbank currency desk, I saw similar players on the market food chain, from the bottom-feeding opportunists to the strategists with vision and integrity. What made it easy to deal with the traders of questionable ethics was that the game was still built largely around one’s own decisions, and that those who merely benefited from others’ losses, mistakes, or gullibility could be avoided and were destined to meet with some form of market justice down the road.

Who Doesn’t Want to Be a Market Wizard?

Trading is the hardest game in the world, where we are always our own worst enemies, and it leaves little room for reckless behavior. Yes, the cheats can get away with stuff for decades and I’ve previously written about why we’ve not seen the last of Bernie Madoff types.

But anyone who really considers himself a trader will eventually meet with his own ego in a desperate struggle for identity.  Either they can learn to trade and feel proud about that fact, or they will shoot themselves in the foot with irresponsible risk, trying to make it big. I wrote about this phenomenon of irrational self-sabotage among the arrogant, the stupid, and the just plain reckless in the July 2008 edition of SFO Magazine.

So, serious, responsible, self-reliant traders have to accept the fact that Wall Street and all other related markets are just like any other businesses—it’s never personal, rarely fair, and often ruthless. While Wall Street wants to maintain an overall image of honesty and integrity, we know better. We know there are many outstanding firms run by ethical leaders, but on the whole, it’s a jungle out there and you have to know who you’re dealing with.

The Players and the Rules on the Food Chain

In the first three parts of this series, we talked about the institutional investors who move markets and how they do it. If these players form a top tier of the food chain, they are likely joined at the top by the “bulge bracket” investment and money center banks. Again, I have great respect for many independent money managers who run ethical businesses and profit only from their own wits and risk management. We only wish we could say the same about the big banks.

Is Goldman Sachs the preeminent shark in these waters? They are clearly the best trading bank ever to trade or bank. And for the most part, I think they are a well-run and ethical organization, much like a PIMCO or Blackrock. They know that markets are all about opportunities of different duration that come and go every week. They pursue outsized alpha and they manage the risk with dispassionate methods and rules.

The rules they use revolve around at least three advantages Wall Street traders have over us little guys: liquidity, information, and speed. If they don’t have capital to trade, they don’t survive. If their counterparts don’t have liquidity, they don’t survive. Capitalism survives at all because we can grease the gears with liquidity before they seize up. The credit crisis of 2008 and the government’s tidal wave response will be studied for another century for the significance of this lesson.

Information is the lifeblood of capital markets. From in-depth research on companies (done on site/in person, not on the web) to getting the government data release in time to trade it, many firms make a mint off of their effective collection and deployment of information. Speed of execution on that information comes next. Those of us who can trade from our laptops know that we have tools available to us that some institutional traders only dreamed about a decade ago. Yes, the playing field has been leveled a lot.

But the global investment firm is in a continuous arms race with its competition to get information and execute on it faster than the next guy. The world these traders live in is what I call “Total Immersion—Instant Access” because of the depth of their information networks and the technology they have to deploy trading strategies, with or without hesitation. And technology ties liquidity, information, and speed together, especially with the clearing and payment structures that make sure every trade settles on time.

Is Technology a 2nd Amendment Right on Wall Street?

Beneath the top dogs of Wall Street and the global investment establishment are thousands of hedge funds, private equity firms, and alternative investment funds all battling for survival. The arena of risk they fight in makes liquidity, information, and speed necessary weapons. The less reputable practices that surface occasionally are the result of these players getting information illegally, or gaming the system with bad information, collusion, and high-frequency tricks in the shadows. These will not go away.

I am definitely a fan of trading technology and wouldn’t give up a lick of it to have avoided any of its misuse. Markets, indeed all of capitalism, are about innovation and progress with a high error rate. We move forward as gamers and opportunists show us what’s wrong with the latest idea. “Dark trading pools” are just another expression of free markets finding the best ways to maintain liquidity, even if that means anonymity for some. On the whole, what is good for millions of average investors makes up for what gets taken advantage of by something like insider trading.

Was anyone really surprised by the business practices of Raj Rajaratnam? The insider trading scandal that broke in late 2009 has quietly slipped behind the headlines. I thought it was really going to get momentum and begin to expose some really big names at lots of firms, from Wall Street and beyond. Sadly, the hunt for the truth is getting squashed somehow. I could be wrong. Maybe it’s not as widespread as I thought. But my bet wasn’t on the greed and corruption of Wall Street. It was on what I know about human nature that hasn’t changed just because we entered the space age. We are still driven by stone age emotions even when we think we are being totally logical (see my SFO piece for more on that).

An Amoral Jungle, With a Ruthless Food Chain

I’ve made several points here about the treacherous landscape of investing: (1) People are people, which means they are often greedy and irrational, no matter what image they try to portray, (2) Wall Street is a business where money comes first, just like lots of other businesses; (3) Capital markets are fantastic examples of democracy in motion, especially since liquidity, information, and speed are almost universally available to anyone willing to work at it hard enough.

If you are surprised that American capitalism survives after all the crises it has gone through, you are not alone. But, the perma-bears who think we need to go through a protracted depression to wring out the excesses are too extreme. If the US is on a one-way course to financial Armageddon because of exploding debt, where else do you feel confident enough to put all your money? The world rests on America’s shoulders, even if we are manufacturing liquidity with “undercover” quantitative easing (this is how Rick Santelli today described the amazingly strong Treasury auctions we continue to see week after week).

Despite all of Wall Street’s collective faults—and I’ve covered quite a few of the ugliest here today—our capital markets will continue to survive because we love the whole game of innovation and entrepreneurship. We want to help others succeed and share in that success. That’s why Goldman Chairman Lloyd Blankfien only half-jokingly referred to investment banking as “God’s work.” I’ll take all the treachery of Wall Street just to keep playing the only game that can improve the entire world’s wealth outlook.

5 Secrets of Wall Street: Profiting from How Stuff Works

Secret One: They Have to Buy Stocks

Secret Two: They Don’t Have to Sell

Secret Three: Sector Rotation

Secret Five: Risk management isn’t a science

Note that the market cycle anticipates the economic one, which means that investment managers learn it’s better to be early than late. And this graphic doesn’t include the yield curve’s influence on the cycle, which they obviously are watching as well. Here is the quick and dirty summary of “which sectors to buy when” under this theory:

Recession Bottom: Cyclicals, Technology, Industrial

Early Recovery: Materials, Energy

Late Recovery: Staples, Services

Early Recession: Utilities, Financials

The early stage recovery is all about “offense” as companies are expected to boost capital spending and investment, and the late stages are for “defense” with consumer staples and utilities the preferred places to put money. Sectors not specifically mentioned here are healthcare, telecom, and consumer discretionary, which is definitely an early cyclical play and 2009 was no exception for these stocks despite the conventional wisdom that the consumer was dead after the wealth and credit destruction of 2008.

When I say that certain industry sectors “perform better,” I’m talking about corporate profits, not the stocks. But, if hundreds of billions in investment capital favors the stocks of certain industry sectors depending on where the economy is in the cycle, the resulting higher stock prices probably help create even more favorable environments for businesses to capitalize on the cycle, whether through financing leverage or acquisitions. In this way, sector rotation could become somewhat self-fulfilling.

Since this type of money movement is causing major shifts of equity capital as often as a few times a year—or as infrequently as every one-to-two years in an average four-to-five year cyclical growth phase—it pays to follow the philosophy. Sam Stovall, chief investment strategist for Standard and Poor’s, is the guru here with at least two books on the topic and a column in BusinessWeek called “Sector Watch.”

For a good primer on sector rotation, see Chris Stone’s article on Investopedia.

Stone includes this quote by Stovall:

“The National Bureau of Economic Research sets dates for peaks and troughs in economic activities, based on its assessment of such factors as gross domestic product and employment growth. Since 1945, the U.S. economy has experienced 11 recessions and 10 expansions (it’s now in our 11th expansion). Growth periods have lasted an average of nearly five years (59 months, to be exact), with the shortest being 12 months from July, 1980, to July, 1981, and the longest at 120 months from March, 1991, to March, 2001.”

Stovall’s data about the average life of growth periods being 59 months contradicts the factoid I threw out yesterday of 43 months. I’m not sure how that too-conservative figure got lodged in my head, but I’d go with Sam on this one. He’s got more economic number-crunching experience and capabilities than I ever will.

Below is a sample of a research product that S&P puts out weekly, which gives great snapshots of the major sectors they track in the form of Relative Strength Charts, with 39-week moving averages and the S&P 500 index as the baseline of performance (green line). It can be accessed for free on the SectorSPDR website.

Is the Sector Game Faster Now?

Sector rotation is definitely worth paying attention to because it’s part of the asset allocation strategies controlling lots of stock market money. Even if you don’t believe the economic cycle approach should be followed religiously, it still pays to know who might be doing what that moves the market.

What you probably notice is that these moves happen more often as hot hedge fund money chases quick returns, buying a sector one month and selling it the next. In a sell-off of a strong area, say energy or retail or biotech or commodity stocks, it’s easy to forget sometimes what’s really going on and that the longer-term sector idea may hold.

For example, we’ve seen dramatic moves in materials and “commodity” stocks in the past nine months, from basic mining products and precious metals to agriculture and fertilizer names. As stocks like Freeport-McMoRan (FCX) and Potash (POT) get traded back and forth in rising channels, you can get whipsawed trying to trade them.

But if you see the forest for the trees—the sector, not just the stock—you can better gauge what institutional money is doing. Financials have outperformed only because they were so battered in 2008, while energy has been a steady place to have money.

Materials and technology were market leaders in 2009 and this does not seem to be letting up yet. Steel stocks started getting upgraded by major investment houses and analysts last month as information channels saw the surging demand from China. U.S. Steel (X) made a huge move after it broke above $50. Admittedly, that was one I missed and would have jumped on for the chart alone had I been paying attention.

Money Flow Windows

Places you can get reliable data on sector rotation are scattered. The Standard and Poor’s charts above give you a solid idea of the longer-term trends. And its Web site always has earnings projections by sector if you want to compare those forward estimates to the current trend. If you are playing a short-term game, you really have to setup your own sector watch lists using ETFs and the top names in them so you can be ready to “buy the dips, and sell the rips.”

Two other sources that are invaluable for macro money flow data are TrimTabs.com, which publishes proprietary analysis by subscription (but even looking at the data that is over one month old is still helpful), and the Investment Company Institute at ICI.org. In addition to lots of free education about investing, they provide two data windows worth checking out:

These “money flow windows” can help you see what trends in market ocean currents are continuing, stalling, or reversing. One area in particular I am watching based on their data is the massive bond fund inflows of the last year and when they will start to reverse. For the second half of 2009, total bond fund inflows dwarfed total equity fund inflows $238.4 billion to minus $11.7 billion! The easy guess here is that when interest rates start to rise, this money will find its way into stocks. Where else can it go?

Finally, StockCharts.com has a terrific interactive tool for viewing the flows and returns of the nine major S&P sectors. It has a sliding scroll bar that lets you look at side-by-side performance of the nine SPDR ETFs in rolling 65-day periods going back four years. Try this tool today. If it doesn’t convince you of the power of sector rotation, nothing will!

Two days left in this five-part series on “secrets of the street.” I’m not sure which one I’m going to roll out tomorrow (I’ve got three in mind), but I’d love to hear from you about what you like so far and what you think should be discussed. Email me at KCook@ONN.tv and be sure to always…

“Mind the Risk, Bank the Profits!”

5 Secrets of Wall Street: Profiting from How Stuff Works

Secret One: They Have to Buy Stocks

Secret Two: They Don’t Have to Sell

Secret Four: Liquidity, Information, and Speed Rule

Secret Five: Risk management isn’t a science

They must meet or beat (1) a benchmark, such as the S&P 500, or (2) their peers in whatever realm of investing they focus, like growth, value, fixed income, international, or sector, etc. No matter how much they doubt the recovery’s strength, they can’t miss the bull train. The flip side of this first “secret” is today’s entry.

Secret #2: They Don’t Have to Sell

If you are playing a game where accuracy isn’t that important, and where you can win even if you don’t have the best score, you have an incentive to take more or less risk and not worry about bad shots, missed opportunities, or turnovers. Think about golf or basketball this way. If you win (get paid your salary and bonus, keep your job) just by being average and scoring in the middle of some peer group, or against some benchmark score, all you have to do is follow the group.

This is exactly the position that many equity fund managers find themselves in. They don’t have to sell their stocks and take profits if the S&P 500 is going down because their benchmark is lowering the bar for their performance automatically. Since they don’t get paid for absolute performance, but for following the index, they don’t worry about corrections in a bull market as long as they are in line with their fellow benchmark peers. (Incidentally, this has been one of the strongest arguments in favor of index mutual funds—you get the market return without the fees, the risks, or the mistakes of the manager.)

This is starting to sound like the easiest job in the world—buy stocks when they are going up, hold onto to them if they go down, and you still get paid! Of course, it’s not this cut-and-dry across the money management world. And there are very good stock pickers and portfolio managers who outperform because they don’t play the benchmark game. But in the aggregate, you can see how hundreds of billions of dollars that are tagged to some index benchmark can move together, accumulating stocks with fresh cash every week and hardly fearing the pullbacks.

This was the “ocean current” I recognized in mid-2009 that made it easy to follow the money into stocks. Every pullback was bought and despite unlimited doubt over fundamental conditions in the economy, earnings recovery optimism was given the benefit of the doubt. This created a psychology among fund managers of fear about missing the upside. Putting money into stocks was not a risk, staying in cash was.

Musical Chairs on Wall Street?

And in case you were ever worried that this new bull market would become a game of musical chairs, with concerns about over-extended valuations sending everybody to the exits at once, all you had to do was watch the price chart for a significant break of the upward trend. The June-July six week “correction” barely registered 9% and the SPX didn’t even touch the 20-week moving average. Maybe we’re due for a real correction now, but none of these pros are too worried about it because their sights are set on the fact we are only a few innings into this recovery.

Yes, the trade of 2009 was made easier by the Fed liquidity machine. But it also had the advantage of “opportunity of a lifetime” price levels and the high probability of being a recession trough. In this environment, portfolio managers look out six to twelve months and imagine how good the economy and earnings could be, not how bad. The average cyclical bull runs 43 months on average, with 15 months being the shortest.

The only chair these guys are worried about getting is the one in the corner with the “I missed the rally” dunce cap. Tomorrow, we’ll look at our third “secret of the street,” sector rotation.

5 Secrets of Wall Street: Profiting from How Stuff Works

Secret One: They Have to Buy Stocks

Secret Three: Sector Rotation

Secret Four: Liquidity, Information, and Speed Rule

Secret Five: Risk management isn’t a science

I made my contribution to busting the myth in these two articles from last May:

It’s Time to Buy and Trade!

Disputing the Buy-and-Hold Tenets

Now it’s time to go over some of the realities that still support the myth, or that at least create the illusion that the collective Wall Street investment machinery is a sound, rational operation with the best interests of your long-term wealth in mind. I’ll cover one “reality” per day this week, starting with a review of what moves stocks in the short-run.

This is not a conspiracy theory. It’s a theory about forces that can make you money. Many active investor-traders don’t worry about any collective Wall Street “machine” because they just view it as one big playing field, full of opportunities for good stock picking. But they are probably already betting on—and profiting from—these forces and secrets.

Secret # 1: They Have to Buy Stocks

Wall Street has built a complex machinery over the decades, with a diversity of investor asset pools controlling many trillions of dollars. Pension funds, insurance companies, mutual funds, and hedge funds are the institutional players that hold the majority of capital and make the market move. But is it their view of stock fundamentals that drive equity prices, or merely their combined money flows?

Investing at its core has never been simply about what you think something is worth, but what the market as a whole thinks, in essence, what the other guy will pay. And with lots of investment capital sloshing around in retirement plans, the money flow becomes part of the fundamental evaluation of equities as investments.

I’ll come back to the fundamentals vs. flow question in a minute, after a few words about the daily business of Wall Street. In its highest art form, it is to raise and deploy capital for other businesses through marketing and sales of stocks and bonds. The ancillary function to being the channel for new capital is to facilitate buying and selling of existing issues of stocks and bonds.

This means most of the daily business of Wall Street is continuous buying and selling, and that means promotion of the business in the highest light is vital to inspire more buying than selling over time—otherwise, elements of the business who make their living off of transactions and spreads don’t survive.

Okay, okay, you knew all this and it makes sense, right? Now for the ocean current underneath all this flotsam and jetsam. Large stock market money flows are driven by fundamental economic analysis since all those big institutional players pay big salaries to economists and equity analysts and data crunchers to find and justify their investment picks.

But even if these experts are divided about the direction of the economy and earnings, their institutions will be net buyers of stocks off of the recession and earnings troughs because they have to buy. It’s hard to say how much and how fast things will recover. It is not hard to see why they have to buy.

An Unstoppable Force Becomes The Bull Train You Can’t Catch

They have to buy because the investment business is structured around outperformance, the objective being to meet or beat a benchmark. For most mutual funds and money managers, the S&P 500 is their performance benchmark. If the economy and the S&P have hit a trough, there is a risk that GDP doesn’t recover and we stay in a recessionary trough for some time. After a systemic banking crisis, this thought was certainly on the mind of many.

But there is a greater risk for fund managers that stock averages move higher and they are not on board. When in doubt about whether the economic data will be strong enough to support the rally, they have to err on the side of bullishness and buy stocks because they will be judged against either the averages or most of their peers who own stocks, not against GDP.

I started writing about this in June 2009 and quickly found myself repeating the act about every other week, summarizing several articles in a piece on October 7 titled The Bull Train You Can’t Catch.

Here is an excerpt which introduces the idea of the “V-recovery spread:”

The V-Recovery Spread
In August, I took things one step further and proposed that what we were witnessing was another unstoppable force: the “V-Recovery Spread.” Or rather, the quest—no, need—for outperformance by equity fund and portfolio managers to meet or beat the S&P 500 and their peers that caused them to buy this spread.

The V-Recovery Spread is more than a hypothesis or clever description. Let me show you how powerful it really is and how it’s been an underlying driver for months: As long as it looked like we had seen the recession and earnings troughs, equity strategists had to be buying stocks because they had to bet that earnings would recover fast enough to keep stocks attractive going forward. The V-Recovery Spread represents the gap between trough earnings and rapid earnings recovery—or at least the expectations of rapid recovery—that would keep P/E multiples low as the cycle builds momentum.

Let’s say you believe the fundamentals of the U.S. economy don’t warrant any meaningful—much less rapid or V-shaped—recovery in earnings. Here’s why you still buy the V-Recovery Spread: if you are running assets of $10 million or $10 billion, you are competing against trillions of dollars all chasing the same few thousand stocks.

In other words, given a choice of which side to err on—buying hope about the V-recovery or sitting on your hands and watching others get rich—you as a professional equity manager cannot be caught short, or without having significant exposure to enough of the right sectors.

So on one side of the market we have fund managers, who don’t get paid to doubt, buying stocks. On the other side are those who think too much about current fundamentals and say, “The market is overbought and ahead of earnings… P/Es are too rich… we don’t know how bad commercial real estate could be… etc.” Their doubt continues to feed the momentum of the bull train because they might just be tempted to chase it very soon.

Good News: a Wealth of Ways to Meet or Beat the Market

In March, I said the S&P 500 Index (SPX) would go to 1,000. In August, I said it would go to 1,100 before year end. In November, I said 1,200 is the minimum we should see in the first half of 2010. I’m no genius market forecaster. My crystal ball was simply in watching the #1 “secret force” of Wall Street. Clearly buying the S&P would have worked in this scenario.

But picking stocks and following the money trail reflation trade in cyclical recovery sectors and commodity based stocks wasn’t too hard either. Everything got trashed in 2008, from tech and biotech to energy and retail, and suddenly you could find bargains across the spectrum. Whether they are still bargains now doesn’t seem to matter because “Wall Street” (the collective investment establishment, which is simply global money managers in aggregate, not some secret society) isn’t ready to sell. I’ll explain why tomorrow in Secret #2.

5 Secrets of Wall Street: Profiting from How Stuff Works

Secret Two: They Don’t Have to Sell

Secret Three: Sector Rotation

Secret Four: Liquidity, Information, and Speed Rule

Secret Five: Risk management isn’t a science

Buy 10,000 March 105 puts for $1.70

Sell 10,000 March 100 puts for $0.40

Sell 10,000 March 110 calls for $1.20

Net debit for the spread: $0.10 x 10,000 = $100,000 with unlimited risk exposure to naked 110 calls, which would require additional capital.

10,000 options = 1,000,000 underlying shares. And 1 million shares x 10,000 yen = 10 billion yen, equivalent to about $107.5 million.

The FXY reflects the price of the Japanese yen in U.S. dollars, so if the price of yen rises in dollars, the yen is getting more expensive. Conversely, if this yen ETF falls from its current price near $107 to $103, the yen would be getting cheaper. And this is exactly what this large options trader is betting on: a weaker yen.

If you are not familiar with the different ways that currency prices are quoted, one more point about the convention of the FXY is in order. Since it currently takes about 93 yen to buy a dollar (quoted as USD/JPY 93.00), converting this to dollars (taking the reciprocal, or dividing into 1) yields $0.010752. The FXY then takes that amount and multiplies by 10,000 to create a share size for the ETF that is functional for investors.

Why So Bearish on the Yen?

The Japanese economy has been in the cellar for more than 15 years now, and the last thing that exporters and government officials want is a stronger currency. Since the U.S. dollar’s renewed strength last month, they have been breathing a big sigh of relief in the land of the rising sun, as many FX watchers had been predicting a challenge of the 80 USD/JPY level—an intolerably strong yen for the Japanese that would force them to intervene in interbank markets and buy dollars with yen to weaken their currency.

The two events today that are providing good opportunity to establish dollar-bullish/yen-bearish positions like the one above came in the form of Japanese Ministry of Finance (MOF) official chatter and the U.S. jobs report. Fresh on the job for his second day, Finance Minister Naoto Kan straddled the policy fence when he said, “Currencies should be determined by markets, but I must be aware that I have the right and the responsibility to take action in emergency situations.” Translation: I’m a free market kinda guy, but l’ll intervene to keep the yen competitive for our exporters if it doesn’t maintain its current lovely weakening trend.

What timing! Just as the yen hit a four-month low versus the dollar of 93.75 to welcome Naoto to his new post, currency traders around the world did the opposite of his wishes and took profits, buying that yen weakness. USD/JPY 93.75 is equivalent to about $106.66, and a move down to the pre-Non Farm Payrolls (NFP) low of 92.86 by 4 a.m. EST was equivalent to $107.69 on the FXY. Since these two different ways of pricing the exchange rates are reciprocals of one another, they move in opposite directions.

And since I don’t believe the FXY trades 24 hours (it is after all a U.S.-based security regulated by the SEC), the highs and lows between it and the cash yen will rarely line up because the ETF misses all of the overseas trading action. More on this and other limitations of the ETF in a moment.

This dollar-selling/yen-buying set the tone for a stronger yen and weaker dollar in currency markets overnight, so that when the U.S. NFP report released at 8:30am ET came in worse than consensus at 85,000 lost jobs-and the revisions were no help either-the dollar quickly lost more ground, trading down to USD/JPY 92.26, or what would have been above $108 on the FXY if it had been open for trading. Though it might seem logical for investors and traders to sell the dollar on weaker than expected economic data, the real story for the dollar these days is about interest rates.

In this environment of extraordinary fiscal and monetary stimulus, we are closely watching when the liquidity will end because this will impact all types of asset trades, from stocks and bonds to commodities and other currencies. The dollar carry trade, where you borrow cheap dollars to invest in other higher-yielding assets, got a jolt last month when threats to monetary stability in the Eurozone (a la Greece and Spain downgrades) and speculation about the U.S. recovery prompting higher interest rates sooner rather than later drove sizable reversals of positions back into the dollar.

By 10 a.m. EST, the dollar rallied back to 93.25 and this is about the time and place that brought our large yen options trader out of the woodwork with the FXY below $107. This trader is clearly betting that today’s dollar weakness/yen strength will be temporary, especially since their large trade only has 70 days to expiration.

Why FXY May Not the Best Way to Play the Yen

Rydex has a handful of these “currency shares” ETFs, including one for the euro, British pound, and Australian dollar. One of the shortcomings that I’ve already highlighted is their constraint of only being available for trading during normal US equity market hours.

