Monday’s Stock Option Trading Strategy!

December 17, 2007
Author: Peter Stolcers, Founder of OneOption

Have you ever watched the hit TV show, "Deal or No Deal"? As long as the contestants have two large amounts showing, they continue to play aggressively. They know that even if they knock out one large amount, they will still walk away with a decent prize. As soon as one of the two large amounts is gone, the safety net has been removed and the risk increases dramatically. That's exactly where this market finds itself today. Over the past two months the market has been able to shoulder all of the weak economic and subprime news because it had rate cuts to fall back on. If the news was particularly bad, the market would price in another rate cut. Last week’s inflation numbers removed that safety net and the game has changed. The Fed is handcuffed and it will not lower interest rates when inflation is heating up. The PPI rose .4%, the biggest increase since February. Including food and energy, prices shot up 3.2% for the month (the biggest gain in 34 years). The CPI was up .8% and this time it wasn't just higher gasoline prices. Apparel, drugs, housing and airline fares also spiked. This marked the largest increase in consumer inflation in over 2 years. US economic conditions are deteriorating, inflation is rising, the Fed is handcuffed, financial institutions are taking enormous write-downs, the corporate earnings growth rate is slowing down, debt levels are high (Federal, State, municipal, personal) and unemployment is edging higher. This is not a bullish backdrop. This week, we will get a handful of economic numbers. They include the LEI, Philly Fed and core PCE. The next time we see a weak economic number, the market will have a negative reaction. The bulls have been stripped of their “bad news is good news” battle cry. That rationale only works when the Fed is in a position to ease and inflation will keep from lowering rates! This week will actually include some important earnings. Goldman Sachs, Morgan Stanley and Bear Stearns will set the tone for financial stocks. I believe the Goldman number could have a negative market impact. If it knocks the cover off the ball, it is because they shorted mortgage lenders, not because financial conditions are improving. The market is expecting a good number and they are the exception to the whole sector. On the other hand, if they miss expectations, they will get nailed. They have been the island of hope for those clinging on to a financial sector turnaround. Bear Stearns and Morgan Stanley will be much more representative of the industry. Since these companies announced early in the earnings cycle, they missed the September weakness reported by other financial institutions. Those losses will hit this quarter and I am expecting a weak round of results. Later in the week, Federal Express releases earnings. They will provide insight on overall economic activity. They already warned of weak conditions and rising costs. As I mentioned before, this time around, bad news will be bad. This release could have a bigger impact on the market than it does on the stock since it is already 18% off of its high. Year-end strength and strong corporate balance sheets might be enough to keep the market from tanking before year-end. From a technical standpoint, the market also feels like it is hanging on by its finger nails. Going into an election year, uncertainty has me believing that trouble lies ahead. Global markets traded lower overnight and that is pushing prices lower today. We are likely to test key support at SPY 146. If we close below it, that will be bearish. I need to temper my bearishness because the seasonal “Santa Clause Rally” starts at the end of the week. We might not see a rally, but this anomaly could support prices. I expect the market to try the downside early and hold. SPY 146 is a big level. The last hour of trading will hold the key. If we sell off, the weakness is likely to continue tomorrow. If we hold, the table might be set for a small rally. This is a pre-holiday/expiration week and choppy trading is likely. Keep your positions small and focus your option trading on selling OTM credit spreads. image

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