The market was flat/down today, discouraged by the news that a certain Presidential candidate would, if elected, “veto every single beer.” Just a gaffe, sure, but did you know that if you drink Magic Hat (pictured) then the terrorists will win?

You mean Vermont separatists aren’t terrorists? Whatever. All I know is that they have beards and don’t like Toby Keith. Close enough.

The other Presidential candidate has the power to decimate entire industries, just by being. The old journalistic fallback, “Markets sell off due to the continued existence of Democratic politicians” just won’t die, even though the the inverse has been proven. On the other hand, if we dispensed with that particular myth, what would Larry Kudlow have to talk about every day?

Interesting Reading

Felix Salmon tells BusinessWeek what’s what when they try to tackle the question of skylines and good architecture. Do go read his post. The short version? Dissing “Old Europe” and gawking at grounded glass projectiles does not count as cogent urbanist analysis. In BusinessWeek’s defense, they are writing for an American audience. So perhaps, instead, they should be praised for not writing a paean to the inspired subtlety of our shopping malls and Wal-Marts.

Zero Beta has a great survey of the participants in this new round of Asian Flu.

Fed funds futures are pricing in a 50bp rate hike by October.

VIX and More shows why, right now, Lehman Brothers (LEH) may be a better proxy for fear than the VIX itself. (P.S. Remember those LEH plays we wrote up last week? They’ve gone swimmingly, and we’ll do a followup in the next week or two.)

Newsletter portfolio status update

We entered our first July position today, details here. Our remaining June positions are in fantastic shape.  We’re happy to see some increased volatility back in these markets; it’s too dang hard scalping dimes when you just know a volatility pop is coming.

We’ve had to adjust each of our three Calendar Options trades for June, and several readers have asked how we determine when to adjust a calendar spread. The basic answer is pretty straightforward, but first, let’s consider the question of why we adjust Calendar Options positions, when we’re always warning about the risks of adjusting iron condors.

When we construct our iron condor trades, we typically choose short strikes that are about one standard deviation away from the current price of the underlying; therefore, the probability of being in the money at expiration is only about 30%. However, the probability of being in the money at some point during the life of the trade is close to 60%. This means it’s more likely than not that we’ll be tempted to make an adjustment. But because the odds favor an out-of-the-money expiration, the adjustment usually turns out to be unnecessary.

A calendar spread, on the other hand, has a much lower probability of expiring with a profit if we just leave it alone. For a typical at-the-money calendar spread, the break-even points are only about ½ standard deviation from the strike, and the odds that the underlying price will end up between the break-even points at expiration are only about 30% to 35%. (In the figure at the left, the two vertical dotted lines closest to the center mark the break-even points; the outer vertical lines are at ±1 standard deviation from the center.) So why would we even want to enter such a trade? Two reasons: Risk/reward and adjustments.

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It was a Fed day classic. Punters buy, buy, buy just before and immediately after the release of the FOMC policy statement, hoping for some kind of surprise (or surprise reaction) that will spark a rally. Then when the smoke clears to reveal that nothing at all has changed - except that the market is still overbought - buyers disappear like ghosts, and Kenny Rogers knows when to run. Lessons to be learned? You bet.

If you just can’t help yourself and simply have to play the Fed trade, remember:

• Whatever happens in the few minutes after the statement comes out is usually just noise. You might be able to profit from it, but you have to be a fast trader.
• Don’t trust the initial reaction. Once traders make up their minds about which way the market is going to move, they’re as likely to be wrong about the longer-term direction as they are to be right. As we saw today, the reaction offered a nice chance to bag a profit with puts on SPY or QQQQ - but it probably isn’t a good idea to hold the bulk of your position overnight.

Bottom line: It takes at least a day or two for the market to digest any Fed monetary-policy statement, especially in the current highly charged atmosphere of tension between inflation and recession-plus-liquidity-squeeze. By Friday, we might have a chance of knowing where the market really is headed post-Fed.

If you’re not already in a pretty delta-neutral place, think about balancing things out tomorrow ahead of the 2:15 fireworks. We closed out one of our newsletter positions today for a small loss so that we can ride through the rest of May expiration with less risk and little concern about the magnitude of any market reactions.

We won’t do the reversal readings tonight, suffice to say that (with the exception of the QQQQs) the indexes have worked off their previous short-term overbought conditions, relieving the pressure by way of time rather than price. Still, if you have a bullish perspective there remain some points of concern. VIX and More has some great material on possible market complacency here, while the Ticker Sense folks remark that when the indexes and so many major sectors are sitting right at or above the tops of their trading envelopes, it might pay to be cautious.

This week should be pretty volatile, with plenty of government data, earnings announcements, and Fed action to push markets to and fro. Many traders are paying special attention to the GDP announcement Wednesday morning and the FOMC news later that afternoon. As is our wont, we advise taking off some risk ahead of Fed meetings.

Markets were very quiet until the last forty-five minutes today, trading on very light volume, and the S&P 500 emini futures weren’t able to break above the 1404 level. Some higher volume selling pushed the Dow and the SPX into negative territory into the close.

Citigroup must have updated the methodology for their panic/euphoria model, as cited regularly in Barron’s. We know this because - as you can see from the chart at left - even at the absolute peak of exuberance back in October 2007, the model gave an official reading of “0″, meaning sentiment was neither euphoric nor panicked. Those of us who were alive and trading during those halcyon days might remember things somewhat differently.

In any case, that same panic/euphoria model registered a reading above 0.3 over the weekend, which must be the highest on record, and only makes sense if you assume that some new methodology has been put in place. We’ll reset our expectations about this metric, and see whether it provides any useful indications going forward.

Speaking of Citigroup: David Gaffen at the WSJ MarketBeat blog has a good piece on why the rally in banking stocks may have overextended itself.

Reversal Readings

Overbought readings persist.

SPY & IWM - above 97
XLV - Health care - 98
XLF - Financials - 95
EWA - Australia - 9
IYR - Real estate - 98
IBB - Biotech - 97
XLI - Industrial - 96
XLY - Consumer discretionary - 96
PHO - Water - 98
IYT - Transports - 98
EWW - Mexico - 1.71