There are at least two more issues traders should consider before using these products:

1) Avg. daily volume in the FXY ETF is 218,000, and 10,000 options are equivalent to 1mio shares. Clearly the options volume exceeds the underlying share equivalence, which is rare in large-cap equities. This may not be a significant factor affecting the functionality or stability of the ETF since cash market positions are likely used to hold the actual yen and the underlying cash market is very deep. But option activity may drive the need for the ETF sponsor to restructure or issue new shares, as happened with the UUP recently.

2) Leverage is very low, even with 50% margin capability in a security account. Though using cash market leverage of 200-to-1 is absurd for most currency traders, and especially for investors looking to hedge foreign or domestic equity exposure, the capital you would have to tie up to get any meaningful return in these ETFs is not worth it. CME FX Futures offer very comfortable leverage of roughly 30-to-1 and variable contract sizes.

For more liquidity in both underlying currency positions and options, CME FX futures and options are the best choice overall. With unmatched liquidity, safety and versatility, they offer the small to medium size FX investor the right tools for the job. See my article about the structure and benefits of these ideal FX products.

This current low volatility is an opportunity, either way you look at it. Buying puts offers protection at a reasonable price after an incredible run in stocks the past nine months. And traders looking for directional opportunities or volatility spikes may find some spots to play as well.

For our Option Trading Alerts Premium service, we initiated a February long straddle on the S&P 500 ETF (SPY), where we paid $5.25 for the Feb 114 call and put combined. Our rationale is based on getting exposure to a resurgence in volatility ahead of earnings season. And if you think the VIX is cheap vol, you should look at these at-the-money strikes trading for under 17%.

To read the full trade explanation and management strategy, sign up for the OTA. It’s free and fast. You can be reading all the recent trade recommendations right here in just a few minutes.

Does Ben Bernanke care about the stock market or inflation? Yes, he wants both higher. In fact, he’ll take any increase in any asset prices because the real problems with this economy are much scarier than stock bubbles, $3.00 gasoline, or a falling dollar.

The real problems are the systemic banking crisis and its ties to real estate, both residential housing and commercial property. Bernanke and Hank Paulson staved off a banking—and therefore, an economic—collapse last year with swift action. But that was only the beginning.

And quickly going from credit bubble to credit freeze in 2008 only intensified the problems that had been brewing for years. This made the next tasks of Fed and Treasury, after halting Depression 2.0, even harder: (1) help banks stabilize their junk-filled balance sheets so they can survive, pay their debts, and lend to businesses and conumers, and (2) help homeowners keep from drowning in their underwater homes, which obviously has spillover effects for banks and the economy at large.

So, where are we now in that healing process? Bottom of the third inning is my guess. But my analysis or opinions aren’t the ones that count. If Ben thinks we’re still in the second inning, we may not see a rise in the Fed funds rate until the fourth quarter.

And keep in mind that the Fed funds rate is not the key benchmark here that he’s worried about. It’s just a symbol of his campaign. The real goal is keeping mortgage rates down, and he has and will continue to use all available tools. Quantitative easing (QE) is all about throwing liquidity at the problem, whether it’s TARP, Treasury and MBS purchases, or other creative credit facilities.

The Fed vs. the Bond Vigilantes

Lots of non-experts (myself included) go on TV and talk about how the bond market “vigilantes” will drive interest rates higher before the Fed thinks it necessary to “take away the punch bowl.” This is barely noticeable now, with 10-year Treasury yields crawling up toward 4% in the past month.

It doesn’t seem like this pace will quicken much, as I’ve talked here repeatedly about the Treasury curve finding it harder to get much steeper. Not an economist or financial analyst, I don’t try to figure out where things should be. As a trader and market analyst, I simply watch what big-money investors are doing and then follow where things are going, and at what pace.

These three articles from the third quarter of 2009 may still be relevant into that of 2010:

September 9:  Don’t Fight Inflation – Buy it! : Asset re-flation has been in full force since early this year, and it’s not over yet.

September 24:  Bernanke’s Bet, Bernanke’s Trim Tab: Fed Chairman stays the course, adjusts gradually.

September 30:  Inflation and Higher Interest Rates Coming? Still Not Yet: The yield curve sees inside the Fed’s mind.

The question becomes, “When does Bernanke think we’ll be out of the real estate-haunted woods?” I am keeping my bets on late this year, more likely Q4 than Q2. Craig Torres’ Bloomberg story this morning, “Commercial Property Is Biggest Risk, U.S. Bank Examiners Find,” has a lot of good quotes and data points that we can assume are front and center on the Fed radar. Here are some bullets I threw together from that piece:

• Loan losses will continue to be historically high and hundreds of banks will fail (this is consistent with the prediction I highlighted in 2Q 2009 from Wilbur Ross that “thousands” of banks would need to fail before this crisis was over).

• Fed Governor Elizabeth Duke said Monday that credit conditions in commercial real estate “are particularly strained.”

• Loan failures in commercial properties like malls, hotels, and apartments hit the economy in a vicious cycle as banks “reduce lending and conserve capital to absorb losses,” thereby impacting investment and job growth.

• Default rate on commercial mortgages doubled to 3.4% in 3Q09, highest since 1993.

• $3.5 trillion in commercial property debt in existence as of June 2009. Over $1.5 trillion in loans will mature over the next three years. As I said in the middle of last year in several media appearances when I first heard these figures, the simple math in Bernanke’s mind is that a big chunk of these loans will struggle to get refinanced, so he’d better keep rates down for as long as possible to keep the bloodbath manageable.

• “Regional banks are almost four times more concentrated in commercial property loans” than the big banks, Torres reports. This is what I talked about in November after meeting a board member of the Chicago Fed who explained to me how small-to-medium sized banks got forced into the risky lending market for strip malls and motels in the middle of the last decade after mortgage monsters like Countrywide squeezed them out of the residential housing market.

• Case and Shiller pessimistic on prime mortgage defaults. I wrote about this trend based on another Bloomberg story on Monday in “How Long the Last Decade’s Housing Hangover?”

• Finally is the question of whether the Fed flinches at the end of March and extends its MBS purchases instead of ending them as announced. Mortgage rates have held close to their record low of 4.71%, ending 2009 at 5.14%. But any quick ascent this year could make Fed officials re-enter that market.

Transparency is King

Some of the best and brightest yield curve minds in the nation are starting to turn up the rhetoric against Bernanke’s methods. Exhibit A is PIMCO’s Bill Gross referring this week in his commentary to the “sugar daddy” that is current Fed policy.

That kind of talk could get tougher. It’s one thing when your average market analyst (think me) says so. But when the steady-hand manager of the biggest institutional bond money in the world says so, it’s a good idea to pay attention and figure out what he sees and thinks. If Gross believes that low interest rates hurt more than help, that makes me think the crisis has many years to go before it’s worked out.

The only thing you can count on now is the Fed continuing to monitor all aspects of the banking and real estate recovery. They will report often on the health of and risks to the patient here because it’s the number one area they are watching. Unemployment, consumer confidence, and inflation numbers are mere symptoms of the disease underneath it all.

Counting on the Fed is not a bad trade either. I think we’re in good hands with Bernanke because he will use the data to direct his policy decisions, and change course accordingly. It’s not all in his hands either—there’s a lot of bright minds and a deep information network fueling Fed policy.

The biggest market participants seem to have their confidence in the same place. How do I know? Well, I don’t know for certain. Again, I just watch what the big and smart money is doing. Now they are voting with their investment dollars that the economy is on the right track and in good hands.

And they trust that we will get plenty of notice if and when conditions are set to change. That’s why I called Chairman Bernanke the Maestro of Transparency weeks before Time magazine made him 2009’s Person of the Year.

Both are worried about the housing market and the consumer. And both believe that once the government fiscal and monetary stimulus are exhausted or withdrawn, the hangover from the last decade’s credit bubble will continue its slow, painful process of wringing out excesses and punishing all but the wealthy.

As I said yesterday in my notes on the prime mortgage chapter of the housing bubble hangover, this systemic, generational financial crisis was not over when the Fed and Treasury bailed everyone out and the stock market bottomed. This debacle will have aftereffects for years to come as $2 trillion in toxic mortgage assets, millions of underwater homeowners, and the unemployed-foreclosure cycle weigh down a real estate recovery.

That’s why the government moved on Christmas Eve to extend permanent “get out of jail free” cards to Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). That Santa Claus surprise was actually a well-planned stocking stuffer to shore up the housing recovery and make sure the implosion of those two massive balance sheets didn’t take the other fragile giants (NYSE:BAC or NYSE:C or NYSE:AIG) down again.

Or, Will Main Street Save Wall Street?

I think when consumer balance sheets and housing are lean-and-mean again in a few years—say 2013—the stock market will make new highs. That’s how Main Street saves Wall Street. The interesting question now is, “How do economic players adapt to this long healing process where rules change and uncertainty still motivates creative profit incentives?”

My friend Joel Block has one idea about how players on Main Street are incentivized to make recovery happen in his first blog post of the new year called, “Have We Hit Bottom?”

Joel is a business consultant who earned his economic street smarts in venture capital and real estate, and now advises entrepreneurs on growth strategies, particularly in real estate syndication.

His idea is for investors to get busy finding real estate bargains, and I found this intriguing because it fits with my idea about “buying inflation” now—and because Joel was inspired by the outlook of a banking insider. Here’s an excerpt from his post about the incentives and the opportunity:

I was speaking last week with a long-time friend who is a senior executive with one of the major banks in the country. He told me that the new strategy for his bank (and the other big ones are on the same track) is to create loans that amortize over a 25-year period instead of the traditional 30-year period. These new loans are five year fixed interest rate loans that are fully amortizing with a balloon due at the end of the 5th year.

The bank’s goal is to set their customers up so that they will refinance in five years. The bank’s expectation is that in five years rampant inflation will raise asset prices dramatically, making refinances easier. Further, many of the problems that exist in the economy now will have taken care of themselves, and refinancing should be easy (or easier).

This executive is convinced that the bank is not setting their customers up to fail, but rather, they are setting their customers up to be able to take advantage of the improvement in the economy five years from now.

Five years is a good healthy period for the “bubble decade” to work things out. I’m with Joel on accumulating solid real estate properties in this environment and now is probably a good time to make some “buy and hold” investments in that asset class. As for equities, I am still a “buy and trade” strategist because the price swings over the next few years (as I said in the very first column here) will be too good to resist.

Double-dip recession or not, the collective anxiety of investors over US debt, deficits, and inflation will keep the stock market as emotional and volatile as ever. And that’s where the short-term trading opportunities are the best.

The primary causes? Joblessness among the upper middle class and ARM resets they can’t stomach. I went to Bloomberg.com to learn more and found the main article by Kathleen M. Howley and Mike Dorning, based on the research of Robert Shiller and Karl Case, the economists who created the S&P/Case-Shiller Home Price Index.

Shiller is quoted in the piece, saying that rising prime mortgage foreclosures are “creating a huge shadow inventory of homes that are still owned, but they’re not going to be on the market in the next year or so.”

Case, noting that “unemployment is not respecting income boundaries” sees signs of recovery for the housing market, but both believe even the rich will default on an underwater home in favor of paying their other bills when cash flow dwindles.

Animal Spirits Prefer New Haunts, Not the Last Bubble

I saw Shiller last week on Larry Kudlow’s show where he offered some cautious optimism after last week’s housing price and sales data. Kudlow was able to get the shy Shiller to admit he saw some “animal spirits” in the numbers. This reference was not lost on those who are familiar with Shiller’s latest book, whose title I love.

Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism (2009, Princeton University Press) sounds like it was written by a behavioral finance theorist, or a trader, not an economist. Here is a guy with his finger on all the data, yet who understands the complex and chaotic truth that confidence often matters as much, if not more, than econometrics.

“I do see some signs of animal spirits , but it’s a mixture,” Shiller is quoted in the Bloomberg article from comments last week. “It would be entirely plausible that we would have a weak housing market for many years.”

Remember, this is the guy who foresaw the tech bubble of the late 1990’s in his Irrational Exuberance and was bearish on housing early in the last decade. And he’s looking at the psychology of the bubble, not just the hard numbers.

Bottom line: Housing to remain haunted this decade by the excesses of the last.

Everyone now seems to understand that Bernanke’s current stance on deflation—that it is the worse of two evils—is built out of his Depression scholarship and his eye on the on-going Japanese specter. But now we wonder if he has the wisdom and the will to tighten rates before it’s too late and inflation roars out of control.

Clearly, the encouraging economic recovery data and bubbling asset prices in stocks and commodities will make the Fed’s exit strategy the number one financial issue of 2010. But I have written extensively this year about why all the handwringing in 2009 was premature and unnecessary:

September 9: Don’t Fight Inflation – Buy it! : Asset re-flation has been in full force since early this year, and it’s not over yet.

September 24: Bernanke’s Bet, Bernanke’s Trim Tab: Fed Chairman stays the course, adjusts gradually.

September 30: Inflation and Higher Interest Rates Coming? Still Not Yet: The yield curve sees inside the Fed’s mind.

From Pushing on a String to Pulling on a Spring

In November, I started to look ahead at how the Bernanke Fed will telegraph an earlier shift in policy if the positive economic recovery data continues to surprise. I wrote a piece about the Fed Yield Curve Building an Instability, explaining how quantitative easing (QE) could be “pulling on a spring.”

The dire consequences of massive debt, deficits, and inflation are not new topics for Kudlow or Rick Santelli. But when they were ranting about them last summer, had they gotten their wish and the Fed tightened then, would the recovery have moved from still-very-fragile to arguably-stable as quickly as it as?

All of these questions became especially relevant this morning after initial jobless claims continued to warm our economic hearts, with continuing claims dropping below 5 million for the first time in a long time. Earlier in the week, the talk focused on how inadequate were the Fed’s two recent measures to soak up liquidity—reverse repos and term deposits. These “sponges” are among just a few of the tools the Fed has to drain money from the system as needed and many brighter economic minds than mine are confident Ben and Co. will use them well when needed.

Bernanke’s Sponge and the Politics of Failure

So now I am in the camp that the Fed can tighten rates and roll back QE in the first half of 2010 and we will be okay—as long as these two conditions are met:

1) Economic data about the recovery keeps its steady upward trend

2) Commercial real estate debt bombs don’t cause financial shockwaves that lead to a double-dip recession

McTeer, when asked by Kudlow how soon the Fed will hike, said he is looking at June. I respect McTeer’s cool, plain-spoken approach to all things Fed. Obviously, draining excess liquidity will start before then. And transparent communication about the schedule and pace will hopefully keep the stock market calm and collected.

Since no one is worrying about the amazingly strong stock market anymore, all eyes are on the Fed’s exit from QE. The danger is that Congressional New Year’s resolutions and autumn election dreams interfere with Ben and Company’s measured plans and careful evaluation of the data. I’m far more worried about the politicization of this exit than I am about Ben’s ability to orchestrate it.

By mid-September, the IBB advanced from below $60 to a 52-week high of $84 and I compiled a quick list of all the bio-pharma deals of 2009 driving this advance in my report “Biotech Bull Train Fueled by M&A”

I chose the IBB as the best instrument for conservative investors after rejecting a few others: the Biotech HOLDRs (BBH), the SPDR S&P Biotech ETF (XBI), and some of the newer, more-focused ETFs whose lack of liquidity or narrowness made them ineffective for my goal, which was simply safe and broad exposure to the industry that avoided both the necessity of expert stock-picking and the excessive volatility of biotech company-specific risks.

But today I came across one outstanding biotech ETF I had overlooked in a great “under the hood” article by Corey Williams of HyperionFinancial.com in their newsletter The Dynamic Wealth Report. Williams quickly breaks down the pro and cons of six funds—including the three just mentioned—in his piece titled “Three Bogus Biotech ETFs… And One Great One.”

An ETF-focused advisor, Williams highlights some of the key criteria for evaluating any ETF: costs, diversification, liquidity, and index construction, which covers elements like security weighting and re-balancing methods. Based on his criteria, he also rejects BBH and XBI and two of the new comers. He likes IBB, but his favorite pick is the First Trust Amex Biotechnology Index Fund (FBT). His simple compare-contrast analysis of XBI vs. IBB vs. FBT is a great lesson in due diligence evaluation of ETFs.

Index Construction is the Key

IBB holds over 120 Nasdaq biotech stocks across all market caps, giving investors exposure to top names like Amgen (AMGN), Gilead (GILD), Teva (TEVA), Celgene (CELG), Genzyme (GENZ), Vertex (VRTX), and Biogen Idec (BIIB) as well as dozens of smaller, up-and-coming biotech names. It’s the small companies that get us excited in biotech investing because these are the places that new blockbuster drug discoveries can come from and turn a $2 stock into $20 ten-bagger.

But these “lottery ticket” stocks are far and few between and you can buy 10 of the wrong ones before you hit the jackpot, to say nothing of the stock that doubles or triples in price on news of FDA trials that eventually never pan out and the stock goes right back down—often in one day on the announcement. That’s why unless you do all the homework on these companies—and understanding biotech research has to be the hardest investing task out there—I think most investors will do better focusing most of their capital for this sector in a well-diversified ETF.

The problem with the IBB is that it is market-cap weighted, which means it will tend to concentrate assets in the big cap names and be underweight the small cap names which we just established have the most potential. While Corey Williams believes the IBB’s wide diversification makes it “quite possibly the best gauge of the biotech sector’s overall health,” he says its big cap bias “will keep [it] from fully capturing the explosive potential of biotech investing.”

XBI holds only 28 stocks and trades less than 125,000 shares per day on average. It has many of the same top-ten holdings as IBB and it is an equal-weighted index, meaning each issue is balanced to be roughly the same dollar slice of the fund pie. This gives small cap stocks more bang in determining the fund’s overall performance. But, with so few names, not many are of the small cap variety that has served the IBB so well this year, trouncing the XBI’s gains 15% to 1% respectively.

The Winner By a Genome

The IBB is certainly worth putting some long-term investment money into but as Williams says, “The secret is investing the same amount in the ‘Big Guys’ as the small start-ups.  That way you get steady growth and explosive upside potential.” His favorite equal-weighted biotech ETF, and the best performer in the sector for 2009, is FBT which is up over 50% for the year.  He believes that this ETF’s fair hand for the little biotech engines that could “gives FBT an edge over other biotech ETFs year in and year out.”

That might be true in the long run. But if we look at the specific stock action that actually gave this biotech ETF its outperformance over others in the same sector, we find a single culprit in 2009: Human Genome Sciences (HGSI). I only discovered this when I looked at a price chart and saw the massive price launch FBT had in July from $21 to $27 in two weeks! Sector ETFs don’t move 28% in two weeks, I thought, so I looked at the top holdings and sure enough, HGSI had grown to 21% by the end of September.

HGSI may have started out “equal-weight” in July when the stock was only trading for $5. But when it launched to $20 in late August, it gave the FBT its sector-beating performance. It appears that FBT has since rebalanced sometime in October, since HGSI is now back down to about a 5.5% weighting along with the other holdings, even as the stock has soared another 50% since then on confidence in its likely buyout by a bigger biopharma brother (probably Glaxo).

My conclusion? There’s a place for both the IBB and FBT in a biotech investment campaign. More importantly, this has been another great lesson in learning what’s “under the hood” of those handy, multiplying-like-rabbits power tools we call ETFs.

From the First Trust fact sheet for FBT:

Fund Objective

This exchange-traded fund seeks investment results that correspond generally to the price and yield (before the fund’s fees and expenses) of the NYSE Arca Biotechnology IndexSM. The NYSE Arca Biotechnology IndexSM is an equal dollar weighted index designed to measure the performance of a cross section of companies in the biotechnology industry that are primarily involved in the use of biological processes to develop products or provide services. Such processes include, but are not limited to, recombinant DNA technology, molecular biology, genetic engineering, monoclonal antibody-based technology, lipid/liposome technology, and genomics. The index is rebalanced quarterly based on closing prices on the third Friday in January, April, July & October to ensure that each component stock continues to represent approximately equal weight in the index.

If you look at a quote chain for January S&P 500 (SPX) options today, you will find that at-the-money (ATM) strike calls and puts have implied volatilities hovering around 16, while the VIX is at 20. A month ago, you would have found a similar picture with the SPX ATM strikes having implied volatility (IV) of 21-22 while the VIX was at 25.

If the VIX is based on SPX option prices and their implied volatilities, why is the VIX consistently higher than the ATM strikes of the SPX? This is due to a couple of factors involving the way the VIX is calculated.

First, the VIX uses nearly all out-of-the-money (OTM) SPX options, or at least every OTM with a bid. Today with the SPX at 1,127, this means from the 1,125 put all the way down to the 710 put and from the 1,130 call all the way up to the 1,300 call. The nickel bid in the 1,300 call creates an IV of 22, while the same bid in the 710 put, over 400 S&P points away, creates an IV of 60!

Granted, these strikes are weighted and plugged into the VIX formula based on their probability of finishing in-the-money (ITM) so that deep OTM options have less effect on the VIX. But, in aggregate, the dozens of OTM call and put strikes with markets that create higher-than-ATM IV, end up creating a slightly higher VIX.

This phenomenon of option markets draws a picture for us—or at least a nice smiley face—because the VIX calculation ends up taking into account the volatility “skew,” whereby OTM options have higher IV than ATM options. This skew creates the infamous volatility “smile” whereby options on the same underlying, and for the same expiration, have different implied volatilities at different strikes.

Second, the VIX calculation uses a blend of the first two expirations of SPX options. So, if the volatility “curve” is sloping upward, implying higher volatility further out in time, so too the VIX with February options included in the number crunching will be higher than January options alone.

To see some quick and dirty pictures of both of these ideas—volatility skew and curve—check out this options chalk talk I did a couple of weeks ago.

How Does the VIX Compare to Actual Volatility?

Two other useful windows to keep an eye on options volatility are (1) to look at the ATM straddle and see what kind of move option markets are implying is most likely, and (2) to compare implied volatility to historical volatility, or IV vs. HV. The first one is easy and something every options trader should be familiar with because it’s a handy snapshot of expected volatility every day.

This morning, the January SPY 113 straddle was trading for about $3.30, which implied about a 68% chance of a move of less than 3% from 113 (SPX 1130 essentially) for the next 18 days. The “68% chance” part is all about standard deviation and statistical probability, the roots of option volatility calculations and the pricing of risk.

The second window is more a matter of your interpretation of the volatility trend and if it will continue or reverse. Below, is a volatility chart of the SPX for the last two months, comparing ATM option IV (the black line) and 30-day historical volatility (HV is the green line). In November, this picture of volatility and our ideas that the market would remain “sticky” at 1100 made us sellers of SPX volatility through a December SPY iron condor in our OTA Premium Service.

What may be surprising or fascinating (or both) for you is that 30-day HV dropped to 13% recently as the S&P 500 did indeed remain very sticky at 1,100. We were right this time and what’s funny about markets is that this unsustainable trend may actually continue into January. That’s a bet that many option traders are making while others load up on cheap vol, looking for the next fear-filled event to shock the markets. Again, it’s up to you to decide if vol is a cheap or dear, if it will get more expensive from here or continue to fall.

Finally, for a professional option trader’s view of the VIX this month—and another useful nuance that might help you decide what’s cheap and what’s dear—catch Steve Claussen’s recent blog post. Steve is the chief investment strategist for broker OptionsHouse, and with more than 25 years of experience in options markets as a trader and a risk manager on and off the floor, he has a wealth of volatility insight to share.

These five stocks are in the top seven holdings in MOO and comprise approximately one-third of the ETF’s weight. MOO has rallied 80% since it’s March lows to a 15-month high of $45.57, and it’s up 125% from the $20-level it hit in November 2008. As I noted in the piece on Tuesday, ag stocks made significant lows during the height of the credit crisis but did not make new lows in March, making this a leading industry group along with technology shares.

This ETF stands out among most “commodity” ETFs because it doesn’t use futures contracts or swaps to invest. This avoids the problems we see in ETFs for oil, natural gas and grains like the USO, UNG and PowerShares DB Agriculture Fund (DBA). Investors who thought they could capitalize on top commodity investor Jimmy Roger’s thesis that agriculture has the most attractive fundamentals of any sector have probably bought the DBA ETF hoping to ride the wave.

But the truth is that DBA, which recently expanded from investing in corn, wheat, soybeans and sugar futures to include soft commodities and livestock, has performed terribly relative to MOO, marking less than an 8% return in the past year. This is more proof that before you invest in an ETF you need to understand what the holdings are and what they are trying to track. A basket of stocks in an industry group or sector might have much more predictable results than one that uses futures contracts and commodity swaps to create returns or track an opaque index.

