Barry gives a great overview of why the holiday shopping season is so important:

Why does this matter so much? Because Retail is serious business: According to the National Retail Federation (NRF), the last 2 months of the year account for 20% of total annual sales. For department stores, its closer to 24% and for jewelers, 31%. And according to the International Council of Shopping Centers (ICSC), nearly a third of retailers profits come in Q4.

A lousy holiday season has deep ramifications: it says a lot about consumer’s budgets; indirectly reflects the state of wages and income. Mostly, it reveals the state of consumer sentiment in real terms, rather than merely expressed in a telephone survey. Last but perhaps most important, consumer spending accounts for ~2/3rds of GDP.

So if retail is the canary in the coal mine, how should you play it? One idea would be to short one of the retail ETFs (RTH or XRT) on a ratio basis against your long indexes, on the theory that bad retail leads to bad markets in general.

But really, if the vaunted American consumer finally gives out, will the resulting recession be of the tradeable sort? Holding some retail shorts won’t do much good if there are barricades to storm. Because if the revolution comes, you’ll want to be short the financials, lol.

Bad news out of Fannie Mae yesterday, and you could probably guess what it relates to.  Yep, bigger than expected credit losses, this time obscured by some fancy-pants accounting.  The stock fell hard this morning, but it bottomed out around 37 and has bounced now back up to 41, a good short entry.

Trade ideas:

1. You could buy the Jan 40 puts and sell the Dec 40 puts to create a nice one-month calendar for a net debit of $1.15.
2. Or if you want a more theta-positive play, just sell the Dec 50 calls and buy the Dec 55 calls for a $0.60 credit.
3. And if you’re already long the stock for some reason, this bounce might be a good time to get out.

As always, with these bonus trades you should do your own due diligence, you will lose money, etc.

Remember those tests in school when you were a kid? Here’s the question before us right now:

Where’s the market going?

A: Up

B: Down

C: Sideways

D: Not enough information

DJI is trading right at its 200DMA as we speak, and while that 300+ point day was nice and everything, nobody really “believes” in it yet.

SPYs are still a full point below the 200DMA, and given that it’s options expiration week we might not see a retest until next week. We’d like to wait to see what happens at the next retest before committing to a position there.

QQQQs are still well above their respective 200DMA, in spite of that recent nastiness - and that’s why we already have a position there.

VIX is holding its nice uptrend on the daily chart. Also, check out the CBOE’s new volatility product, the VXV. It tracks the 3-month SPX implied volatility (the VIX tracks 1-month IV). Good commentary from Adam and Bill. Those other two new products (VPD and VPN) are interesting, too.

Summary

The dilemma is this: on the one hand, if the major financial institutions who are holding lots of inscrutable Level 3 assets don’t come clean about exactly how much value they have and how much risk they’re exposed to because of those assets, they won’t inspire confidence in investors. On the other hand, if the major financial institutions who are holding lots of inscrutable Level 3 assets try to come clean, accept big writedowns, place a value on those dubitable assets, and suffer the resulting short-term hit, it’s quite possible that no one will believe them anyway.

Analysis

David Weidner at Marketwatch [hat tip Roger Ehrenberg] talks to some analysts who think the financials need to just get all the bad news out at once - clear the systems, so to speak. Sure, this would provoke some additionally immediate worry (to put it mildly), but the thesis here is that it’s actually the fear of future writedowns that is doing more damage. The key quote:

A couple of analysts I spoke to said that the best thing financial firms can do to rebuild confidence is to look at every asset on the balance sheet and mark it to market. If it can’t be sold or if its value is unclear, it should be written off. That write-off should be a one-time event.

“They need to be as straightforward as possible about what their credit risks are,” O’Shaughnessy said. “What’s really killing them and killing investors is the uncertainty that surrounds it. Nobody’s sure if the write-down is going to be $500 million to $1 billion or more.”

