Wednesday’s Stock Option Trading Strategy!

January 23, 2008

The did not capitulate yesterday and we are testing Tuesday’s lows. Use the last hour as your guide.

This market can be described using one word – fear. Yesterday, prices plunged before the open in response to a 10% drop in overseas markets. Fear that a US economic slow down would spread globally encouraged traders to head for the exits.

The Fed followed through on promises made last Thursday. In dramatic fashion, they lowered the Fed Funds Rate by .75%. Mind you, we did not even see a move of this magnitude after 9/11. The market had a muted response initially, but throughout the day prices firmed.

In overnight trading, Europe dropped 5% and Asia rallied. The ECB is steadfast in their interest rate policy and only one of nine members voted to cut rates. This is putting pressure on the European stock markets.

In early trading, the market has tested yesterday’s low and so far it has been able to bounce above that level. As always, the last hour of trading will tell us where we go from here. If the market closes in positive territory, I believe that we could see a nice snap back rally. I have outlined 2 potential targets in today’s chart. If the market closes near its low, we have not found the bottom and additional weakness lies ahead.

Money is rotating out of the strong sectors and into the weak sectors. The four horsemen (AAPL, GOOG, RIMM, AMZN) and commodity stocks are getting nailed. Financials, retail and homebuilders are rallying. I would not trust the rally in these sectors long-term. Once the commodity stocks bottom out, they will present a good long-term buying opportunity.

Panic selling creates margin calls. I believe the rotation out of market leaders has been caused by margin calls on leveraged accounts. Excessive leverage by hedge funds could create another huge round of selling. The credit markets are already very tight and margin is a form of credit. If brokerage firms have been increasing margin requirements since last March’s decline, then this may not be a big problem at this juncture.

On a fundamental basis, stocks are cheap even with lowered earnings growth. Corporate balance sheets have never been stronger and they will use some of their cash to buy back shares. As interest rates decline, the risk/reward ratio improves for equities.

We will continue to get more earnings this week and there aren’t any substantial economic releases. Those are both positives of the market. Next week, all eyes will be fixed on the FOMC’s statements. Another .5% rate cut is factored into prices. It doesn’t seem to matter what the Fed does, the market takes issue with the action. At this juncture, I believe the easing is meant to address credit issues. The stimulus that results from lower interest rates won’t help the current situation since it takes at least a year for this policy to bear fruit.

The bears are firmly in control and earnings are the only potential bright spot.

Take your lead from the market’s close today.
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January 22, 2008

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