Opportunity on the Pullbacks

POT is down 11% this week. MOS is down 5%. MON is down nearly 4%. ADM is essentially flat since its July highs above $32 and DE is still near its 52-week highs above $55. If you can’t pick which stocks to buy, or don’t have enough capital to place the right risk-appropriate bets, the MOO ETF might be the way to go. It allows you to buy them all and worry less about week-to-week fluctuations in this mega investment trend that will carry on for years.

Plus, you get exposure to lots of other names besides these five, so that you are diversified among many seed, fertilizer, machinery and food competitors. And the global diversity among the companies means you gain broad expertise across many geographies and economies addressing the challenges of feeding the world. MOO is down about 3% this week, and looks like it should have good support between $40 and $42. Here’s the fund description from the Van Eck website:

The Agribusiness ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the DAXglobal® Agribusiness Index. The Index provides exposure to companies worldwide that derive at least 50% of their revenues from the business of agriculture. As such, the Fund is subject to the risks of investing in this sector.

• Thursday, December 10, I wrote about the Dec 65 straddle (combined premiums of the put and call) trading for $6.40 at 77% implied volatility
• Wednesday, Dec 16, during the webinar, it was trading for $5.30 at 105% implied volatility
• Today, Thursday Dec 17 (one day before Dec options expiration), the 65 straddle is trading for $5.20 at 138% implied volatility

The obvious question is, “Why do the implied volatilities tell us the option prices are so high—rising 50 volatility points from 77% to 138%—when clearly the price of the straddle has been declining?”

Why implied volatility seems to sometimes soar higher in the week before expiration even as option premiums decline

The short answer: Because the option premiums are “decaying” less than the pricing model “theoretical value” would dictate they should.  In other words, the option premiums imply a volatility that is extremely high simply because they aren’t losing their time value the way they are expected to.

The long answer: Theta is the option “greek” that tells you how much an option premium should decline with each passing day. This is commonly known as “time value decay.” For instance, if the theta of the March 65 puts in RIMM is -0.030 and the Dec 65 puts are -0.787, you can see that theta gets bigger as you get closer to expiration. Most option traders know intuitively that time value decay accelerates in the last few weeks of an option’s life.

As theta gets bigger with each passing day, and takes more time value premium out of the options with each passing day, this lowers the theoretical value of the option. But if an expected event like earnings is on the horizon before expiration, options can stay bid well above their theoretical value. This results in a much higher implied volatility. Below is a snapshot from an OptionsHouse quote chain for RIMM puts.

The big caveat to this discussion is in understanding the extreme nature of implied volatility the closer you get to options expiration. First, remember that implied volatility is expressed as an annualized number. It looks distorted to talk about 138% volatility with a few days to expiration, but if you just think of the option straddle pricing in a potential 8-10% move upon an event, it makes more sense.

By this I mean that if you take the straddle price of $5.30 and divide by the strike price of 65, you get 8.2%. This means option markets are pricing in a potential 8% move, up or down, after earnings. After September’s quarterly report moved RIMM 15%, this Dec straddle seems tame (see my piece from last week).

Yes, 138% implied volatility seems too high. But, the market makers who sell you these options know what to expect from a RIMM earnings event and they can’t take the risk of selling any cheaper. They’ve seen this movie before and it ended badly, and not just in the last quarter. Market makers have to take a lot of small bets with “theoretical edge” to make money, not a handful of big bets that put them “all in.” So, with a few hours to go before RIMM’s next thrilling report, the pros are definitely not rolling the dice.

Buying straddles or strangles on the SPX or SPY are two ways to play a spike in volatility. A straddle is the simultaneous purchase of a call and put, usually at-the-money. If you buy the January SPY $111 straddle for $4.70 today, you need the market to move by that amount higher or lower just to break even on the trade. Or you need a rise in volatility to generate an increase in the option premiums. A move of $4.70 would equate to roughly 45-50 points on the S&P 500 index, which seems perfectly reasonable in the next month—except for the fact that it hasn’t been happening for five weeks and those who have tried to get long or short the market, or buy volatility, have lost money.

A less-expensive way to play volatility is the option strangle. A strangle is the simultaneous purchase of an out-of-the-money (OTM) put and call. Here is a trade idea we looked at on Monday, a strangle on the SPDR S&P 500 ETF (SPY):

With stock market volatility at levels not seen since before the meltdown of Lehman and the start of the credit crisis, traders may want to position for a move out of the S&P 500 Index’s (SPX) five-week consolidation around 1,100. One affordable way to do this is by buying an option strangle on the SPDR S&P 500 ETF (SPY), which is the simultaneous purchase of an out-of-the money call and put. This option-trading idea can become profitable on a shift in price or a rise in volatility.

SPY Strangle Trade Details:

The SPY is currently trading at $111.80.

Strangle–

• Buy the January 107 put for $1.16 per contract
• Buy the January 115 call for $0.84 per contract.
• Net debit of $2.00

This strangle is now trading for $1.80, a loss of $0.20 in two days as the market continues to barely drift higher. When I looked at this strangle on Monday, implied volatility for the 107 puts was around 21 and the 115 calls were trading for about a 16 IV. The vols are the same today, and the time value in these January options simply continues to decay. This trade could still pay off if some event causes a spike in volatility, but for now it is only an insurance policy for the return of vol.

Or, Still Time to Sell Vol?

What has definitely worked for the past few months is selling volatility. In our Premium Option Trading Alerts service, we sold a December iron condor on the SPY, collecting $0.50 for selling both the 105/103 put spread and the 117/119 call spread. That play proved worth the risk as the S&P has marked time around 1,100.

Here’s another idea I had last Friday for selling an even larger trading range in the SPX:

The broad stock market, specifically the S&P 500 Index (SPX), appears poised for a modest rally in the first quarter of 2010. This option-trading strategy, an iron condor, can tolerate a 165-point trading range (absorbing both an 8% rally to 15-month highs and a subsequent 13.5% correction) and still capture a 55% return on risk at February expiration.

Iron Condor Trade Details:

The SPX is currently trading at $1,102.81.

Below are the elements (one bull put spread, one bear call spread) for this iron condor. Please note that a brokerage platform that provides for four-legged spread trading (such as OptionsHouse ) will allow the simultaneous execution of all four legs, typically paying one spread trading commission to do so. Additionally, if you so choose, you should then be able to set a limit order for the spread as a whole, thereby securing a better credit.

Iron Condor Part I: Bull Put Spread –

• Sell the February 1,020 put for $17.75 per contract
• Buy the February 1,005 put for $15.10 per contract
• Net credit of $2.65 per spread

Iron Condor Part II: Bear Call Spread –

• Sell the February 1,185 call for $8.50 per contract
• Buy the February 1,200 call for $5.80 per contract
• Net credit of $2.70 per spread

Overall credit for the spread: $5.35 (or $535)

Profit/Loss Details:

Maximum profit: $5.35 (the total premium collected) minus commissions.

Maximum risk: $9.65 (the difference between put or call strikes minus the premium collected). Return on risk is approximately 55% for this strategy.

Upper breakeven price: 1,190.35 (the strike of the sold call plus the total premium).

Lower breakeven price: 1,014.65 (the strike of the sold put minus the total premium).

Clearly, commodity stocks and agricultural names—especially those having anything to do with fertilizer and potash—were strong performers out of the bear market lows of 2009. In fact, many of the leaders like ADM, Potash (POT), and Mosaic (MOS) were so strong, they launched off of their October-December lows and didn’t make new lows in March when “Armageddon” was on the economic menu.

What’s Driving the Agricultural Bull?

Two words: China demand. More broadly, and with three words, I would call it, ”Emerging markets demand.” As developing/emerging economies around the globe make the transition from agrarian to industrial economies and their rural populations boost the need for urban jobs, housing and infrastructure, two shifts happen with food. First, these formerly rural populations grow less food for others and themselves. And second, as they became further detached from those local cultural dynamics of subsistence agricultural, they also change their diets.

This second point sets the stage for an exponential increase in food demand. Why? Because urban populations change their diets by moving up the food chain ladder and relying more on animal sources of protein as opposed to good old soybeans. David Hightower explained this dynamic to me recently. He said just think of 1.5 billion people used to living on a few dollars a day raising their living standards and rapidly going from eating a grain-based diet to an animal-based, processed food diet. Hightower’s forthcoming book will focus on many commodity trends of the next decade, and food dynamics will figure prominently.

Bottom line: It takes a whole lot more soybeans to make a cheeseburger in the city than it does to feed a family for a week in their old way of life.

This got me thinking about these trends and I went looking for more perspective, short of just going to the USDA website and piling through the stats myself (which I will definitely have to do when I’m really bored). According to Chris Mayer in the Dec. 7 edition of Agora Financial’s investment letter The Daily Reckoning:

“The average Chinese person spends 40 cents of every additional dollar earned on food. In India, it’s about 70 cents of every additional dollar. What do they buy? They buy more meat, more fruits and more vegetables. Their calorie intake rises. That’s why the UN says we’ll need to boost food production by 70% by 2050 – a big task, given increasing restraints on water and quality arable land.”

What About Brazil?

We know the commodity/emerging markets back story: Insatiable global demand for raw materials, energy and food to grow dozens of industrial revolutions in Asia, South America, and Africa — and at a much faster pace than 1880’s America.  These mega forces are driving the prices of stuff like oil, wheat and copper higher. But money will be made in understanding the individual chapters in this decades-long epic. Ultimately, each revolution—be it BRIC or Southeast Asian or African—depends on the resources of other economies and geographies.

Brazil is a good example of one BRIC helping build another. China has a problem in that it’s the largest importer of soybeans and its available arable land (that which can be use for growing crops) is limited and shrinking due to industrial/urban pressures. China also has a lower level of water resources relative to its size and population. Why is water so important? Mayer states, “Soybeans require a lot of water – 1,500 tonnes of water for one tonne of soybeans.”

Brazil has a vast plain of arable land and lots of water. And Brazil is the second-biggest exporter of soybeans behind the US, so it looks as though China will continue to depend on Brazil for its future supply of the crop. There’s one thing Brazil needs though to keep that happening and make use of the 250 million acres of yet-to-be-tilled arable land: fertilizer. The climate is perfect for growing but the soil is weak on nutrients like phosphate and potash. Again, from Mayer’s report:

“According to estimates by SLC Agricola and Morgan Stanley, the average new acre of farmland in the [tropical savanna known as the] cerrado requires 14 times the amount of phosphate and three time the amount of potash of a typical American acre. This means that it is expensive to grow grains [in Brazil]. You need a high soybean price to make it worth the effort – and there is more to it than just adding the nutrients.”

What Mayer means here, of course, is infrastructure – road and rail access for equipment, workers and grain shipping. Connecting the dots, he points out the simple math of China’s increasing demand for Brazil’s beans driving demand for fertilizer and agricultural systems in general. Mayer concludes in his piece, titled “Food… The Trade of the Decade,” that this isn’t cause for gloom and it’s not a new crossroads. During the Great Depression, while consumption of things like clothing and jewelry fell 50%, “purchases for food—even for meat—held steady.”

A Trade Idea for the Decade of Food

I called John Person this week and asked him what he still liked in the space. Here’s what he had to say:

“I too believe the fertilizer sector will remain hot through the next decade. One stock I am in and want to buy more of is China Green Agriculture (CGA), the Chinese fertilizer company.”

From the OptionsHouse Research site: CGA produces and distributes humic acid organic liquid compound fertilizer through its wholly owned subsidiary, Shaanxi TechTeam Jinong Humic Acid Product Co. Ltd. All of TechTeam’s fertilizer products are certified by the PRC government as green products and suitable for growing Grade AA `green` foods, also known as green products that contain little or no chemical materials, as stated by the China Green Food Research Center.

Though the stock has gained 450% this year already, it is still a newly discovered—and profitable—small cap fertilizer company with probable room to grow. With a market capitalization of about $400 million, a P/E of 20, and only two analysts following the company, I am wondering if John is on to something here. Whether you love or hate the position that a Chinese company has within its government-run economy, global investors are making money off of steady growth in many sectors and this one seems more grounded (sorry) than their internet stocks that are all the rage. Now, if you’ll excuse me while I take a look at these June 20 calls trading for $2.

Today, he’s ready to take some profits off the table since GOOG is about as close to the $600 strike as it has been or is going to get with less than five trading sessions until December options expiration. Why is the $600 strike so important? Because, as you know if you’ve followed any of our discussions of butterfly strategies, the center strike where you are short two or more options is the point of maximum gain.

Here were the original trade details from Dan the week of November 9^th:

• Buy 20 GOOG Dec 590 calls for $7.50
• Sell 30 GOOG Dec 600 calls for $5.00
• Buy 10 GOOG Dec 620 calls for $2.00

Net cost for Dan’s butterfly was $2,000. Traders who did not want to put on this kind of size could still execute the spread in the smallest possible quantities with a ratio of 2 x 3 x 1 and thereby spend only $200.

As you can see, this butterfly is slightly different than the typical 1 x 2 x 1 convention. Its 2 x 3 x 1 ratio attempts to benefit as much as possible from the bull call spread component, where Dan is buying twenty 590/600 verticals for $5,000 (20 x $2.50 per share x 100 shares), and offsetting that cost by selling ten 620/600 verticals for $3,000 (10 x $3.00 per share x 100 shares). Here’s a Profit/Loss diagram of the trade from the OptionsHouse Trading Tools:

Note the maximum profit of nearly $18,000 achieved if Google is at $600 at December options expiration. This is certainly not the only way for this trade to be profitable. As GOOG approaches $590, the value of this butterfly will increase and profits can be taken at any time. And indeed, profits Dan has as GOOG has moved from below $570 to $595.

From Dan this morning:

“I thought that now would be a good time to take off part of the Google spread. We can buy 15 of the GOOG December 600 calls at 2.70 and sell ten of the 590 calls at 7.60. We have already more than doubled our money while leaving half of the spread on.”

Dan’s original cost for this trade (and his maximum loss) was $200 for 10 butterflies, or $2,000. By selling 10 x 15 of the 590/600 call spreads, he takes in $3,550, for a net realized profit thus far of $1,550. And he can probably more than double his initial investment overall if GOOG continues to trade close to $600 over the next few days.

What about the 620 calls he is still long? Well, those remain on because he is still short fifteen 600-strike calls and long ten590 calls and he needs the 620 calls to hedge the position. But, as Dan’s creativity with options would have it, he’s got an idea there too and he emailed me back 10 minutes later with this:

“One more adjustment. Buy five GOOG December 610 at 0.75 and sell 10 December 620 at 0.20. That leaves us with a 10×15x5 spread.”

So here Dan is suggesting to spend a little bit more cash (about $175) to lower the strike of the long calls and keep more of the butterfly profits if GOOG runs much beyond $600 this week.

Be sure to read the original trade idea and watch my interview with Dan to get all the details on the rationale and execution of this unique butterfly strategy by a professional options trader with more than 20 years of experience in the pits of the CBOE.

But what if we only get $60 as the economy stalls on any number of potential potholes and bond rates start to move the yield curve even before the Fed signals a rate hike is coming? If the S&P runs up to 1,200 and it starts to look like second- and third-quarter earnings won’t be as rosy as $75, we’d be much closer to a 20 multiple. That’s rich, even for raging equity bulls.

If the “over/under” numbers here are $75 on S&P 500 earnings and 17.5 on the market multiple, that puts the index at 1,313. I’m ignoring the upside surprise scenario of $85 because I have been in that camp for three quarters and now think the odds are skewed for the consensus, or the under. Can we see S&P 1,300 by year end? Sure, but the obstacles still are numerous:

• Rates start to rise

• Dollar-fed liquidity trades need to unwind

• Credit problems in emerging markets could bubble to the surface and force further flight to safety

• The US jobs picture double-dips and causes money managers to flinch on GDP projections

The View from the Chart

I’ve said for all of 2009 that the market would get drawn higher to its longer-term moving averages because it was too far away from them. Massive stretching away from the mean means one thing—unstoppable reversion to the mean, much like a rubber-band or vacuum or whatever analogy you like best. We achieved the 100-week moving average at 1,100 in November.

The next target is the 200-week, sitting just below 1,250. This is another perfect “magnet attractor,” not least because this is where the S&P was before Lehman imploded and took the market with it. We will return to the scene of the crime when people least expect it, can’t believe it, and money pours back in. The pros will be selling the market there.

But the momentum of mean reversion has slowed considerably. In mid-November, I said the S&P would remain “sticky” at 1,100. But I thought this would occur as a natural tug-of-war between bull runs to 1,150 and bear scares to 1,050. Instead, we got a market trading in a 20-point range between 1,110 and 1,090 for five weeks!

I don’t think this slowing of momentum lowers the odds of getting to 1,200 in 2010. I just think it’s going to be a choppier path to get there. Despite how tired and ready to roll over the market looks at 1,100, I think portfolio managers will be buying into the first quarter as the liquidity environment is still ripe for risk-taking. But a lot of good news is priced in and we are getting close to a point where bad economic news — job losses, bank failures, long rates moving higher even while deflation looms — could just as well make the market go sideways-to-nowhere for five months as enthusiasm about earnings potential meets reality.

The good news is that we’ve got a broad market well-supported by its 10- and 20-week moving averages. These can hiccup and even cross, and the market can still head to 1,250 next year. In fact, a 10% correction would be healthy for this cyclical bull market. We came close in June-July with a 9% correction and large investors have not been as fearful since, with the CBOE Market Volatilty Index (VIX) unable to get above 32 again and seemingly very comfortable below 25. After Dubai and Greece, I just shudder to think what kind of debt crisis or credit downgrade has to surface to really make large investors flinch that much.

What may be different this time is that there won’t be any surprises since information transparency around this report is high. What’s the same is that the prices being paid for options have steadily risen ahead of the event.

Since the stock was knocked down from 52-week highs in September, RIMM shares have drifted lower and may have carved out an important bottom and buying opportunity above $55. And news that the company is planning a big push into the Chinese market has encouraged investors about the mobile device maker’s future.

If it does go on to earn more than $4 per share in the next four quarters, and fight back for market share against Apple’s iPhone, paying $65 for a 16 times forward earnings multiple might be considered a bargain to some technology investors.

Here’s a volatility chart using OptionsHouse data with both stock and options volatility, showing the recent increase in option premiums similar to the three weeks before their September report.

The green line is the stock’s historical, or actual, 30-day volatility. This is calculated as a moving average based on actual daily movements of the stock. The near-vertical up-and-down lines in late September and early November denote the actual movements in the stock. In September, when the stock gapped down 15% in a day, actual volatility spiked from 30% to 60%. In November, when RIMM slowly rallied $10, actual 30-day volatility fell 20% because the stock started making much smaller daily moves, in addition to the fact that the big down day in September dropped out of the calculation.

The black line is the volatility implied by options prices. It is usually calculated as a mean volatility for at-the-money option prices and tells you what volatility option players are expecting for the stock based on what they are willing to pay for puts and calls. This is how options “imply” a volatility that may be significantly different from historical volatility. In mid-August, implied volatility for RIMM options began to steadily rise from 45% to nearly 60% ahead of the September earnings announcement.

In late October, as RIMM and the broad market fell, options implied volatility rose as demand for puts increased. And despite the fall in actual volatility of the stock, options implied volatility has stayed high for RIMM, bumping up against 60% as we approach the December earnings event.

This week, implied volatility for December at-the-money options, which expire the day after RIMM’s report, has been as high as 80% and part of this may be due to hopeful call buyers as well as fearful put buyers. As a basis of comparison, implied volatility for further-dated RIMM options is much lower and closer to the mean, with January and March implieds trading in the mid-50s.

At 11:00 AM Eastern Time, with RIMM shares trading up over $1.00 to breach the $65 level for the first time in a month, December 65 calls and puts are trading around $3.20 at a 77% implied volatility. The combined prices of the put and call, the so-called “straddle,” are then trading for about $6.40, implying an expected stock move of nearly 10% in either direction from $65. Even if RIMM’s report isn’t expected to surprise anyone, option players are willing to bet on high stock volatility anyway.

My rough analysis at the time was based on the fact that the miners as a group had underperformed the price of gold by as much as 40% for the previous three years. Based on end-of-August levels from 2006 to 2009, the price of spot gold moved from $650 to $950 while the GDX went nowhere.

But this analysis was very shortsighted because I didn’t go “under the hood” of the miners to find out if there was a good reason why the group had performed so poorly. I also accepted the blessing of a major investment house, JPMorgan Chase, on the top-three names in the GDX as “good enough.” In a research note from October 26, JPM analyst John Bridges said, “Every portfolio should contain some gold or gold equities, and our valuation metrics point to Barrick, Goldcorp and Newmont as the most undervalued stocks.”

Since Barrick Gold Corporation (ABX), Goldcorp Inc. (GG), and Newmont Mining Corporation (NEM) are the three largest components of the GDX, comprising about one-third of the ETF, I had thought this was the safest way to play the miners. Then I found out more about their past gold hedging practices.

Barrick, in particular, has their hedge book wrapped around them like a ball and chain, with 9.5 million ounces sold forward this decade and half of that below $400! And apparently, Wall Street analysts push their stock, reluctantly or otherwise, knowing in full that the company has claimed for years to be resolving the hedge book issues without much success.

In early September, Barrick announced it would be eliminating remaining gold hedges and completing a new stock offering to help offset some of the exposure, selling about 80 million shares and taking a $5.6 billion third-quarter charge. To be fair, the forward sale commitments for 9.5 million ounces are less than 7% of Barrick’s total reserves. But four million ounces are for floating rate contracts that could cost the company at least another $2 billion. Interestingly, JPMorgan was one of the underwriters of Barrick’s secondary offering.

At least two conclusions can be drawn from this picture. First, my data above is just a broad-stroke analysis of one miner’s exposure to past hedging when gold is on a tear. I am merely sharing what I have uncovered in the past 24 hours and investors should seek out more research reports on Barrick and any other miner they are considering.

My main point is that these facts raise questions about many of the miners’ actual leverage to the price of higher gold. For many in the GDX, gold moving higher actually hurts. I would look at Agnico-Eagle Mines (AEM) as one miner that claims to have never hedged.

The second conclusion is that I clearly did not do my homework before recommending a December iron condor on the GDX for our Option Trading Alerts last week. I was betting on a stable trading range in the miners for 12 days and walked right into a gold correction and two downgrades of Barrick (see my Monday article). Hopefully my loss in this trade will become your gain at some point in terms of higher quality research.

For those new to futures trading, you first need to understand how leverage and “margin” work for these products. Futures markets do not use margin requirements in the traditional sense as defined by an SEC-regulated securities account. Instead, Commodity Futures Trading Commission (CFTC)-regulated futures contracts operate on a “good faith deposit” called a Performance Bond that is some percentage of historical daily volatility. This method is built on more than 150 years of experience by exchanges in managing the risk of trading and hedging positions in Chicago futures markets.

When an exchange creates a new futures product, they assign a multiplier to produce an overall contract value that is representative of what hedgers and other institutional users can equate to their needs. The multiplier for the big S&P 500 Index futures contract is $250, producing a contract value of $275,000 with the index at 1,100.

Next, the exchange (in this case CME Group), analyzes the recent volatility of the underlying index and assigns a measurement of daily risk. This is sort of a “worst-case” look at what could happen in terms of standard deviation moves in a single day. Why is the single day so important? Because every day, futures markets employ a process known as “mark to market,” whereby the gain or loss of all positions are accounted for and money moves from losing positions to winning positions.

Brokerage firms who are CME Clearing Members are accountable to the CME Clearing House to see that all gains and losses are properly channeled every day, and in some cases, twice per day. If a Clearing Member firm does not perform this duty, the exchange can subject them to fines, trading restrictions, and appropriate seizure of funds. This is how mark-to-market works well at managing risk and leverage in regulated Chicago futures markets, even if the practice causes problems for banks on Wall Street dealing in exotic and illiquid OTC derivatives.

The Performance Bond for the CME S&P 500 full-size contract is $22,500 for traditional institutional hedgers (pension funds, mutual funds, etc.) and exchange members, and $28,125 for purely speculative players who are not hedging existing cash positions. What historical volatility data are the exchanges using? That depends, but it is usually a function of at least the previous two quarters, since Performance Bonds are intended to be robust and often only changed every quarter. The speculative position Performance Bond of $28,125 is about 10.25 percent of the current contract value, giving large traders like hedge funds 10-to-1 leverage.

