Monday, March 12, 2007

HOTS Weekly Options Commentary

HOTS Weekly Options CommentarySocialTwist Tell-a-Friend
Peter Stolcers

The character of the market has changed in the last two weeks. From September through most of February, we experienced a nice, tight upward trending channel. Option premiums dropped to historically low levels and the public borrowed on margin to buy into the global growth story. Along the way, we heard the words “soft landing” over and over again.

Out of nowhere, we hit an “air pocket” and the bid to the market was gone. After establishing a low Monday, the market rallied the rest of the week and formed a “V” bottom. The initial drop tells me that there was a legitimate concern with the Yen-Carry trade. Most of the large brokerage firms that clear hedge fund trades also engage in proprietary trading and they know the risk exposure. On the retail side of the equation, the public was reassured to stay the course. Paper losses were mitigated last week and now retail traders are hoping for another rally to make them whole. I believe a warning shot has been fired and the market will retest the lows from Monday.

The “air pocket” I spoke of is caused by fear and it suggests that liquidity is drying up. A few weeks ago, China raised its reserve requirements. Two weeks ago, Japan raised interest rates and last week the ECB raised interest rates. Domestically, lenders are tightening credit policies after seeing the defaults in the sub-prime sector.

I see two problems. First, traders are over-leveraged. The run-up in emerging markets, the Yen-Carry trade, the premiums being paid in private equity deals and the debit margin carried by retail traders are examples of excess speculation. Secondly, the market lacks a catalyst. Earnings guidance indicates a single-digit growth rate for next quarter and the Fed is not going to ease. A few weeks ago, the path of least resistance was up and that was all the market needed to move higher.

There are three events that will drive the market this week: quadruple witching, earnings from Goldman Sachs, and the CPI/PPI. SPY 141 is a critical level because a number of technical indicators are converging on that point. Some traders will view it as a pivot point to switch from short to long. Last week’s bounce represented a Fibonacci retracement. The rally brought the SPY right to its 100-day moving average and to a horizontal support/resistance level. A close above SPY 141will put me into the “neutral camp” and a pullback will confirm my short-term bearish bias. At this juncture, we have to take our lead from the price action. In very short order, the market will tell us how to position ourselves.

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