What a difference a day makes!

That was one hell of a bad one, showing us how skittish the markets still are and how easily investors can be chased out of the financials.  I misjudged investors in the morning, thinking surely they can’t possibly fall for the same old rumors about FRE and FNM for the second time in 30 days but I was wrong, FRE was chased back to the July 11th low of $4.39.  That was the day investors were also stampeded out of LEH, who hit a low of $12.40 that Monday and is still hovering around $15.

FRE had a choppy few days, then shot up to $11 on July 23rd after getting some verbal support from Paulson and Bernanke, which sparked the huge financial recovery but, in the great world of "what have you done for me lately" no news has become bad news as the hyenas who were driven off last time are coming back to poke at their prey. 

I want to take you back, back in time…  All the way back to July 11th, whenFRE had fallen from $25 to $4.39 in 30 days as GS, Cramer and they usual pack of hyenas went on the attack and stoked fear of holding the GSEs.  That day, Piper Jaffray came out with a note that said: "There has not been one significant piece of macroeconomic or company-specific news on either company to drive the decline," in Piper’s view.  "They believe FNM will likely not need new capital unless credit losses rise to over 40 bps, which would be about triple current levels."

The drop in June began on a bullish competitor’s speculative note on capital and proposed FASB accounting changes (dispelled by the regulator). FNM/FRE’s regulator, OFHEO, put out a press release last night saying "they are adequately capitalized with capital well in excess of OFHEO-directed requirements, have large liquidity portfolios, access to the debt market and over $1.5 trillion of unpledged assets."   Piper also warns that this is irrelevant as market fear is so high fundamentals don’t matter..

I bought 5,000 shares of FRE in the Stocks Portfolio at 10:11 and sold $5 puts for 1.05 but had to capitulate and take .90 for the $5 longs as it looked not quite as bouncy as I had hoped.  If forced into buying more FRE at the expiration, our basis will be $4.46 so I have no desire to DD at this low price but I don’t see anything that has changed since July 11th and, according to the WSJ: "Representatives of Fannie and Freddie reiterated that their capital remains at levels above the minimum required by their regulator."  The knock on this is that "many analysts consider that minimum level too low to withstand the potential credit losses ahead."

If you believe housing is worthless and will never regain value in the next 10 years, then yes, FRE and FNM need more capital.  If you believe we are near a bottom, then they are fine.  FRE said they will raise $5.5Bn in capital but they do not need it immediately and they are waiting for market conditions to improve.  That is why GS and Co., the same people who will be giving them the $5.5Bn have gone on the attack - to send a message to FRE that they’d better accept the funding at this valuation ($3Bn vs. $15Bn they were worth in June) and like it or the "analysts" can make their life a living hell.

It’s a scam and nothing more.  Even if you don’t have faith in FNM and FRE, it’s a great opportunity to pick up other financials as the sector got trashed in their wake.  I still like C, BAC, WM, HCBK and the XLF long-term but be warned that July 11th was not the bottom, we bottomed the market out 2 trading days later, on July 15th, when the Dow finished at 10,900 so watching where we hold the line on this scare will be critical.

Don’t forget, we already have a solution for the morrgage crisis and the hyenas are taking advantage of this break in Congress to shake people out of their positions.  Things are not the same as they were in July, oil is down $35 since then, putting $700M per day back in US consumers’ pockets.  The scary housing figures we are hearing is based on data that measured the exact point at which food and energy inflation spiked up beyond unbearable levels and crushed the consumers.  Food and fuel costs caused delayed mortgage payments and led to record delinquencies.  The problem is we won’t see the turn in data until October at best since that’s when we get most of our August reports so I’m buying on faith and not much more…

Let’s say you decide to deposit $100,000 into a brokerage account.  You decide you will check your portfolio on a weekly basis.  Now let’s further assume that the first week has passed and you are about to log in to your account.  But before you do, you are told that one of two things has happened in the past week.

[1]  Your portfolio went up $10,000 and then dropped $10,000

[2]  Your portfolio went up 10% and then dropped 10%.

So, the trivia question is:  In case [1], what should you expect your account value to be and is that the same figure as in case [2]?

If you answered $100,000 in case [1], you would be absolutely correct!  If you answered that this is the same as in case [2] you would be absolutely incorrect!  Why?  Well let’s take a look at what happens when the portfolio rises 10% first; it goes from $100,000 to $110,000.  But then we’re told it drops 10%.  10% of $110,000 is $11,000.  So the portfolio drops from $110,000 to $99,000. 

