One common misconception in trading options is the “US vs. THEM” mentality that many retail traders embrace. If a market maker makes money, that must mean someone, somewhere, lost money. There is an overwhelming (but incorrect) supposition that options trading is a “zero-sum” game. So there is the notion that market makers are out there making money at someone else’s expense. This perception is not true. Options have different utility functions for the different users, and the option market makers play an important role in the entire trading process.

For instance, if I hold a long position of 500 shares in IBM stock, I may want to overwrite an out-of-the-money call to generate income and the premium collected can hedge some degree of the downside risks to owning the stock. Remember, nothing is free in options trading, and I sacrifice some upside potential in the stock if my shares are ultimately called away at the strike. In order to accomplish this strategy, I need to find someone who is willing to purchase that out-of-the-money call option.

There might not be another public retail customer, someone who has a desire to own the right to purchase IBM stock at that strike price currently. A professional options market maker, however, has the responsibility to show a bid and an offer for all listed options. He is likely trading the implied volatility of IBM options and is able to perhaps give a higher bid for this option, boosting the credit I can collect. The fact that professional market makers exist at all (and are able to provide liquidity when public orders are not present) has helped listed options trading volumes enjoy spectacular growth the past decade.

Bid/ask spreads have never been tighter. This liquidity has enabled retail investors to transfer risk and hedge their stock portfolios at a cost (reduced bid/ask spreads) substantially lower than prior generations of stock investors.

Taxes are a cost for both retail and professional traders. The Obama Administration has also discussed a transaction tax on securities trades. Any additional taxes and costs involved in trading interfere with the free flow of capital and likely decrease liquidity and increase the Bid/Ask spreads of the markets. Ultimately, the retail customer will bear the brunt of those added costs, facing wider bid/ask spreads.

From the OH research tab, we see the likely reason why.  InterMune is recently up $1.03 to $16.65. The FDA advisory committee is expected to meet and provide guidance to the agency regarding the approvability of pirfenidone to treat idiopathic pulmonary fibrosis (IBF).

Today’s ITMN call option volume of 12,195 contracts compares to put volume of 2,637 contracts. February option implied volatility is at 67, March is at 174, April is at 165, and July is at 155, versus its 26-week average of 92, according to Track Data.  These readings suggest large price movement in March.

Events such as FDA drug approvals can create binary situations during which most options theory is thrown out the window. A positive result here may send the stock above 25 dollars a share; a negative might send the stock back below 10. Option theory is based on stocks trading and being able to be hedged dynamically. Meaning if a stock trades from 16 to 25, it traded at every penny between those prices. Obviously, this stock will likely experience a gap when those findings are announced.

Based on this example, it appears that you cannot sell options in ITMN and think you are selling “high” implied volatility. There is no way to dynamically hedge the resultant position.

The risk to selling options is significant, theoretically unlimited, and is much more than the potential reward, which is limited to the premium received.

Well … how the tables have turned. The headlines about a recall of five million cars in the U.S. and plant shutdowns are causing Toyota now to have substantial reputational risks going forward. Ford Motor (NYSE: F), specifically, is being held up as a company that refused to take the government bailout last year and from its auto sales numbers, Ford appears to be doing just fine as a private enterprise.

FOX News is reporting that Toyota is expected to sell 103,000 vehicles in January, down 11.9% from one year ago, while Ford is predicted to sell 126,000 units, up 33.4%. The actual numbers will be released on February 2nd, when earnings are expected to come out as well. TM shares have lost more than 11% of their value over the last four days.

While OptionsHouse does not make buy or sell recommendations of specific securities or investment strategies, investors who believe that this story is not over, might consider going long the February 75-80 strangle for $3.10 with the stock currently trading at $77. Owners of the 21-day strangle risk 100% of the premium paid, but have unlimited theoretical profit potential outside of the breakevens of $71.90 (down 6.6%) to the downside and $83.10 (up 7.9%) to the upside.

Some investors may believe that the worst is over, however any gains in the shares would be guarded and limited to the upside. Those believing that the stock will be range bound inside of these breakevens may be attracted to selling this same 75-80 strangle. The risk to selling a strangle are unlimited and are only suitable for only the most advanced options traders. The potential reward is limited to the premium collected.

The OptionsHouse profit/loss calculator (available to those with a free virtual trading account ) gives a good visual representation of these breakeven prices using a parity graph and sliding the “days to expire” to zero.

After the first half hour, however, the stock volume and enthusiasm dropped off precipitously. With the absence of buying volume, the price fell off as well. With the pullback, many option traders were quick to offer calls, thinking the implied volatility would come in, and the stock would likely pull back further. After all, stocks can’t go up 20% with the overall market down, right? Those traders that piled in on the short side of the 65 calls mid-morning, selling them down to under $1.00, saw the stock trend back higher (albeit on low volume); these calls gained 60% from their lows.

Oftentimes, premium sellers are too eager after earnings announcements to sell options without regard for the future possible stock movement.  We still have 22 days until February options expire, and the stock has just moved more than 12 dollars.  No buy or sell recommendation here, but those investors that desire long exposure to Netflix could consider those 65 calls.  They are now sitting less than two dollars out-of-the-money and they are offered at $1.60 at the market close.  For investors who think today’s move was too far, too fast, the February 60 puts are offered at $1.45, given long put holders a limited risk way to play a retracement and profitability, should the shares fall below 58.55 by expiration.  The risk to a long call or long put is 100% of the premium received, while the rewards are theoretically unlimited.

Also, many stocks can have outsized moves on earnings events and be largely ignored after the event. Just make sure you analyze the risks and rewards of all option trades looking forward, never backward. What I mean here is just because the earnings are in the past doesn’t necessarily mean there will be no volatility in a name going forward.

No offense, Mr. Greenberg, but AIG hardly seems to be in the class of widows and orphans. This is a multi-billion dollar company with a phalanx of attorneys. Should we feel bad for them because they did not know, understand, or react to the terms of the contracts they were entering?

He thinks the government should voluntarily reduce both the interest it is charging AIG and its 79.9% stake in the company. Let’s make no mistakes here. AIG was insolvent last fall. The existing equity holders at the time should have been completely wiped out. What they have now is a gift. It is amazing how little responsibility Mr. Greenberg wants to accept for the firm’s role in the mess we just went through. Mind you, most of this occurred after he had left, so it is not like he was personally responsible for the trades. He just happens to still own a ton of stock.

Anyway, what should Mr. Greenberg do if he wants to trade around his views? If he really thinks the government will give back a chunk of its stake in AIG, he should look to buy options. Volatility has collapsed in this name, so calls investors can buy now have better break evens than they did six months ago. Currently, the Jan 2011 (because the government always takes a long time to do anything) 50-strike calls are priced at $2.09 at Friday’s close. Considering how levered the company is, and depending on how giving the government is, the stock could make large moves. The risk to buying options is 100% of the premium paid.

The other thing investors could consider is buying put spreads in GS, with the maximum loss limited to the net debit paid.  Greenberg seems to be implying that GS was not playing nice in the OTC sandbox. He wants “investigative reporters” to look into it. If GS is going to be made the scapegoat, its stock might be at risk. A trader could buy put spreads on this stock, or trade risk conversions by buying downside puts and selling upside calls. This is a risky strategy, but Hank is accusing the firm of some serious stuff.

The benefit of the risk conversion strategy is that a trader does not have to pay a lot of premium. Based on Friday’s close, traders could buy the Jan 150 puts and simultaneously sell the 200 calls for only a $0.30 premium. The risk is that if you have this position on, you are effectively short naked calls and have unlimited risk. Considering most of the government seems to be GS alumni, betting that the government is going to go after them is a stretch. If GS stock were to rally above 200, the person with the risk conversion on could be subject to very large losses.