O’Shaughnessy doesn’t recommend that everything be written to zero, but underestimating risk is what initially got these firms in a bind.

So, mark all the crap debt and bizarre “assets” to market. But wait: isn’t a major part of the problem the fact that so many of these assets are classified as “level 3,” which is code for “impossible/difficult to mark to market, since no market exists for them”? The Economist explains:

The uncertainty is compounded by the difficulty of finding a “fair value” for these complex instruments. The fall-back method recommended in a recent paper by the Centre for Audit Quality, an industry research body, is to employ “assumptions that market participants would use”, a technique known as “Level 3”, which becomes subject to strict accounting regulations in America on November 15th. But “Level 3 is not that useful,” confesses a risk controller at a big European bank. Banks have tended to use it as a bucket into which they throw any securities they find hard to value and then make an educated guess at the price. Among Wall Street firms, the soaring amounts of Level 3 securities now exceed their shareholder equity.

In other words, banks got into this problem in the first place by acquiring assets that were difficult to value. And not to be annoying or coy or whatever about it, but how exactly do Weidner and the analysts he’s speaking to propose that the financial firms place a value on these oh-so-difficult-to-value assets? The imaginary conversation goes something like this:

Goldman Sachs: Dammit, we’ve bought all these CDOs and all this paper, but we don’t know what it’s really worth. Let’s just dump it in the Level 3 bucket.

Analysts: Ok.

[Bear Stearns breaks ranks, confesses to bingeing on Level 3 assets. Markets freak out, XLF drops like a rock.]

Analysts: WTF guys, your not knowing what these assets are worth is freaking everybody out!

Goldman: Like we said, we don’t know what it’s all worth. Nobody does.

Analysts: Tell us what your stuff is worth!!!

Not a productive way forward. Again, the real Catch-22 of it all is this: even if the big banks attempt some really big writedown of all their mysterious assets, the inscrutable nature of the assets means no one will ever have any good reason to believe any specific valuation. If Morgan Stanley says some L3 asset that was originally valued at $2M is actually only worth $1M, why shouldn’t we assume that that asset is really only worth $500k? Once you start dealing in unknown quantities, it’s not like you can suddenly announce some arbitrary number and expect everyone to believe you.

Bottom-feeding -fishing value investors and others will probably see to it that the financials don’t actually take the further hits they deserve, and hey, we’re not wishing for a bear market or anything. But without some painful and serious - really, really serious - bloodletting on the part of the banks, it’s not clear how or why any average investor should have confidence in them.

Something downright Kafkaesque about this whole situation…

Just came across a good post from The Options Insider founder Mark Longo about the advantages of using options on the S&P 500 ETF (SPY) instead of the traditional SPX options.

We’ve written about the advantages of ETFs over traditional index options many times before (see our trading rules), but Longo makes a great case for the specific reasons why SPY is a superior choice for most investors. Some people probably don’t know, for instance, that if you want to trade SPX options, you’re limited to one exchange, the CBOE. By contrast, SPY options are licensed for trading on all six options exchanges. Another important difference is that while the SPY options are electronically traded, there’s still a big open-outcry element to the SPX products. Now, we like market makers as much as the next guy (however much that is), but given the choice between a dispassionate, egalitarian server in an air-conditioned room somewhere and a stressed, possibly hungry, probably sweaty market making human on an exchange floor in Chicago, we prefer to route our trades to the former.

Advantages of the SPY options over the SPX options:

1. tighter spreads - smaller strikes mean narrower spreads, and penny pricing certainly helps
2. faster fills - computers are faster than humans. Deal with it.
3. competitive volume - not exactly a comparative advantage, but you’re certainly not disadvantaged from a volume/open interest standpoint these days if you want to trade the ETF options
4. better risk management - smaller strikes also mean you can slice and dice your risk with more precision than before, and you don’t have to put on a large position if you just want to hedge an existing position

Lastly, if you have no idea what the graphic above is talking about, see here.