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.

The Myth of Volatility

Common financial "Wisdom" states that the US stock market produces superior returns compared to other assets such as Bonds, Cash and other savings vehicles, even commodities. These returns are obviously necessary in order to get ahead of inflation and prepare for a period of retirement in relative comfort and enjoyment. There are certainly periods where this is true; however there are also periods of significant downturns, which represent the associated risk for achieving these superior returns. The theoretical "Best Practice" in dealing with these periods of uncertainty is to "Buy and Hold" for the long term, however many investors struggle with this strategy. In practice, while the Stock Market is more volatile than other asset classes, it ultimately tracks to the overall economic fundamentals and dramatic moves in one direction are met with dramatic moves in the opposite direction. Longer term economic trends can span periods measured in generations, resulting in the need for a more sophisticated investment perspective beyond a simple "Buy and Hold" strategy, or as I like to call it "Buy and Pray." This article will get into why you might want to think twice before assuming the Stock Market makes a stellar return over the next couple years.

The dramatic moves, referred to as volatility, are what draw many of us into participating in the stock market, tapping into basic psychological desires of excitement, euphoria and ultimately the logjam of fear. The way these emotional draws generally play out however, are the wrong decisions are made at the worst possible moments, leaving the retail investor significantly behind potential returns because basic human psychology runs counter to making the right moves in the market. The reality is that very few investors catch even one side of the market extremes and very few trades actually take place at those dramatic points on the charts.

There is a huge industry with many interests touting mythical returns, and a lengthy line of consumers following along. There are currently more mutual funds than tradable stocks, each collecting management fees out of the assets they've locked up. There is a never ending supply of software providers, trading systems, books, classes, seminars and other get rich schemes ready to hand over the keys to the American dream of endless riches for a small price. Financial vehicles have become so sophisticated that few professionals truly understand how the various financial markets operate and interact with one another. For the last several years, the financial services industry has been the largest sector of the economy and I still can't get my head around understanding what relative constructive value this industry provides to the progress of humankind, although it's been a hell of a ride for trading opportunities.

The main bellwether I look at to gauge the stock market is the S&P 500 index (ticker SPX). This is a composite of the 500 largest US Stocks, which is a pretty wide range of companies. I prefer this vehicle to the Dow Jones industrial average, which is a more subjective index of only 30 stocks and the individual exchange indices, which are more sector sensitive. The SPX is also the most heavily traded financial asset and is generally used as the performance baseline for mutual funds and other investment vehicles. Here's a monthly chart of the S&P500 starting in 1999. To the left of the chart is a stunning bull market winding its way back to the early '80s.

In technical analysis terms, this is about as beautiful a "Double Top" as one could find. The top yellow line represents the high achieved during the Dot-Com boom. Towards the tail end of 2007, this high was tested and the market failed to sustain that level. Likewise, the lower level represents the low made in 2002. In late 2008, this low was tested and the market bounced off of that level as a support. The important thing to note with technical analysis is that markets often react to recognizable price patterns; in large part because so many traders are watching the same patterns that it becomes a self fulfilling prophecy. Currently, the SPX is nominally above the 750 support level and the technical perspective would be that if that support level is broken, the next one will be tested. Unfortunately, there isn't a clear next level of support. But there is more to the story….

In the following chart I plotted the annual US Gross Domestic Product (GDP) and the S&P 500 dating back to 1950.

This time the SPX has been smoothed for inflation by adjusting against the Consumer Price Index (CPI), as was done with GDP. GDP makes a slow and progressive ascent up the chart, which is representative of a long term growing and stable US economy. Over that time, the stock market has its Bull and Bear periods, with the high being the pinnacle of the DotCom boom. Notice how the more recent bull market fell short of the highs of 2000 when using inflation adjustment? This is an indication that we've been in a relative corrective period for the last eight years. The other interesting thing to note on this chart is the black line, which is an exponential regression of the S&P 500 over this period. Note how closely it follows GDP over the long haul while the Bull and Bear periods fluctuate across the chart? That comparison is an indication that the stock market stretches between extremes, but eventually finds equilibrium, which in statistical terms is a reversion to the mean (against GDP). This is what volatility is all about.

When the market performance is adjusted for inflation, the high achieved in 2007 and the low tested in 2008 are substantially lower in real-dollar terms compared to the levels of the 2000 market cycle. In fact, you need to look back to 1995 to find levels that equate to today's ranges. That's a sobering thought for me considering that was only a brief time after I had started investing for my retirement. In the next chart, I'm plotting the same data; however I've normalized GDP to be a constant in order to evaluate the relative valuation of the stock market against GDP:

This is where things get really interesting. What are illustrated here are the longer term valuation cycles of the market relative to the overall economy. There are certainly intermediate trends, which are visible in the choppiness from year to year. For example, the period between 2003 and 2006 represented a recovery period after the bear market of 2001 – 2002, but it was in the context of a larger correction cycle. The big picture is that the market pricing structure relative to GDP has very long trends. Comparing the current cycle to the last major cycle, there is a potential for several more years of undervalued stock prices.

