Sometimes, we get so inundated by economic data, trading indicators, and market commentary, it’s hard to get a sense of what the market looks like from an external perspective. What does the “man on the street” really think?

For some fresh perspective, we’ll turn to Matthew Yglesias, who is more of a “man in the chair” blogger-journalist, really, but who gives a succinct take on things (and, incidentally, is pretty fantastic if you’re looking for some straightforward political commentary):

Economy Party!

Man, I sure am glad all our economic problems are solved now that new home sales are slightly up (though still way below where they used to be) on falling prices. It’s a new day in America! These are some seriously bizarre times. [link]

We’ll also note this longish piece from the Economist, which blames the current financial crisis on overly cheap credit, insufficient risk management, and inadequate regulation. All of which have been obvious for awhile; but again, it’s not clear how some increased liquidity and opaque housing numbers are sufficient evidence that the worst is over.

Lastly: one of the big fundamental stories driving some China stocks is that the Olympics are coming. Think of CTRP (ctrip.com), a Chinese Expedia of sorts. Hypothetically, what would it take to unwind that story? China obviously is staking quite a lot on the Olympics in their attempt to show the world how modern and powerful they are. But what if this Tibet thing really blows up, and a critical mass of countries start a real boycott? It could be a disaster for their markets, precisely because so many investors may have already priced those Olympics earnings into the related stocks.

Cynics might suggest that Western democracies only care about human rights when those rights aren’t an inconvenience. And those cynics would be entirely correct. But boycotting the Olympics because of “human rights abuses” is precisely the kind of empty symbolic gesture that, if you’re a hypocritical Western power looking for an edge, you absolutely want to make, because it costs you nothing economically, could do serious damage to a rising rival power, and may be net beneficial for your reputation, especially if you’re not the U.S. This isn’t a prediction exactly, but it would be ideal for American interests (in a very crass and selfish sense) if some small and morally uncompromised European countries led the charge, and then were joined by Britain, Germany, and Russia, providing “hypocrisy cover” for the U.S. to later join the boycott. But maybe U.S. participation isn’t needed. In any case, it’s interesting to speculate on whether (or how much of) an “expectation premium” is priced into Chinese stocks.

One thing to remember during big market swings like this is that the probability that an underlying will touch a particular OTM option strike is always higher than the probability that that option will expire in the money. In other words, the odds of an underlying pushing up against your breakeven point (assuming you’re selling OTM credit spreads) will always be higher than the odds that you’ll have a losing trade. So if you jump ship every time the waters get a bit choppy, well, that’s a really easy way to drown.

Sentiment in the media and the blogosphere seems to have shifted bullish, as everyone seems to be convinced that the double bottom is in and happy days are here again. (Barry notes some of the bottom-callers.) We’re not so sure that a couple of news-driven rallies and a Fed gift to JPM is enough to dispel all the troubles that we were all so concerned about in January and February.

We may add another April position to take advantage of this bullish movement since last week; however, we also want to see some confirmation - so on the SPX, we’d like to see a move up to the 1380-1390 level. Although the rally today showed stronger internals than the action we saw last week, there are reasons to be cautious:

• We are in a recession.
• The housing data released today shouldn’t have been party-inducing. As Calculated Risk notes, your dancing shoes really should stay in the closet until at least the March existing home sales numbers are released.
• Major indexes are quickly approaching short term overbought status, as measured by RSI(2). DIA, SPY, QQQQ, and IWM are all showing readings near or above 90.
• Nice fib retracement today to the 38% level - see SPX, for example.
• All of the volatility indexes (VIX RVX VXD QQV VXV) at or below their 50MAs.
• The financials, which have been so key to the market action recently, are also short term overbought and may have put in a topping tail today. See GS chart at right, though the same basic story is playing out in C MER LEH JPM et al.
• Volume today? Decidedly uninspiring.

A couple people vehemently disagreed with our post suggesting a cautious entry into gold this week. Maybe they’re right: maybe the commodity boom is over, maybe the housing troubles and liquidity problems are a thing of the past, and maybe the Fed is going to start getting tough on inflation at the next meeting and will start raising rates. And maybe Mount St Mary’s will beat UNC tonight and go all the way to the finals. But at least a few others also see a chance to start small in gold here. [Mark Hulbert, Peter McGuire]

Roger Ehrenberg at Information Arbitrage is skeptical of all those cheering the Fed:

I mean, a snap-back in the wake of hundreds of billions of Fed intervention was not particularly surprising, no? But read some headlines today and it is as if the Fed and Bernanke have won. Won what? A three-day reprieve from a long-term problem that is necessarily exacerbated by the Fed’s historic injection of liquidity to avert crisis? I mean come on. Can’t we even wait a few months before knighting Sir Ben and anointing him “Slayer of the Evil Commodities Bubble?”

Andy Swan of Mytrade (which includes us in their options section - awesome!) has started posting about the iron condors he’s trading, calling it a “Be the House” strategy. This is exactly right: the two best metaphors for trading iron condors have always been the casino and the insurance company. But the reason we really appreciate Andy’s post is that he takes the small-and-steady approach to position management:

And…this position is just getting started….I’ll end up with 8-10x this position by expiration day. 2-3 times per week I will add to the position by putting on a new vertical spread on the high or low side (depending on which way the markets are moving that day), slowly moving closer and closer to the live price of SPY over the next 3 weeks. For example, today I might sell options that are $7 or $8 out of the money, but next week I’ll be selling options $5 or $6 out, all the way up to expiration week where I will likely be putting on trades that are merely a buck or two out of the money.