However, if there are names you follow that you feel could have large moves over the first half of the year, you may want to think about things like long options or debit spreads using out of the money options.  Why?  Well, if the premiums you pay are lower for these spreads, then your break-evens are actually better.  I looked at AIG as an example of this. 

AIG was one of the most volatile stocks of 2009.  Its 52 week range is $6.6-$55.9, and now it is trading at $30.  Implied volatility is down about 50-75% from its peak.  This is a stock that has huge leverage because of the amount of debt it is paying back the government .

If you think this stock will not have any value after its asset sales, the May 20 puts are trading at $1.25.  I know that is 50% out of the money, but this is a leveraged stock.  Let me show you how much cheaper these are than they would have been 6 months ago when volatility was higher.  If the implied volatility of these doubled (which is where implied volatility was), these options would be worth about $4.75 with the stock in the same place!  That is a 280% increase with no movement down in the stock.  

If you think the stock is going to make another run at its highs, the May 35-50 call spread is only trading about $1.8, and it has a maximum value of $15.  If volatility doubled, the spread would be worth about $2.4, without any move in the stock.  That is an increase of 33%.  While that pales in comparison to the outright puts, it is a huge move for a spread that does not have that much vega.

I presented one example to the upside and one to the downside because I am not making a recommendation on AIG.  If the stock just sits at $30, these strategies will lose eventually because of time decay.  This was an example of how much lower options premiums are, and how traders should at least look at these factors when picking a strategy to employ.  As always, the trader needs to pick the right direction of the stock and time of the move (or lack of move) to be profitable.

The company will issue $17 billion of common stock, $3.5 billion in equity units of which $2.8 billion will be recorded as equity, and the other $700 million is debt.  Lastly, C will issue $1.7 billion of common stock to employees in lieu of cash compensation.

If this wasn’t enough, the US Treasury will also sell up to $5 billion (1.3 billion shares) of the 7.7 billion shares of common stock that it holds.  The balance is expected to be sold over the next 6 to 12 months.

The offerings have not been priced yet, but the combined company and Treasury shares being offered could approach six billion shares being sold – so it’s no wonder the stock is lower today!

This is very costly and dilutive to existing shareholders, but it will remove the stigma of Citi being the only bank with government capital and extraordinary assistance still being required.  Along with that stigma, continued government ownership would include government assistance in the corporate boardroom, something no CEO wants.

“I believe that the transaction tax still has a great deal of merit,” Pelosi told reporters. “The concern that many of us or others have had is that it will send … transactions overseas.”

To me, the fear of losing financial securities’ business overseas is the only thing Representative Pelosi has right. Pelosi said she thought the idea might have currency among a public that is eager to see Wall Street firms “pitching in” to help the government grow the economy. “I think there would be a market for it among the American people to say that we are all participating in the economic prosperity of our country, and we are all pitching in to continue that prosperity,” said Pelosi.

In reality, it is obviously a tax on investment and savings. Every 401(k), mutual fund, and IRA investment that buys any investment would be affected by this tax.

“Proponents of a transaction tax argue that a small 0.25 percent tax on stocks would be paid for by the highly paid financial traders and would not affect most Americans,” reads the letter. “This is simply not true. A tax on stock transactions would be passed through by brokers and affect every single person who owns and invests in stocks from small business owners to senior citizens.” The British attempted to issue a Stamp Tax on their colonies in the 1700s. How did that turn out for them?

These December options have traded predominately on the bid side, which likely indicates selling action here. The March 12.5 calls have also been active, with more than 1,300 contracts having trading mainly on the offer, implying a buyer. The investors may be closing down long options in December (where open interest is over 8,000 contracts) and buying in-the-money calls at the March 12.5 strike, effectively rolling out a stock-replacement strategy.

With this strategy, investors use call options to “replace” long stock for exposure to any share increase. The maximum loss for a long call is limited to only 100% of the premium paid, which is always lower than the share price. The reward to a long call is theoretically unlimited to the upside in the shares.

To me, however, the story is that in spite of the weakness in the markets, the VIX is lower, indicating sellers of option premium in the S & P 500 Index on which it is derived. It has been a quiet day in the SPX pit itself but I have been shown only offers coming out of the pit. Given the Thursday holiday and the half-trading day on Friday the weakness in implied volatility could be expected.

However we will have the release of the November 4th FOMC meeting minutes later today, which could provide an excuse for the afternoon direction. Also Friday we will have anecdotal evidence coming in as the holiday retail season kicks off with Black Friday.

Sellers of premium ahead of the expected long weekend of decay may be surprised if those premiums do not decay as expected. That said, it doesn’t appear that many traders are willing to step up and own options through what currently looks to be an extremely quiet five days ahead.

Investors often look to the VIX to try to gauge the next move in the market, or whether the level of implied volatility is a buy or a sell.  The VIX could give misleading signals in both of these regards.

First off, the VIX is an estimation of what the 30-day level of volatility would be if such an instrument existed.  The index is both interpolated between the first two month levels trading in the SPX and then derived from the midpoint of the bid and ask of the individual options. Also, the out-of-the-money options on the put side particularly have the greatest weight on the level of the VIX.  This level has become extremely volatile lately as option traders seemingly are quick to buy out-of-the-money put options in down days and are just as quickly selling out of them with a market rally.

Given the recent movement in this index of volatility, the vol of volatility is so high that it would not surprise me at all to see the index crack below the 20% level at some point before the end of the year - or, for that matter, blow back above the 30% level.  Inputing the VIX into the Probability Calculator on the OptionsHouse platform tools suite shows one standard deviation up and down to December expiration is currently 16.24% to 29.78% using the Historical 30-day volatility, currently 105%.

Click here to enlarge

Lastly, remember the VIX options are not for everyone and extremely complex.  They trade off of the VIX futures, not the cash.  For more information on the unique settlement of the VIX, check out the OptionsHouse blog.

Amazon (AMZN) is a great company when you consider that they almost invented the online retailing space.  They will be a retailing force for years to come considering how strong their results have been.  The Kindle looks like a hit.  There doesn’t appear to be a large debate over any of these claims.  However, that being said this stock seems priced for perfection.

Here is my concern with this company:  Its P/E ratio is north of 75.  How can a $56 billion company grow enough to justify a multiple more than double that of Google (GOOG) and Apple (AAPL)?

Well, I was going to say they better execute to perfection.  Their margins are not huge, and expectations are high.  Also, there is risk that the Kindle, which seems like its growth engine, gets swamped by the Apple Tablet.  This is still mostly true.  AMZN is really getting the benefit of the doubt on a lot of stuff.  However, as I was writing this, our CTO stopped by for something unrelated, and I asked his opinion.  He loves AMZN, and it has nothing to do with books.  AMZN is way out in front in something called cloud computing.  Rather than buying a bunch of servers and paying to keep them in a data center, an online business can just put its code on AMZNs cloud, and buy CPU capacity by the hour.  There are a couple of reasons this is great, especially for small- to mid-size firms:  First, things like hardware and data centers are both expensive and a front-loaded cost.  Using the cloud lets you pay for what you use, and not spend a ton of money initially to get your site into production.  The other nice complement is that if AMZN is hosting these companies’ servers, they can also pitch to sell their wares when applicable on Amazon.com.    From what I am hearing, Amazon is way out in front in this space, but new competitors could always come in here and take over, potentially.

I think the next six months are really critical for AMZN.  Two things:  As always with retailers, earnings around the holiday season are exceedingly important.  Throw in the fact the last earnings had a huge move, and to say this will be anticipated, is probably an understatement.  Also, AAPL is rumored to be launching its tablet computer.  The Kindle is great, but this type of product is AAPL’s bread and butter.   What if investors see the entrant and get worried about AMZN’s market?  There definitely seems to be room to the down side.

The cloud computing business is going to take a longer time to play out, but it has the potential to open a whole new revenue stream for them.  It makes me less negative on their prospects to grow than I previously was.

