Options Market Recap, February 27, 2009

Worst Start Ever Brings 12 Year Lows!

Ouch ... another very tough week on Wall Street as the broad market lost -4.5% for the week bringing the Year to Date loss to -18.6%! In the long history of the stock market, that is the largest decline ever over the first two months of the year. Furthermore, the -18.6% decline brings the broad market index to a 12 year low. Investors that are long stocks are clearly losing money, and most are losing lots of money. Could we now be at market lows? We sense investors are very apprehensive with many sitting on the sidelines. Volatility and fear could be poised for another strong run. If volatility returns, the market could take another severe turn downward. Our concern is that we just do not see a lot of positives on the immediate horizon to help push the market significantly higher, particularly in light of the worsening economy. Even if the market has hit bottom, the upside may be limited over the short term, whereas the downside risk remains high.

Economic Conditions Deteriorate!

Last week the financial sector and economy were again the big market drivers, although there was a surprise development in Healthcare. Investors remain wary over nationalization of large banks as the government now owns 36% of Citigroup common stock. The Obama administration announced its Capital Assistance Program, which includes stress tests for banks that will determine the capital assistance levels provided by the government. But it was the deteriorating economy that brought the most bad news. Existing and new home sales, along with home prices all declined more than expected and provided further evidence that we have not yet hit that elusive bottom in housing. Bernanke gave the market some hope in his latest congressional visit when he said the recession may end in 2009 with recovery in 2010. We hope the Fed chairman is right, but suspect that could be a little optimistic given that economic conditions continue to deteriorate. For example, fourth quarter GDP was reported to be sharply lower (-6.2%) than its advanced reading of -3.8%. That is a big difference and shows just how quickly economic conditions deteriorated. The other surprise was the announcement from Obama that he will cut Medicare spending as part of his healthcare plan. The healthcare sector, which had been holding up better than most, proceeded to lose more than 11% for the week following those remarks. On the employment front, jobless claims continue to hit record levels resulting in the lowest consumer confidence readings ever recorded.

Option Tips for Investors?

Do we have option tips for investors? We expect the market to swing between a trading range of 725 and 850 over the near term. We also expect volatility (VIX) to trade between 35 and 55 over the next month. With that in mind, we may look to write a call on the VIX at 55 and write a VIX put at 35 if we can get in at good prices. This strategy allows us to pick up income as long as the index trades within this range, the most likely scenario. We may also look to write options on the market index. Writing puts are always more risky in volatile markets, so we would look for a put around an exercise price of 700 to give investors more breathing room. However, we consider the downside risk high, and if the market does move down further, it could be a sharp and severe move. Given the risk, these investments should only be made if the price is right and expiration is near term. For a market index call, we would look for one to write in the 875 range. Investors can be a little more aggressive on writing call options, as the current market is far more bearish than bullish right now. This is still a short term traders market, and can be quite rewarding for option investors that can handle the risk.

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