Weekly Options Recap, March 20, 2009

Market Holds Gains From Prior Week!

The broad market advanced 1.6% last week, a good showing in that it held the extraordinary gains achieved over the prior two weeks. The market declined on Thursday and Friday as investors took profits, although there was enough resistance to still end the week with a weekly gain. We view the market strength shown last week in a very positive light as investors did not run following the recent strong advance. Our sense is that investors may begin to return to the market. As cash flows in, the demand for stocks will rise, driving stock prices upward. It is still too early to say the worst is over, although we are encouraged with the recent resistance the market has shown. Our view is that the S&P will remain rocky, swinging back and forth within a trading range of 150 points. We expect the economic struggles to continue over this year, and that will temper the stock market advance. The stock market is usually a leading indicator for economic recovery, so the stock market should begin to recover well before the economic conditions improve. Overall, we want to see the market display strength and resistance over several months before feeling comfortable that the bottom has been reached. Another strong indicator will be first quarter earnings, for which reports will begin April and May.

FED Purchases Expand!

Last week the economic news was somewhat mixed. Industrial production declined slightly more than expected, although at a slower rate than the prior month. Inflation figures also rose more than expected, but remain at very modest levels. On a positive note, housing starts and building permits both showed unexpected increases in February. Housing starts in particular showed a very large percentage increase. Both signs are encouraging, but we want to see an uptrend with several months of advances before calling a housing bottom. The biggest news for the week came from the Federal Reserve after announcing they would purchase up to an additional $750 billion of mortgage-backed securities. In addition, the Federal Open Market Committee decided to purchase up to $300 billion in longer-term Treasury securities and $200 billion in other agency debt. Bonds rose sharply following these announcements and stocks too followed that lead. To date, the FED has been aggressive with monetary policy by dropping interest rates to near zero levels. The commitment to expand purchases of troubled assets has propelled their program to a new level. We do think these measures will help both the economy and financial markets find and regain their footing over the near term. However, we do have long term concerns over the amount of this funding and the resultant burden placed on taxpayers in future years. Over the long term, we certainly would expect interest rates and inflation to rise sharply in response to all of the government spending and outstanding debt. We do not expect interest rates to rise this year in light of a sour economy, but at some point in the future, consumers and taxpayers will bear the burden of the actions taken today.

Option Tips For Investors!

Do we have option tips for investors? We expect the market (S&P) to swing between a trading range of 700 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 consider writing a call option on the market index in the 825 or 850 range if we can get in at a good price. Right now, we consider writing call options less risky than writing naked puts given the downside risk in the market. In addition, we are more protected writing call options since most of our other portfolio positions are long stock positions which will tend to move in opposite directions to the call position. In short, if we guess wrong on writing the call that will mean the market has risen sharply which will benefit our long stock positions and mitigate the loss on the call. We still consider the market downside risk high, but are encouraged that the market held the large prior week gains. We may also buy calls and puts on the market index if there are large swings that show signs of a market overreaction. It was a positive sign that the market held the gains from the prior week. However, it is still too early to call a bottom is this rocky market. Frankly, we want to see the trend in stock prices and consumer confidence move up over several months before we go all in with our option allocations. This is still a short term traders market, and can be quite rewarding for option investors that can handle the risk. We are 80% cash, but will continue to look for short term trading opportunities.

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