From an options perspective, this is déjà vu.  About 10 years ago, people who sold calls in AMZN because it was overvalued were out of money long before the stock broke back down (remember the Blodgett call for $400?).  There is definitely a ton of momentum behind AMZN due to the recent run in the stock from $90.   Based on history, naked shorts should closely monitor the upside moves in the stock, due to the unlimited risk of the option.

For people still bullish on the stock, you might consider a couple of things:  Maybe some upside butterflies out until April since earnings are after January expiration.  Consider limiting the amount of premium that you pay out since the stock has had a huge run.  This works especially well if you have a limited upside target.  Call spreads can work, too, but you most likely will pay out more premium. Buy-writes are another possibility where you take in a little premium.  Since your play is bullish, all of these strategies will lose money in a down move.

For people bearish on AMZN:  you may consider selling call spreads or buying puts, but, currently, the premium is relatively high in the puts.  You will be at risk if the stock rallies.  You can do spreads if you have a target downside price to work around.

Obviously, this helps the perception that the housing market is stabilizing, and the recovery can continue to gain traction. However, last week the Federal Housing Administration (FHA) had to delay its audit results because of questions between itself and its auditor. This is not a good sign, as far as I can tell.

Previously, I have written about issues surrounding the FHA. Unlike Fannie Mae (FNM) and Freddie Mac (FRE), the FHA has an explicit guarantee from the government. It guarantees mortgages so lenders will be more willing to accept mortgages, rather than making loans itself.

However, the FHA has some rules that may not run in parallel with best lending practices. One of the biggest problems is that people can put as little as 3.5% down. Independent mortgage brokers (yes, some of the same guys who pushed the subprime garbage) can get people into these mortgages now. Their track record speaks for itself around cutting corners to get people in the door and make a commission. With the demise of subprime lending, the FHA has gone from less than 5% of all mortgages to approaching a quarter of all new mortgages. This is a huge driver in the market now.

FHA loans appear to be defaulting at an alarming rate, which may cause the Administration to go to the Treasury to get more money to meet its capital requirement. This happens without a trip to Congress. Now the government has two choices: tighten lending standards around the FHA to get the default rate lower, or just keep it going to pump up home sales. Part of this doesn’t matter because the loans it has made over the last couple of years are out the door. New standards will not help them. Going forward, however, it would possibly slow defaults.

As always, the politicians are going to probably take the easy way out. Don’t change requirements, and pay the bailout on the back end. They are playing against the clock. If housing prices go up, then this is less of an issue. Fewer defaults will ensue if people make money selling their house. However, if the numbers get really bad, they might be forced to tighten the lending policy. That would probably stop a lot of progress in getting through unsold inventory. Not great for the homebuilders.

If you want to read more about some of the issues around FHA check out this piece from National Public Radio (NPR).

More than 200,000 options traded Friday, October 30, 2009, due to a pending release of results around their Lupus drugs. Bloomberg wrote an article noting that JP Morgan had been telling customers to buy bullish options ahead of the results. They felt there was a 70% chance of a successful outcome.

Well, they were right. The stock was up 35% Monday from $18.69 to $25.28. Let’s look at the performance of the November calls (I assume these are the so-called bullish options). Now to be fair, I do not know when JP Morgan made the call, and where the options were trading at that time. I will just use the closing prices from Friday and Monday.

Okay, so the stock outperformed all of these calls on a return basis. So much for the “leverage of options”: Unless you bought options with a very high premium and delta, you may have lost money buying calls on a 35% up move. That is less than intuitive. All the calls listed above actually ended Monday’s trading in-the-money.

Well, the market is not stupid. Because of the magnitude of this event, implied volatility was really high. If you wanted to buy these calls, you really had to pay high premiums for them. Now the real question is what would have happened if the results were bad. All of these options would have lost a huge percentage of their premium with a down move. It makes the calls seem really risky, unless the stock would have declined more than 30%. My guess is that it would have with a negative result.

A strategy that could have been employed in this case may have been a buy/write. This is a strategy that consists of buying the stock and simultaneously overwriting an upside call. The high premiums of the calls would have provided a downside hedge, if the results were negative, while still providing compelling returns to the upside. Now granted, we have the benefit of hindsight here, but let’s continue the exercise to learn for future events.

If you were bullish on the event as JP Morgan recommended, buying the stock at $18.69 and overwriting the 22 calls at $2.95 would have a downside hedge to $15.74, or 15.7%. The maximum profit is capped above 22 in the stock, however, though adding the call premium to the upside in the shares provided a total return of $6.26 or 33.5%. Strike – stock + call premium (22 – $18.69 + $2.95 = $6.26 ).

The risk to a buy/write is having your stock called away at strike, potentially limiting your upside gain. Of course the more significant risk is if the stock price falls, the maximum potential loss is the total dollar amount paid out. The stock price less the amount received on the short call.

This morning’s Wall Street Journal highlights the problems that some smaller Asian countries face with their currencies in relation to both the U.S. dollar and the Chinese yuan.  Because China has pegged its currency to the dollar, its exports have not gotten more expensive with the dollar’s decline.  However, this is not the case for Thailand, South Korea, and Malaysia.  They directly compete with China in exports to the U.S., and they have seen their currencies gain value.

As we discussed a few weeks ago, that leaves them with some unsavory choices:  buy tons of dollars to keep their currency from getting even more expensive, or let their currency appreciate, and write off a chunk of the export market.

Well, South Korea, Thailand, and Malaysia have been buying a lot of dollars to keep their currencies in check.  The problem is that they are not as big as China, so they cannot control it as much.  Combined, the three countries added more than $20 billion in U.S. dollar reserves in September, but their currencies still appreciated.

To say the least, they are annoyed with China’s pegging of the yuan to the dollar.  It is making it tough for these other Asian companies to compete.  One Thai business official is quoted in the WSJ article, explicitly calling for a weakening of the baht in relation to the dollar.  If other nations just dump their currencies into the open market, we may be setting the stage for inflation because money is likely to flood the system.

Currently, Apple shares have a weighting of 15.666% of the index! By comparison, yesteryear’s giants pale in comparison. Microsoft is a 5.02% weight, Cisco Systems (CSCO) only a 3.15% weight, and Intel a mere 2.51%. Another highflyer – Google (GOOG) – also is relatively underweighted at just 5.09% of the index.

Apple shares were overweighted by Standard and Poor’s when the share price was foundering. The current reason for Apple’s excessive weight within the NDX is the aforementioned phenomenal share price performance during the last six years (compared to other stocks in the index):

To be fair, MSFT and INTC have paid out dividends but they amount to approximately $6 and $3, respectively.

Even with this outperformance, the excessive weighting does not appear to be  justified by the current market caps of these companies.

• Apple, with its 1600% gain, has a current market cap of  $179 billion

• Microsoft, with flat performance has a LARGER market cap of $232.6 billion

• Google, with one-third  of AAPL’s weighting, has an EQUIVALENT market cap of $173 billion

• Intel, with negative performance, still has a cap of $113.7 billion – yet only a sixth of the weight

• Cisco has a cap of $140.5 Billion and only one-fifth of the weighting

• Dell has a cap of $30 billion.  Remember there was talk that Dell might buy Apple in the late ‘90s… maybe they should have!  The weighting of DELL shares in the index is an insignificant fraction of a percent, 70 basis points.

There is clearly a new gorilla in the index. S&P may see the need to reduce the Apple weighting in the NDX and the related exchange traded fund, the PowerShares QQQ Trust (QQQQ), to equalize the components. If this happens, indexers will be forced to lighten the number of shares they hold in Apple stock.

So in essence, Apple could theoretically be penalized for its own success.

According to a Bloomberg article, only 37% of new currency reserves are being held in dollars, which is down from the 10-year average of about 63%.

