Markets showed some strength today, although not nearly as much as some were expecting. The Dow hit an intraday high of 12,326 (up 100+ points) but each intraday rally was consistently met with selling pressure. The conventional wisdom is that this was largely end-of-the-quarter “window dressing” by the institutions. Kind of an ugly window, no matter which curtains you put up: the major indexes are still all off 9% or more YTD.

We closed one of our April iron condors for a nice 11% gain, and we still have two other trades open for April, both of which are in excellent shape. This uncertain and oscillating market environment, while unpleasant for the buy-and-hold crowd, is ideal for option sellers.

Reversal Readings

We’re adding a new feature to our periodic market commentary posts, called “Reversal Readings”. A lot of readers ask for updates on the relative strength of various sectors, so in the future we’ll include notes on ETFs for the major indexes and sectors that are showing strong short term overbought or oversold conditions. This is just one indicator among many, but our goal with this feature is to give you a tool for looking at short-term trading opportunities based on mean-reversion tendencies.

At the close today, we’ve flagged the following names:

XLV - Healthcare - 9.3
XLB - Materials - 10
GLD - Gold - 3.65

These are the relative strength index (RSI) readings for the equities listed. Typically, a 2-period RSI reading above 95 or below 5 indicates a high probability of a reversal in the following trading session or sessions. We list any readings above 90 or below 10 for your information. More to come on this feature in future posts.

By the first half of 2006, before the Federal Reserve had even stopped raising interest rates, economists were beginning to recognize where things could very well be headed: monetary policy easing, forced by a slowing economy and tightening credit, would both put downward pressure on the dollar (which already had resumed its decline by the end of 2005) and cause yields on U.S. Treasury bonds to plummet. The inflation risk was obvious to any educated consumer watching the news, but what some economists and analysts were also starting to consider was the possibility of a U.S. dollar end-game - foreign governments and institutions unwinding their dollar investments. The majority of experts dismissed the idea, arguing that investors couldn’t shun the dollar, because they’d be shooting themselves in the foot by causing their huge dollar-denominated holdings to lose even more value.

Fast-forward to this week. Despite sporadic reports that China was cutting back investment of its foreign reserves in U.S. Treasuries and other dollar-denominated assets, the media had pretty much lost interest in the story and was keeping its myopic focus on the housing crisis, the credit crunch, and the Bear Stearns failure. Then on Wednesday, an article in the Financial Times confirmed that migration of foreign funds out of the dollar is real and spreading.

The Times reported that South Korea’s National Pension Service - the fifth largest pension fund in the world - “will no longer buy U.S. Treasuries because yields are too low.” The story quotes an NPS spokesperson:

“It is difficult to buy more US Treasuries because the portion of our Treasury investment is already too big and Treasury yields have fallen a lot,” said Kwag Dae-hwan, head of global investments at the NPS. “We need to diversify our portfolio away from US Treasuries and we find asset-backed securities and corporate debt more attractive because of wider credit spreads.”

This is a very big fund, but surely one institution in one country does not a trend make. True. But the very next day, another Financial Times story revealed that Chinese exporters are moving away from the dollar:

According to Alibaba.com, the online company that matches Chinese suppliers with international buyers, the vast majority of their almost 700,000 Chinese suppliers no longer use dollars to settle non-US transactions to minimise foreign exchange risk.

“They are moving to euros, pounds, Australian dollars or even quoting prices in renminbi,” David Wei, chief executive, told the Financial Times. Moreover, he added, prices quoted in dollars were now often valid for just seven days compared with the 30-60 days common previously.

And there also was this item from Bloomberg earlier in the week:

Asian Central Banks Look to Invest Reserves in Region

By Arijit Ghosh and Aloysius Unditu

March 24 (Bloomberg) — Central banks from 16 Asian nations may invest more of their $1 trillion of foreign reserves in the region’s debt as Federal Reserve interest-rate cuts reduce returns on U.S. assets.