After the big market swing in January, several people started asking why we don’t use hard stops in our trades. The answer is that iron condors already have hard stops built in, since they’re defined-risk positions. Andy gets this point right, too:

Despite ALL of that insanity, this position was profitable by being market neutral and taking advantage of premium-decay of the out-of-the-money options that we sold.

On the other hand, huge numbers of traders saw all of their directional positions STOPPED OUT FOR LOSSES during the violent swings up and down. That’s the problem with stops….they hit.

Instead, we sell premium and establish positions with a DEFINED RISK and therefore need NO STOP whatsoever. We can sleep at night because we know that the worst case scenario is already defined and acceptable to us!

In other words, you should ask whether you’re comfortable with the worst case scenario for any given trade. If you’re not, then that’s a crystal-clear signal that you’re over-allocating capital, and should consider diversifying across more trades, more strike prices, multiple months, multiple underlyings, etc. etc.

Reader Tony L. asks about the plethora of names for option spreads out there:

I’m not a novice trader, and I’ve read a few books on options. But to be honest it’s hard to keep track of all the different kinds of spreads out there, especially when you start doing trades with three or more legs. I mean I know the terminology: verticals, diagonals, butterflies, iron condors, double diagonals, calendars, etc. But how to keep them all straight in my head; how do I know what spreads to use, and when? Thanks.

Great question: especially when you’re first getting started in options, it can be daunting to have to learn what all those spreads are. It seems like homework - and is definitely more complicated than flipping stocks, right? Compare: you have a stock, and you can buy it or sell it. Or you have an underlying stock or index or commodity, and you can trade any number of spreads on that underlying, and you can sell the spread to open, or buy the spread to open, and you have to choose an expiration cycle, and…

But it needn’t be so complicated, once you realize that trading option spreads is all about managing risk. And when it comes to risk-defined options spreads, there are actually only two types of spreads, from which all other traditional spreads can be constructed. They are:

• Calendar spreads - in which you are long (short) one option that expires in a nearer month, and short (long) another option that expires in a farther month.
• Vertical spreads - in which you are long (short) one option that is closer to the underlying price, and short (long) another option that is farther from the underlying price, where both options expire in the same month.

Can we really explain all those other complex spreads in terms of these two simple constituents? Let’s find out:

• Diagonal spread - is just a vertical spread plus a calendar spread, where one of the vertical options overlaps with one of the calendar options. Example: put together a long SPY May 134/135 call vertical, plus a short SPY May/June 135 call calendar, and you get a short SPY May/June 134/135 call diagonal.
• Iron condor - is just two short verticals (a short vertical call spread and a short vertical put spread) stuck together.
• Butterfly - a butterfly is just a long vertical plus a higher or lower short vertical.
• Double diagonal - is just what it sounds like :)

Brain teaser: what about straddles and strangles?

Member Frank C. submits the following:

The geniuses in the business press attributed today’s gains to anything from lower interest rates to the Philly Fed manufacturing survey not being quite as bad as expected. But at the same time, jobless claims rose to 378,000–18,000 more than expected. Why lower interest rates were suddenly a sign that happy days are here again, when only the day before the market clearly judged that the Fed’s 75-bps easing wasn’t going to solve the finance industry’s problems overnight, and why a report that begins, “Activity in the [Mid-Atlantic] region’s manufacturing sector showed continued weakness this month,” plus 378,000 pink slips, are signs that the economy isn’t as bad as previously thought…well, let’s just say that we’re dubious.

Maybe we’re due for a real rally after all: News that big investment banks are starting to take advantage of the Fed’s new lending program certainly was a relief to a lot of traders, as was an analyst upgrade of Fannie and Freddie. But another, exceedingly fleeting, factor had something to do with today’s big rally as well: options expiration. During the last trading day before expiration, market makers have to adjust their hedges to cover their short calls and puts. This leads to a phenomenon known as “strike peg”.

Strike peg refers to the tendency for equity prices to move towards the strike prices with the highest open interest at expiration. The idea is that it’s in market makers’ interest for the underlying to trade at a price that minimizes their cost of satisfying their obligations to holders of their short in-the-money options. A market maker can’t move a stock to a desired price on his own, but the activity of all the market makers trading into the final hours before expiration to cover those obligations can be a significant force.

Let’s look at where the open interest was in a few issues today. Index options have the most influence on the market, but they stopped trading Wednesday afternoon–so we’ll look at the index ETFs instead: Open interest in SPY March puts and calls was centered between 132 and 133; in QQQQ, the majority of open interest averaged out between the 43 and 44 strikes. SPY closed the day at 132.08, and QQQQ ended up at 43.09–strike peg.

Since the big investment banks were given a lot of credit for today’s sharp rally, it’s worth examining where the open interest lay in a few of those stocks. For Citigroup, it was clustered in the 22.50 to 27 range; outstanding contracts on Merrill and Amex both peaked at the 45 strike. In each case, the open interest lay well above where these stocks opened the day, and thus created an incentive for market makers to drive their prices up.

Although strike peg has only a temporary influence, at the last minute it can blow up credit spreads you thought were going to expire out of the money. This is yet another reason why we close out our iron condor positions at least a few days before expiration.