On top of all this, we even got a conspiracy theory article last week out of Great Britain with the premise that China, Russia, Japan, and the Arab oil-producing countries were secretly meeting to tie oil to the price of a basket of currencies and gold, which would further weaken the dollar.

Photo By AComment

Sounds pretty bad, and it should. The U.S. government has resorted to printing money in order to work itself out of the financial mess of the last couple of years. U.S. interest rates are still very low by historical measures as well.

This should not come as a huge surprise to people. For years, the U.S. government and economy has lived off its proverbial credit card. As a nation, we are not unlike the owners of homes that are under water. We are overleveraged with uncertain employment prospects going forward. Now that our credit is in question, people are going to be less willing to hold unlimited amounts of U.S. dollars.

So we have structural issues, and we have an administration that has only given lip service to a strong dollar policy. Think about this: A weak dollar and any inflation that comes with it may help the U.S. economy on a couple of fronts.

First, as always, the weaker the currency, the cheaper its exports look overseas. China and Japan kept their currencies artificially low for years to export their way to financial strength. With U.S. consumer demand anemic at best, this may be the most likely way to get things moving.

Second, we have a huge inventory of unsold homes here in the United States. One theoretical byproduct of inflation would be a move higher in real estate prices. Getting a bounce in the real estate market would reduce the number of homes under water, and maybe get sales moving in the mid-to-higher end of the market. We could kill two birds with one stone, in essence.

While this may make sense in theory, there are practical risks to devaluing your currency. Once the inflation genie gets out of the bottle, we may not be able to put it back in. People will be relatively poorer if assets go up more than their incomes do. Their house might not be under water, which is great, but they still might have issues with things like food, gas, etc. Also, it could be a disaster for people who rent.

One thing I don’t think has gotten a lot of play (but is really interesting nonetheless) is the reaction of other countries. They all say they want to reduce dollar holdings, but many of them do not want the dollar to go lower. If the U.S. government is not going to step in to prop up the dollar, they have a couple of unsavory choices.

They can sit on the sidelines and watch their currency gain in value. Their exports will become more expensive, and their economies will be at risk. Alternatively, they could band together with other exporting countries and prop up the dollar without the help of the Fed.

How do you do this? Buy a lot of dollars, which is exactly what they claim they want to avoid. In fact, the Chinese systematically do this already. They peg both the yuan and the Hong Kong dollar to the U.S. dollar. If the dollar goes down, so does the yuan. The thing is that China appears to have been a co-conspirator in the cycle of the U.S. overextending itself.

The U.S. needed a creditor, and China has been willing to take huge dollar reserves and live with relatively low rates. This has helped the Chinese fund their economic growth through massive trade surpluses. If they stop taking dollars, their export machine could be at risk. This does not just affect China, but also places like Thailand and South Korea, who compete with China in the export market.

If I were a betting man, I would always think that politicians are going to do the short-term fix. They will print more of their own money to devalue it vs. the dollar. If the world again is awash in money, things that are likely to gain in value are hard assets. The wheelbarrow becomes worth more than the money in the wheelbarrow full of money.

What these foreign governments most likely want is for the U.S. to prop up the dollar. It saves them from having to make the tough choices. You may see some saber rattling here. In fact, that may be what is going on now. China will probably continue to be associated with players (Iran and Russia) who want to strip the dollar of status as the world reserve currency in order to pressure the U.S. to stop the dollar’s descent through raising rates and removing liquidity from the market. The U.S. seems to be very focused on its domestic issues, so this may fall on deaf ears.

So what does this mean for the markets? Well, if there is a continuing currency devaluation in the U.S., you would expect companies that are big exporters to do well. They make money in Euros or yen and those turn into more dollars down at the bottom line. Their products also become relatively cheaper. Companies like General Electric (GE), Caterpillar (CAT), and Intel (INTC) sell a lot of things overseas.

If this plays out where inflation becomes the norm, you would expect to see hard assets increase in value. Oil, agricultural products, and metals go up in value, which help the producers of these. Think Exxon Mobil (XOM), ConocoPhillips (COP), and Bunge Limited (BG). The users of these take a relative hit, though. This would include airlines (jet fuel), chemical makers like Dupont (DD) and Dow Chemical (DOW) (much of their stuff is petroleum based), and packaged food makers like General Mills (GIS), who have to pay more for grain to make cereal. None of this is completely black and white: BG needs a lot of fertilizer, which uses oil and will most likely go up in price. However, the thought is that they will be able to pass along this price increase to the end user.

In terms of market volatility: This all depends on how we get there. Some inflation is typically good for earnings and the stock market compared to bonds. If it is fairly orderly, volatility should not go up that much. Over time, as the U.S. economy picks itself off the mat, you would expect the dollar to gain strength back as a currency, especially if we get the budget deficits under control.

The risk is that as we do this little dance with all the international players and something goes haywire. If countries band together and decide that oil is going to be priced by a basket of currencies and gold, there are going to be tons of headlines about the dollar’s demise. It could move the market lower. If China really threatens the U.S. with a massive unloading of most of its dollar reserves, that is going to kill the bond market and add some volatility. I just think that is risky for China, so it seems unlikely. Over time, they are probably going to try and diversify away from dollar holdings, but causing turmoil in the financial markets will hurt them just as much as the U.S.

The reason this is important goes back to the risks and reward characteristics of options. Options are a derivative, meaning they primarily get, or derive, their value from something else, known as the underlying.

In the case of stock options, equity stock values are the underlying. The value of an option is determined by many factors including underlying price, strike price, time to expiration and, very importantly, the volatility of the underlying equity. The reward for owning or being long an option is participation in upside movement in the stock for a call and participation in downside movement if long a put.

The risk of being long a call or put is limited, but it is 100% of the premium paid for that option. The total loss of the premium will occur if the stock price is not higher than the strike price for a call or not lower than the strike price for a put before expiration. With only one week before expiration, this decay of option value is at its highest as the expiration “day of reckoning” is fast approaching. Time value will quickly become zero.

Earnings, of course, can be big market-moving events for individual stocks. The expected volatility is often higher during the period following a company’s announcement as expectations are replaced by real results and the share price moves can be dramatic. This uncertainty increases the potential value of an option on a stock, which is another way of saying the implied volatility of the options typically increases prior to the earnings event.

So we have two factors that both have a very significant effect on options price – decreasing time and increasing uncertainty – and these factors are battling it out this week.

Fifteen percent of the 1,000 highest-capitalization companies will report this week, and we will see a heavy financial flavor. Among the financial companies scheduled to report this week are JP Morgan Chase (JPM), Goldman Sachs (GS), Bank of America (BAC), Citigroup (C), Morgan Stanley (MS) and Charles Schwab (SCHW). Google (GOOG), IBM (IBM) and Intel (INTC) are big technology hitters that are also reporting this week. Also, industrial and other high-cap names such as General Electric (GE), Johnson & Johnson (JNJ), Abbott Labs (ABT) and Baxter International (BAX) are due to report this week as well.

The bottom line is that the risk and reward profiles are much more immediate this week. If the earnings numbers are as expected and the share prices do not move dramatically, option volatility will likely collapse extremely quickly. However, if earnings surprise, the movements in the stock can be extreme. In this case, the value of the option to buy a call or sell a put could be very rewarding indeed. Be aware of the unique trading characteristics that may arise this week.

Treasuries have sold off, giving up their initial gains and showing rising yields. This seems to be helping equities. Perhaps all hope is not lost.

Yesterday’s late day sell-off was possibly predicated on Goldman Sachs predicting a much worse payroll number than the initial forecast. And, guess what. They were right! This may be a case of selling in front of the number. Now that the actual number is released, the shorts are scrambling to cover their “profits” before they disappear.

Looking for an online broker that specializes in options? Be sure to visit OptionsHouse to check out their platform, performance, and price.

