Unforeseen Risk Scenarios (Geeky Options Talk)

Today was quite an interesting day on the markets with the Fed injecting another Trillion dollars into the economy. The equity markets reacted reasonably well with the major indices closing up a percent or two after trading down most of the day. The S&P spent a few minutes just above 800, which is significant for a number of technical reasons, and I found it interesting that the stock market backed off the highs rather quickly after the meeting. You can take a look at my last post to see what my opinion moving forward from here is (which has not changed and is not positive). Personally, throwing a trillion dollars around doesn't seem like a good indication of a healthy economy. Although the movement in equities was interesting today, the reactions in markets that are more directly affected by monetary policy were downright violent. Bonds, currencies, gold and related assets were moving in staggering ranges.

There are a number of things I considered writing about today, but the one I wanted to highlight was an area of risk that's hard to forecast from a trading perspective. As an options trader, the concept of risk can become very complex and there are a number of factors that need to be managed in an options trade. The beauty of options is that there are a variety of strategies available to define your risk related to direction, volatility and time. At the end of the day, however, there is a market maker on the other side of your trade, who is also interested in managing risk. Typically, market makers collect the lion's share of the bid/ask spread (slippage) on transactions and will periodically hedge themselves from directional risk in whatever they are trading. When markets start to really move, the market makers will typically widen the bid/ask spread to price in the additional risk they are willing to take on because they realize they have more directional risk in their positions.

I happened to be in a delta neutral position on the Euro today. There were two parts to the trade. First, I placed a straddle, which consists of a simultaneous call and put and is designed to make money with a significant move up or down in the underlying asset. The problem with a straddle is that it typically loses money most days while you're waiting for the big move. To mitigate this I placed calendar spreads on either side of the straddle, which would also make money with an up or down movement, but would make some money if the Euro goes nowhere and offset losses in the straddle. So the idea here is that I don't care whether the Euro goes up or down, but I'd like to see some signs of life in the next month or so. The last couple days, the Dollar has been drifting down, so the overall strategy was working pretty well, although slowly. The plan for managing this trade is to close out the calendar spreads if they hit the target strike price and open new calendars around the straddle. If there are good gains in the straddle itself, then additional adjustments to lock in profits are necessary.

Today I got very happy because I checked the quotes and the Euro was trading right at the strike of one of my calendar spreads (making money) and I went to make my trade adjustment. (This was a huge move in the currency markets and was quite unexpected in such a short timeframe.) What I found however, was a bid / ask spread of $0.00 / $4.60 across the option chains. This wasn't a data issue – the market makers got freaked and essentially stopped trading. So here I am with a trade that did what I wanted it to do and no market to sell into in order to carry out my trade plan. By the end of the trading session, the market opened up to a certain extent, however the Euro had moved beyond my target by that point and I wasn't able to get my optimal exit. Luckily, the overall trade strategy benefited from the moves today, but the reaction of the market is an important risk management consideration. The lesson here is that when markets reach extreme stress points, assumptions about market efficiency and liquidity can fall apart very quickly.

Correlate this experience to the leveraged debt markets and it's not a big leap to see why the economic fallout has been so extreme. When big moves started happening in the debt markets the same phenomenon happened and the markets dried up. The problem is that these bets were all in one direction and had highly leveraged penalties for being wrong. I would love to see some of the TARP money going to education about Risk Management rather than bonuses to (expletive) executives that just don't get the concept. The "Likely Worst Case Scenario" is quite different from the "Worst Case Scenario."

The Devil’s Sucker Bet (SPX 666)

On Friday, the S&P500 (SPX) hit a new multi-year low and put in a support at 666. Wow, what a magic number. Are there larger forces at work here? Could it be that the market is finally sending us a message and that even if the Government falls short on policy efforts, at least the bastards on Wall Street are going to Hell? Then again, it could be that the economic system itself is to blame, with eminent destruction of our Hedonistic lifestyles and damning all Capitalists and Consumers to eternal torture. Then again, it could be pure coincidence. Having had a few sordid chapters in my past including friends that have been accused of Satanism (but really just enjoying Heavy Metal), I couldn't resist the attention grabbing headline on this post. What else can a CNBC skeptic do to compete with John Stewart's scathing and hilarious review of the network?