The E-mini Creates Leverage for the Independent Trader

When CME introduced the S&P E-mini contract in 1997, it was an immediate success because it offered a tangible way for small-to-medium sized traders to participate in index futures. One-fifth the size, by virtue of its $50 multiplier, the E-mini offers affordable leverage on the biggest equity index benchmark. This reduction in contract value translates directly into a reduction in the Performance Bond, $5,625, while maintaining the leverage of 10-to-1.

How can this leverage create a more efficient use of capital for active SPY traders? If we look at a 500-lot position in the SPY vs. one E-mini contract, which achieves the same dollar point movement, here’s the math:

500 shares SPY:     Each $0.10 = $50

One E-mini futures contract:     Each S&P index point (1.00) = $50

Securities account using 50% margin:     500 shares x $110.00 = $55,000 for a net margin requirement of $27,500

Futures account using Performance Bond:     One contract x $5,625 = $5,625 to gain the same leverage as 50% margin in SPY

This increased leverage and efficient use of capital comes with some limitations and caveats.  First, $5,625 is merely the “exchange minimum” Performance Bond and different brokers may require a bigger deposit.

Second, the exchange also designates “Initial” and “Maintenance” Performance Bond levels. This means that if an account position drops below the Maintenance level, it must be restored to the Initial level or the broker can liquidate the position. Third, a futures account may or may not be used in conjunction with a securities account, and so having two accounts may not be an efficient use of capital for some traders.

Call your broker and inquire about Performance Bonds, both initial and maintenance levels, as well as account structures and commissions.

I thought I would look at three areas of investment and risk-taking to give us an idea of what we might expect for the next few weeks as the implications of this much greater than “jobless” recovery are reevaluated.

1) Stocks Stalling

I said four weeks ago that I thought the S&P 500 would remain “sticky” around 1,100. But that was based on a trading range between 1,060 and 1,160 as I thought we’d see a nice rally and then pull back. Since then, the market has gone absolutely nowhere, making my prediction look like a severe understatement.

And market leadership is faltering. We saw Goldman Sachs (GS) give up the charge and not make new highs with the broad market in the second week of November. Now Apple (AAPL) has tired and resigned its leadership role, closing below its 50-day moving average last week.

The Wall Street Journal this morning showed some great snapshots of this “tortoise and hare” market since the March lows that highlight another change in returns. Small and medium-size stocks outperformed large caps by 30 percentage points up to October, but since then, the S&P 400 and Russell 2000 indexes have lagged the Dow Jones Industrial Average. Their research suggests that this is a sign of a maturing bull market.

2) Gold Falling

The correction in gold was not surprising and all we needed was a catalyst like a bullish jobs number to get the take-profits train rolling. As I wrote here on Friday, I expect the gold bull to continue after some decent back-and-fill trade between $1,100 and $1,150. The extent of excessive speculation in this market will determine how close we come to strong support at $1,050.

What is worrisome is how professional investors are reacting to the mining stocks as investments here. Many of the big-name gold equities were down 7-9% and two downgrades of Barrick Gold (ABX) in as many days make me wonder if there is going to be a disconnect between the miners’ earnings and the price of gold in 2010. Thomas Weisel cut ABX from “Overweight” to “Market Weight” on Friday and Credit Suisse reduced their rating from “Outperform” to “Neutral” today.

Both firms noted uncertainty for the company’s shares based on a U.S. Appeals Court ruling in San Francisco concerning environmental issues at Barrick’s Cortez Hills project in Nevada. So, this raises another issue for mining stocks that may add weakness to the picture of an industry group so dependent on the price of a single commodity. In fact, gold producers’ fates may be more tied their natural resource than oil producers’ are to theirs.

3) Dollar Carry Trade Reversing?

The dollar is the current “funding currency of choice” for all types of carry trades—stocks, commodities, other currencies. As I described here in September in articles such as The FX Carry Trade and Currency Carry = Interest Arbitrage, a stable or widening interest rate gap fuels carry trades. In other words, if you know you can borrow cheaply for an extended period and invest in things with rising yields and bull trends, you have a significant edge in the trade.

When Friday’s job report woke up anyone who was planning on near-zero rates for dollars well into next year, the scramble was on to take profits. For others who just got in to these trades a little too late, they were running scared to get out, even if they didn’t understand what was going on, i.e., that the market was reacting to the new possibility of interest rates moving higher much sooner than expected.

Does this mean the U.S. dollar carry trade is over and we’ve seen the dollar bottom? Not exactly. The “big and smart” money moves the carry trade. Large institutions with big war chests take big stabs at all kinds of carry trades, in all geographies, currencies, and time frames. So, the big guys were certainly taking profits on Friday in gold (and gold stocks) and in euros and Aussie, maybe even piling in for a short-term short trade. But in the big picture, they are not done with this carry trade because they likely still think the Fed is going to remain on hold with interest rates in the first half of 2010.

Bloomberg even carried a short note this morning confirming this from the likes of JP Morgan, where they say that Friday’s jobs report actually “justifies buying risk” in other currencies versus the dollar. Here is the full quote from Bloomberg reporter Anna Rascouet:

“Payrolls validates dollar shorts versus all currencies but the Japanese yen,” a team of analysts led by John Normand, head of global currency strategy in London, wrote in a research note dated Dec. 4. “Even before payrolls, the speed with which Dubai faded from headlines suggested a certain global resilience.”

The big and smart money is playing the dollar carry trade from all angles and time frames. There is too much left in it to let it go this soon, especially since the Fed won’t even be near still “accommodative” levels of interest rates—such as 2%—for at least another year. After the weak hands are flushed out of this temporary reversal in the dollar, the big players will be positioned for the next leg up in stocks, gold, and currencies.

“Mind the Risk, Bank the Profits!”

This is not to say that gold wasn’t due for a pullback regardless of jobs data. Every parabolic move in any asset is ripe for correction and this newly-loved commodity was no exception with its run from $1,050 to over $1,200 in just four weeks. I said so last week on  CNBC’s Closing Bell with Maria Bartiromo when I suggested we were near a blow-off top that would flush out the weak hands.

Who are the weak hands? Small and medium-size traders, from my cousin in Minnesota to the mini-hedge funds with assets under management (AUM) of less than $10 million. Their margin calls at futures brokers across the globe are going to keep risk managers at their desks long after the markets close today. How do I know? Well, besides knowing a few of those hardest-working people in futures trading, I also know how traders who got stopped out when gold was $25 lower likely got back in a time or two only to get chopped up and stopped out at $50 lower.

Ironically, this morning I was reading my freshly printed copy of the Goldman Sachs Commodities Outlook for 2010 with raised gold price forecasts of $1,350 by 2011 and $1,450 by 2012. Their primary argument for this bullish view, besides supply and demand issues, is extended easy monetary policy. I’m sure nobody from GS reads me, but I upped my gold forecast last month from $1,200 by next October to $1,400 by next December. This view of gold is based on five forces I see that add to the momentum since the technical breakout above $970 in September:

1) Central banks accumulating gold now, after selling it 10 years ago and greatly boosting supply

2) Gold producers reducing, or completely foregoing, forward hedging sales

3) Gold producers still years away from peak production capacity achieved about 10 years ago, because many have only gotten traction this year post-credit crisis

4) More large investors starting to observe gold as a quality hedge against the decline of the dollar (i.e., vital portfolio diversification)

5) Gold as a “hard currency” is viewed as a hedge against deflation, as well as inflation, so no matter the economic environment we are in a long-term secular bull

Regarding points 4 and 5, we all know that hedge funds are buying gold for the long term, but I’m wondering what happens when conservative pension funds start to say, “We need a 5% allocation to precious metals in this environment of monetary instability.” That’s easily gold at $2,000 when that force unfolds in full.

An Emerging Gold Bull (The market and me)

On Aug. 21, I said, “I don’t follow gold that closely, but believe it could see a spike to $1,200 in the next year just because so many are afraid of the dollar falling out of bed and more cracks surfacing in the systemic banking crisis.” Since then, two things have changed for me. Firstly, I upped my forecast for gold in 2010 to $1,400. Secondly, I follow gold much more closely now.

On Sep. 2, I called the impending breakout above $970 in the morning when the high was only $965. This easy prediction was visible on the chart via the big consolidating triangle formation of 2009 between $1,000 and $865, and the even larger swings since 2007 with highs of $1,000 and lows of $700. The key here was that gold kept coming back to knock on the door at $1,000 ever since March 2008, and it wasn’t going away. This breakout finally made me a believer in the “barbarous relic.”

On Nov. 25, I raised my forecast for gold to $1,400. But this is my conservative number, just as I think $1,350 is Goldman’s “at least” number. Global monetary policy may be the linchpin that determines how conservative we really are. If short rates start to rise by the third quarter, we may be too aggressive. In my article that day, “Beyond Inflation, Gold as a Monetary Phenomenon,” I showed a table of central bank bullion holdings, measured both in tons and as a percentage of foreign currency reserves. FX reserves are going to be the new litmus test of monetary strength as gold comes to be viewed as real money again. And with China only holding 2% of reserves in gold (as of the 3Q 2009), I expect them to buyers for some time longer.

Throw the Miners Out With the Metal?

This morning’s panic sell-off in gold meant the mining stocks got hit too. At 3:00 p.m. EST, gold futures were down over $60 (about 5%) and bouncing off of $1,150 while the baskets of mining stocks seemed to take it on the chin worse. The PHLX Gold and Silver Index (XAU) was off 6.75% and the Market Vectors Gold Miners ETF (GDX) fell down 6.5% at its worst level. I think this is a buying opportunity right now in the equities, since their earnings over the next two quarters are not dependent on gold’s panic today.

Buying the GDX anywhere below $50 is a good long-term investment as the top 3 names, Barrick Gold (ABX), Goldcorp (GG) and Newmont Mining (NEM), will be under heavy accumulation after this correction is over. Selling cash-secured puts and out-of-the-money put spreads on the GDX is a way to profit from the opportunity with less cash outlay. The ETF will have far less volatility than the individual names and overall less company-specific risk.

With the GDX around $50, the December 50 puts are trading for $1.85 and the January 50 puts for $3.25. Selling these cash-secured puts could provide the opportunity to buy the ETF with a cushion, or to potentially gain profits from option premiums as you sell “insurance” to the fearful crowd. To sell put spreads or cash-secured puts, you must be comfortable with the risk/reward dynamics of these strategies and know what effective cost basis is your target. If you are not familiar with the cash-secured put strategy, send me an email at kcook@onn.tv and I will be happy to direct you to some great resources at ONN.tv for learning this precision option tactic.

Buy the Dips, But Beware the Bull Train You Can’t Catch

This gold market is going to become the next “buy the dips” mania. And as happens in a stealthy, run-away bull market for stocks, you can never get in exactly where you want. Where will support be and where will buyers come in before you get a chance? You can put some round numbers on the levels that will work just fine because they correspond to pauses and stutters the market made on the way up.

Here’s my road map for “buying the dips” in gold right now:

$1,150 you can nibble at the GLD and buy the GDX

$1,100 you can place strategic long positions in the GLD and GDX, as well as sell cash-secured puts at the $105-strike in the GLD and the $45- to S48-strikes in the GDX

$1,050 you can buy with both hands

The trick is in being prepared and knowing your risk tolerance. Since we aren’t trading with the leverage of futures and really looking for longer-term opportunities, we should be able to establish strategic positions without worrying about the weekly swings. Many days, the 5%, 50-point sell-offs will bounce quickly and not give you a chance to get in. Remember, you are competing against professionals with their fingers on the trigger when these opportunities come.

“Mind the Risk, Bank the Profits!”

His models, driven by more than 200 fundamental and technical indicators, usually identify turns in the market two or three times a year, and even as bullish as he’s been on gold for years (a buyer since $500), he’s been calling this year for a “cycle high” next year in February around $1,240.

I spoke to Mr. Nenner on the phone Wednesday afternoon and asked him about all the usual suspects of the current one-way risk trade: stocks, gold, oil, and currencies. Nenner was a securities and trading analyst for Goldman Sachs for twelve years before forming his own firm to advise hedge funds, banks, brokerage firms, family offices, and individual clients. Throughout his 25+ year journey in financial markets, Mr. Nenner developed his system of pattern forecasting and securities analysis, building a computer program to run all the indicators, including his proprietary use of cycle analysis.

Here are some specific ideas from our conversation, with all errors or omissions belonging to me (see below for how to get a free trial subscription to his actual research updates):

• The S&P 500 Index (SPX) is likely to make an important high before year end. A close below 1,102 is a short-term sell signal. Below 1,066, Nenner wants to be short the market because his long-term cycle work is forecasting another recession for 2011, as interest rates on the long end are finally allowed to rise to their natural levels and suffocate the economy.

• Gold has been aiming for a short-term top above $1,124, and may still put one in before it resumes the climb to $1,240 by February. Above $1,245, will mean a new upside target. Nenner has been long gold producers stocks Barrick (ABX) and Newmont Mining (NEM) for years, as well as recommending long-term call positions in other names to his clients.

• Crude oil is still in bull mode and will crawl higher in 2010, despite lower equities. The current weakness is less a function of excess supply than a subsiding of the excess premium that got built into the forward “contango.” The carry trade that allowed market participants to buy spot oil, store it in tankers, and sell the futures out a year on the curve for as much as $10 in profit, has now been squeezed out to more realistic levels below $2.

• The short dollar trade may have almost as much life as long oil into 2010. The euro cycles remain bullish to December 28 but will likely stall at $1.5150. Above this level, $1.60 is in the cards. For the Australian dollar, Nenner is on a long-term buy signal (he’s been long since 65 cents) and his first target of $0.9480 is clearly in sight. Its commodity sister, the Canadian dollar, is on its way to parity despite jawboning from the Bank of Canada that they are not fond of such a strong currency. Nenner says you can’t fight the fundamentals of resource-rich Canada. Without a banking crisis anywhere near the US or European extremes, oil and gold demand drive the need for Canadian dollars.

To learn more about Mr. Nenner and his Research Center, visit www.CharlesNenner.com. Then click on the green “SEE CURRENT RESEARCH” button in the upper right to sign up for free sample research.

Charles also told me if you specifically request it, you will be given a free trial to his daily and weekly market research notes. I’m not sure what his institutional clients are currently paying for this work, but I’d bet it makes even two weeks of free insight worth its weight in gold.

Limits to Growth—iPhone as the Center of Gravity

Instead of debating margins, returns on capital, and overall growth rates, I liked Ashworth’s focus on the iPhone’s numbers as the pivotal determinant of Apple’s success going forward. iPhone sales in fiscal 2009 were all of the 12% revenue gain. As Ashworth noted, “If you exclude its iPhone sales, which jumped 266% from $1.84 billion to $6.75 billion, revenues actually dropped 2.8%.”

The company’s top three products comprise two-thirds of sales and the iPhone will likely soon become a bigger share than the MacBook or iPod once international markets are fully penetrated. Clearly, having all of its eggs in one basket is not the best strategy for any company, let alone a tech giant with a $180 billion market cap. Even as they continue to build on their 17% market share in the “smartphone” market, competitors Nokia (NOK) and Research In Motion (RIMM) are not going away without an innovation-driven war, not to mention what Google (GOOG) will invent to “bypass” mobile services from wireless providers.

iPhone sales projections, according to Ashworth’s analysis, approach nearly 30 million and 40 million units for each of the next two years vs. 2008 and 2009 sales of 11.6 million and 20.7 million units, respectively. This double again in iPhone sales in another two years “should generate $12.68 billion in fiscal 2011” depending, of course, on actual unit prices, he adds. Ashworth then suggests we assume that everything goes great for the next two years and iPhone revenues go from 18.5% to 30% of total sales and all other product areas are flat. Even in that optimistic scenario, should investors still pay five times sales ($42.47 billion estimated in 2011 based on the preceding figures) for a market cap of $212.4 billion?

To go from a market cap of $180 billion to $212 billion is only an 18% return in two years. That’s a stock price of about $237 (based on a 894 million share float). So, maybe AAPL gets there within two years, but Ashworth seems to think that this growth trajectory has been fully priced in and that the risks are to the downside for these projections, which means the stock may make a trip to $150 before it goes to $250.

AAPL Price Action Not So Encouraging

• Stock looks weak now drifting around $200 and fighting to keep its head above the 50-day moving average at $195. What looked like a consolidation to me last week, looks like plain old weakness now when you consider the next issues on the chart…
• Double-top high formation favors bears: $208.71 all-time high on Oct. 21, then $208 on Nov. 16.
• Overextended from 200-day moving average at $150 and from long-term weekly moving averages (100-week at $142 and 200-week at $122).

Betting on quality growth and a great brand story, equity portfolio managers have picked Apple to top their Holiday wish list. But, with the stock 75% owned by those institutions and 18 out of 25 analysts with a strong buy rating, it may be that the big and smart money who could take the stock higher are already all in. Given Ashworth’s iPhone revenue analysis, and my technical sentiments, this is a recipe for a pullback.

1) “Durable competitive advantage,” to borrow a tenet from Warren Buffett, is an understatement for Apple. From computers and mobile communications to gadgets and “apps,” this company makes products that people fall in love with and feel they can’t live without. It’s not just a matter of the “cool” factor of their products and stores—it’s about productivity tools that people crave for both their business and personal lives.

Between me and my teenagers, I’ve lost track of how many iPods we have and I am finally breaking down soon and buying my first iPhone.

2) Valuation is what divides most investors on this stock. Growth managers are paying a 32 multiple now for trailing earnings and with AAPL expected to earn at least $8 next year, they are only paying a forward multiple of 25. Is that too expensive for growth? Maybe, but I have to think that with new “must have” product innovations, strategic alliances and distribution channels at their behest, and foreign markets to conquer, most of the surprises coming out of Cupertino for the foreseeable future are to the upside.

3)  Market leaders in a strong market continue to lead. AAPL shares are ascending on the trajectory of their 10- and 20-week moving averages, and until those are violated, the upward trend is still worthy of respect. How vulnerable is Apple to a weak economy?

Maybe the company’s products have such a “durable competitive advantage” that the economy doesn’t matter that much. In either case, the long-term chart tells a story of a phoenix. In 2007, AAPL went from $80 to $200. Early-2008 jitters about the subprime crisis brought it back to support at its 20-week moving average near $120, before it launched back to $190. Obviously, it was among the wreckage of late 2008 with every other quality stock under the sun. So, the question I ask is this:

“What if AAPL should have always been a $150 stock with a 30 multiple in the past two years and has just now resumed its growth trajectory?” In other words, I think that despite “hot money” flowing back in to quality momentum names like AAPL, the long-term earnings trend of the company is getting priced fairly into the stock. As the stock stalls here at $200, while the S&P marks time at 1,100, my bet is that it will continue to be a market leader and growth fund managers will have it on the top of their buy lists when stocks make new highs in the next three months.

Tomorrow, I will present the strongest arguments for a bear case on Apple. Meanwhile, feel free to send comments and ideas to kcook@onn.tv.

“Mind the Risk, Bank the Profits!”

Then along came a little debt “problem” in a city of development excesses known as Dubai—hundreds of manufactured private luxury islands, the new tallest building in the world, and indoor ski hills in the desert—and the VIX was found to be irresistibly cheap again. As I said at 4:30 am on Friday morning on CNBC Worldwide Exchange (and again on Squawk Box), we would likely see a 25 print on the VIX and 28 bid would be the “panic switch” for lower equity markets this week.

The VIX nearly got to 26 Friday before settling in around 25 on the back of the market’s recovery from a pre-opening futures drop near 4%. Today, with word that the central bank of the United Arab Emirates will provide loan support for the struggling developer Dubai World, the S&P 500 is just pivoting around 1,090 and the VIX hugs 25.

What does a VIX of 25 tell us about market expectations for future volatility? And why did I think a VIX of 28 would be the “panic switch?” First, since the VIX is calculated based on a 30-day rolling blend of the front and second month out-of-the-money SPX option prices, it is basically telling us the options are implying a roughly 68% chance the S&P 500 would be within a range of 25% higher or lower one year from now.

Volatility is almost always expressed as the annualized standard deviation of price changes. If it’s historical volatility we’re talking about, it’s past price changes. If it’s implied volatility, expected price changes. But we can convert that annualized volatility into a monthly number by dividing by the square root of 12 (3.46) since volatility is proportional to the square root of time.

Volatility is all about Time

25 divided by 3.46 = 7.23. This means that in one month’s time, we can expect the S&P to move within a range of 7.23% higher and 7.23% lower. From 1,090 on the S&P, that would be about 79 points. Expressed as a monthly number of 7%, 25% volatility sounds a little more meaningful.

But this conversion to a monthly volatility is not as reliable as a more ready measure of volatility—the at-the-money (ATM) straddle. Here, simply add together the option premiums of the ATM same-strike put and call to get the price of the straddle. December ATM straddles for the SPX, with expiration in 18 days, are indicating professional option players are expecting a move no greater than about 43 points, a potential 3.9% move in either direction. And January ATM straddles are trading around 67 points today, about 6.1% of 1,090.

The monthly VIX number seems like it should fall in between 43 and 67, so what gives? Well, ATM options for both December and January are actually trading at implied volatilities closer to 21%, not 25% like the VIX might suggest. Again, why the discrepancy?

Because the VIX calculation uses every out-of-the-money (OTM) option with a bid as inputs for its “black box” number crunching. So from the Dec 1085 puts all the way down to the Dec 695 puts, which currently have a nickel bid, are at least 50 put strikes consumed by the VIX model. Those deep OTM puts represent one-half of the infamous volatility skew, or “smile,” whereby OTM options can have much higher implied volatilities than the ATM options. The calls from 1,090 on up to 1,260 make up the other half.

Panic Switch

Okay, enough VIX technicalities… the bottom line is that the market continues to look calm and relatively fearless. Is it complacent after a 60% rally off the March lows and vulnerable to a big 10 or 20% correction? Maybe it is.

But the options markets aren’t telling us that quite yet, with only a small adjustment back to less complacency at a VIX of 25. In late October when the S&P dropped more than 30 points in one day and the VIX went briefly above 30, the bears were licking their chops for an extended drop. The market reversed just as quickly and all those OTM November and December put options that were purchased left a sting as their volatility value plummeted by over 30% and their hopes for intrinsic value never saw the light of day.

If the market does get fearful and the VIX gets above 28, I would take that as a warning sign that this volatility move could be sustained and that the bears will get their wish. Based on the fundamental, technical, and sentiment factors driving this young bull market—especially its “Wall of Doubt” (see my series of articles about “The Bull Train You Can’t Catch”)—I think the odds favor continued market calm/range trading over panic.

For more details on the structure and uses of the VIX, join Jud Pyle and me this Wednesday at 4:30 ET for a free webinar, “Understanding the VIX.”

Bernanke has guided Fed monetary policy and communications with a steady, even hand. From the actual policy decisions made to less-official speeches before universities and business groups, his analysis of the economic crisis and the proper means to address it have been clear, unequivocal, and backed with conviction — even if we disagree about their appropriateness.

This stands in contrast to his predecessor, Alan Greenspan, who seemed to take pride in his brand of Fed-speak obfuscation when he said something to this effect:

“If you think you understand what I said, I probably misspoke.”

Don’t get me wrong — I like AG and think he did the best he could with the information he had and the specter of Japan-style deflation glaring at him. But, he probably got a little academic and ambiguous for some market watchers when he spoke on the dismal science that is economics. And he didn’t apologize for indulging in the economist’s favorite qualifier, “on the other hand.”

So what are Bernanke and Co. doing right? As I’ve said repeatedly to inflation and deficit hand-wringers for months (see my “Bernanke’s Bet, Bernanke’s Trim Tab” from Sep 24th), he’s set a good and stable course for the U.S. to recover from what could have easily become the worst financial disaster in our history. And he spoke plainly and clearly along the way, knowing that the policy actions he was taking were drastic, for good cause, and not to be deployed or removed on whim.

This Chairman must be allowed to take some small pride now in the fact that his decisions and convictions are being proven correct. Would we (our markets, our sanity) be handling the Dubai debt contagion so well today if he hadn’t? The proper role and deployment of Fed policy is to take a long-term macro view and stick with it until long-term macro data and feedback indicates you do otherwise.