Expect premium levels to spike and the negative prognosticators to get plenty of media time. This could build on itself. Treasury Bonds are rallying sharply as a safety trade as well as possibly an indicator of the weak demand the loss of jobs means for the economy. The 30-year yield is back under 4%.

The market has rallied a ton in the past six months. An old Wall Street adage is that markets take the escalator up and the elevator down. It certainly looks like we are riding the elevator.

Looking for an online broker that specializes in options? Be sure to visit OptionsHouse to check out their platform, performance, and price.

The ISM (Institute for Supply Management) manufacturing index declined 0.3 percentage points to 52.6 despite the expectation for a gain to 54.0. This appears to have sent fears of a stalling economy. If this is the case, the rally we enjoyed over the past quarter could come to a dramatic close.

The CBOE SPX Volatility Index (VIX) also seems to be confirming this as it has spiked above the 27% level, indicating a bid for option hedges in the SPX index on which this is derived. My source in the middle of the SPX pit has confirmed there has not been any “panic” with people reaching for puts since many traders have spread hedges in their positions already in expectation of this move.

The VIX implied measure of volatility has been at a steep premium to the 30-day historical actual volatility lately. Yesterday the VIX closed at 25.61% and the 30-day historical was measured at 15.6% or a 10.01% premium. This may indicate the implied measures, expecting today’s movement, may mean the selling will not be extended. The rationale in this case may be, if investors have hedges in place they are more likely to buy dips rather than sell into the weakness.

Looking for an online broker that specializes in options? Be sure to visit OptionsHouse to check out their platform, performance, and price.

This poor showing in August raises the question of whether the Cash for Clunkers stimulus program was just a temporary band-aid. Whether the production growth we have seen in the past months led to increased inventories with no incoming orders in the following months. The market is at an important technical price point (1045 in the SPX). It will be interesting to see if this poor durable number will embolden the bears to press the market lower.

Today, a University of Michigan confidence survey (survey 70.5) and New Home Sales figures (440K expected) will be released. Look for the market to react to surprises here as well.

Initially, I believe the futures would sell off hard from the shock, but wouldn’t a rate rise be the vote of confidence that the recovery is upon us from the highest financial power in the land?

I don’t believe for a second that the target rate will be changed today in the face of 10% unemployment, but it is time to start thinking about what the reaction will be when the money spigot begins to be turned off.

Yesterday, an article by Liz Capo McCormick on Bloomberg stated, “The Federal Reserve has started talks with bond dealers about withdrawing the unprecedented amount of cash injected into the financial system the last two years, according to people with knowledge of the discussions.”

This withdraw of the cash from the system would be in the form of repurchase agreements, aka “reverse repos”. A reverse repo drains cash or liquidity from the banking system as the Fed sells securities to its 18 primary dealer banks for a specified period of time.

So the end of easy money is somewhere in the future. The balancing act of when, and how much, the Fed takes will be the greatest challenge. The goal will likely be to stem inflation before it returns without choking off the delicate economic, and so far, job-less recovery.

A cash-secured put sale has the advantage of not needing a margin account to trade as long as the account has the money in cash to cover the purchase of the stock at strike price. Many investors use put sales to pick an entry point to buying the stock below the current price.

The risk to a cash-secured put sale is being forced to buy the stock at the strike price when the shares are trading lower. However, if you already planned to purchase the stock today at $7.59 and instead issued a “put” for the stock at $7.50, your actual entry price for the purchase would be $6.75 ($7.50 less the $0.75 cent premium).

The real risk to selling a put vs. buying the stock is that if the stock rallies sharply from here, your reward in that case is strictly limited to the premium received, which may be much less then the appreciation in the share price.

Investors can consider cash-secured puts as an alternative way to enter into a long stock position.

From a market standpoint, it is a good sign that companies are out there making acquisitions again. It shows they are getting more confident about their prospects going forward. Also, the fact that these transactions were done in cash shows confidence by both Adobe and Dell in their share valuation. If they had poor expectations going forward, they probably would have thought more about paying with stock.

Of course, waiting until your outlook brightens has a cost. Omniture is trading below $10 this year, so Adobe waited until it almost doubled in price to put in a bid. Perot Systems traded below $11 in March, so now Dell is paying almost triple that. If the acquirers would have made these bids in the first quarter, it seems like they could have gotten them for less money. In their defense, this is not an easy call to make.

In terms of company-specific points on these deals, I think the Dell acquisition really should be noted. The whole goal of Dell was to be the most efficient box maker for many years. However, this has become a much harder position for it to maintain. It has been hurt on one side from Apple, who has gained market share with its combination of slick hardware, multi media winners, and solid operating systems.

Dell also faces tough competition in the corporate market from Hewlett-Packard, which has integrated its Compaq acquisition from years ago, and has a large consulting wing to go along with its hardware. Buying Perot appears to be somewhat of an admission by Dell that just making cheap boxes with the lowest cost basis in the industry may not be a winning strategy.

As far as the Adobe/Omniture linkage, I think most people probably have never heard of Omniture. However, they are in an area of huge importance to online firms. They help track information for websites on their customers’ behavior, and on the performance of the money these companies spend for online ads.

With greater percentages of advertising budgets going online, these companies need to ensure they are spending this money wisely. Omniture has a product that does this in great detail. In my opinion, Adobe is smart to stake out its position in this space because it should continue to grow in importance down the road. But this is an expensive acquisition for ADBE from a financial perspective. Omniture actually lost money in the second quarter and booked only about $87 million in revenue. It is a way, however, for Adobe to refill its pipeline of products (much like a large drug company buying a biotech firm).

One other note — Omniture has settled above the $21.5 bid price from Adobe. This means there are people who think Adobe will raise its bid, or that another player will come forward and make a higher bid for the company.

For the underlying securities, they are going to multiply the current margin requirements (25% for long and 30% for short) by the amount of leverage, e.g. 200% for double-levered and 300% for triple-levered ETF’s. That means if you are short a triple-levered ETF, you will now have to post 90% of the price of the underlying.

For naked options sellers, there will be a similar ramp in calculating margin. Currently, the amount in addition to the option premium that needs to be held back is 15% for broad-based indexes and 20% for narrow ones. These amounts for leveraged ETFs will now be multiplied by the amount of leverage the ETF gives.

Portfolio Margining accounts will also have their current limits multiplied by the amount of leverage the product gives.

Day trading buying power numbers will also be multiplied by the amount of leverage. Basically, a security that has a 25% margin currently but is triple leveraged will actually need 75% of the market value.

I think that this will cause a dramatic decrease in the volume traded in these securities. There is much less advantage now to trading them in terms of leverage compared to the standard ETFs. It will be interesting to see how this plays out in December.

For a reference point the SPX index started the year at a level of 903.25.  So with today’s close at 1028.93 the overall market is up almost 14%.  It is more impressive to remember that on March 9^th the index closed at 676.53, after hitting a intra-day low of 666.79 (up 54% from intra-day low)

On the sector front the best performing sector has been Info Tech up almost 40% YTD.

Within the highest weighted Tech companies Apple (AAPL) stands out,  up almost 100% .  Google (GOOG) a more pedestrian 51%.  Microsoft and Intel 27% and 38% respectively.

Also a leading sector the Materials sector has enjoyed just over a 30% YTD return

Freeport McMoran (FCX) a copper and gold company stands 167% higher than the start of the year!

Heavy weight Monsanto (MON) is only better by 18%

Consumer Discretionary names as a sector are up by 23.6% from the start of the year.  This sector as it is driven by consumers has definite winners and losers.  McDonald’s Corporation (MCD) which was a relative bastion of safety in the last quarter of 2008 is actually down9.8% on the year.  This is likely because investors have rotated out of safety into higher beta higher risk names.

Ford (F) is back from the dead, taking the pole position of the top 15 members in this sector up 237%.  Remember this company did not take government money as Chrysler and General Motors (MTLQQ.PK) did.  Amazon (AMZN), up 61%, Target  (TGT) up 37% and Kohls (KSS) up 45%, are three retailers that compare favorably.