Now how can this help us in our trading decisions?  In its simplest form, this tells us that if we were to simply buy stocks that over the long run had a tendency to rise up substantially and fall down substantially ie starting at 0% and rising up and ultimately falling back to 0%, the volatility is impacting long-term returns.  In statistics, that percentage swing would denote variance, which in turn is often equated with risk.  Another term for risk is beta.  High beta stocks tend to move more than the market and tend to have greater variance.

So, if you are in the market for the long-term, you should certainly pay close attention to the impact of variance.   Over time the impact to the $100,000 portfolio is not just a drop of $1,000 as in the period shown above, but that portfolio erosion continues over time to the detriment of overall wealth.  Unless….

Unless, you know how to take advantage of such volatility.  Buying and holding stocks is about as advanced a trading technique in this day and age as owning a cell phone that simply operates as a phone.  Why accept bare functionality when you can combine the basics with so much more.  In the stock market, this means using options.  (In cell phones we already know they come with email, calculators, personal organizers, GPS etc).

Phil, Opt, fellow PSW members and partners at Stock and Option Trades are all here to help.  Take advantage and learn how to use volatility to your advantage!

What a nice weekend!

Musharraf is resigning and Russia is actually responding to diplomatic pressure and pulling troops out of Georgia while being villified in the WSJ.  On top of that, MTU upped it’s bid for UB to $3.5Bn- a huge sign that the banking crisis, even in California, may finally be bottoming out, at least on the commercial end, where UnionBanCal specialized.  Mitsubishi already owns 65% of UB so we can assume they know what they are buying so we have an "insider" buy of a $9Bn California bank back at the top of their trading range, close to 100% off their lows of just last month.

This caused the dollar to turn back up in pre-markets, pushing oil back to negative numbers after trading as high as $114 in Asian trading.  Commodities in gerneral continue to fall, led by gold’s biggest weekly decline (8%) in 25 years - so very bad timing for Micheal Phelps, who just won a ton of gold in Beijing…  That did not stop BHP from posting amazing profits as they have their 6th consecutive quarter of record profits and record output.  This will be great for acquisition target RTP but they are likely to fly up a little too fast to make a play in the morning.

Speaking of record output, Pelosi said the Dems will cosider allowing additional offshore oil and gas drilling in a new legislative proposal they are working on over the vacation, including expanded drilling in Alaska.  They also want to the SPR to be used to smooth price fluctuations and to put money from the newly opened reserves into programs to boost alternate energy and mass transit in order to make a more immediate impact on consumption.  Also affecting the price of oil on the peace front is news that Israel may be offering Palestine sovereignty over Arab neighborhoods in East Jerusalem.  Gee, I don’t know what’s going to be left for oil bulls to pump the price over if this keeps up!  Oh yes - hurricanes!  We do have one brewing off the coast of Florida but it’s not helping as energy traders try to squirm out of positions before we fail $110 and head back to $80 a barrel. 

That may come sooner than we think because Monash University in Melbourne says they have "copied a process found in plants that uses sunlight to make hydrogen from water, potentially a cleaner and lower-cost method of making the gas for use in fuel cells…  The method developed by the scientists uses a catalyst system with a coating that can be impregnated with a form of manganese, a chemical essential to sustaining photosynthesis in plant life," said Monash University.   The production of hydrogen using nothing but water and sunlight offers the possibility of an abundant renewable, green source of energy for the future.  Testing showed the catalyst system was still active after three days of continuous use, producing oxygen and hydrogen in the presence of water, electric energy and light, it said.   Gosh, it’s amazing where a little R&D will get you these days…

TWX’s "Dark Knight" passed "Star Wars" with $471.5M at the box office and now sets their sites on Titanic, which made $601M.  This should be a big boost to the film business, which is a boost to both the California and Florida economies so some very good undercurrents building there.

The Nikkei had a very nice morning, gaining 1% while the Hang Seng gave up about the same, making an ugly turn below the 21,000 mark near the close.  China is suffering from a lot of "sell on the news" action around the Olympics and there are a lot of plays there that are starting to look interesting again, now that they are 50% off their highs.  Pakistan flew up 4.5% on news of Musharraf’s peaceful resignation and our beloved SNE’s snapped back up 2.5% while TM remains a great deal under $91.  The Shanghai Composite fell to the 5% rule, down 55.9% from the beginning of the year so you can imagine the investor mood over there!