The other conclusion that one could make would be that there is still room for additional correction and comparing the current value to the point where the turnaround occurred in 1982, the SPX could easily move down to 600. That's a pretty scary number. The last time the market was at that inflation adjusted level was in 1991, which was when I graduated from college. Of course you can also find that level in 1987, which was when I graduated from High School, and the period between 1965 and 1969, which was when I was born. Are you doubting the buy and hold strategy yet?

As a point of interest, let's take a look at the first chart again, this time adding in one additional investment strategy, which is of course beautiful because it happened to someone else (maybe) in the past. I usually hate it when analysts do this kind of curve-fitting analysis, but it's my article and I can add what I want. Looking back at 1982, which was the bottom of the most recent long term valuation cycle, 30 Year Treasury Bonds were paying out between 13 & 14%. The blue diamonds represent the non-compounded returns of a bond investment over that period. The market value on those bonds would also be substantially higher today than their original cost, which is not reflected in the chart, but makes the strategy even better. Also keep in mind that the stock market was about to take off into its greatest bull period of our lifetime, which had returns during certain periods significantly higher than 14%.

If you had been insightful enough and able enough to invest in bonds at that time, compare where you would be compared to the stock market today (isn't that an alluring statement). Your returns would be 50% higher and you wouldn't have gone through the bloodbath losses during the crashes of 87, 2000 and 2008. Of course you would have had to ignore some amazing bull stock markets and spent a good chunk of that time underperforming what peers might have been able to return during these periods – I don't know many people that can do that. I'm also not suggesting you go out and buy bonds at this point. As a matter of fact, I suspect bonds are one of the best shorting opportunities in years. The point with this last exercise is to illustrate that the markets provide occasional opportunities for outperformance, but these opportunities aren't around all of the time. From my perspective, "Patience and Preparedness" are more effective tools to approach the market than "Buy and Hold."

The good news in looking at all of this information is that throughout all of this market volatility, GDP has remained relatively stable and the prospects for a recovery in the broader economy are somewhat inevitable. Although there will likely be painful adjustments, the US economy will be fine over the long term. At some point there will be another incredible bull market in stocks, but I'm not optimistic about that happening in the next few years, but more on that at another time.

Introduction to the Financial Rant Series

These are confusing times when it comes to the economy: Where's the next big layoff number coming from? What's my company going to do? What the @#$% happened to my 401K – or is it a 201k? What's the stock market going to do next – do I wait it out to make my money back? And do I really understand what a Credit Default Swap is?

I'm finding myself increasingly compelled to write about my perspectives on the financial markets and the economy. I'm certainly not an economist, but I have a better than average interest in the markets. By the way, aren't economists in charge of making effective economic decisions to ensure a healthy economy? What's up with that? There's an overwhelming amount of information floating around about the current economic crisis and I have been frustrated and disturbed by the lack of accuracy and timeliness with popular reporting. The challenge, as with any analysis of the news, is how to sort it out to make effective decisions.

I'm concerned that as a nation, we don't have an effective strategy in place for supporting the demands of retirement and we need to have a more active dialogue about developing a framework for supporting post-employment lifestyles. In today's world you MUST be an investor in order to survive past that last paycheck, yet there are inherent barriers for individuals to become successful at this. One of the observations I've made over the last several years is that the average retail investor doesn't realize the extent to which the deck is stacked against them. The reality is that huge money, massive political clout, staggering computing power and many of the finest minds in the world are competing to funnel money into their own pockets and out of yours. As an active trader, I can tell you that the markets are designed to hurt as many people as possible and their application as an investment vehicle is secondary to their true function in society, which is to shift risk. In a later article I'll get into the mechanical reality of what the individual investor faces when they enter the markets, but we'll get there in good time.

In this series I'd like to lay out my analysis of the longer term economic picture and how it will affect the financial markets. For many reasons, I believe that the Stock market is setup to underperform for an extended period of time and I'll be exploring the rationale of that belief system. Some of the key components to it are the impact of a long term economic valuation cycle that is currently playing out, the maturation of the ERISA act of 1974, and the collapse of investment capital at a time when retirements are accelerating and catalyzing investment redemptions. I'll also take a few moments to rail against the Wall Street establishment, but probably not for the reasons you might think.

'Til next time…