The consumer staples sector is higher by only 3% as investors have rotated out of traditional safety stocks.  Proctor Gamble (PG) is down 13% Wal Mart (WMT) is down almost 9% and Coca-Cola (KO) is up only 8%.

Lastly Financials are up 17% for the year.  This sector has had the biggest thrill ride at the lows it was down over 50%, from the lows it is up 143%!

Goldman Sachs (GS) is up 94% to lead the charge

American Experess (AXP) is higher by 84% as the consumer is still using the little green cards.

In the Banking subsector Wells Fargo (WFC) is still down on the year losing 7.3%

Citigroup (C) still has issues down 22%

Bank of America (BAC) has recovered 27%

And J.P. Morgan Chase (JPM) is up a respectable 36% which is great by most measures, unfortunately they measure vs. Goldman Sachs typically.  So Jamie Dimon is probably disappointed.

The next move in the overall market is anyone’s guess.  The 10 day historical vol is calculated today at 10.79%.  The CBOE SPX Volatility Index (VIX) is stubbornly staying near the 25% level, possibly indicating we are entering a more volatile trading environment into the last 4 months of the year.  The more dispersion between sectors, and between stocks in performance the more “normal” trading will be.

Remember the stock market is the ultimate forward looking indicator of future cash flows and expected growth for the economy and individual companies.

There is no better indicator out there.

Regulators Examine Goldman’s Trade Tips

BofA Denies Misleading Its Investors on Bonuses

Charles Schwab takes on Cuomo

When markets drop as they did in 2008 the public wants villains and the media seems to have an endless supply. Today’s serving of news is a course in “evil” banks and brokers.

What I find interesting is the market’s reaction to these headlines.  The mini S&P 500 futures are actually predicting higher – opening up over half a percent.

This is likely due to the fact that the market is forward-looking, despite the headlines, and the misdeeds of 2008 are in the past. The crowd may still want someone to blame for the losses of last year, but it’s important to remember that last year’s transgressions have very little to do with forward earnings for companies and future prospects for the economy.

“We believe we will be able to pay back the government and we hope we will be able to do something for our shareholders as well.”

The effect of this news on options action has been phenomenal! More than 300 thousand contracts have traded, with huge volume going through on the calls and puts. This likely reflects mixed opinions amongst investors as to the future value of the equity here: Long options limit the risk to the premiums paid while given exposure to price moves up and down. The potential risks to owning options is the loss of 100% of the premium paid and AIG options are currently trading with implied volatilities approaching 200%!

The risk bid is definitely in evidence, as the CBOE SPX Volatility Index (VIX) index of 30-day implied volatility is up almost 15% to practically 28! We have spoken about how the VIX and especially the forward VIX has been much higher than the actual historical volatility in the SPX; something had to give. Either the market would begin to actually move in a more dramatic fashion, or the implied levels of volatility would have to come in.

For today at least, we are getting our answer. The market is down 2.5% at this point and it appears investors, rather than feeling this is a buying opportunity, are feeling that this time they need more put hedges in place. They are subsequently bidding up straddles across the board from September to December. This possibly indicates that the crowd was caught unprepared; they didn’t have puts in place coming into this morning.

I am by no means a China expert, so I will not wade into whether Mr. Makin is on the mark or not. With its markets rallying 75% from their lows, China, however, appears to have been the rock in this recovery over the last six months. If investors lose faith in China’s ability to grow without huge exports, the global indices could give up a lot of their recent rally.

I think this underscores how interconnected our market is to Asia, specifically China, as the Shanghai Index was down more than 6%. Commodity prices are imploding, taking many material names in China down a limit of 10%. European stocks are down as well, approaching a 3% decline. The CBOE SPX Volatility Index (VIX) has remained forward sloping, meaning the VIX futures expiring in September are 12% higher (3.1 volatility points); this suggests a concern about the market heading into the September-October period. August premium levels have been lower than the further-out months, however, which hedges in August may lessen the impact of today’s selloff in the U.S.

1. China Shanghai Index down 3% … this hurts the commodity bid and throws a wrench in the global recovery theory.
2. Commodities are in free fall, sending the materials sector down more than 3%. The dollar index is higher and other fly-to-safety instruments are bid.
3. University of Michigan survey hits 63.2 vs. expected 69. Consumer sentiment is surprisingly(?) BAD!
4. Market is lower by 1.5% … S&P 500 Index (SPX) slips back under 1,000.

The CBOE SPX Volatility Index (VIX) is back approaching 26% volatility; shorts have been burned badly recently and there do not appear to be many existing shorts to provide a bid for shares when they actually do fall. New buyers, therefore,would be required to stop a falling market.

Also, with the poor Retail Sales figures from yesterday and the continued loss (albeit slowing loss) of jobs, did analysts actually expect consumer sentiment to improve? Only off the back of a rally in the equity market? That confidence can be especially fragile. This afternoon – heading into the weekend – will be especially interesting to see if fear or greed wins the day.

This just reinforces my belief that markets tend to go where the “crowd” least expects. The CBOE SPX Volatility Index (VIX) is back above 26%, so don’t be surprised if the market continues lower or possibly (even more surprising) regains momentum to the upside.

One interesting show I received from my sources is the September 37.5/47.5 one-by-three call ratio spread. This trade has the initiating order buying 25,000 of the 37.5 calls and selling three times as many 47.5-strike calls to collect a 10-cent credit. This spread has an upside breakeven of 52.55% in the VIX index.

The maximum profit for this strategy is at the short strike of 47.5 where the position would be worth $10 (the difference between strikes) plus the credit received, or $10.10. The maximum loss is unlimited due to the two additional short 47.50 calls. Above this strike, this strategy loses two points for every volatility point higher in the index. The September VIX futures, on which the VIX options trade, is currently approaching 29.

Considering how much debt the U.S. is issuing, there is plenty of room for all types of securities. By September, the government will have issued $1.8 trillion in debt for the previous 12 months. That is a record amount. As we continue to run up the U.S. government’s “corporate card,” investors may want to think how this plays out over the next few years.

The pending home sales jump of 3.6% has spurred the financial sector to gain almost 1%, which is driving the major indexes to a slight gain on the day.

I would expect the market to chop around the unchanged level. As the CBOE SPX Volatility Index (VIX) has trended higher the past week, the test will be whether the investors that have purchased options will continue to hold them with the market’s actual moves not justifying the volatility premium paid. Keep an eye on the VIX, which is currently at 25.4%.

My question to Barney Frank is this: If you are going to try and limit how many people make over $1 million, then are you going to reduce your estimates of government tax receipts from its surcharge to pay for health care? Seems like the House Health Care plan needs as many people making over a million dollars as possible, doesn’t it? No million-dollar pay packages severely limits how much money a 5.4% surcharge will take in on income over a million bucks.

I actually like the idea of giving shareholders a say in executive compensation. However, I think the people in Washington will be surprised at the answer they get. Shareholders are going to want to pay people who make a lot of money for the firm really well to keep them. Take a poll of Ford (F) shareholders right now, and I would bet that Mr. Mulally gets a huge pay package. They might even vote for him to get his corporate jet back. If you are a Ford shareholder and you look at what just happened to the people who owned GM and Chrysler stock, you love this guy.

Personally, I think that the House is giving the SEC an impossible task. How are they going to efficiently judge risk individuals’ take vs. their compensation? It is just too complicated, and they will never keep up. The job of the financial regulators is to put limits on the excess use of a firm’s balance sheet to put it at risk.

Increasing margin requirements, forcing OTC derivatives to go through a centralized clearing apparatus, and actually holding the ratings agencies to some kind of reasonable standards are ways you make firms safer. Trying to figure out if Employee #2547 at a place like Goldman should only get paid $700k instead of $1.25 million does not seem like a plan that will work.

