On a day like this, you really need to start off any post with some good news.  Apparently, one of the greatest television shows of our time might be made into a movie: we’re talking about Arrested Development.  So you see, there is hope for this country after all.  (Nevermind that we’re all so scared of the boogeyman that the government will be warrantlessly watching the movie over our shoulders; that’s a matter for another day.)

Okay, now to the issue at hand.  Markets gapped down at the open and never looked back, closing at the lows on higher volume.  Severe technical damage has been done to the indexes on a short and long term basis.  Key support levels from March 07, January 08, and March 08 should have held the selling in check, but the bears blew right through those lows.  This was a high volume, high intensity day in which no buyers ever really stepped up.  We kept hearing things throughout the day like, “Where are all the value investors?”  Off acting like Milford men, that’s where.

Before the open this morning, we sent a note to subscribers describing why we were still in full bearish mode:

Our opinion is still that we are in the midst of a bear market and that any rallies will be short-lived and indecisive.  Some market commentators (especially in the rah-rah corporate media) have been calling for another rally like the one we saw off the March lows.  The primary reason we reject this view is that the sectors that provided leadership during the March rally (tech, transports, energy) now appear overextended - or at least weakened - and we haven’t seen any new leaders emerge…

More importantly, we said that this was as good a time as any to tighten up those allocations and double-check your risk tolerance:

One other important point here is that this is a good time to double-check the allocations you’re working with.  This applies not just to our newsletter trades, but to your whole portfolio.  Revisit each open position, and ask yourself whether you would be comfortable if you ended up exiting that individual position for a 50% or even a 100% loss.  If the answer is no, then dial down your allocation.

Today was a perfect example of why we prefer to trade spreads on ETF options instead of the traditional big index products.  SPY quoted contracts a few pennies apart today, which is typical, while you could catch similar SPX strikes at a dollar and a half wide or more.  Good luck getting a fast and fair exit in the SPX pit on a day like today.

Where do we go from here?

The first thing to say is that action like this is not to be blown off - even if we bounce up 200 Dow points over the next couple trading days, that wouldn’t negate the horrible market internals and total lack of support we’re seeing now.  That said, here are some factors that may favor a snapback sooner rather than later:

• $SPXA50R - the percentage of S&P 500 stocks above their 50 day moving average has been a helpful tool in the past for discerning market tops and bottoms.  Over the past four years, on the five occasions when this indicator has been at 20 or below, the S&P 500 has been significantly higher in the weeks following.  Now that it is fashionable once again to disparage technical analysis, we’ll note that this particular indicator is actually quasi-fundamental: when too many high quality stocks are irrationally sold off, value-chasing buyers invariably step in to snap them up, and that tide lifts even the less seaworthy boats.  Click on the chart for a full view.
• RSI(14) - this is the old standby, the 14 period Relative Strength Index.  Going back to 1999, there are only about 15 occasions when the RSI(14) has fallen to 30 on the SPX daily chart.  When that happens, the index is almost invariably higher the following week(s).  One interesting, if unsettling caveat is the fact even a slow-moving indicator like this can get oversold and stay oversold through a pretty nasty fall, as happened twice in 2001 and once in 2002.  Even so, unless we’re in the middle of a slow motion market crash, the odds still seem to favor some moderation in the near future.
• $VIX - normally, this is the part where we comment on some beautiful VIX spike and how investor fear has gotten really overblown. But the story here is actually the relative complacency in implied volatility.  Not sure exactly what’s going on there, expect that in all likelihood the smart money has been putting on robust hedges for weeks now.  This is also a data point in favor of not using VIX options as a proxy for regular index price movement - there’s absolutely no guarantee of any 1:1 relationship.  But anyway, what do we make of the conventional wisdom that you can’t get a market bottom without a VIX spike?  Who knows?  (Well, our future selves of 3-4 weeks from now know, that’s who.)

One last thing.  If your portfolio got hammered today and you’re looking to rebalance, don’t kill all of the positive theta trades you have going by throwing in the towel and loading up on expensive puts.  If you want to get in on this trend, sell some OTM index call spreads; if you’re an uber-contrarian, sell some not-so-OTM put spreads.

The July cycle so far has largely been a waiting game for our Calendar Options strategy. We wanted to wait until we’d closed out at least some of our June positions before opening our first July calendar spread. Then came a nasty expiration day, followed by the period of uncertainty heading into the Fed’s two-day FOMC meeting.

Today we again find ourselves sitting on our hands. We’d planned to open a second July calendar spread this morning, after the dust had settled post-Fed, but we got a dust storm instead. Sometimes the best way to trade is not to trade.

Nevertheless, it would be nice to balance the 48 delta of our EEM July/Sept 140 put position with another trade that has zero or negative delta, so if things settle down tomorrow we’ll be looking to open a bearish-to-neutral July/August calendar spread. But if the sell-off continues, we’ll have to focus on managing our risk by adjusting our EEM position ahead of the weekend.