The Fed may be in danger of “pulling on a spring” that creates future instability on the yield curve (as I wrote about last week), but it all comes down to which side of the inflation-deflation chasm we dare to err on. Though this sounds like a short-term, politically-motivated question to some—especially with an election season approaching next fall—it is actually a long-term issue. Look at Japan if you have any doubt.

My figures about total above-ground gold supplies of 150,000+ tons and specific levels of central bank holdings were based on multiple sources, but primarily data from the World Gold Council.

From the introduction on their website at www.Gold.org: “Founded in 1987, the World Gold Council (WGC) is an organisation formed and funded by the world’s leading gold mining companies with the aim of stimulating and maximising the demand for, and holding of Gold. WGC is the commercially-driven international marketing organisation for the gold industry. Our members are gold mining companies of all sizes, with operations spanning six continents.”

Clearly, this informational site has a bias. And the members list reads like a who’s who of big gold stocks, with these names among the 25:

Barrick Gold (ABX)
Goldcorp (GG)
Newmont Mining (NEM)
Agnico-Eagle Mines (AEM)
Kinross Gold (KGC)
Yamana Gold (AUY)
Royal Gold (RGLD)
Coeur d’Alene Mines (CDE)

That said, the site is packed with statistical papers and starting points for investment research. Here’s a slice from one of dozens of PDFs that you can download just for registering:

World Official Gold Holdings, September 2009 (Source: WGC)

The complete WGC list includes 100 nations, going all the way down to Central African Republic with 0.3 tonnes. I chose to go up to number 16 so I could get the UK in there. I remember earlier in this decade when gold was trading under $300 and the Bank of England sold the majority of their reserves. Gordon Brown, the current Prime Minister of the UK, was then Chancellor of the Exchequer and he helped drive a major reform of Britain’s monetary policy by transferring control of interest rates to the BOE.

At the time, I figured Mr. Brown was onto something and so I concurred with him and Keynes that gold must indeed be an obsolete and barbarous relic. How wrong we were. And this will be proven when we see the updated figures for central bank holdings at the end of this quarter. We will see that both the tonnage and percentage figures for many governments have grown substantially in the past three months.

Cost of Production and Trimming the Hedges

I was disappointed with my interview on CNBC because I left out one of the more subtle driving-forces of gold’s rally—beyond demand from central banks, inflation hawks, and mere speculators riding the wave. The big gold producers have been doing less hedging, whereby a mining company can sell gold as forward contracts, locking in a sale price today to eliminate uncertainty about tomorrow’s price. Some, like Agnico-Eagle (AEM), have never hedged.

AEM recently reported a quarterly loss, but the firm is confident that this will be quickly reversed as their rapid investments to ramp up production enable them to take advantage of their very low “cost of production” near $450 an ounce.

Gold production hit a high around the year 2000 that has not been seen since. And getting new or existing mines “in production” takes time. So this is also driving near-term demand, as global mines won’t get near that production peak for a few years. But what’s often more fascinating to me in markets than the fundamental supply/demand picture is the psychological drivers. What less hedging by producers does is create two important feedbacks on price:

1) Less hedging reduces supply flow to commercial users and central banks. This sort of creates a supply worry that buyers of gold are not accustomed to, especially at these record prices.

2) Producers doing less hedging is similar to public company insiders buying their own stock. It’s optimism about future prices (i.e., revenues for gold producers) and profits that cannot be ignored.

I have written about the potential for a “momentum melt-up” in gold and as much as the last two weeks look like a near-term frenzied top to some, I don’t think we are there yet. We haven’t even begun to see the kind of panic that can come from a dollar rout that makes gold trade like hard money. I am thus raising my forecast for gold in 2010 from $1,200 to $1,400.

“Mind the Risk, Bank the Profits!”

What comes through when you listen to Owens is this: what is driving development in the rest of the world is more than government stimulus dollars. It’s the emergence of new, large middle-class populations all hungering for nice homes, efficient means of transportation, and jobs. This means infrastructure and housing development will see continued support from governments and will drive private investment money into virtuous cycles of development, job creation, GDP growth, and re-investment.

In a November 17^th interview with the Financial Times, Owens said he was disappointed with CAT’s performance in some Asian markets. “JCB (of the UK) has kicked our bums in India, and I am determined we will do better,” he said.

Time will tell if CAT can wrestle market share from overseas competitors, but they’ve done it before with strategic commitments to the areas of the world they are trying to serve, building plants in all key markets. And a deeply diverse catalog of product offerings for multiple industry sectors–from housing, energy infrastructure, and transportation to telecom, mining, and energy generation–doesn’t hurt their exposure to the global boom either. Especially when they have products like their award-winning diesel engines with customers in all these markets.

Last week on CNBC, I saw an interview with Jim Rickards, senior managing director of market intelligence at Omnis, a think-tank consulting firm specializing in national security intelligence and defense issues. He explained that the price of gold could easily be at least $4,000 in the next few years because of these driving forces:

1) When gold is viewed as money, its price will re-value much higher. Right now, Rickards believes gold is just trading on supply/demand fundamentals. He uses simple “eighth-grade math” to point out where gold could trade if it moves on a “monetary vector” - divide the money supply by the gold supply and you get anywhere from $4,000 to $11,000 per ounce depending on what figures you use. Conservative estimates for total gold supply (all that has ever been mined) fall somewhere around 150,000 tons, equivalent to nearly 5 billion ounces. If global M0 money supply is equal to USD $5 trillion, that puts gold’s “monetary” price at $1,000 per ounce.

But if you put the onus on central banks exclusively to hold gold to back their currencies, the math looks a lot different. Assuming the world’s total financial reserve of gold among central banks and institutions is about 1 billion ounces, the global M0 figure of $5 trillion in paper currency gets you to $5,000 per ounce for gold. The U.S. is holding about 270 million ounces currently and that seems to be what Rickards might be using along with strictly U.S. M1 of $1.6 trillion. This simple math gets you almost $6,000 an ounce.

2) Despite the Fed’s implicit sanction of a dollar decline based on long-term free market cycles, the world is different now than in previous dollar swoons. Rickards says that in the 1980’s, when the world agreed the dollar was too strong and the Plaza Accord took it quickly down 50%, our creditors were Japan, Europe and Arab countries—all regions dependent on the U.S. for national security. China is now our biggest creditor, and since they don’t depend on the U.S. militarily, we lack certain leverage.

I’m not sure this aspect is as important as the economic trade and currency peg “marriage of convenience” between the two nations, but Rickards addresses that also. He says that what’s going on is a giant game of chicken where both are shorting their own currencies, willing to devalue to help themselves at the expense of the other. He obviously sees the dollar as the big net loser here.

3) Inflation worries and fear in other asset markets keep gold bid, even without considering it money. Just think about inflation in other commodities like crude oil, which could be on the way to a decade of triple-digit prices.

How Many Barrels Does an Ounce Buy?

Another window on the proper price of gold might be another highly-valued asset like oil. Although non-renewable, we’re not sure if we’ve seen the peak in supply yet and it is certainly more crucial an asset to the daily functioning of industrial economies. In other words, oil may not be money, but it certainly has huge power to influence the value of the dollar.

So, what’s the relationship of oil to the original money, gold? For decades, an ounce of gold relative to a barrel of oil has traded in a dollar ratio from as low as six barrels per ounce in 2005 to as high as 36 “bpo” in the mid-80’s. People who follow this ratio say you “buy at 10 and sell at 20.” Right now, with gold above $1,150 and crude above $75, we’ve got a ratio of about 15. That leaves room to run higher.

Here are some other “possible future” gold/oil ratios:

Gold at $1,200 and Crude at $70 = 17

Gold at $1,300 and Crude at $85 = 15.3

Gold at $1,500 and Crude at $100 = 15

Gold at $2,000 and Crude at $150 = 13.3

Looks like gold can stay “cheap” on this basis for sometime as long as crude holds above $70.

Most recently, Simons was the special academic advisor to NQLX, known formerly as Nasdaq Liffe Markets, where he directed the development of equity market derivatives. Concurrently he had been a clinical professor of finance at the Illinois Institute of Technology’s Center for Law & Financial Markets, where he directed, at various times, the Center’s fixed income, energy, and trading tracks. Mr. Simons began his career as an economist with the Amoco Corporation and went on to design econometric trading systems for crude oil traders.

I’m relating a chunk of his career and accomplishments because I’m about to explain a point of view of his that is very macro and very complex. I just want readers to understand that this isn’t coming from your average market analyst (think me), but from someone who lives and breathes economic research (he’s got a Bloomberg terminal in his house, for crying out loud!). This guy not only knows his stuff, but he loves to teach, so he has no vested interests in spinning the truth for any alliance with any institution.

So, I put the question to him: “Howard, is it the Fed’s job to defend the dollar, and if so, should they raise interest rates now to do so?”

Technically speaking, “No.” That was his answer on the Fed’s job, and whether they should step in to defend “arbitrary” exchange rate levels. But he elaborated that the Fed was still a very large force in determining the dollar’s value indirectly through monetary policy and, therefore, they can’t ignore the effects of that policy. Simons calls the central bank’s current trick to save the economy and its wealth “the right of seinurage,” which is simply the oldest money trick of all—print more of it (you can see our 2 ½ minute interview when it posts on the site Monday morning).

Borrow Short, Lend Long—Until the Music Stops

I agree with Simons about the Fed’s appropriate “hands off” response to the dollar at this time when it has much bigger things to worry about and focus on. I’ve written many articles here about this topic and the piece I wrote for MarketWatch on October 29^th, “Decline and Fall of the U.S. Dollar” was the third-most read article that day with more than 200 comments. My views obviously sparked some emotional opinions for many.

But here’s what I learned from the good professor that I didn’t even consider previously. If the Fed holds short rates at zero, the positive sloping yield curve encourages certain types of behavior among investors and borrowers that does more than create the obvious potential asset bubbles in stocks and commodities.

What occurs is at least two effects: (1) normally risk-averse savers are forced out of conventional money-market instruments to seek higher yields in longer-term and riskier vehicles, and (2) corporate borrowers are encouraged to shorten the maturity of their debt and become what he calls “floating rate payors at the short end.”

These behaviors build an instability in money and bond markets that will not be unwound smoothly or gradually. It’s similar to the problem we created in the housing market earlier this decade where low short rates encouraged banks to offer home borrowers very attractive ARMs that allowed them to buy more house than they could afford, with little forethought about where the future yield curve would have them re-set in a few years.

From Pushing on a String, to Pulling on a Spring

Simon’s “yield curve instability” thesis is also a function of what the Fed does on the long end. Treasury notes and bonds aren’t sitting at such low yields merely because of Fed quantitative easing measures. The current curve also encourages institutional investors to borrow short and buy bonds, thereby locking in over 4%, even though you’ve got a huge maturity mis-match. A couple of weeks ago on CNBC PowerLunch, I referred to this situation as the yield curve being “unnaturally fixed.” Denis Kneale made a smug remark that we had a good laugh about, but after the laughter, you still have to wonder.

I wonder if the Fed has gone from “pushing on a string” with extraordinary liquidity measures to “pulling on a spring” that will make the yield curve shift dramatically and cause money-market participants to scramble for vital liquidity. If you recall the credit crisis of 2008, it wasn’t so much that money market funds were in jeopardy… that was a symptom of a much larger problem. Corporate borrowers could not use the markets the way they needed to fund their daily businesses. That was a severe “shut-down” risk for the entire economy with huge potential shockwave effects.

When the Fed begins to withdraw from quantitative easing, the yield curve will have already started to shift. Inflation hawks and dollar defenders think we can withstand 2% rates right now. But the forward yield curve I look at every week at the CME through Eurodollar deposit futures (and Howard Simons probably looks at every hour in his research lab in the suburbs of Chicago) says that the market isn’t anticipating short rates near 2% until early 2011.

This is because of two factors. First, the market in aggregate (essentially the big and smart money like PIMCO and Blackrock and quantitative hedge funds controlling trillions of dollars) believes the Fed will stay on hold for a while because Ben Bernanke and Co. fear a Japan-style deflation far more than rising inflation down the road. Second, the yield curve, natural or otherwise, is encouraging borrowing and lending that builds in big duration gaps to capture big yield spreads.

When these guys think the Fed is even thinking about pulling the liquidity plug, they will move yields where they are destined. This also creates a feedback loop that CNBC economist Steve Leisman talks about when he refers to the “terminal rate.” This is the idea that once Fed transparency reveals “this is where we are headed,” the market will take rates there too quickly and suffocate the recovery.

So, who knows when this economy is really out of the woods? The Fed isn’t taking any chances and is going to escort Goldilocks all the way until they are certain—even if they lead her right into heavy traffic.

They are buying stocks because the environment is ripe for it. We’ve seen the recession trough and the earnings trough. The economy and stocks are recovering rapidly and will continue to do so until there is evidence of a coming double dip.

Interest rates will remain very accommodative, and contrary to the wishes of inflation hawks who want the Fed to put the brakes on, it ain’t gonna happen in the first quarter.

Finally, every portfolio manager is competing against some broad market benchmark and against his or her peers. Those who manage less than $1 billion are dwarfed by a factor of thousands. Combined with Fed-supplied liquidity, the question of which train you ride is clear—the bull train is safer.

So how far will the pullback go before enough institutional money sees bargains it can’t resist? Somewhere around S&P 1,040 is about as low as I think any pullback will go. Buyers will come in and wrestle with frenzied sellers before then, but the healthy back-and-fill process necessary to continued upside could take us back to test the October lows.

Is a bigger correction necessary to wash out “overdone” speculation and weak hands? I don’t think so because we are not really in an “overdone” stage of the upswing. We are still in the “wall of doubt” stage where lots of money on the sidelines can’t believe stocks can go back to pre-Lehman levels (1,250 on the S&P 500) because the economic environment is so bad. This is a good recipe for more upside.

Where is this “mild pullback” analysis wrong? If highly-correlated risk assets move in tandem, it could be confirmation of a bigger S&P move to 975 at the lowest. The VIX goes above 30, oil below $68, and the euro below $1.42 would be good examples.

It’s been easy to be a bull on this market for eight months. Maybe it does need to get hard again with a swing to more pessimistic sentiment. Your ace in the hole is the fund manager/V-recovery bull train that won’t exactly stop at your station at the lows before it heads back north. You may have to jump on early to make it aboard at all.

And this week we have CEO Blankfein making headlines for two public gestures. The most prominent would be his announcement that GS is joining forces with Warren Buffett to provide $500 million in funding for education and small business initiatives. The less important, though as much discussed, is his off-the-cuff apology for the firm’s participation in financial practices that helped feed the crisis of 2008.

Much will be written about the great institution and whether or not it could have been greater when it had the choices. On October 16, David Pauly writing on Bloomberg.com suggested many other uses for Goldman’s $20 billion in bonus dollars, like sharing them more equitably with all the firm’s employees, increasing their “paltry” dividend, or buying another bank. Today on Bloomberg, Mark Gilbert says that “Goldman’s $500 million Is a Day Late, Dollar Short.”

Are Blankfein and company getting cute with this philanthropy to patch up things on the PR front? I don’t care. They are one of the best bank-trading institutions ever to bank or trade. They are not perfect in every way, just excellent in the ways that count most. This may not keep the share price of its stock from falling below $170, but it will certainly make me a buyer of the company at lower levels.  And in the short-term, I am staying with my December bull put spread as long as the stock holds above $175.

An iron condor is involves the selling of two out-of-the-money (OTM) vertical spreads, one an upside call spread and the other a downside put spread. The basic idea is that you are not sure which direction the given stock or index is going to trade, but you are pretty sure of what range it might trade within, and thus you can comfortably sell option spreads around that range.

Here’s a recent example from the ONN Trading Ideas that assumed the SPDR Gold ETF (GLD) was likely to trade between $103 and $120 into January:

Iron Condor Part I: Bull Put Spread –

• Sell the January 103 put for $1.02 per contract
• Buy the January 102 put for $0.86 per contract
• Net credit of $0.16 per spread

Iron Condor Part II: Bear Call Spread –

• Sell the January 120 call for $1.47 per contract
• Buy the January 121 call for $1.30 per contract
• Net credit of $0.17 per spread

Overall credit for the spread: $0.33 (or $33)

Profit/Loss Details:

Maximum profit: $0.33 (the total premium collected) minus commissions.

Maximum risk: $0.67 (the difference between put or call strikes minus the premium collected). Return on risk is approximately 49% for this strategy.

Upper breakeven price: $120.33 (the strike of the sold call plus the total premium).

Lower breakeven price: $102.67 (the strike of the sold put minus the total premium).

The key with any iron condor is being willing to pick a trading range you feel confident about for a given time period and then being willing to sell both spreads simultaneously around that range. Some traders like to sell call spreads near the top of the expected trading range and then sell the put spreads near the bottom of the expected range to get the most option premium income possible. This way of building the iron condor one spread at a time as the stock, index, or ETF moves around can have advantages.

But it also assumes that you can time the market’s movement. And this goes against the basic approach of the condor that says we don’t know if, when, or where the market will move around in that range—or even if it might defy our expectations and go through the short strike of the spread we have sold.

In this sense, by selling both spreads at once (which can usually be done for one commission on all four option legs) we capture a good chunk of premium and actually lower our overall risk to an adverse price movement.

Here’s what the risk/reward profile of the spread at expiration looks like on the OptionsHouse Profit/Loss Calculator:

This graphic representation of potential profit and loss gives you a mental picture of what you are trying to accomplish with this spread. You can see the area of profit you capture if the GLD stays within $103 and $120. And you can also see how you begin to give back some of that profit if the ETF passes through either of those strikes, and how losses accumulate past the breakeven points of $102.67 on the downside or $120.33 on the upside.

The beautiful thing about this winged spread is that you can’t lose on both ends of the range. The stock, index, or ETF you are trading can’t go through both spreads at expiration. You can be exposed to an unrealized loss if volatility rises and the price you would have pay to buy the spread back rises. But you are always free to buy back any side of the iron condor if conditions change and you feel the potential reward doesn’t warrant the risk.

Keep in mind, I’m just using this spread as an example and I can’t know if it is appropriate for your experience, goals, and risk tolerance. What I recommend every aspiring iron condor trader do is use the OptionsHouse Trading Tools, like the P&L Calculator and the Probability Calculator, to experiment with iron condor ideas you might have.

Building them and dissecting them is so easy, it’s really the ideal way to practice and get used to all the risk/reward dynamics of these versatile option strategies. If you don’t have an OptionsHouse trading account, sign up for a free virtual account where you can place the trades and see how they evolve in real-time with all the profit/loss exposures marked continuously.

In the Trading Ideas section of ONN, we recommend two or three iron condors per week. Keep an eye on them and before you consider trading them, plug them into the OptionsHouse tools to make sure you fully understand their dynamics. If you have any questions about iron condors, send them to me at kcook@onn.tv. And, as always…

“Mind the Risk, Bank the Profits!”

The S&P has since moved 6% higher, to 1,110 from 1,045 in eight days. So, is now the time to take profits? Many investors probably thought so last week as the market rallied up to the October highs and settled back below 1,095 marking some sort of potential double-top—or so they hoped, as they continued to sit on the sidelines, or worse, as they continued to short or sell upside calls.

But to fight this market is to hope against forces and multipliers of forces you don’t understand. It’s what I’ve been writing and talking about since July, and summed up in articles like S&P Rally to 1,100—Despite the Fundamentals  and The Bull Train You Can’t Catch.

Bernanke Reassures

When Big Ben spoke today before the Economic Club of New York, he gave us confirmation of two key drivers of recovery and asset reflation. First, despite all the handwringing about inflation, bubbles and exit strategies, the Fed will still remain accommodative for an extended period because they think it’s the right thing to do given the current economic circumstances. Any questions?

Second, not only are they carefully watching all the important data points on jobs, bank lending, housing and consumer health, they have many tools available to reverse the “extraordinary liquidity” of the past year’s policies. In other words, they still want to spark some inflation and are not sure we’ve got enough of it yet to risk removing stimulus from a still-fragile recovery.

The only knee-jerk reaction in any market was the euro as it dropped about 90 pips in 10 minutes in after the release of his prepared remarks. And true to currency traders’ hyper-sensitive form, the euro climbed right back as any mis-reading about the Fed getting ready to remove accommodation was, well, re-read.

Hightower and the Oldest Contrarian Indicator

When I interviewed David Hightower this morning and we discussed an indicator he’s been using for 20-some years to time the S&Ps, he humbly mentioned that he was the very first paid stock index analyst. Since he’s been at this awhile, this is worth listening to.

His indicator, the CFTC Commitment of Traders (COT) report, is bread and butter for futures traders. It details the positions of large traders, both commercial hedgers and speculators, as well as aggregate positions among smaller groups of non-professional speculators.

The most watched stat that comes from this data is the net position of commercial traders, which many analysts feel leads the market by two or three weeks. For example, if commercial positions are “net short,” indicating that more short futures contracts than longs are held among the pros, this could be considered bearish because the “big and smart” money is positioning for some trend change or acceleration. The caveat here, of course, is that the commercials are generally institutional investors such as pension funds and hedge funds that often maintain a net short position because of the way they use S&P index futures to hedge or manage existing risk.

The second most interesting stat we get from the COT report on the S&P’s is what the small speculators are up to. Dave pointed out that the “net spec long” position of essentially retail traders has risen to near 60,000, meaning that combined long and short positions come out with the longs ahead by that number of contracts. Is this a high number indicating wild speculation among retail traders and thus the ultimate contrarian indicator?

Not exactly. The highest “net spec long” we’ve seen from this group is about 110,000 bullish contracts in March of 2001. And confirming this indicator’s contrarian success we find that these traders were basically flat (longs = shorts) during the depths of the financial crisis at the end of 2008. To their credit, they did turn net bullish 80,000 contracts during the first half of 2009.

So, we’ll keep an eye on Hightower’s “Cab Driver Indicator” and see if it runs to a bullish extreme above 100,000. Given that the use of S&P E-mini futures has at least doubled since 2001, the bullish extreme could take us much higher.  See my full interview with David on our StreetSmarts segment posting on ONN.tv Tuesday.

As independent investor-traders expand their reach into multiple asset classes, one of the most popular markets attracting their attention is currency trading, also known as foreign exchange, or “FX” for short. Since 1971, when the Bretton Woods system of fixed currency exchange rates collapsed and the era of floating rates was born, the Chicago Mercantile Exchange—now called CME Group (CME) since going public and acquiring the Chicago Board of Trade—has been the innovator in providing retail access to this huge, bank-dominated market through its currency futures contracts and options on futures.

CME FX Futures contracts trade in sizes that offer self-directed investors safe, efficient, cost-effective access to FX markets. For instance, the Euro FX contract is 125,000 euros and is priced in dollars. The Australian dollar contract is 100,000 “Aussie” and is also priced in dollars, as are most CME FX products. Yesterday, Euro FX traded more than 317,000 contracts (50% of the FX volume) and the Aussie traded nearly 108,000 contracts (9%).

While 317,000 may sound like low volume for a stock, for CME FX Futures where the contract sizes are over 100,000 in foreign currency, the underlying notional value (i.e., how much currency is actually being traded or hedged) is in the billions. For instance, 317,000 contracts x 125,000 euros x $1.4850 = $58.8 billion in notional value. This is how the FX markets dwarf all global stock and bond markets combined in daily volume.

Here are some of the big volumes in Euro FX options recently, with underlying notional values:

Thursday 12^th Nov

• Dec 1.5500 Calls                1,386 contracts                   5 delta                  = €173 million

• Jan 1.5700 Calls                 1,373 contracts                   10 delta                = €172 million

• Dec 1.4700 Puts                1,357 contracts                   33 delta                = €170 million

Total Euro FX Option trades amounted to $2.8 billion in notional value.

Overall Nov 12^th volume $5 billion in FX Options, all currencies.

Friday 6^th Nov

• Dec 1.4700 Puts                1,223 contracts                   38 delta                = €153 million (open interest is now 2667 or €334 million)

Overall Nov 6th volume $4.4 billion in FX Options, all currencies.

Wednesday 4^th Nov

• March 1.3000 Puts           2,000 contracts                   7 delta                  = €250 million (open interest was reduced but still stands at €1.15 billion for this strike)

• Nov 1.5100 Calls                1600 contracts                   11 delta                = €200 million (open interest is at €315 million and it expires Friday 6^th Nov)

Overall Nov 4th volume $4.8 billion in FX Options, all currencies.