Europe has perked up considerably off their open and is up about half a point as of 9am.  Miners and oil companies are leading the rally off BHPs news and the hurricane report so it’s certainly not the kind of rally we want ot see.  BP $60 puts may make a nice play as they test $58.50 if oil can’t hold $114 this morning and RDS.A $65 puts should also offer us a fun play against the morning excitement but tight stops on both as we watch the $69 line on Shell.

The morning looks very nice but it’s likely to be a low-volume Monday and I’ll be taking it all with a grain of salt as the market has done little to prove to us that it’s gone only manic and will be skipping the depressive phase later in the week.  Last week was so good for us that I’m not looking to blow it all by getting wrapped up in irrational exuberance.  The Briefing.com economic calendar is light this week with PPI playing the starring role tomorrow:

It looks like a fun week ahead but let’s give today a chance to unfold before we get too crazy.  Lots of good earnings this week and we’ll be looking at those during member chat as well as in the evening post.

Today’s tickers: XLE, AMGN, CIT, LEH, CMC, MAS, JCG, TXN, CY, MSFT

XLE - Mounting dollar strength and rising consensus on waning demand sent crude prices lower today, creating a “breakfast of champions” for stocks that showed staying power for most of the session. Shares in the Energy Select Sector SPDR closed 1.6% lower at $70.96 – nearly $10 off its 50-day price average. We took a look at the option activity to see whether traders might be positioning for continued unwinding from the year’s highs, and found a 10,000-lot put spread in the December contract between strikes 63 and 70 that seemed to reflect an outlook of further declines. Both sides of this spread traded to the middle of the market, so we cannot pin down the order flow here with certitude, but given the prices paid relative to bid/ask values, it appears likely that the trader bought puts at the 70-strike level for about $5.28 per contract, selling as many lots at the 63-strike for about $2.54 apiece. Using a long spread at these levels allows the trader to knock off about half the price of the long put position, while putting a cap on anticipated downside. Incidentally, a put spread could also be sold short at these strike levels to bet on a rebound in oil prices by year’s end. In this case the trader would take the $2.74 spread as a credit, looking for a rebound above current levels by December 19.

AMGN - Unusual options activity occurred this afternoon in biotech Amgen, the maker of drugs for cancer and psoriasis, just one day after the stock benefited from Goldman Sachs’ decision to add the stock to its “conviction buy” list. Shares racked up another 52-week high today with this afternoon’s 1.4% gain to $65.10. What caught our attention, however, was not the call activity – which outnumbered that of puts by a factor of 1.4 – but a diagonal calendar put spread using distinctly out-of-the-money strikes in September and October. Again, this volume was logged to the middle of the market, so our read of the direction is largely conjectural. But it looks as though the trader may have sold 10,000 lots of September 52.50 puts for 26 cents apiece – reasonably assured that this credit will remain intact as Amgen shares remain well above the 52.50 level over the next month – and then bought 10,000 lots of October 55 puts at 76 cents apiece. This isn’t strictly a directional play, but a means of using volatility and time decay to advantage. Assuming this is the way the volume went, the trader is content to allow the value of the short September put position to dwindle away at a more rapid pace than the long October position. This long October put, meanwhile, could gain in volatility (and value) if Amgen shares turn tail and decline by mid-October. Current premiums suggest just a 13% likelihood of Amgen shares dropping $10 by that deadline.

CIT - A sizable 1-by-2 call spread, possibly put on by a well-capitalized individual or an institution, caught our attentions today as it would seem to imply a slow-but-sure road to recovery for CIT Group, the provider of commercial and real estate financing. Shares in CIT Group are down 60.9% for the year to date, but have recovered 51% of their value from July 15 lows – outpacing the gains seen in other S&P financials, a group that CIT Group has otherwise lagged mercilessly behind for much of this year. Shares reversed early losses handily to close 3.2% higher at $9.51. The long 1-by-2 call spread activity in the January ’09 contract involved a trader buying 1 $10 strike call for $2.10 and selling two 15-strike calls for 70 cents, resulting in a net debit of 70 cents per trade. Essentially the trader is looking for continued upside past the $10.70 level in the first of the year, but is confident that the share price won’t breach $15 – half the position at this strike in a 1-by-2 call spread is uncovered short, leaving the trader vulnerable to exercise (and unlimited losses) in the event of a share price rally. The volume here appears to have involved about 19,000 lots at the lower strike and about 38,000 lots at the upper strike, making the size of the trade worthy of note in its own respect – the volume here represented 16 times the normal level of activity seen in CIT Group shares.