The clamor over whether “speculators” are driving oil’s parabolic run-up has become almost deafening, with the number of Congressional hearings on the subject reaching 40 this week and the price of oil dominating the nightly news. For every market analyst making the case for a speculative frenzy, the media have found an industry expert to argue that high oil prices are justified by the underlying supply–demand imbalance and weak dollar. If this sounds familiar, it might be because the scenario looked quite similar when the housing bubble came to a head.

Way back in 2005 when the Philadelphia Housing Index peaked. . .no, make that 2006 when it took a major hit. . .er, wait,. . .2007 when it fell 50% from its January high—the National Association of Realtors and the National Association of Homebuilders still refused to admit that current home prices were unsustainable. The real estate bubble was due partly to low mortgage rates, partly to speculation, and mostly to buyers’ fear that if they didn’t buy now, they’d have to pay more later—but it took months of housing declines before the “experts” would admit that things weren’t exactly hunky-dory.

Yet the future was crystal-clear to anyone looking at the chart on the left. The Japanese stock market in the late 1980s (black line) defined modern bubblology, and the tech bubble (blue line) carved out a paragon of the hyperbolic spike. By the time real estate (green) had traced the same vertiginous ascent, the writing was on the wall.

Now the price chart for oil (red) is looking eerily familiar. Ignore the fact that oil appears to be peaking at the same level as its predecessors—each plot is scaled to the vertical dimension of the chart—but note the rate of ascent over the past year. That vertical wall is the scarlet ‘B’ that flashes “bubble” in ten-foot neon lights.

One of the most credible arguments against the speculation theory comes from Daniel Yergen, “one of the nation’s best-known energy experts,” according to the New York Times. A Times article yesterday focusing on Mr. Yergen’s expected testimony before Congress summarizes his position as follows:

As the ninth hearing of the month gets under way on Wednesday, . . .Daniel Yergin, is expected to tell Congress that the focus on speculation is largely misguided.

Mr. Yergin will join numerous other energy experts who have declared that the rise in oil prices can be explained by basic economic factors, such as the limited growth in supplies in recent years, a weakening dollar, a global surge in energy demand and a string of production disruptions in countries like Nigeria.

Buy wait—there’s more:

Mr. Yergin said the market is relentlessly bidding up oil prices in response to deep-seated fears that the growth in demand will keep outpacing the growth in oil supplies in coming years.

“There is a shortage psychology in the financial markets and that is reflected in the price of oil,” Mr. Yergin said in the interview. “You are seeing a lot of people who have never invested in commodities who are now piling into the market. But calling it speculation is way too simplistic.”

Notice that Yergin doesn’t just overlook the bubbly nature of current oil prices—he actually confirms it, with phrases like “deep-seated fears” and “shortage psychology in the financial markets.” And he doesn’t even touch on forces like the automotive manufacturers’ fixed-price gasoline offers, which must be pumping a huge amount of money (temporarily) into the futures market as these companies hedge their incentives.

But it’s two additional developments that put us over the top. For contrarians, there’s the premier of the cable-TV reality show Black Gold. And for the politically focused, there’s the Republicans’ no-holds-barred drive for legislation permitting oil drilling in previously prohibited off-shore locations, including the Arctic National Wildlife Refuge—heedless of the fact that it would take ten years to have any impact, and that this impact would be minuscule.

Granted, there’s no way to know when the oil bubble will burst. Also granted that the fundamentals do support a certain price that’s above where consumers would like it to be. And yes, the dollar’s weakness is reflected in the price of oil. Unlike the Nikkei, tech, and housing, however, this bubble is likely to deflate only partly, before resuming its climb until alternatives displace oil as our primary energy sources

Position in United States Oil Fund (USO).

Reader S. V. raises an interesting question:

I am working on scenarios to trade the contra-ultra indexes like SDS to take advantage of either a combo spread (selling puts and buying call) or another method to take advantage of price movements while reducing risk.   Any thoughts?

Interesting idea.  These Ultrashort ETFs have really gained in popularity and most of them (like SDS, DXD, QID) now have enough volume to make them decent trading vehicles.  The actual stock, that is.  The options are another story.