The options implieds as well are back to “normal” levels from a year ago when the two-month implied volatility traded in the low 30% level. Given that the stock is up roughly 15% in the past month, investors looking to protect those gains while remaining exposed to further upside in the shares may be looking at a stock-replacement strategy using options. This strategy typically uses in-the-money calls to “replace” a long stock position. As always, when you buy or go long an option, the maximum loss is 100% of the premium paid, but 100% of an option’s premium is almost certainly less than the dollar exposure of a long stock position. The reward for a long call as compared to long stock is one-for-one above strike price.

To say that Alan Mulally, the CEO who came over from Boeing, has navigated the treacherous waters exceedingly well is an understatement. Ford stock has actually outperformed Toyota (TM) and Honda (HMC) over the last three years (although it lags on a five-year basis). These comparisons are easily seen by using the OptionsHouse streaming charts.

Anyway, from a trading standpoint, the stock has broken out in a huge fashion. Is it overdone? Well, we will have to see if it can keep sales going post “Cash for Clunkers.” Implied volatility – now in the low 50s – has come in considerably due to the lessening of bankruptcy concerns. If you are interested in trading this stock, you might want to take a look at using options instead. www.ONN.tv now has an Option Finder, which will estimate returns on option trades based on your view on the stock. Take a look.

Another measure of risk appetite and fear is the TED spread. It is the interest rate banks have to pay to borrow money over the U.S. Treasury. Last fall, when people thought the system was going to collapse, this spread hit 460 basis points in October. That means a bank would have to pay 4.6% over what the Treasury paid on an annual basis. This is an incredibly high number. It has dropped all the way down to 30 basis points currently. This is a drop of 93%. WOW!!! The Wall Street Journal notes today that these rates spreads are now approaching levels we consider normal. Basically, a 25-basis-point TED spread means we are out of panic mode. The first thing I think of when I see this is that all of these banks should be paying back their TARP money soon, since the private markets are functioning again.

There are a lot of valid criticisms of how the Fed and the Treasury reacted to the events of last fall. We also have to deal with paying for some of this over time. I would think, though, that Mr. Bernanke and Mr. Paulson have some right to do the equivalent of pointing to the scoreboard to justify a lot of their actions.

Now for the economy to move forward, the banks actually have to start lending more money out to their clients. Additionally, businesses have to start hiring and spending.

The Direxion Daily Financial Bull 3X Shares (FAS) lost 78% since its November inception given the elevated volatility in the market throughout the last year, making it the "winner" between the two.

However, on the other side, the Direxion Daily Financial Bear 3X Shares (FAZ) lost almost 95% of its value! People seem to think these products will both decline again, but they should remember that these instruments are considered day-trading vehicles – it could be a very long time before both decline again so significantly since volatility during that period was at an all-time high.

Now there could be danger for the longs and shorts if the market is not as volatile and the value of these levered instruments doesn’t fluctuate. Also, they could follow a somewhat more intuitive path, with one rallying and one declining, which would start to require regular rebalancing of the shorts.

Both of these stocks have a negative short stock rebate, or a cost charged every day to be short. This charge will likely grow larger with more demand on the short side of the trade. If in fact the stock becomes impossible to locate, the risk increases that short positions may be bought-in prior to the trade becoming profitable.

Again there are complex risks associated with using these vehicles and these risks can be huge. And don’t forget the creator of these complex ETFs, Direxion, makes money from fees, whether investors buy, sell, turn a profit, or lose money.

These are newly listed strikes so there wasn’t any open interest until today. Clorox has been mentioned before as a potential takeover candidate and the company is scheduled to release earnings the first week of August – keep CLX on your Watchlist!

Elsewhere, biotech company Genzyme (GENZ) is down 7% after announcing earnings and issuing a mixed guidance that was lower than expectations. They have been involved in sanitization at a plant, causing a shutdown in production. The company believes there will be shortages that they will not be able to meet in the second half of this year.

Today we are seeing an investor sell the August 50/55 strangle at $2.00. This strategy is likely expressing a view that trading in Genzyme will be range-bound between the 48 and 57 breakeven points in the stock price. If the stock finishes between strikes, the seller keeps that premium received. The risk to this strangle sale, however, is theoretically unlimited.

• Human Genome Sciences (HGSI) is up over 200% today after announcing they met their primary endpoint in Phase 3 trials for a potential treatment for Lupus.




• Orexigen Therapeutics (OREX) is up over 25% after announcing they met primary endpoints in a search for helping treat obesity.
• A.P. Pharma, Inc. (APPA) is up over 20% since the FDA accepted its NDA for treatment of chemo induced nausea and vomiting.

And in the weirdest news of the morning, Harmon International Industries, Inc. (HAR) ran up more than 20% in pre-market trading because some little- known news service, AME, claimed the CEO of a private equity group announced his intention to buy HAR for $49.50, which would be almost a 100% premium. However, HAR recently came out and denied it had received a bid. The stock opened up only 5%. We will see who is right.

Both MHP and MCO are off by more than 50% from their respective highs, so they have taken a hit from the financial crisis already. However, I have been somewhat surprised by the relative lack of outrage directed at these agencies in the wake of a massive financial crisis. When I consider what happened to Arthur Andersen after the Enron scandal (i.e., it is no longer a company), it seems like the ratings agencies have gotten off pretty easily to this point.

There are differences in the analogy, obviously. The biggest being that Arthur Andersen was eventually charged with a crime, and that has not currently been the case with the companies rating Collateralized Mortgage Obligations (CMOs), Collateralized Debt Obligations (CDOs), and other non-traditional investment vehicles. However, even if the rating agencies played a smaller role in this mess than Arthur Andersen did in the Enron problem, the enormity of this crisis seems to outweigh that.

Since it is always easier for me to think in terms of probability, look at it this way. These are just my round estimates and my opinion/guesses at things, but here is an example. If Arthur Andersen was, say, 50% responsible for Enron, and it was a $100 billion mess, they have $50 billion dollars’ worth of responsibility. In terms of the ratings agencies, if they were only 10% responsible for this crisis, but it ends up being a $2 trillion problem, that is $200 billion dollars’ worth of responsibility. This is my point about how the outrage directed at them seems muted in comparison.

The companies have a lot of other businesses besides ratings, so maybe everything is already priced in. However, if there is a groundswell to punish these guys going forward – and this groundswell is led by the SEC – there may be headwinds in the future.

Think about that August call sale for a minute … the stock is trading at $1.55 roughly at the time of the sale, making the premium received 32% of the stock price. The risk to overwriting a call is having the stock called away at the strike price.

My sources are showing me offers and trades of more than 25,000 contracts in the Jan 2011 50 calls, the 45 calls and the 40-strike calls.

My source is showing me a seller of the July 7.5 puts 1,500 times at 45 cents per contract. Now the open interest in this line is a hefty 17,000 so this is likely a closing order. The OptionsHouse Hotlist is also picking up a buyer of the July 7.5 calls. Again, given the open interest, this may also be a closing transaction. Closing transactions can also indicate bullish sentiment!

My floor source is showing me the August 10 straddle being offered 1,000 times at $1.76 per straddle. This offer likely represents a belief that the stock will trade in a relatively narrow range with the earnings event now in the past. The risk to a short straddle is unlimited as the strategy is short a naked call and a naked put. The potential reward is limited to the premium received.

On Thursday, July 9, 2009, the following securities will undergo a reverse split:

• FAS – Direxion Daily Financial Bull 3X Shares will undergo a 1-for-5 reverse split
• FAZ – Direxion Daily Financial Bear 3X Shares will undergo a 1-for-10 reverse split

In our opinion that we have vocalized previously, history has shown that levered ETFs may not be ideal buy-and-hold securities, due to the mathematics of achieving a DAILY three-times price move of the underlying index. Because of this they both appear to be destined to decline in high-volatility environments. To counteract this, it appears the Trust company has decided to reverse split them to get the price higher. These may be fine day-trading vehicles for some investors, but please beware! It is likely that these products will have an ongoing history of reverse splitting!