LEH - News that legendary investor George Soros had upped his holding in seen-it-all brokerage Lehman Brothers kept shares higher for much of the day before a late-session snooze resulted in a flat close at $16.19. With heavy traffic on both sides of the sentiment divide as traders sought to close out positions at August strikes between 15 and 17.50, we were more interested by traffic in the October contract, which showed interest in 22.50-strike calls and 20-strike puts. Volume at each of these strikes appeared to have been sold.

CMC - Shares in steel producer and recycler Commercial Metals Co. declined 2.5% today to $25.65 on no apparent news catalyst – and it looks like one trader picked the moment to position for a recovery in share price by year’s end. Shares are down $14 since peaking at their 52-week high back on June 24 – a decline that has been more or less unmitigated ever since. The option activity today, which pushed overall volume to nearly 6 times the normal level, appeared in a 6,000-lot long call spread in the December contract between strikes 30 and 40 for a debit of about $1.59 – a position that requires at least a 22% recovery from current levels to break even, and could even imply a test of that 52-week high by year’s end.

MAS - Shares in Masco Corp, the owner of KraftMaid Cabinetry, Delta Faucets and Liberty Hardware closed 5.5% higher today at $18.97, one day after similar gains for a number of leading homebuilder stocks. While Masco shares are down 12.4% for the year to date, the current share price represents nearly a 40% premium to its July 15 low, and a comparison of its option implied volatility (47%) to its far-higher historical record of volatility (54%) indicates that option traders have relaxed much of the risk expectation for Masco shares in the coming month. While we observed in yesterday’s column that many option traders had pointedly not abandoned defensive protections in homebuilders in later-2008 contracts despite respectable gains for these stocks since mid-July, today’s action in Masco shows one trader staking a bet on continued moderate upside for Masco by mid-January. It looks here as though the trader positioned long of the January 20/25 call spread, a position that would carry a debit of $1.35 – but may have shaved 35 cents off the price of the position by selling 12.50 puts. The resulting trade would leave the trader looking for a break above $21 – a 10% gain from current levels – but cap the upside at $25. Overall option activity in Masco Corp showed up at 15 times the normal level.

JCG - Shares in preppy clothier J. Crew Group bounced quickly back from earlier session lows to close 2.4% higher at $27.84. An increase in options trading volume to nearly 6 times the normal trading level showed traders positioning in December 27.50 puts at $3.74 – very close to the asking price for a buyer although this trade was logged to the middle of the market. It also appears as though this trader may have sold a strangle in the March contract, selling a put and a call concomitantly at strikes 25 and 40. This position would have yielded a $4.04 credit that could have covered the cost of the December put position completely, while creating a perimeter of anticipated share price movement into next spring. While a sold strangle is not a directional trade per definition, the strikes involved here would seem to prolong the already very muted performance of J. Crew shares. While the stock has traded as low as $27 and as high as $52.40 over the past 52 weeks, the stock has traded consistently south of the $40 level since May 30, when it saw its biggest loss in two years on a cut in sales guidance for 2008. Overall, call and put positions in J. Crew are relatively evenly divided.

TXN - For a second consecutive session we’re seeing heavy call volume in Texas Instruments, where shares closed 1% lower at $25.52. Today’s trading activity took overall options volume to 3 times the normal level, with brisk interest at the September 25 and – more significantly – the October 30 strike calls at 25 cents apiece. We cannot confirm that this is opening positioning occurring, since the current volume lies within the reported level of open interest. The 25-cent premium at this position reflects only about a 13% chance of probability that Texas Instruments shares can break past $30, a level unseen in the chipmaker since late-June. Put-buyers, meanwhile, also appear to have targeted the October 22.50 level.

CY - Option implied volatility in Cypress Semiconductor, the maker of memory chips, image and optical sensors, and programmable logic devices, rose 20% on the session today amid a 12.8% rally for shares to $30.65. The advance for shares started before the bell, after the company announced an offer to buy nearly $600 million in convertible bonds. The current implied volatility reading at 45% still rests slightly below the historic volatility reading on the stock. An ensuing wave of call buying at strikes 30 and 31 in the September contract sent overall options trading volume to 4 times the normal level.

MSFT - Finally, while Microsoft shares closed flat at $27.84, today’s heavy volume of around 111,000 contracts included the apparent rollout of a short volatility position from the August 26 straddle to the same position in September. The price of the September straddle would provide a seller with $2.49 in initial premium today, more or which he or she is likely to keep if Microsoft shares show little vacillation between now and September 19.