“This is something that most of us, that are not yet investing in, will be looking at,” Bangko Sentral ng Pilipinas Governor Amando Tetangco said in a March 23 interview in Jakarta. There can be “some kind of shift” to Asian sovereign bonds, Central Bank of Sri Lanka Governor Ajith Nivard Cabraal said in a separate interview on March 22, after a weekend meeting of policy makers from the region.

What happens if this trend continues? A sell-off in U.S. Treasuries would cause market interest rates to rise, despite whatever the Federal Funds target rate may be. Rising interest rates would make it tough for the economy to start growing again. At that point, all those assurances we were given that the recession would be “short and shallow” would fly out the window.

Quick review tonight: the markets have moved well off the overbought levels we noted a few days ago, and are now actually approaching relative strength levels conducive to a short-term bounce or pause. Volume has continued to be unimpressive. Perhaps more interesting is the fact that volatility has just drifted lower along with this modest selling, which typically doesn’t occur.

Our April positions are all showing significant profits at the moment, and a few more favorable days of trading may have us itching to take some profits off the table. We expect to see some buying into the March close, and this current indecisive state should be resolved by next Tuesday or Wednesday at the latest. If the markets move down, we’ll be sitting pretty; if this small rally resumes, we may have a nice opportunity to put on a small April or possibly a May position.

If you’ve ever wanted to use a straddle (buy a put and a call at the same strike) to take advantage of an earnings-driven price move, you’ve probably learned that once you get within a few weeks of the earnings announcement, the at-the-money options are so expensive that a move big enough to cover the cost of all that premium seems rather unlikely. What smart straddle buyers are doing is setting up their positions weeks before a company’s earnings announcement is even on your radar, then when you do get the idea to make the play (or go with a directional bet, buying just the puts or calls), they’re happy to sell you their options at ridiculously inflated prices.

Here’s an idea for getting in on the game early enough, we hope, to make a profit. Hewlett-Packard (HPQ) has scheduled its next earnings release for May 15. According to IVolatility.com, HPQ options have an established track record of implied volatility rising 30% or more going into earnings. As of this writing, you can pick up the the May 47.50 calls for about $2.25; the May 47.50 puts are selling for about $2.75 - so the net debit for the straddle would be $5.

If all goes as planned, buyers will drive up the price of our options once they start thinking about that looming May 15 announcement. As implied volatility peaks a day or two before the 15th, we would, ideally, close the position for a profit.

But have no illusions, folks - this is a speculative trade. If the IV of our HPQ options hasn’t changed by the time May rolls around, we’ll probably have lost 50% of our premium. Also, we’ll need to trade stock around this position in order to stay delta-neutral (on moves of $1 or more in either direction). Considering the risk and the effort, we strongly suggest that you use this idea just for an entertaining paper-trade - or at least analyze the risk and reward potential thoroughly yourself before putting any of your hard-earned cash on the line.

Not much action today. The consumer confidence index fell to a five-year low, consistent with the notion that everyone is now well aware of the recession.

The RSI(2) numbers on the majors:
DIA - 79
SPY - 91
QQQQ - 95
IWM - 94
EEM - 92
XLE - 84
XLF - 61
FXI - 95
EWZ - 92
XLV - 88
XLB - 92
EWA - 89

As you can see, today’s sideways action didn’t do much to digest these short-term overbought readings; on the other hand, underlyings can push right up to 100 before turning back down. Volume has been consistently drifting lower since March 14 and was lower again today. The volatility indexes ticked lower and are all now below their 50DMAs. If we had to guess we’d look for some action tomorrow morning, as we get reports on durable orders for Feb., new home sales for Feb., and crude inventories all by 10:30. After that, it’s anybody’s guess, although we’re looking for some selling by Thursday/Friday.

We sent two bonus trades this morning to subscribers, on RTH and IYR. The IYR position is a calendar spread, but is already up $0.10. The RTH position is up $0.15, for a one-day return of 3.5% on capital risked.