While I do believe that the actual number on Friday is totally coincidental, the action over the last few days has provided some interesting technical clues to what might be developing in the market. Let me caveat here that I generally view the market as a chaotic environment and that any analysis tool has to be taken with a grain of salt. I'll also caveat that I'll be writing about some technical market detail without a lot of explanation, so forgive me now. From what I've learned, Technical Analysis (or any other analysis) is not an effective tool for predicting the future, however it can provide some insight for understanding what has happened in the past and what might be happening currently. Predicting the future can be fun, but is pretty dangerous for trying to make money. So let's dust of the Elliot Wave Theory and see what might be going on and have some fun in the process.

In my last post, I took a macro view of the economic and market cycles over the last 60 years and concluded that the SPX could see 600 without too much effort. Around that time (when the SPX closed at 821) I drew the following lines on the weekly chart to see how an Elliott Wave pattern might be forming up. Technicals hadn't been working for me in a while and I'm still reeling from the market's thrashing on sentimental reactions, but I felt it was a time to take a step back and look with a fresh perspective. Elliott Wave Theory is an analysis tool that posits that markets move in a series of patterned trends (impulse waves) and counter trends (corrective waves). A lot of the theory relies of Fibonacci numbers, which oddly enough do seem to play out in the market action and I drew out Fibonaccis on the charts in this post. There are some great resources out on the net and in popular Technical analysis literature on Elliott Wave Theory, so I'll leave it to the true experts for a full explanation of the theory. For Ellioticians, it looked like we had potentially put in a Wave 4 pivot the first week of the year based on weekly charts, although I was skeptical at the time before the big red bars started to show up. For the Wave 5 pattern, I simply used the Wave 1 line and tacked it on to the last pivot point, which coincidentally landed right on 600 as a price target and thus caught my interest since I had (dangerously) pinned that number into my memory after my last post.

So what does this mean for the shorter term picture, particularly after a huge up day like today? Today's action was quite impressive and it looks like we're in for a bit of a bear market rally for the next leg. If the pattern holds, we should quickly run up to 800 to 875 in the next few sessions. The CNBC Wonks have been talking bottoms pretty convincingly for a few days and I suspect that within a few days, optimism will start sweating out of the reporters. A couple days of this and everyone will be talking about the deal of a lifetime in the next bull market. I'm sure that someone will even posit that Warren Buffet's comment that the economy has "fallen off a cliff" is the seminal turning point of the bear market. Hell, even the President is recommending folks to buy stocks. This is the sucker bet I mentioned in the title of the post and one should exercise extreme caution at this point. Let's take a look at a daily chart:

One of the key characteristics of Elliott Wave analysis is that it is a Fractal system. When the market is in a larger Elliot wave pattern, the patterns within the legs of that pattern should mimic the patterns of the larger trend. For example, a major impulse wave should contain 3 smaller impulse waves and 2 corrective waves within it. Presuming we are in a true 5 wave bear market, the blue lines on the daily chart represent the shorter term patterns (including projections) within the last leg down in the weekly chart above. The long blue line that goes off the right of the chart is the same price projection drawn on the weekly, however recent price action has been even more aggressive than anticipated back in January.

So back to the 666 support level… Corrective waves like the one we just entered and seem committed to as of today are characterized by rapid moves against the trend (I still find it odd to talk about an up-move as a correction). Take a look at the ABC pattern (Purple) in between wave 1 and 2 on the daily chart. This is the type of pattern I would expect to see develop over the next couple weeks – high volatility and fast moves to the upside, although the next development should be more pronounced than the January & February action. Once we put this in, and get into the 800s, I think we'll see the final leg down in the bear market (to 600 or so) and we can get back to some reasonable bullishness. I'm pretty sure there will be some catalyst that we'll look back in history and ascribe significance to this final down move – could be a terrorist event, a natural disaster, commercial real estate foreclosures, a currency default or simply the market doing what it needed to do, but there will be something.

So that's it with predicting the future for today. I do think that the market is charged for a bit of a rally at this point, although I'm skeptical of anything sticking. I'm also totally skeptical of my own analysis, including the beauty of Elliott Wave, but for now, avoiding jumping in with the herd seems like the best position and being ready for either direction is prudence. That's the beauty of options.