1. A big difference here is the lack of volume.  In the case of SDS, the open interest in the July ATM puts is listed in the hundreds - not thousands - of contracts, versus open interest of 18,000 in the SPY ATM calls.  Where this really makes a difference, though, is on the side that anticipates a market sellof (SPY puts; SDS calls).  SPY puts usually have higher open interest, so it stands to reason that on an inverse index, you’ll have a lot more liquidity on the call side (since people typically only think of the inverse products for hedging purposes, whereas it’s natural to turn to a normal index for both long and short purposes).  In the SDS Julys, the call open interest is still only in the 2000-3000 range, which isn’t untradable, but isn’t compelling, either.
2. The spreads on these options are also a bit wider in the inverse products.  Why hassle with 0.15 or 0.20 spreads on these inverses when you can trade the index ETF options and thereby bask in the unrelenting glory that is penny pricing?  One of the lowest circles of market maker hell would have to be an open outcry SPY pit.
3. The inverse products don’t always behave as you might expect.  Adam over at the Daily Options Report did a whole series of good posts on this topic, and the gist is that because these products are designed to track the performance of their index on a daily basis, they’re not going to move in tandem over time.  So if you want to be short technology, buying QID isn’t necessarily going to give you the same outcome as if you just shorted QQQQ.
4. Which bring us to the biggest reason to avoid trading inverse product options: it’s a totally superfluous approach.  We’re kind of burying the lede here, but you can construct the same position with ordinary index ETFs options that you can using the inverse ETFs, and with none of the disadvantages that we’ve outlined above.

Let’s take S. V.’s example.  Say you’re long some stock in SPY as a core portfolio position, and you want to protect your downside.  Collaring your stock is a great way to do that, because each 1-lot position gets you short 100 deltas and carries almost no gamma, so the hedge is easy to size and you don’t have to worry about your hedge losing its potency if the underlying makes a dramatic move.  S.V. wants to put on a combo spread in SDS options, which entails selling puts and buying calls with the same strike prices in a 1:1 ratio.  No matter which strikes you use, that would get you long 100 deltas, which (since this is an inverse of SPY), is like being short 100 SPY deltas.

You can build the same position by selling calls and buying puts (again, with the same strikes, same month, on a 1:1 ratio) in SPY.  The liquidity should be better (making the hedge a touch cheaper), and the value of the position should move in direct inverse correlation to the movement of SPY.  The only reasons we can think of why someone might want to use options on an inverse product instead would be 1) to take advantage of the leverage built into the UltraShort ETFs, or 2) to construct a fancy arb of the disparate movement between the inverse product and its index.  But 2) is difficult and expensive, and not what S.V. was asking about.  And 1) doesn’t hold water here, since options are already leveraged, and it’s a lot easier to just use a few more options contracts than to risk underperformance or mismanagement in a leveraged fund.

The first month of Calendar Options trading was characterized by the high day-to-day price volatility typical of market transitions. As the late-March to mid-May bear-market rally came to an end, we were buffeted in the buying climax and the sharp selling that followed—but we still came out with an average profit of 6.59%, handily beating the market. (If you’re wondering how we come up with our dollar return and percent return figures, see Calendar Options: How We Calculate Returns.)

Performance comparison

Market performance for the past month:

• S&P 500: −7.54%
• Dow Jones Industrials: −8.81%
• Russell 2000: −2.09%
• S&P Covered Call Fund: −5.62%
• Calendar Options: 6.59%
  Note: The time period measured is from expiration to expiration.

June Calendar Spreads

• EEM June/Sept 140/150 Double-Calendar: 16.72% return – No sooner had we opened this trade than EEM took off on a 5% rally over four days, forcing an adjustment. The following Monday brought a dramatic reversal, and three weeks later EEM was nearly 10% off its climax high, when we had to unwind the first adjustment. A relief rally brought the position back to our 15% minimum profit target Monday before expiration.
• RTH June/July 95/100 Double-Calendar: –4.23% return – We opened with RTH in the middle of what looked like a developing trading range. We were right about the trading range, but two adjustments were triggered, by a false breakdown and then a false breakout. With our position on the ropes, we made a third adjustment to up our odds of recovering our loss. On Monday before expiration, we were able to close nearly all of our position for a 1.41% loss; but to get the remainder filled we had to lower our limit price later in the day, for a 7.04% loss. The –4.23% return above is the average of our two fills.
• IBM June/July 125 Calendar Spread: 7.28% return – IBM had its share of volatile swings as well. A sharp two-day rally, culminating in a breakout, triggered a first adjustment, and after a reversal and two 2+ standard-deviation down days, we needed to reduce our risk by adjusting again. With the market looking shaky and our gamma risk growing, we closed the position four days before expiration for a modest profit.

June Reading

Anyone interested in following the Calendar Options strategy should be sure not to miss these key posts:

• Introducing Calendar Options
• Calendar Options: Five Things You Need to Know About Calendar Spreads
• Calendar Options: Puts or Calls?
• We Get Letters: Calendar Options Position Sizing
• Adjustments, Part I – Why We Adjust
• Adjustments, Part II – When We Adjust
• Calendar Options: How We Calculate Returns
• Adjustments, Part III – How We Adjust

We opened one July calendar spread, on EEM, last week. Even though EEM lost $4.63 on Friday—twice the one-day standard deviation—we’re already showing a small (1.15%) profit. We plan to enter another position this week if volatility stays near its Friday range, or drops significantly.