Tuesday 3^rd Nov

• Nov 1.4750 Calls                1,092 contracts                   41 delta                = €136 million

• Nov 1.4250 Puts                1,557 contracts                   3 delta                  = €195 million

• Nov 1.4550 Puts                1,196 contracts                   24 delta                = €150 million

Overall Nov 3rd volume $4.6 billion in FX options, all currencies.

CME offers free real-time FX Futures and Options quotes on its E-quivalents page.

What makes CME FX Futures the best platform for the small trader?

CME FX Futures average daily volume exceeds $100 billion in notional value. Now, let me highlight why the underlying futures are the vehicle of choice.

1) Safety: the CME Clearing House is recognized as the premier model for guaranteeing safety of customer funds and contract performance. In the 160+ year history of Chicago futures trading—yeah, we invented it here—no customer has ever lost money due to the failure of any other single trader or firm. In essence, you have no “counter party” or fraud risk trading at the CME and this financial safeguard imperative is driven 24/7 by constant risk monitoring and “mark-to-market” settlement of open positions so that no losses can accumulate without sufficient margin capital. In other words, the losers have to pay the winners every day, and sometimes twice a day!

2) Liquidity: FX is the largest market in the world, having grown from average daily turnover of $1 trillion in the mid-90s to over $3 trillion this decade. The massive cash, or “spot,” market is driven by large trading institutions like global money center banks, hedge funds, and portfolio managers and is referred to as the “interbank” market.

And all those large players also use CME FX Futures so that the futures markets have grown right along with the spot market’s “trillion-dollar day,” but at a much faster rate. When CME FX went electronic earlier this decade, volumes nearly doubled every year from 2000 to 2005. To give you an idea of CME FX Futures’ contribution to the trillion-dollar day, the underlying notional value of yesterday’s trades in Euro FX and Australian dollar contracts alone equates to over $70 billion, about 2.3% of the average daily turnover in global FX (using $3 trillion as a baseline). Total CME FX volumes often approach 5% of total trading and this makes it rival interbank platforms such as EBS or Reuters as one of the most liquid.

3) Speed: The CME Globex trading platform is built to handle tens of millions of trades per day. And the architecture behind it is supported by world-class technologists working 24/7 to maintain and improve it. Next to the CME Clearing House, the Globex trading engine is CME’s most prized asset and they intend to keep it that way.

Looking at liquidity and speed together for a moment, an often overlooked aspect of CME FX Futures is that the dozens of large interbank players get their access by sending live streaming prices into Globex. This means they are constantly providing liquidity through automated, algorithmic price feeds. What traders often wonder is why a typical market depth order book doesn’t always reflect all that size. The answer lies in the fact that futures trade in a tight relationship with the spot market based on interest rate differentials between currency pair countries (the US vs. Australia, for example). See my pieces on The FX Carry Trade and Currency Carry = Interest Arbitrage for an introduction to this topic.

CME leaders learned long ago that the key to success of their futures markets was in linking them as directly and efficiently as possible to the spot market. They achieved this through dedicated market maker programs and superior technology. What happens with the algorithms is that when a new futures order comes in at the bid or the ask—or even in between these very tight markets that often trade one-point wide in the major currencies—the order will get executed quickly because of competition among human market makers and algorithms who are all trying to capture arbitrage price differences between the futures and the cash. These price differences are sometimes fractions of a point, but they add up for the institutional trader who is constantly dealing in high volumes.

The point is that since the spot market is so enormous and the futures are linked to that market by dozens of sophisticated players, the futures become as liquid as the bigger market. In fact, sometimes the actions of banks and hedge funds in the futures markets can be the tail that wags the trillion-dollar dog!

The Best FX Market Just Got Better for the Small Player

With the introduction this year of Forex E-micro contracts, CME has done it again on the innovation frontier for small traders. These futures contracts are 1/10^th the size of the big ones, and are offered in conventional interbank terms, like USD/JPY. See the CME product page to learn more about these “precision-sized” contracts for playing FX or testing a system.

Flipping through my Commodity Trader’s Almanac 2009 by Jeffrey Hirsch and my friend John Person, I found their statistical focus on the gold seasonal:

“Seasonally speaking, it is best for traders to go long on or about Nov. 18 and hold until about Dec. 3. Over the last 33 years, this trade has worked 26 times for a success rate of 78.8%. The cumulative profit tallies up to $25,960. What is interesting is that this trade has had an eight-year win streak starting from 2000.”

The profit tally they refer to is based on entering and exiting one front month gold futures contract during the two-week period. Granted this is a short-term trading window, but that is the nature of their work in the Almanac—they are highlighting the optimum short-term trades that have delivered consistent returns over many decades and can be tied to fundamental cycles or patterns.

Wither Dollars, Buy Stuff

On Wednesday, Nov. 4, before the Federal Open Market Committee released its policy statement, I wrote S&P 500 Bull Case—5 Reasons to Buy about why the market would continue higher after the Fed announcement. We’re 5% higher since then, and I still see further upside into the new year based on the dollar carry trade, global growth and “the bull train you can’t catch.”

So the question is: With the terrific run-up in gold in the last 2 1/2 months (which I also wrote about on Sep. 2 as it was breaking out of a huge consolidation by crossing above $965), will this short-term seasonal trade work this year or is the market so much bigger now that it is just as likely to pullback?

Today at noon EST, with the S&P 500 fading from the 1,100-level and unable to score a close above it, and with the dollar staging a small comeback above $75 on the DXY, December gold futures are down $7 to $1,107.50 after surging to new highs yesterday near $1,120.

In my mind, the answer to the question is simple: Gold is still going to $1,200 in the next year, so you want to find ways to position long that you are comfortable with, whether that is buying the GLD, GDX or individual metals/mining companies like Freeport-McMoRan (FCX), Barrick Gold (ABX) or Newmont Mining (NEM). The short-term trade in the CME/Comex Gold Futures contract carries much more risk since the leverage of trading 100 ounces of gold makes each dime worth $10.

For a short-term trade with very defined risk that doesn’t require gold to move higher, and could even sustain a 4.5% move lower, check out Jared Levy’s trade idea today in ONN’s Premium Option Trading Alerts service.

But this “fly” has some twists that keep the initial cost down by taking advantage of selling volatility on a bet that Google shares aren’t likely to trade much higher than $600. Here are the trade details:

• Buy 20 GOOG Dec 590 calls for $7.50
• Sell 30 GOOG Dec 600 calls for $5.00
• Buy 10 GOOG Dec 620 calls for $2.00

Net cost for the butterfly is $2,000 (the premiums above were from Monday, but even with GOOG up nearly 1% today, the spread can still be done for around $2,000 net).

As you can see, this butterfly is slightly different than the typical 1 x 2 x 1 convention. Its 2 x 3 x 1 ratio attempts to benefit as much as possible from the bull call spread component where Dan is buying twenty 590/600 verticals for $5,000 (20 x $2.50 per share x 100 shares), and offsetting that cost by selling ten 620/600 verticals for $3,000 (10 x $3.00 per share x 100 shares).

Here’s a Profit/Loss diagram of the trade from the OptionsHouse Trading Tools:

Note the maximum profit of nearly $18,000 achieved if Google is at $600 upon December options expiration. This is certainly not the only way for this trade to be profitable. As GOOG approaches $590, the value of this butterfly will increase and profits can be taken at any time.

In addition to the short vega position (essentially, short volatility) of this fly, which would be harmed by a rise in implied volatility, its structure creates positive theta that benefits from options decay as time passes, especially the closer GOOG is to $600. To see all the Greeks (options risk analytics) and how they change when you build butterflys with various strikes, the OptionsHouse Profit/Loss (P&L) Calculator is a great tool because it has everything on one page and lets you quickly add and delete strikes, move forward in time, and even adjust volatility all at the click of a mouse.

I asked Dan what he wanted to call this unique fly… a broken-wing, unbalanced, or skip-strike fly? He replied, “How about a positive theta ratio spread with wobbly winged upside protection.” That about says it all.

1) Peak oil: This is the idea that we are in sight of reaching the maximum amount of oil in the ground and in reserves after which time, production and supply will necessarily drop off.

2) Speculator scourge: Much vilified, yet to be convicted, the energy market speculators remain in the spotlight, or at least in the back of our minds. Maybe fear of another speculative overreaction that sends oil to 2008 highs is behind the charge that IEA supply estimates are too generous. Is the US government in cahoots with the IEA to keep the market calm with phony stats? I doubt it, but anything is possible.

3) Emerging growth: So far, this is the force with the most data behind it—the rising GDPs and energy consumption of emerging market countries around the globe. Whether or not abundant, cheaply borrowed dollars are driving prices higher, there is real demand out there from economies with high, single-digit growth rates. And many of those nations are still in the early stages of their industrial revolutions.

4) Surplus supply: How bad has the global recession impacted demand? Apparently not enough to keep oil below $70. And then when all we hear is that supply is at record levels, it makes you wonder if the market is trading on different dynamics, or a different time frame.

5) Exploration, shale, and alternatives: New oil discoveries continue to be made, oil sands make Canada the Saudi Arabia of the Western Hemisphere, and green energy possibilities all seem to make peak oil less of a threat.

Given all these conflicting forces, oil has become one of the most interesting trades around. As a former currency trader who loved the FX market because it was a 24-hour, geopolitical chess match, I like to call crude “the other currency” and say that “dollars are priced in barrels.”

All this debate makes crude a great market to trade too, with lots of liquidity and lots of opportunity. The chance to pick high-probability trading ranges in the commodity and the companies who profit from it are diverse. My favorite strategy all year, as a low-risk, high-probability play, has been selling iron condors on the SPDR Energy ETF (XLE).

Here’s a good one for December:

Iron Condor Part I: Bull Put Spread –

• Sell the December 53 put for $0.73 per contract
• Buy the December 52 put for $0.56 per contract
• Net credit of $0.17 per spread

Iron Condor Part II: Bear Call Spread –

• Sell the December 63 call for $0.48 per contract
• Buy the December 64 call for $0.32 per contract
• Net credit of $0.16 per spread

Overall credit for the spread: $0.33

If you actively trade stocks and you don’t pay attention to news from the world of equity options, listen up. Here are five ways to profit from options action:

1) Big Volume: When institutional traders want to build a bigger position in a stock without moving the market, they often use options to do it. Since every options contract represents 100 shares of underlying stock, a purchase of 5,000 calls or puts is pretty meaningful and something you should pay attention to if you have, or are considering, a trade in that stock.

Every morning in the SideWinder Update, we report on sizable volume trades in equity options. The broker OptionsHouse also has a “Hot List” of high volume option trades. And daily articles from Jud Pyle in his Volatility Overlays column always seem to find what the big and/or “smart” money is doing in options.

2) Implied Volatility: Options prices are determined by expectations about future volatility and thus risk. The prices of options imply a certain expected volatility. When option prices move higher without the underlying stock volatility increasing, this is a bet by option traders that future volatility/risk will be higher.

For instance, in September before Research in Motion (RIMM) reported earnings, the implied volatility of its options had been sharply on the rise for over a month. This was not surprising to options traders who have seen volatile moves in RIMM shares following its earnings report. This higher expected volatility was driven by both put buyers seeking protection and call buyers looking for a breakout in the stock. As it turned out, the bears were right, and anyone who bought put protection, and sold calls to finance them, did very well.

3) The Straddle: Options traders are obsessed with volatility of all kinds. But one simple measure of vol is the at-the-money (ATM) straddle. When the combined prices of the put and call both go up from the day before, more risk and uncertainty is getting priced into the stock. For instance, if a stock is trading at $25.49, the ATM straddle is the price of the 25 call and 25 put added together.

Every day, options lose a little of their value as time passes.  But if the straddle price is rising, options volatility is on the move higher. Stock traders have to decide themselves if this increased expectation for volatility aligns with their bullish or bearish views, but it is useful info nonetheless. The SideWinder Update points out straddle moves every day.

4) Premium Sellers: Many option traders, from institutions to one-man operations, make their livings from selling option premium. When stocks trade in ranges, the premium sellers try to sell upside calls at the top of the range and downside puts at the bottom. This doesn’t create the trading, but it’s worth noting that lots of sober opinions are getting expressed.

In other words, these are the folks who don’t think XYZ is going to the moon, or the basement. They just play the range by selling iron condors and other credit spread strategies. Another element of this that supports the trading range is that when someone sells a call to an options market maker, that market maker must sell the stock to hedge. And vice versa with puts—when the market maker buys puts from the put sellers, he or she then buys stock to hedge.

5) ETF Options: The expanding universe of ETFs offers stock traders new vehicles for expressing their views across multiple asset classes with lower cost and risk. Institutions use ETFs and their options for sector rotation and efficient asset allocation on a daily basis because options provide leverage and versatility they can’t get anywhere else.

The daily volume in an ETF may not give you an idea about “big money” moves in or out of a given sector, but the options action will. Stock traders should make it part of their weekly routine to watch for big volume in sector ETFs for ideas about broad-market trends. Don’t miss my articles of the past two days on “Big Options Action in ETFs.”

Health Care SPDR ETF (XLV): $28.68 up $0.48 or 1.70%. Volume: 1.82 million shares

Dec09 30.00 Calls: volume over 11,052, trading last: $0.20 OI: 19,382

Dec09 28.00 Calls: volume over 11,025, trading last: $1.15 OI: 11,473

XLV is the SPDR Healthcare Sector ETF. This looks like a call spread buyer for 11,000. This is a sector entering its own secular bull run as boomers will increase demand for healthcare products and services for the next 10 years.

iShares MSCI Brazil Index (EWZ): $72.57, up $1.55 or 2.19%. Volume: 22.63 million shares

Dec09 65.00 Puts: volume over 31,420, trading last: $2.04 bid: $2.03 ask: $2.09 OI: 29,925

Dec09 70.00 Puts: volume over 15,353, trading last: $3.50 bid: $3.55 ask: $3.70 OI: 7,326

EWZ is the iShares MSCI Brazil Index ETF. Here we have a put spread buyer, likely seeking some protection below $70 after this market more than doubled from its March lows. Notice also that this spread was done as a 2 x 1 ratio, thus letting the buyer actually collect a credit of about 50 cents if they bought the 70 put once and sold two 65 puts. This would be a mildly bearish play and would have unlimited risk below $65.

A more aggressive bearish play in this put spread would be if it were done as a “backspread,” where more options were bought than sold. In that case, the trade would have sold the 70 put once and bought the 65 puts twice, for a net debit of 50 cents. This strategy would have suffered a loss on the short 70 put until $65, and then have unlimited profit potential below $65.

ProShares UltraShort 20+ Year Treasury ETF (TBT): $47.72, up $0.74 or 1.58%. Volume: 8.81 million shares

Nov09 50.00 Calls: volume over 31,729, trading last: $0.37 OI: 21,444

Dec09 52.00 Calls: volume over 10,169, trading last: $0.67 OI: 4,017

TBT is the ProShares Ultra Short 20+ Year Treasury ETF. The fund is designed to capture 2x the inverse of the Barclays Capital 20+ Year U.S. Treasury Index. Investors here may have been using this vehicle to hedge against (or speculate for) an unfavorable move in the Treasury yield curve before the Fed announcement yesterday. In other words, if they were concerned about a sudden rise in rates, buying these calls would be one way to hedge or speculate on that event.

ETFs and Options: How to Follow the Big Money

Big option volume in ETFs is indicative of institutional traders—be they mutual funds, hedge funds, or other portfolio managers—trying to shift exposure, re-balance assets, or simply hedge an existing position.

Earlier this week, I attended a great seminar by State Street Global Advisors on “Portfolio Construction Using ETFs.” In addition to picking up ideas for my (free) monthly webinar series “Sector Rotation with ETF Options,” I got a good sense of the depth of institutional involvement in these products.

Here’s one dramatic snapshot of why they use ETFs for diversification and efficient market exposure. In 2008, one of the worst-performing market areas was Emerging-Market Stocks, down more than 53%. And this happened after it was the star in 2007 with a 40% return. This year as of 2Q09, EM leads all other large-asset classes in stocks and bonds, up 36%.

When the credit crisis sent the world to sell everything last fall, EM got hit the worst. Who knew when it was safe to buy risky stocks again? Buying the iShares MSCI Emerging Markets Index (EEM), was one relatively safe way to buy the worst-performing market area that was bound to bounce back.

The EEM, probably one of the largest ETFs with over $12 billion in assets, is up 53% this year and holds stocks from China, Brazil, South Korea, Taiwan, South Africa, India, Hong Kong, Russia, and Mexico in about 80% of its coverage.

A 53% return doesn’t bring you back to flat if you were long those issues last year, but it’s still an outsized gain this year across a broadly diversified mix of countries and economies still benefiting from the global boom and high single-digit growth.

The Vanguard Emerging Markets ETF (VWO) is also a good alternative tracking the same MSCI index. I believe it has very low expenses, has returned 61% this year, and invests in 550 stocks around the world. It also trades good average volume of 10+ million shares per day.

For more ideas about ETFs, be sure to visit my friends at www.ETFDesk.com.

“Mind the Risk, Bank the Profits!”

By 10:00 AM Eastern Time, more than 100,000 of these calls had traded, most on the offer price at 15 cents with the UUP down about 15 cents. Open interest in this strike is just over 40,000, so this should be seen as a very large trade, especially with less than three weeks to November expiration.

At 11:00 AM, volume in the November 23 calls hit 150,000 and then the December 23 calls showed up with 9,700 on the tape. By noon, this same strike posted 228,500 contracts trading and volume on the December calls was almost 27,000. With open interest in the December calls just over 207,000, these traded for about 25-cents per contract.

This bullish options action could actually be a hedge for an institutional portfolio with positions that would be exposed adversely to dollar strength, or it could be a speculative trade. As I discussed yesterday, the “dollar carry bubble” may have short bursts that reverse and scare out smaller players. But the size of this trade indicates a large trader is more concerned about a near-term reversal than most.

This makes the first of five reasons we may have seen the lows for November and December:

1) Bearish Momo Stopped: Last Friday’s selling momentum never got traction this week and the “buy the dips” crowd came in above 1,025.  Above 1,055 this morning will be bullish to take out 1,063 after Fed announcement at 2:15 ET.

2) Fed Constancy: The Fed today will likely not make any nods toward tightening any sooner than the market already expects—which is at least six months away. Fed transparency will give us at least three months’ notice before a hike is coming. Any language change in statement today will not be a shock.

3) Dollar Carry Trade: Fed’s extraordinary liquidity “for an extended period” will fuel stocks and commodities higher and the dollar lower. The “big and smart money” is showing no fear of a reversal, stampede, and collapse of this trade yet.

4) Bull Train You Can’t Catch: The theme I talked about in August and September is still in play. Fund managers are buying the V-Recovery in earnings and the economy and they can’t be left behind. Even if economic stats indicate it’s not a “V,” they will still buy and err on the side of being long as earnings recovery makes upside surprises their greatest risk. There are trillions of dollars all chasing the same metric of “meet or beat the S&P.”

5) 1,100 for a Week Wasn’t Enough: I’ve been talking for months about the market gravitating back toward its longer-term moving averages, like the 100-week steaming down just above 1,100 in September and October. The S&P futures kissed the 100-week right at 1,099. The 200-week moving average is up around 1,250, where we fell of the cliff after Lehman’s failure. Once above 1,100, the market will be attracted to this area in the first quarter of 2010.

Bottom line is that this market will not go away without another fight at 1,100, especially with the 200-week now dipped below and looking for a challenge to its steep downward slope.

“Mind the Risk, Bank the Profits!”

Sunday’s Financial Times hosted another polemic on “the mother of all carry trades” from Nouriel Roubini. He’s worried about another asset bubble fueled by cheaply borrowed dollars that apparently could remain cheap for an “extended period,” according to the Fed.

This, as all FX traders know, has a multiplier effect because when a carry trade goes really well, you get the double-whammy of the interest rate spread and the currency appreciation. The example I have highlighted here most often this year is the Australian dollar, which gains against the dollar as it also earns the 3% difference in rates (see my pieces The FX Carry Trade and Currency Carry = Interest Arbitrage).

Roubini points out not only how dangerous this is for the leveraged “bubble traders,” but how bad it is for a real economic recovery. As the US dollar bumps along near its historic lows, he theorizes that what is occurring is more like traders borrowing at negative 10% or 20% to buy oil, gold, euros, and our favorite risky asset — equities.

When this bubble pops, it will hurt more than the traders, he argues. “People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade.”

Translation: We are building leveraged risk into the system all over again—the same kind of leverage that took down Wall Street financial institutions and ultimately threatened the portfolios of Main Street.

He goes on to describe the artificial support this bubble is getting from the Fed’s quantitative easing asset purchases. This adds to the instability of the trade because the yield curve is held unnaturally low, much like a stretched rubber band. I wrote about this last week in Dollar as Scorecard and Symptom when I quoted Axel Merk:

“… if the Fed helps to engineer that markets cannot price inflation into bond prices, there has to be a valve. This valve… will be the US dollar.”

Reversal, Stampede, Collapse

In a single paragraph, Dr. Doom uses these three nouns to describe what’s coming when this giant carry bubble pops. The reversal is what happens when the music stops and everybody scrambles for the few open seats. This will come when the Fed finally signals “extraordinary liquidity” and “extended period” are over.

This will not happen at the end of tomorrow’s two-day Fed meeting, by the way. But we have seen it happen before. I saw it in 1998 when the Fed and the Bank of Japan (BOJ) intervened to fight dollar strength and the yen carry trade. They knocked the dollar down hundreds of points from 140 USD/JPY to 130 in a day, costing billions to many firms.

The stampede in this case will happen once the smart money knows the jig is up. Right now, they are confident the carry trade is still in force because the Fed will be on hold for another six to nine months. That’s why oil, gold, equities, and the euro are still up here. We saw a little scramble away from risk and toward safety last Friday when the S&P dropped 30 points, but that was just a test.

The collapse will be brutal he thinks, especially the longer the bubble is pumped with “dollar air.” Not so much for Wall Street this time. Maybe for hedge funds. Definitely for Main Street.

“The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”

Dollar Doom, Not So Fast

Why am I suggesting his panic is extreme and that the mother of all carry bubbles is likely to deflate more slowly? First, because I think Bernanke and Co. have their finger on the pulse of this recovery and will no more create another bubble than they would allow a deflationary collapse that would ever prevent it. That’s what I said in my MarketWatch piece last week.

Second, last night we got another interest rate hike and tempered words from the man in charge of one runaway carry trade, Glenn Stevens, governor of the Reserve Bank of Australia. While the market was baking in at least 50 basis points in raises from the RBA this year, the central bank statement implied that they may now be done for the year with the October and November 25-basis point moves and do nothing further until January or February.

Both the Aussie and the euro reacted strongly to this news overnight and traded below strong support levels at $0.8950 and $1.4680, respectively. This is another bump in the road for the “runaway carry bubble.”

Which isn’t to say that the dollar carry trade is over. Just that it can also unwind slowly too, and not burst like everyone expects.

“Mind the Risk, Bank the Profits!”

Here are the details of the trade idea published Friday morning when the stock was trading around the $105 strike:

Iron Butterfly Part I: Short Straddle –

• Sell the December 105 put for $7.10 per contract
• Sell the December 105 call for $7.80 per contract
• Net credit of $14.90 per spread

Iron Butterfly Part II: Long Strangle –

• Buy the December 75 put for $0.55 per contract
• Buy the December 135 call for $0.65 per contract
• Net debit of $1.20 per spread

Overall credit for the spread: $13.70 (or $1,370)

Profit/Loss Details:
• Maximum profit: $13.70 (the total premium collected). Minus commissions.
• Maximum risk: $16.30 (the difference between strikes minus the premium collected).
• Upper breakeven price: $118.70 (the strike of the sold call plus the premium).
• Lower breakeven price: $91.30 (the strike of the sold put minus the premium).

The trade rationale was simple. The combined prices of the 105 put and 105 call, in essence the 105 straddle, were implying that the stock could move as much as $14.90 from $105 before December expiration. That would be a move of about 14.2%. According to our data, the largest stock move after an earnings in the past year was about 24% last fall.

But the three most recent reports in 2009 averaged less than 10%. And after industry cohort CME Group Inc. (CME) reported earnings of $3.35 Thursday, six cents better than First Call estimates, the stock reaction was very mild. Expectations for the ICE third quarter are $1.15 after $1.04 a year ago. Both exchanges seem to give very good guidance about earnings so that Wall Street is little surprised.

