Monday’s Stock Option Trading Strategy!

Tick, tick, tick... As traders say, we are "dead till the Fed". This morning’s rally is simply the bulls squeezing the “shorts” ahead of tomorrow's FOMC meeting. A .25% rate cut is expected and a small probability of a .5% rate cut has been priced into bond prices. The market will be anxious to find out when it will get its next "fix". The Fed’s rhetoric will be closely scrutinized and "dovish" statements will result in a rally. Conversely, "hawkish" statements will result in a sell-off. Given the weak dollar and inflationary concerns, I believe the Fed will hold its cards close to its vest, keeping its statements balanced. Consequently, I see a greater chance for a market sell-off than a rally. Weak economic numbers continue to surface and financial institutions are in dire need of capital. Huge write-downs continue, but the firms are able to line up capital. Today, UBS took a $10 billion write-down. However, they were able to secure capital from the Singapore government. MBI was also able to secure $1 billion from a private equity source. Typically, lower US interest rates result in lower LIBOR rates. LIBOR is the global benchmark for the cost of capital. A major concern is that our rates have come down, but the LIBOR rate has not. This means that the cost of capital is still high and that the Fed’s actions are having little impact. Interest rates and earnings drive the stock market. If lower interest rates are only having a marginal affect, earnings will need to drive the market to new highs. As we learned this quarter, the earnings growth rate continues to slow. We also discovered that it may be a long time before we know just how dire the current credit situation is. I doubt the market will mount a sustained rally without material participation from financial stocks since they comprise nearly a fifth of the S&P 500. Later this week we will year from LEH. They announced early in the earnings cycle and I believe that the last quarter excluded the September weakness experienced by most other financial firms. They may have also waited to see how progressively other firms wrote-down their assets. As a result, I am expecting a weak number. Retail sales, the PPI and the CPI could also weigh on the market once the rate cut euphoria wanes. Technically, the market is near heavy resistance at the all-time high and I believe there is a lid on this market. The option trading strategy during these conditions is to sell out of the money call credit spreads. For today, the momentum is to the upside. Under normal conditions I would advise you to stay long and ride the rally for the rest of the day. Ahead of tomorrow's announcement, it is possible that traders will lighten their longs after the recent rally and we could see the market pullback. I am not telling you to short this rally, I'm just telling you to use more caution and a place tighter stops than normal. Keep your positions small.

Daily Bulletin Continues...