A strangle – the simultaneous purchase of a call and put with the same expiration but different strike prices – is typically bought when the trader is expecting an outsized move in a stock but not sure on the direction of the move. The wider the strikes selected, the less the premium is required for purchase, but the greater the movement required to make the trade profitable. As recently as June 29th, ICE shares were was trading near $120 and the continued bidding for strangles indicates an expectation for this volatility to continue even further.

My floor source is reporting that the August 57.5 puts being sold 3,000 times at $1.86 per contract. This strategy somewhat picks an entry point at which the seller is willing to own the shares if they pull back: the strike price minus the premium received, or $55.64 in this case. If the stock stays here around $60 or goes higher by August expiration, the seller keeps the premium as profit.

The implied volatility in new AIG shares has exploded today, up to almost 140% volatility! On the options front, we are seeing a collar trade in July where the initiated order is buying the July 12.50-strike puts and selling the 17-strike calls 3,000 times. The price of the split shares was over $24 per share on July 1st when the split was enacted. The current price is around $14 and today’s options action seems to be predicting even more weakness.

It came across this morning’s news tape that EMC Corporation (EMC) would be boosting its all-cash offer for Data Domain to $33.50 per share. Also NetApp Inc. (NTAP) announced they have received regulatory approval from the Securities and Exchange Commission to buy Data Domain for $30 per share in a cash-and-stock deal.

DDUP has rebuffed bids from EMC and the directors have agreed to the NetApp bid. The stock is trading for a premium to both offers, however, suggesting this "dance" is far from over.

The options action today also implies further action may be expected. The July 35 calls have been bid and bought at 20 cents. This bullish activity may suggest that an additional, even higher bid may be coming for the stock in the next two weeks!

Keep an eye on the CBOE SPX Volatility Index (VIX)! We have two opposing forces at work today. One is the decay that options will encounter over the extended thee-day weekend and the other more immediate fear is what the negative jobs number throws into the market. This early drop will likely cause the VIX to spike initially. If the second move is also higher, then fear is winning over decay.

The timing appears to be too close to be considered coincidental. This leads me to believe the same customer is looking to hedge against a downside move in these department store leaders for the remainder of this year.

At the very least, this action seems to indicate an attempt to protect against negative impact in the market if the so-called economic recovery, as predicted by the pundits, fails to manifest and consumers remain tightfisted through the holiday season.

Meanwhile, options activity is heating up on Biogen Idec Inc. (BIIB). The shares are down almost 7% this morning following the disclosure of another case of PML (progressive multifocal leukoencephalopathy) associated with use of the biotech firm’s Tysabri product. BIIB is seeing a pickup in option activity with 18,000 contracts already crossing the tape today.

The July and August 50 puts traded 3,000 times each in morning trading, possibly indicating the purchase of a calendar put spread. This is likely a put holder rolling out his protection from July to August, expecting this event to not be resolved in the next three weeks. In other words, the investor could be closing out his July puts and opening fresh August puts in an effort to hold on for a longer period of time.

The five-year auction results were strong, following the strength shown in the two-year yesterday. Next up is the seven-year auction tomorrow, completing this record auction size this week.

So most major market averages managed a gain yet again today, keeping that 50-day moving average above the 200-day, a bullish indicator. Only the Dow Jones Industrials moved lower. Boeing (BA), down 6% today, dragged the index to a loss of 23 points. The blue-chip average closed a fraction under 8,300.

Specifically, 1,000 July 40 puts have been bought with the stock on a 50 delta. This means the initiating order is buying 1,000 puts and buying 50,000 shares of stock. This stock hedge takes away the immediate exposure to the direction of the stock. Also, the July 45 call is being bought untied – without any stock hedge – at 2.65. This out-of-the-money call is possibly looking to take advantage of the 5.5% pullback in the stock today.

Large index trades are often used as tools for institutional portfolio managers to quickly change exposures in the market from cash to equities. This trade represents 945 million dollars in notional exposure to the S&P 500 index above the 945 level. The risk of the trade is 100% of the total premium paid or an estimated $8.5 million. The buying of upside calls in a declining market adds to the expected rise in the CBOE SPX Market Volatility Index (VIX) as the market travels down the “Negative Skew” curve in SPX options. The VIX is markedly higher at 31.8%.

It also released individual country forecasts as well, calling for the U.S. economy to drop 3%. Japan’s economy is expected to drop 6.8% with Europe sliding 4.5% lower. These increases in the contraction of the global economy throw cold water on the hope for a V-shaped recovery, as well may dampen the confidence the consumer has begun to show that the worst of the recession is behind us.

It looks like these put buyers will be hugely rewarded as the patent infringement suit was decided in favor of Reynolds American (RAI) and against Star Scientific. It appears that this stock may have been a one-trick pony as the stock is down roughly 80% in the pre-market, down to 90 cents, which makes the 2.5 puts have an intrinsic value of $1.60. (The risk to this trade was the stock staying above $2.50 and the customer losing the premium paid.)

The puts were bought for approximately 30 cents. That makes the one-day return more than 400%!! Not bad for one day!

The Direxion ETF Trust company announced a reverse 2-for-1 split for the Daily Mid Cap Bear 3x Shares (MWN). I must say I am surprised. Why didn’t they reverse split 10 to 1? Or at least 3 to 1. This should have the immediate effect of doubling the price so this product can move more each day and again, in my opinion, march toward eventual value destruction.

Research in Motion Limited (RIMM) earnings have hit the Street and the stock is down 6% in after-hours trading! This is not enough of a move for the long holders of options, as the premiums (expiring tomorrow) are anticipated to lose most, if not all of their time value if the stock remains between70 and 75.

This highlights the danger of buying options for a one-day event just prior to expiration. The risk is the loss of 100% of the premium in a very short span of time. The reward, however, was unlimited if the stock had an outsized move. Six percent lower does not appear to be an outsized move!

Just 18 companies in the S&P 500 index have managed to avoid losing ground today. Many investors have been calling for a pullback, calling the recent gains too far and too fast. This kind of morning selling we have seen before and lower prices have attracted buyers. It is possible, however, if the market doesn’t show some signs of support in some sectors, the selling pressure could intensify or buyers might disappear, leading to more significant losses!

Watch the VIX, already up 1.5 vol points, or 5.5%, to just under 30% volatility. If that spikes up further, it may be interpreted as a predictor of greater weakness.

The 10-year note is now yielding under 3.8% after touching above 4% earlier this week. Crude oil is pulling back as well today, down $1.00, though whether the consumer sees some relief at the pump remains to be seen.

Traders have been pointing to 950 as the top of the range in the market, which has caused the implied volatility of the index to come in. If we can hold today’s gains that could force buyers who have been sitting on the sidelines to commit funds to the market for fear of missing out on the next potential rally.

The CBOE SPX Volatility Index (VIX) is now negative on the day as this recovery is yet another indicator of the lower end of the market’s recent range holding. A range-bound market possibly will entice option traders to lower their offers on options in the S&P 500 market, the index on which the VIX is derived.

Increased economic activity is giving more credence to the inflation argument, too. Bonds are down, and oil prices are higher (albeit slightly). The 30-year bond is now yielding over 4.6%. July Oil futures are approaching $70 per barrel.

The question is … can the U.S. get the economy going, print a ton of money, take on a lot of debt, and NOT debase the dollar and cause huge inflation? If the economy does not pick up, we could be stuck in neutral for an extended period like Japan in the ’90s. If we flood the system with too many dollars to get the economy started, will we look like a hyper-inflation third-world country? This will definitely take some finesse. The jump in rates and commodities prices shows that people are starting to think about inflation more…