Option Traders – Scale Into Short Positions On a Failed Rally.

March 11, 2008
Author: Peter Stolcers, Founder of OneOption

Yesterday, the looked horrible. Rumors of a huge write-down at Bear Stearns crushed the stock and drag down other financials. The company quickly issued a statement to refute those claims, but the selling pressure has not abated. Traders are waiting for another financial failure and they expect a big one. This morning, Thornburg raised its expected write-down to almost $700 million. That is a 50% increase from a week ago. That’s how quickly things are changing. Traders smell blood and they are selling everything in sight. Investors are panicking and they are pulling funds out of equities at a rate of $2 billion a week. Before the open, the Fed announced a new temporary lending program that will allow bond market participants to swap mortgage backed securities that they can't currently sell. Primary dealers are able to pledge less liquid AAA rated mortgages in exchange for very liquid Treasuries. I have heard some analysts refer to this as a mortgage bailout program. I disagree. The Fed is simply resolving the liquidity crisis. It is not assuming any mortgage related risk. After a 28-day period, the securities are swapped back. If the loan defaults, that liability will be assumed by the financial institution, not the Fed. This program is substantial and it provides more than $400 billion in Treasuries. Companies like Thornburg Mortgage and Carlyle Capital Corp. will benefit. However, this is a temporary loan and it does not address the bigger problem. The economy is deteriorating and the unemployment rate is on the rise. Foreclosure rates on all loans came in at 2% last quarter, the highest rate since 1985. Payment delinquencies are up to 6% on all mortgage loans and they have also been rising at a fast pace. Meanwhile, home prices continue to decline. Many people will simply decide to walk away from their homes when they have negative equity. The largest number mortgages convert to ARMS in July and that will put additional strain on homeowners and lenders. The Fed is throwing the kitchen sink at the problem, but it won't change the fact that people own more home than they can afford. Yesterday, I spoke of the dangers associated with a bear market rally. This is exactly why I instructed subscribers to trade small size. These rallies can be fast and furious and the moves are larger than anyone expects because of short covering. Today's rally is already losing steam and it is a much better shorting opportunity than the one we had yesterday. I believe this market is a short and the SPY 125 level will fail. Restaurants, healthcare, financials and publishers make up my favorite plays. Use today's high as your stop. This market feels like it will close lower today. image

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