So selling the 105 straddle and hedging with a deep out-of-the-money strangle to collect a net credit of $13.70 is a bet that ICE shares will stay between $91.30 and $118.70 up until December, which would only be a move of about 13% either way from $105. Selling the iron butterfly doesn’t mean you have to hold the position until expiration. You may be able to close for a profit sooner if the implied volatility of those sold options comes down considerably before then.

According to the Implied Volatility tool at OptionsHouse, prices paid for options in the past week have crept up from 40% to 50% implied volatility (IV). This seems like a big move, but in reality 40% was among the lowest levels seen in the past year, so IV was really just getting back to its average levels for the past six months.

The one volatility event that does stand out for ICE shares was in July, when speculation about possible legislation affecting their business negatively sent the stock down from $110 to $85. Both implied volatility and realized (actual or historical vol) jumped from 50% up to 70% at that time. Even though we have an idea that this earnings event will be muted in terms of volatility, this type of move is something to keep in mind as a possibility.

Here’s a snapshot of what the iron butterfly looks like on the OptionsHouse P&L Calculator:

Clearly, you have to be right about the post-event movement of the stock, or you end up taking on more risk. Since you are not hedged in this particular iron butterfly until $75 or $135, you could face a maximum loss of $16.30 per share if the stock trades through either one of those levels.

Finally, you can also look at the iron butterfly as a combination of two credit vertical spreads that have a common strike. You are selling the 105/135 call spread and selling the 105/75 put spread. If you go to the OptionsHouse P&L Calculator, you can practice building these strategies and dissecting their risk/reward dynamics, which is what every aspiring iron butterfly trader should do before entering this strategy.

Royal Dutch Shell, also reporting before the open, missed the mark by an even wider margin with EPS coming in at 53 cents versus First Call estimates of 96 cents. A Bloomberg story quoted Shell executives as saying a “quick recovery” in energy demand and prices is unlikely.

This bearish tone on oil demand from the producers themselves makes me wonder about the likelihood of oil trading much higher from here. Crude oil is up more than $2.50 today, back above $80 on the strong initial third-quarter GDP and bounce in equities, but even $85 oil won’t necessarily help the profits of the big integrated firms that much more.

Chevron is due to report its earnings before Friday’s market open and First Call is expecting $1.47 EPS. For those current holders of CVX shares who want to hang on, an options collar might be the order of the day before the close today. Here’s one buying the near-month put for downside protection and selling a second-month out-of-the-money covered call for a small credit:

Buy November 75 put for $1.25

Sell December 80 call for $1.65

Net credit of $0.40

With essentially “free” protection through November expiration below $75 and further upside potential of another 3%+ through December, this “skip-month” collar might be a conservative way to play the earnings event.

Even if you are concerned about having your shares called away by December expiration on further strength in CVX, you might consider that $80 will be a strong resistance point for the stock and you will most likely get a chance to buy them back as they mark some time trading there.

Do ITM debit spreads = OTM credit spreads? I notice a lot of traders have a preference for credit vertical spreads & iron condors. Aren’t ITM debit spreads synthetically equal to OTM credit spreads (e.g., AAPL 200/205 bull call spread & AAPL 205/200 bull put spread) and iron condors = to long condors? If that is the case – how does one choose which one to go with – i.e., the credit side or debit side?

I love this question because it really gets new option traders thinking about the basic mechanics of risk/reward with spreads, and about option synthetic relationships. On Oct. 27, I pulled up a quote chain for December Apple (AAPL) options so we could use real prices for the examples. With the stock trading around $197.50, the bid/ask premiums for puts and calls at the 190- and 195-strikes were:

190 Strike: call 13.50 ask; put 5.75 ask

195 Strike: call 10.50 bid; put 7.75 bid

Now let’s construct the in-the-money (ITM) debit call spread vs. the out-of-the-money (OTM) credit put spread. Both are bullish strategies with identical risk/reward characteristics and payoffs. In both, we want the underlying shares to stay higher than $195 to achieve max profit and avoid losses:

190/195 bull call spread debit is $3.00
Potential return on risk is $2/$3 = 67%

190/195 bull put spread credit is $2.00
Potential return on risk is $2/$3 = 67%

The fact that the spread premiums create precisely the same return is not surprising, even though traders may be able to get into these spreads for slightly better or worse prices that will affect which one they prefer. That said, they are still synthetically equivalent (a property of put-call parity relationships) and thus virtually identical in terms of risk/reward.

So, if the strategies are essentially equivalent, which is what makes synthetic option relationships work, which do you choose? It may simply depend on what type of trader you are. Here are a few reasons different traders choose among equivalent credit or debit strategies:

• For option traders who are only approved for buying options and spreads, they have few choices. Their broker or type of account may not allow any short or credit strategies. This may seem unfair if the strategies are equal, but that’s how options are treated to protect account holders and brokers.

• For active option traders, especially institutional professionals, it comes down to efficient use of capital. They are able to sell more OTM spreads and iron condors because they collect premium upfront, have minimal and/or offsetting margin collateral requirements (i.e., portfolio margining), and can earn meaningful interest on balances. Additionally, professional traders are often trading these synthetically equivalent strategies against long and short stock positions, capturing arbitrage profits from conversions, reversals, and boxes.

• For traders who focus on volatility strategies, they may prefer selling spreads and profiting from “overvalued” options and time decay, while trying to avoid ever paying up for options volatility. Theoretically, this volatility issue shouldn’t matter that much in equivalent spreads. But because they think “selling is better,” it dominates their strategies.

A final issue affecting all traders to various degrees is commissions from exiting spreads, or from exercise and assignment at or before expiration. If you sell the 195/190 bull put spread and it stays OTM as you had hoped, your options expire worthless with no additional commissions. But the 190/195 bull call spread staying ITM will require you to either exit before expiration and pay commission(s), or pay the commissions from exercise and assignment at expiration.

How to Practice for Free

Understanding option synthetic relationships and equivalent spreads launches your options trading expertise to a new level. If you still struggle with the concepts, you could pick up a book that explains put-call parity and synthetics.  You could also read my article in SFO Magazine from January of this year called, “The Balancing Act of Put-Call Parity.”

The best way to learn this stuff is to practice putting together the spreads yourself with tools that let you simulate their risk/reward profiles. For that, I can recommend no better tools than the OptionsHouse trading platform, which I use every day to build spreads and break down their dynamics. If you don’t have an active options trading account with OptionsHouse, at least open a free virtual one to try the great tools.

The Profit&Loss Calculator let’s you quickly assemble spreads just by clicking on the bids and offers in an option chain. It builds the graphs for you and allows you to watch their progression through time and changes in volatility. You can also quickly eliminate and add option legs and stock to the same graph.

When it comes to understanding the value and risks of options and spreads before you trade them, this kind of practice is priceless.

Remember that before you actually start employing the three steps, you should have a solid understanding of what an equity option contract is. To further your education beyond what is offered at ONN.tv, please ask your broker about a publication from the Options Industry Council called Characteristics and Risks of Standardized Options.

Step One: Pick a stock you’d like to invest in. To complete this step, be able to address/answer these issues:

Know why you like the company as an investment before you buy its stock or options.

Do you believe the company’s value or growth story make it an attractive buy now?

Consider consulting your financial advisor or broker before you invest.

Is the money you will use earmarked as longer-term investment capital or short-term trading capital? Know what money you are using and what you are attempting to achieve.

Step Two: Evaluate the risk and reward of the investment. To complete this step, you must dive deeper into your goals and determine how an option could help, or hurt:

Can you afford to lose all or part of your investment? What if you are right about the stock rising but your option is approaching expiration with less value than you paid for it? What will you do to manage either the profit or the loss on the option investment?

When do you need all or part of the money back as cash? Six months? Six years? If you need the money in six weeks, stay in cash.

If you are going to buy call options, will you buy contracts representing more shares than you could afford to buy of the stock outright? This gives you more leverage, but increases your total dollar investment and risk.

Know what are you trying to accomplish. For example, are you trying to capture the 10% appreciation you expect in Apple (AAPL) shares from $200 to $220 in the fourth quarter? Or are you trying to benefit from a 20% move higher over the next six months?

Are you bullish on biotech or alternative-energy stocks, which can often have volatile moves dependent on research or regulation? Often, option plays here can pay off nicely, but picking the right stock and giving the option investment enough time to develop is critical to success.

Step Three: Choose an option that balances your risk/reward goals. Prioritizing Time vs. Value vs. Price is the “decision matrix” for options:

You have three elements to prioritize that will determine which option suits your goals: time, moneyness (intrinsic value of the option), and the option premium you pay (your maximum risk).

By deciding which two of these priorities are the most important to you in any particular investment, the third is essentially determined for you. For example, let’s say you want about six months for your investment idea in AAPL to work, and you want to buy an at-the-money (ATM) option because it offers you about a 50/50 probability of success.

From the AAPL option chain below, courtesy of the OptionsHouse trading platform, you can see that an at-the-money (ATM) option with close to six months of life will be the April 200 call contract, currently trading for just under $20 per share with AAPL at $200. Spending $2,000 for an option (100 shares per contract times $20) still sounds like a lot of money, but that is far less than the shares themselves and your risk is limited to that amount—but then you already knew that about options risk, or you wouldn’t be here!

While you’re looking at this chain of ATM options, it’s a good time to do what I recommended in the original article on Step 3—practice finding different options by switching around your criteria. Try these combinations of priorities and find the option that matches:

1) A call option with at least 12 months of life that is only out-of-the-money by 15%.

2) A call option with about eight weeks to expiration (from Oct 27^th) and costs under $10.

3) An ATM option with about three months of life that I might be able to buy for less than $10 if the stock drops a few dollars.

What if these option premiums are more than I want to invest? You have at least two ways to solve this problem: (1) look at only farther out-of-the-money (OTM) options, knowing that it may reduce your probability of success, or (2) look at stocks with lower prices than AAPL. Either way, go to OptionsHouse and sign up for a free virtual trading account to practice finding more options that suit your risk/reward goals.

There’s a casino in the Midwest that advertises with the slogan “This is about to get interesting.” Now that finding options for your investment goals is more accessible, you have just opened up an enormous market full of opportunities, with combinations and possibilities for success that dwarf the gaming tables.

Regardless of whether it’s the Fed’s job to defend the dollar, we should first wonder if low interest rates are the cause of the dollar’s current state and then if raising them will solve the problem. I say “no” to both questions.

The dollar’s decline has been in motion for many years, if not decades. Trade deficits and budget deficits, financed by growing public debt, have always been a burden on the dollar’s perceived value overseas.

When we monetize that debt, whereby the Fed buys Treasury and agency mortgage-backed securities and increases its balance sheet, we have printed new money and the world usually knows it. This activity has taken an unprecedented upturn on the heels of the financial crisis.

The dollar is a scorecard of U.S. performance in the global economy, but it is not a stable one. Since the writing was on the wall about the dollar’s perceived value before the credit/housing bubble blew up, why should we not expect the dollar to be taking a hit now when we cranked up the printing presses to bail ourselves out, thereby diluting the dollar?

And the dollar made its all-time low in March of 2008, before the credit crisis really got rolling in the post-Lehman turmoil. That was a level on the dollar index around 71, while during 2009 it has only been slightly below 75.

So, yes, low interest rates at some point this decade contributed to the bubble, but the current low level of rates are not what is driving the dollar down now. To those who say that the commodity reflation/risk appetite trade was fueled by extraordinary dollar liquidity from quantitative easing, I agree.

But this was also a vacuum reaction taking back all the flight-to-dollar-safety that occurred the previous six months when the euro collapsed from $1.45 to $1.25 in 4 weeks. One could as easily argue that the dollar should never have strengthened so much on a fundamental basis. That it did is actually proof that demand for dollars can outstrip supply in a crisis.

As a scorecard of performance and a symptom of crisis, we must address whether the dollar is accurately reflecting the debt-inflation reality and consequent future value of US economic exchange. Our investment markets are more than ever painted with the same brush as our government securities markets because of public debt and inflationary monetary policy.

Foreigners must either stay in dollars and suffer price inflation (as US citizens do by default) or be ever concerned about how their dollar’s translate when they repatriate.  In an environment of massive quantitative easing, currency fund manager Axel Merk described what we all knew intuitively as soon as the TARP plan was announced and why that concern comes front and center now:

“… if the Fed helps to engineer that markets cannot price inflation into bond prices, there has to be a valve. This valve… will be the US dollar.”

Defend the Symptom, or Heal the Disease?

Now, to the question of whether raising interest rates will help defend the dollar. Short-term, it will because it will cause a reversal in market psychology and positions. The short dollar/long everything else trade will see a hiccup of profit-taking and short-covering.

Longer-term, it probably won’t make much difference because of all the healing our banking system and economy have yet to do. Brookings Institution Senior Fellow Barry Bosworth thinks the de-levered consumer could clip as much as 3% from GDP for many years ahead.

And where is our debt picture headed with a record $1.4 trillion budget deficit coming down the river? Global investors will use cheaply borrowed dollars to buy inflating stuff, including carry-trade currencies such as the Australian dollar. And central banks will use their dollars to diversify their FX reserves as long as U.S. debt and deficits continue to grow.

But is the dollar in danger of crashing? Not likely, and higher interest rates now may actually pose more of a threat. More than a scorecard of U.S. economic performance that makes wide swings to find equilibrium, the dollar is also just symptomatic of what our capital markets have done to it.

If Wall Street abused markets with excessive leverage and irresponsible use of derivatives, it’s showing up in the dollar now. If Washington overlooked the problems brewing earlier this decade with GSEs Fannie and Freddie and how they were allowed (encouraged?) to unnaturally fuel a housing bubble, it is also showing up.

In the end, how can we defend the dollar in word (“strong dollar policy”) or deed (raising rates) when we didn’t make the grade?

Casting a full light on the debacle, here’s a question I started asking last October after the S&P cratered 30% in 10 trading days: Were the last five years of corporate profits a sham, fueled by a credit bubble? That’s an extreme view, but one foreign investors might be asking nonetheless.

We need to rebuild our capital markets and restore confidence in them for wealth to return to our shores as fast as it leaves. I am bullish on U.S. capital markets and our economy. The dollar will be much higher in the next decade. If I am wrong, it won’t be because we didn’t raise rates in the last quarter of this decade.

• Step One: Pick a stock you’d like to invest in.
• Step Two: Evaluate the risk and reward of the investment.
• Step Three: Choose an option that balances your risk/reward goals.

Now it’s time to make the decision that gets us in the game.

Step Three: Choose an option that balances your risk/reward goals

The great thing about options is that you have so many to choose from. The problem with options, for some people, is that you have so many to choose from. Since I’m a glass-half-full guy, you know this is a “problem” I like to have.

Do I buy a January option with three months to expiration, or an October option with 12 months to expiration?

Do I buy an “expensive” option with a high probability of success, or a “cheap” option with a low probability of success?

The short answer for each is… “it depends.” But the wealth of option choices can be quickly simplified by looking at your decision as a function of just these two features—time and value. These two will determine the price you pay for your option.

Once you pick your stock, you will have dozens of different call options to choose from across different expiration months and with different amounts of value that traders call “moneyness.”

Moneyness is a word options traders made up to describe how much intrinsic value, or real worth, an option has. For example, with a stock at $50, the 45-strike call option is in-the-money (ITM) by $5 and has that much intrinsic value. The 55 strike call is out-of-the-money (OTM) by $5 and has zero intrinsic value.

Regarding time, the farther out on the expiration calendar you buy a call option contract, the more time you are giving for your investment idea to work. The price for that choice—i.e., the option’s premium—is usually higher.

The more moneyness an option has, the more it will cost to buy it. The “Time and Money” graphic below gives you a snapshot of how these two big factors can affect an option’s price.

Price and Probability

Here is an extreme, blanket statement about options that doesn’t apply in all cases, but is generally true and helps me make a point about probability, the lifeblood of options:

The more an option costs because of the combination of its time value and its moneyness value, the more valuable it is because it gives you a greater probability of success.

This means the lower-right quadrant of “Time and Money” is where the best values among options are found, where you are buying the most time with the most intrinsic value.

This doesn’t mean you should always buy options with 12 months to expire that are deep in-the-money. Just think of that as one end of the spectrum where if you spend more, you get more value. In between the extremes represented in the graphic are at-the-money options with six months to expiration.

The point is that you get to determine the precise levels of risk you want to take and value you want to secure. If you only want to risk $500 on your call option investment, then you have to find the best combination of time to expiration and intrinsic value that suits your outlook.

Blue Shirt, Red Tie, Brown Sandals—or How to Decide Which Option to Buy

So how do you choose from so many combinations? Just begin making the decisions about time, value, and risk as you scan option quote chains and you will quickly narrow down the field of candidates. Once you decide on any two of these, the third is determined for you, similar to the way you might pick out clothes for work and follow certain rules of fashion—except with options, the decision matrix gets precise pretty fast and once you choose two priorities, the third is not as negotiable as bad fashion sense might be.

For instance, if the amount of time the option gives your investment idea to work is the most important consideration to you, then you make that decision first and thereby instantly narrow the field.

If you want to buy an Apple (AAPL) call option with about three months of life, you might pick the January 2010 options. Now you are just looking at the January chain and can focus on your next decision criteria.

Next, your maximum risk consideration might be most important and you decide you only want to invest $500 in the option. Once you’ve decided this, scanning the option chain gives you the January 230 call trading for around $4.00.

There, you’ve just simplified the process of buying an option. I recommend taking the three decision criteria— time, moneyness, and option premium (your maximum risk) — and switching them around, making each the number-one or number-two priority and playing with their variations. Practice finding options like this on your broker’s quote chains, with different stocks, and you will become very comfortable with the prices and the probabilities of options.

How Do I Know the Prices I See Are Fair?

New option investors often wonder where the premiums they see on a quote chain are coming from and how we can tell if they are reasonable or fair. Because options give you so much power and flexibility in controlling bigger assets with small amounts of cash, their pricing is all about time and future risk—and that’s the arena of probability calculations.

Option markets for large companies with heavily traded stocks (think S&P 500 names) are very liquid and competitive. Professional option market makers and institutional traders use sophisticated real-time computing technology to help them find the “fair value” for the prices of millions of options every second.

This crowded, speed-of-light competition means most option prices tend to trade in narrow ranges around that fair investment value. The pros are always looking for opportunities that arise from relative price differences between stocks and their options that allow them to capture arbitrage profits. And the basic components of option pricing models are so similar, only the pros need worry about the small differences of their proprietary calculation over their counterparts’ model.

What this means for us is that the option prices we see every day are pretty accurate measures of current and expected value as determined by supply and demand. And for options, expected value is all about probability.

So you can have confidence and know that 99.9% of the time what you are seeing is a deep, liquid, and competitive market based on constant calculations about future risk. And the technology that makes it all possible is right at our fingertips as well. The independent investor is indeed very fortunate to have high-tech access to options, “the power tools of finance,” to capitalize on the business of investment probabilities.

I hope I have helped you get over the fence and ready to buy your first option. Next time, we’ll talk about how to manage the potential profit of your call option investment for maximum gain. And in case you are wondering how buying options with short life spans of 3 to 9 months fits into a long-term investment plan, I will cover that as well.

Often, we talk about a lot of advanced trading concepts or options market dynamics and assume that all of our faithful viewers have already made their first option trade.

Recently, one of our video production super-geniuses (the guys who make me look good on camera) said, “I hear this options stuff all day, and a lot of it makes sense, but I still don’t think I’m ready to trade an option.” Now Andy is a really smart guy (and not just about video stuff), so it jolted me a little to hear this.

I started thinking, “Yeah, this happens all the time. People get immersed in learning something new, but sometimes the flood of information can be overwhelming and you end up working with complicated topics that confuse or distract you from the real benefits and tangible power of some of the simplest strategies—like just buying a call option as a way to invest in your favorite company’s stock.”

And to my mind, the best way to learn is to do. So I decided to draft a no-nonsense, single-page instruction sheet that would get people past any confusion, hesitation, or fear about their first option trade. If they can understand and follow these three steps, they will be on their way to ramping up their learning curve.

• Step One: Pick a stock you’d like to invest in.
• Step Two: Evaluate the risk and reward of the investment.
• Step Three: Choose an option that balances your risk/reward goals.

These simple steps are for investors who understand the mechanics of an option contract. I’m not saying you have to know everything, just the basic rights, risks, and opportunities for profit or loss. If you are confident in your knowledge about how buying a call option can help you (and how it can hurt you), then you are ready.

If not, first check out the Options Physics Basic videos where I introduce, define, and explain the basic mechanics of buying a call option in Apple Inc. (AAPL). Assuming you are past that point and ready to dive into these steps, I will delay no further.  We”ll look closely at steps one and two today, and I’ll cover the third step in more detail tomorrow morning.

Step One: Pick a stock you’d like to invest in

Before you can consider your first call option to buy, you need a stock to invest in. If you’ve bought stocks before, this should be easy. If not, talk to friends, relatives, and your financial advisor or broker about investment ideas. Investing is all about balancing risk and reward, so you are really deciding if your money is better put to work in a stock vs. cash, or real estate, or bonds, or antiques.

All of those investments may offer greater potential return than cash, but not without added risk. A good question to begin with is “Can I afford to lose part or all of this money and is the investment risk worth the potential return?”

And never underestimate the importance of time horizon. When do you want your money back? Buying stock is all about investing in future growth and profits of the company in question. And it’s also a bet on the economy at large, as well as the industry the company is in.

If you want to buy AAPL or Ford or GE or CME, you have to estimate when you think this investment will pay off. Are you willing to put your money in a stock for five years because you believe that its price will be much higher then?

Bottom line: do your investment homework to pick your stock.

Step Two: Evaluate the risk and reward of the investment

When you went through the Step One “investment homework” process, you probably did some risk/reward analysis, but you may have picked your company stock based on emotion too. Who doesn’t love AAPL, right? So, now it’s time to look at risk and reward again.

How much money are you willing to put on the line for your favorite stock idea? When do you absolutely want your money back? What kind of return are you expecting over what time period? What will you do if the company’s story changes—competition heats up, regulation upends its industry, fraudulent accounting surfaces—and you decide you no longer want to own the stock?

These are the questions you ask yourself before you invest. It’s your money and no one likely will protect it better than you. Once you are confident in your investment thesis and comfortable with all the possible outcomes—including your contingency plans—then you can consider the power of using options for your idea.

Remember to check back tomorrow for step three.

“Mind the risk, bank the profits!”

Options are power tools, and that power has risks as well as rewards. Just as we can use a saw to either cut a piece of wood precisely, or cut off our hand, we can use options to control assets for profit, or create more risk for ourselves.

I bring this up because I’ve lately found myself explaining more complex option strategies, such as calendars and diagonals. I think options trading is fascinating and so I always enjoy working with a variety of its tools in different market environments. But, I also want to make sure every trader that listens to me understands all the risks of any strategy I’m talking about.

What makes options power tools? A combination of four things:

• High Leverage

• High Versatility

• Lower Cost (relative to their underlying stocks)

• Lower Risk (relative to… Oh, just see below)

This last point needs further commentary. Options give you “lower risk” relative to conventional long or short positions in stock, IF you are in a limited risk strategy, say when you buy a call or buy a put spread.

Even then, you must weigh that defined risk against what you are trying to accomplish with the stock and see if you have achieved the balance of risk and potential reward (or hedging) you’re after. Paying too much for an option or a spread with a low probability of success may create more risk than if you had done nothing—even if you were right about the direction and magnitude of the stock move.

The Probabilities of Risk and Fun

What makes options endlessly fascinating? Endless combinations. And the three-dimensional complexity that comes from managing stock risk across the spaces of time, price, and volatility.

Some people love casino games, like poker or craps, because betting on random outcomes is fun. And it’s even more fun when you think you can gage probability accurately in card games, where a gaming edge is actually possible, as opposed to roulette where the probabilities are stacked against you from the start.

Options markets offer even more opportunities and variety to search for trading edges. There are nearly 2.6 million five-card poker hands while the combinations of stock option strategies easily puts the possibilities in the tens of millions.

Just thinking conservatively, 2,000 stocks x 10 strikes (figure five each for puts and calls) x 4 months = 80,000 options to chose from. Multiply that by 40 (10 strikes x 4 months) and you get the idea of the combinatory possibilities as we just stuck our head above three million without even trying.

Something for everybody, in all risk and time frames. Plus, since options trading thrives on the “stock stories” underneath them, they deliver a whole lot more interesting and variable outcomes than 52 cards ever could.

And before you enter a single one of these million-plus trade ideas, you get to evaluate them for their risk and reward characteristics and potential. How? By simulating the position in a P&L Calculator or Risk Viewer like the ones at OptionsHouse.com. Even if you’re just learning a strategy, I can think of no better way to understand its risk profile than to see it visually in these calculators and tools.

So, if you haven’t made options part of your investment tool box, now’s the time. The tools available today to the self-directed investor to learn and trade and manage risk are so powerful and easy to use, option pros only dreamed about them 10 years ago. If you don’t have an options trading account, talk to your broker or investment advisor and see if you’re ready.

Then check out the tools we use every day at OptionsHouse to learn and teach option strategies. Even if you’re not ready to trade, it costs nothing to open a free virtual account and learn how to use the tools that help you make use of the ultimate financial power tools—options.

While the calendar spread may require a lot of “price precision” to be profitable (you have to be right on both the timing and direction of price movement), the diagonal gives you more versatility because your choice of strike prices is so varied. The typical calendar uses one strike, while the diagonal allows you to combine different months and strikes to create literally hundreds of risk/reward and timing combinations on the same security.

In this way, the precision is in your hands instead of against you. But this amount of choice comes with a price, and there are few hard-and-fast rules across diagonals because of the variety of combinations. Each diagonal must be evaluated for its own risk/reward dynamics. A few more comparisons with calendars, and then we’ll get to some real-world examples.

The volatility component of calendars vs. diagonals also favors the latter with more choices because the diagonal can take advantage of volatility skew between different strikes, not just different months (sometimes called the term structure of volatility).

Skew is the effect where out-of-the-money options may have higher implied volatility than at-the-money options for the same security, and is often referred to as the volatility “smile” because of its happily curved graph.

Another important, but by no means final, comparison between calendars and diagonals is how you limit risk. In a long calendar spread, risk is limited to the initial debit paid, so even if the option strike falls in-the-money and you are assigned on the short leg, your long option offsets the position point-for-point.

In a long diagonal spread, you can create additional risk by selling an option that is closer to being in-the-money than the option you are buying farther out in time. Even if you do this spread for a credit, you face all the risk of the difference between the strikes. For instance, if you sell a 60/70 call diagonal and the stock rallies through the $70 strike, you are at risk for $10 minus the credit received, if any.

What long diagonals and long calendars share is the fact that risk is limited through the purchase of the farther-dated option. Here are four examples of diagonal spreads, each with its maximum risk and a description of its corresponding view of the underlying:

Apple Inc. (AAPL)–

• Sell NOV 210 call/Buy DEC 220 call for a $0.15 credit
• Max risk = $10 – credit
• Neutral outlook short-term
• Bullish after NOV expiration

Apple Inc. (AAPL)–

• Sell DEC 210 call/Buy JAN 200 call for $6.50 debit
• Max risk = $6.50 debit
• Neutral-to-bullish outlook short-term
• Bullish after DEC expiration

SPDR S&P 500 Index (SPY)–

• Sell NOV 105 puts/Buy DEC 100 puts for $0.10 debit
• Max risk = $5.10
• Neutral outlook short-term
• Bearish after NOV expiration

SPDR S&P 500 Index (SPY)–

• Sell NOV 105 puts/Buy DEC 110 puts for $3.15 debit
• Max risk = $3.15 debit
• Neutral-to-bearish outlook short-term
• Bearish after NOV expiration

Before trying any of these strategies, options traders should study the unique risk/reward dynamics of each individual spread. One way to do that, which I highly recommend, is to practice diagramming these strategies on your broker’s P&L Calculator, if they have one. If not, try a free virtual account at OptionsHouse.

Since its June lows of 78, the dollar index has fallen about 3% further. No panic, no freefall. Just a slow grind lower as players from central banks to mutual funds, multinational corporations to hedge funds and carry trade currency programs, all position themselves for investments that are not dollar-based.

We don’t know exactly how this movie ends, but my thesis is that “it’s all relative.” Despite its lack of originality, this is an especially important idea about currency relationships and cross-border economics. The world’s relationship with the biggest, strongest economy on the planet is one of necessity and symbiosis.

The dollar will always be a “king” of sorts. It’s just that right now we are trading lots of them in return for stability and growth. Time will tell how low the dollar index goes (new lows below 70 next year?) before it bottoms and heads back towards 100 again for its next 7-10 year cycle. So far, I still stand by all the points below as we embark on that journey.

1. Little positive correlation between strong equities and strong dollar.
2. “King dollar” was not the story during the credit crisis that took EUR back to $1.25.
3. Dollar sell-off began in March with the  equity bottom and commodity “reflation.”
4. China diversifying reserves is an old story whose time has come.  Will get priced in slowly.  No panic here.
5. Bailouts, Deficits, Inflation-Oh My! Generational, systemic crisis needs quantitative easing, more than economy needs fiscal restraint.
6. Global economy needs U.S. economic vitality more than U.S. needs a strong dollar.
7. Can’t have BRIC/EM growth without risk appetite in other major currencies.
8. Truth is that EU is in no better shape right now-the euro is not going to $1.75, but if it did, we’ll adapt quite well.
9. Oil – the other gold – and commodities in general are the best inflation hedges.
10. The U.S. is not a perfect economy, it’s just the best and only game in town.  It’s all relative in a global economy of fiat currencies and wealth driven by productivity innovation.

In many cases, he doesn’t need to call anyone because the numbers tell him exactly what’s going on, whether it’s a particular option spread strategy that is apparent, or some fundamental news is driving a stock and bringing out option buyers scrambling for protection. Other times, when a few thousand option contracts cross the tape, he can’t tell right off the bat if the big customer is buying or selling.

But in these instances, he has one of an option trader’s favorite tools: delta.

Like most option pros, Jud can decipher with a little simple math using the delta of options, whether or not a big trade was driven by a buyer or by a seller of the options. Before I go over that math, let’s review delta as a concept and as a tool.

Crunching Numbers to Find the Secret Code

Delta is a numerical value that describes an option in several interesting and useful ways, such as how much the option’s price should move for a $1 move in the underlying stock, how much the option is almost exactly like its stock, and what the probability is of the option being in-the-money by expiration.

A short definition of delta would be the sensitivity of an option’s price to changes in the underlying price. A shorter definition would be the speed of the option. If an option has a delta of 0.500, you can think of this as 50% and it means that if the underlying stock moves $1, the option price will move only 50 cents.

Delta is calculated within an option pricing model by a function that compares the option strike price to the underlying stock price and accounts for probability and the passage of time. Say what?

That mouthful sounds complicated, but if you know a little about options already, you can break this down step-by-step. First, comparing the option strike price to the underlying stock tells you about its value. Since an option gives you the right to be long or short the stock, its value is comprised of intrinsic value (the real worth it has if it is in-the-money) + time value (the worth it has due to future possible price movement).

Second, the option pricing model assigns a probability to every option that quantifies the likelihood of that option finishing in-the-money (ITM). This number is the delta, and it changes dynamically as underlying prices change and time passes. The number produced by the pricing model is between 0.000 and 0.999, and traders speak of 0.103 as a “10-delta” and 0.591 as a “60-delta.”

Show Me the INs, ATs & OUTs of the Money

At-the-money (ATM) options have deltas of around 0.500 (a “50-delta”), which means they have roughly a 50% probability of finishing in-the-money. This makes sense because buying an ATM option is like a coin toss. We have a 50/50 shot at being right about a $40 stock moving up or down tomorrow or next month and causing either the 40 call or put to move in-the-money.

What deltas do out-of-the-money (OTM) options have? Less than 0.500 as you might have guessed because they should theoretically have less than a 50% chance of finishing ITM. So with stock at $40, the $45 call might have a delta of .300 (a “30-delta”), and the $35 put might have a delta of -0.300 (also a “30-delta” but of the put variety. I’ll explain the minus sign in a minute.

Correspondingly, that means ITM options should have deltas of greater than 0.500 because they have more than a 50% chance of finishing ITM. So with stock at $40, the $35 call might have a delta of 0.700, and the $45 put might have a delta of -0.700. Deep ITM calls and puts have deltas really close to 0.999 and -0.999, so the $25 call might have a delta of 0.95 and the $55 put might have a delta of -0.95. So, why do puts have a negative sign in front of them?

Calls Have Positive Delta, Puts Have Negative Delta

The next thing we need to learn about delta is how it’s calculated differently for puts and calls. And the only real difference we need to worry about is that calls have positive delta to indicate their inherent long position and puts have negative delta to indicate their inherent short position. We mark calls on the probability scale from 0.000 to +1.00, and puts from 0.000 to -1.00, with the whole numbers +1.00 and -1.00 representing the stock itself. Traders speak of stock as a “100 delta” position because the next one-thousandth up from 0.999 is 1.00.

What do all little options want to be when they grow up? A full 100 shares of stock, of course! In other words—assuming options had feelings and wishes—they’d want to finish in-the-money… which means they’d want to have a delta equal to that of +1.00 for calls, or -1.00 for puts. Until expiration day, and we know the final destiny of those yet-to-mature options, their deltas tend to stay within the probability scale of +0.999 to 0.000 for calls, and -0.999 to 0.000 for puts.

And here’s how the delta of an option moves as the underlying stock price moves: if stock moves from $40 to $44, the delta of the 40 call might move from 0.50 to 0.65, while the delta of the 40 put might move from -0.50 to -0.35. Notice that as the stock price rose, the call gained in delta value while the put lost delta value.

Delta Tells You How Much an Option is Like its Stock

Since options want to grow up to be like stock, but they have this funny tendency to follow the stock back and forth as if it’s a tug of war between the calls and the puts, delta could be described as a measure of who’s winning. Delta is telling you minute-by-minute how far each side has come and how far each little strike still has to go to become a full 100 deltas.

Options that are deep ITM have deltas close to 0.999 for calls and -0.999 for puts because they are nearly 100% like the underlying stock.

Traders might speak of these deep options as “100 delta” or as “trading for parity” because they have almost no time value relative to their large intrinsic value. They might also call them “an exercise” because they are so likely to be exercised at expiration, or sooner if there is a dividend event or they are part of a hedge that needs to be unwound.

Options that are deep OTM have deltas close to 0.000 and thus they have almost zero equivalence to the underlying stock.

As the underlying stock price changes, an option’s delta must change too. As stock rises, call deltas move away from zero, closer to +1.00, and put deltas move away from -1.00, closer to zero. As stock falls, call deltas move away from +1.00, closer to zero, and put deltas move away from zero, closer to -1.00.

How to Use Delta to Gage Option Buying vs. Selling

Finally, now that I’ve spent half of your day explaining the mechanics of delta, I will reveal the “delta secret” we use to figure out if options are being bought or sold. Since option markets are so liquid and competitive, option prices tend to move in lock-step during the trading day with their stocks. So you would expect all “30-delta” options to move about 30-cents for every $1 move in the underlying stock. A $1 up move would have the calls up 30 cents and the puts down 30 cents, and vice versa for a $1 move down in the stock.

What if the stock moved $1 higher and the 30-delta calls only moved 15 cents higher? Clearly, someone is selling those calls and the market makers are perfectly willing to let them do so.

What if the stock moved $1 lower and the 30-delta puts moved 50 cents higher? Clearly, someone is buying those puts because they moved far higher in price than their delta would dictate was fair value.

That’s it! Now you know the secret of delta that will allow you to figure out if unusual options volume is the result of buying or selling.

Three Ways to Think About Delta That Make It Such a Great Tool

Before I go, let me give you a handy reference guide to delta to help you remember its power…

1. Delta is the rate of change of the option relative to its underlying stock—in essence, the speed of the option.

2. Delta is the probability the option will finish in-the-money—i.e., how likely is it the option will end up trading for parity because it is virtually equal to a position in the stock from the strike price?

3. Delta is the “hedge ratio” or equivalence to the underlying stock—i.e., it tells you how much stock you need to buy or sell to exactly hedge an option position.

Today, trolling the ONN Idea Generating Platform (IGP) for more time spread trade ideas, I found Google (GOOG) topping the charts. Why? Because the October options, with two days to expiration, are giving you a great chance to sell out-of-the-money premium and use it to pay for longer-dated calls.

Of the four GOOG time spreads in the top ten, here was my favorite considering the stock is currently backing off its 52-week closing high set yesterday above $535 and was rejected from a new high at $536.90 this morning.

• Sell the October 540 call for $10.25
• Buy the December 540 call for $24.25
• Net debit of $14.00

If you like the idea of having long exposure to GOOG into December but you don’t want to pay a lot for it, this time spread may be the strategy of choice. Keep in mind that your maximum risk with a long time spread is the initial debit paid and that you could lose that entire amount if the GOOG goes above $540 before October options expiration or stays below $540 up to December expiration.

The ideal situation is for GOOG to stay below $540 for the next two days and then rally hard into December.

If this time spread is done as a volatility trade, you still want the stock to stay below $540 and give you chance to sell a pop in perceived risk before October options expiration. What could put more risk for GOOG shares on the horizon? How about an earnings event.

With the company reporting earnings tonight after the market close, option players are placing their bets. The October 530 straddle is pricing in the potential for a $23 move in either direction, which is more than 4% of the stock’s price. In many recent post-earnings moves, the stock has traded only 3% higher or lower.

Even if GOOG does rally above $540, it is still possible for buyers of this time spread to make money if the volatility value of the December call explodes higher while that of the October call falls to zero and the option simply trades for parity. In this case, they can sell the spread for a profit on Friday before October expiration.

Should they not trade out of the position on Friday and the short October call is in-the-money, they will face assignment and may be forced to exercise their long December call to cover the obligation to sell 100 shares of stock. If their broker doesn’t allow them to be short the shares over the weekend and into Monday morning, this is the most likely scenario, but all investors need to talk to their brokers and determine standard practice.

Let’s watch and see who wins this options battle over GOOG earnings—the sellers of volatility or the buyers.

Because they involve options in different expiration months, calendar spreads imply that you are “trading time,” often selling a near-term option to help pay for a longer-term option you may want to own for more exposure to expected future price movement.

The third name for calendar spreads is horizontal. This comes from the “spatial” relationship that option series listings used to have on trading floor wall boards and screens, where one expiration month series might sit side-by-side with the next month in chronological progression. Thus, if you traded a spread across different expiration series (what we call quote chains now in the electronic trading world), you were moving “horizontally” in time.

Personality #1

I already introduced one of the calendar spread personalities—the one that lets you buy a longer-term call or put with help from selling a near-term option. This is how many option traders approach the calendar spread. For instance, let’s say an investor wants to own a January 2010 call option on Halliburton (HAL) because they want to secure exposure to at least three months of upside price movement, but they think the chances of the stock moving right now in mid-October above $29 are slim.

One perfect way to employ this bet on “quiet now, with upside later” is to buy the January 29 call for $2.22 and sell the soon-to-expire October 29 call for 67 cents, for a net debit of $1.55. We found this spread on the ONN Idea Generation Platform (IGP) earlier this week when the stock was trading about $28.75 a share.  Important dates to keep in mind for this trade are October options expiration this Friday (October 16) and HAL’s earnings report on October 19.

The best outcome for this trade—and all calendar spreads—is for the stock to trade as close to the strike price as possible without going through it, which causes the options to go in-the-money. That way the spread has the most value, especially as the near-term October option rapidly loses time value and the January option has its highest time value (without volatility moving higher).

Below is a snapshot from the OptionsHouse Profit/Loss Calculator of this spread one day before expiration with the underlying right at $29. It shows the premium collected from the October call as fully realized theoretical profit. This means that, theoretically, we should be able to sell the spread we bought for more than $1.55 because it will cost little or nothing to buy back the short October option (five cents, maybe) and we get to sell the January call for a higher premium since the stock moved higher from $28.75 to $29 with little decay to the farther-dated option.

But if our interest is primarily in owning the January call for some time period going forward, we want the October option to expire worthless and then to be left with our long January call that we “bought on the cheap.” At that point, our position “morphs” into a long call and we can sell it whenever we wish up to January expiration.

The outcome scenario we are least likely to want is the stock rallying through the strike price before October expiration causing assignment of the short option. In this case, our long January call would be used to offset our obligation to be short 100 shares of stock and the trade would be closed. Alternatively, we always have the right to close the spread anytime before expiration or assignment. And depending on your broker’s guidelines and rules, you may be able to “trade out of” the short stock position and keep your long call if you request this and you have sufficient capital and trading approvals.

Personality #2

The other way you can look at calendar spreads is the way the option pros do—as a volatility trade between expiration months. The most common scenario for option pros who make their living doing “volatility arbitrage” is to sell near months when their volatility is substantially higher than farther-dated months.

In the HAL spread, October implied volatility (IV) for the at-the-money 29 strike was around 53%, while January IV was below 40%. While this volatility spread between different expirations may seem significant at 13%, it has to be compared to the trends in historical and implied vols for the stock. And any near-term events must be considered too. It is highly likely that HAL IV is pumped up because of their expected earnings report next week.

Traders who are willing to sell near-term volatility in quietly up-trending markets may find the long call calendar spread a useful tool. Or, you may simply like the idea of financing your long-term call purchase with the time decay of a soon-to-expire call. Calendars can also be done with puts, and with either of the same two views—as a “vol” trade, or as an affordable directional trade in a quietly down-trending market.

The great thing about the calendar spread is that it gives you two ways to profit, in two time frames. You can either capitalize quickly on volatility differences and rapid time decay of the near-term leg, potentially selling your spread for a profit within weeks or days. Or you can take the bet that your short option will expire worthless, letting you keep the time value premium and letting you ride your long option to further profits on a directional move.

Last month, Research in Motion (RIMM) surprised the Street, and not in a good way. On top of the long calls I was recommending as a stock substitution strategy (spend $5 to $10 per share on January at-the-money and out-of-the-money calls vs. buying the stock at $80), I welcomed Jared Levy’s idea to “collar” the stock the day before earnings and gain some affordable downside protection with a long put paid for by a covered call.

Jared’s recommendation to buy the October 80 put and sell the October 95 covered call for a small credit (essentially making the downside put protection free) was the right move, as RIMM quickly proved when it
gapped down more than 15% on its disappointing guidance.

If you own stock ahead of an event like earnings, the options collar – where you buy an at-the-money or out-of-the-money put and finance it with an out-of-the-money covered call – just seems like a no-brainer.

With a big week of S&P 500 earnings ahead, including: Johnson & Johnson (JNJ), Intel (INTC), JP Morgan Chase (JPM), Goldman Sachs (GS), General Electric (GE), Bank of America (BAC), Halliburton (HAL), and Google (GOOG), investors who own these stocks may want to look at possible collar strategies for affordable protection.

The RIMM collar was unusually favorable with such high volatility built into the premiums of the options that investors could sell an out-of-the-money covered call with three weeks to expiration for more than an equally-out-of-the-money put. This was because the implied volatility of calls had been steadily bid up for weeks as investors bet on upside for RIMM.

Big Blue Gains: Protect or Let ‘Em Ride?

Let’s look at possible collar strategies for IBM (IBM) this week before they report on Thursday after the market close. One thing worth noting is that October options expire on Friday, the day after IBM releases its results. Some investors who own the stock may see value in simply buying the Oct. 120 put for about 50 cents and having cheap protection below $120 in case of some volatile surprise on the company’s outlook.

The merit of this idea is that if anything very negative is revealed in this earnings report, you will be protected if there is an immediate negative reaction in the stock. The weakness of the idea is that if the reaction is delayed until the following week, the October put position won’t help you because it will expire and be marked to Friday’s closing price for the stock.

I won’t even discuss selling the October 130 call in IBM (currently trading at a new 52-week high this morning of $126.50) as a complement to buying the put, thereby creating an October option collar. Why not? Because if we are not going to buy a very cheap put in October for protection, there is no point in selling away the upside of this very strong stock in October and collecting only 90 cents to do so.

IBM looks as though it will power higher ahead of and through earnings this week and keep forging higher with the likes of Apple (AAPL) and GOOG. Granted, this is how RIMM looked three weeks ago. But given the strong price action of this tech leader since last November, and noting that it didn’t make new lows with the rest of the market in March, we want to buy put protection and only sell a covered call at an upside target that gives it more room to run on that strength.

Here are some other collar ideas for IBM using November and January options:

(1) –Buy the November 115 put for 95 cents and sell the November 135 call (covered) for 95 cents.
–Net cost: $0.00.
–Downside protection below $115 and short covered call faces potential assignment and sale of underlying shares at $135 through November.

(2)–Buy the November 120 put for $1.95 and sell the January 140 call (covered) for $1.20
–Net cost: $0.75
–Downside protection below $120 and short covered call faces potential assignment and sale of underlying shares at $140 through January.

The idea behind using a November put and a January covered call is that we are primarily buying put protection for the earnings event and the November put takes care of that risk. Selling the January covered call is a way to gain more premium while moving the strike price of the short obligation up to allow for more upside in the shares.

Given that IBM looks poised to lead tech and the market higher, I would lean toward not using an options collar and simply buying puts outright to protect long stock positions. Why? Because selling covered calls just to pay for puts may not be worth it since missing 20% of the stock’s upside could be as great a risk to some investors as a 10% drop in the stock.

Here are two put protection strategies without using an options collar:

(1)– Buying the October 120 put for 50 cents as the most aggressive protection strategy. It offers the least protection (in terms of time) for the least cost.

(2)–Buying the November 115 put for 95 cents is more conservative because it buys a longer term of insurance, even if we’ve moved the strike $5 further out-of-the-money. Remember, when it comes to put protection, we are really buying “disaster insurance” for the unknown risks that surface when company reports collide with Wall Street expectations.

As always, investors need to examine their own risk/reward preferences and goals. There is no single right answer when it comes to using options for risk management. The myriad choices for protection that options give you may seem confusing at times, but really it all comes down to balancing risk and reward over time and costs. You get to decide what mix of these elements best suits your situation, with a given stock, at a given time.

When you are long stock going into an earnings event, your first and best consideration may be thinking in terms of your greatest downside risks. Then, knowing how to buy affordable options insurance via puts and collars — that can provide valuable protection against report “disasters” like RIMM’s last month — should be part of every investor’s overall education and portfolio management.

Here’s how traders think about new 52-week highs: if it’s strong, you buy it. This goes against the logic that markets tend to revert back to their mean, which is also an important trading tenet. The difference that makes a difference between these two ideas is a matter of momentum and extremes.

Since a body in motion tends to stay in motion, stocks with momentum will keep going—especially as they attract more attention and latecomer buyers. This is exactly what we are seeing in names like Apple and Goldman as average investors finally say, “Hey, maybe that guy I saw talking about Apple at $150 going to $200 was right—I think it’s safe to buy here now.”

You could easily substitute GS for AAPL in my example since the prices are very close. And not so ironically, the momentum-driven price movement that $150 stocks make on their way to $200 has been seen many times before by experienced traders. Yes, these stocks will mean-revert back to some level nearer to their 20-week moving averages— ironically, both near $160—but meanwhile, “momo” has the upper hand and professional traders will squeeze every last drop out of it, buying the dips so they have something to sell to the newcomers at every new high.

The technical analysis/day trading psychology I’m talking about here has a scientific basis as well. The social science field known as behavioral finance has documented this type of crowd behavior with money and risk for decades now and the results are eye-opening enough to have inspired new investment funds based on them.

I learned about our irrational investment tendencies first as a trader and after discovering the behavioral research, I put forth my own thesis on the matter, suggesting in a 2004 paper that “Your Brain Wasn’t Made to Trade.” You can read a version of that unpublished paper in an article I wrote for SFO magazine in July 2008, “The Mental Models of Financial Sabotage.”

Remember when President John F. Kennedy inspired the nation to believe we could put a man on the moon? That kind of optimism made us productive to an extreme. We overshot our own expectations and capabilities, as if it were a time of war. Markets swing on a similar pendulum of emotional extremes (see my earliest “Buy and Trade” pieces for a fuller explanation of my approach).

As we go back to the moon 40 years later for fresh research purposes, our favorite stocks make fresh highs on our favorite emotion—hope. Apple and Goldman probably have their sights set on $220 in the next six months. I don’t think you have to buy them yet, particularly with GS reporting next Thursday in a big week of third-quarter earnings releases. But there will be thousands of investors and traders with millions of dollars all looking for the same pullback opportunities, so you won’t get as good a chance or price as you might hope for.

“Mind the Risk, Bank the Profits!”