Friday, March 20, 2009

An Object Lesson in Options

Today being a triple (or, by some standards, a quadruple) witching day, in which stock options, futures and index options all expire, it was amusing and insightful to watch the activity of the markets and the money flows as the week progressed. Triple witching happens every quarter, in the final month of the quarter on the third Friday of the month. Usually markets are quite volatile leading up to the date, and when the expiration of options occurs in the middle of a rally or sell-off, the action can be wicked.

This week had a couple of added bonuses in the form of the AIG flap amid the continuing economic crisis and the regular FOMC meeting and their release on Wednesday. The overhang of AIG bonuses and revelations of just how much money the Fed funneled through the conduit to counterparties was fodder for Monday and Tuesday, a little early for the options players to make serious moves. In fact, most were holding or still buying, staking out positions for the kill later in the week.

On Wednesday, at 2:15 in the afternoon, the Fed announced that they would be buying up to $300 billion in Treasury Bills, in essence creating money out of thin air to buy bonds. It's a desperate strategy which has never resulted in anything other than rampant inflation. But the Fed and the government isn't worried about that now, they just want to prevent complete collapse (they don't know that they, by their very actions, are going to cause it) of the financial system.

Mind you, the financial system in this country is so horribly broken by decades of intrusion, intervention and manipulation, one can scarcely believe stock prices at any point. As they are chimeras by nature, stock prices can be moved around by people with lots and lots of money. People like the Federal Reserve, the government and major banking and trading operations on Wall Street.

So, when the Fed made their dramatic announcement on Wednesday, the traders (crooks or thieves, if you like) were at the ready, pushing the Dow Jones Industrials up 150 points in just 5 minutes time, added more after that and then sold off a bit into the close. I said, in that day's entry, that the smart money was already out and the trading rhythm of Thursday and Friday bore me out (I also made a few bucks on the moves).

On Thursday, the Dow gapped up at the open near the previous day's high, but immediately retreated and soon was touching down in negative territory, repeatedly bouncing off 7400, which developed into a serious support level for the full afternoon and into the next day. That it was plucked out by traders as a line to defend was plausible, since the high on Monday was 7428 and the close on Tuesday was 7395.

Perfectly and somewhat hauntingly, the average bounced off this level repeatedly from around 11:30 am on Thursday to just before 1:00 pm on Friday. Every time the market began to pull below that level, there was a wall of support to push prices back up. That was until just before 1:00 pm Friday, when people holding options contracts began worrying, because holding until expiration either means you get nothing or you have to buy or sell a specific equity at your strike price, so the action was just about done unwinding.

It was at that point that 7400 was breached completely in one death-dive. The Dow fell over 100 point in the next hour and change, and, after 2:00 began heading for 7250, at which point bottom fishers came in and short covering began in earnest. Eventually, however, the die had been cast. The options traders had made their money, trapped their counterparties and escaped, apparently off to enjoy the first weekend of Spring out at the Hamptons or up in Connecticut. The Dow closed, as did the other indices, close to its low of the day.

Dow 7,278.38, -122.42 (1.65%)
NASDAQ 1,457.27, -26.21 (1.77%)
S&P 500 768.54, -15.50 (1.98%)
NYSE Composite 4,832.13, -105.09 (2.13%)

For the session, internals were indicative of the general direction. Declining issues outpaced advancers, 4582-1821. New lows opened a bit more space between themselves and the paltry number of new highs, 79-10. The highs-lows are still in a range from which they can roll over, but as has been the case in the previous six or seven times its happened since October 2007, it will only be for a day or two before the bull reverts to a scared calf as ravenous bears threaten its life.

One caveat is that some stocks are looking at 52-week highs that aren't that high. The decline had already begun by this time last year, though not in great earnest. The bear market rally (whether we are still having one is now very much in doubt) could run for months, though I personally doubt that it will last even a couple more days and definitely not past mid-April. In any case, the daily new highs and new lows is a metric which has provided incredibly strong insight into market movement, at times even predicting major moves and always true.

Volume on Friday was very high, higher than even Wednesday and Thursday. Expect the trading activity to fall off somewhat over the next two weeks as traders will be listening for early signs from companies considering 1st quarter results. Of course, the severe crisis of confidence, credit and money will continue to reverberate through the canyons of Wall Street and beyond.

One note on today's volume. There were more trades on the NYSE than the NASDAQ, the first time that's happened in a very long time (2002 to the best of my recollection).

NYSE Volume 2,465,968,000
NASDAQ Volume 2,421,536,000

Commodities were subdued, relative to equities. Crude oil lost 55 cents, closing at 51.06. Gold was off $2.60, to $956.20. Silver tacked on another 30 cents to finish the week at $13.82. Long term holders of precious metals are sitting pretty.

As for whether the rally will resume on Monday, there's quite a bit of evidence that it will not. Stocks were boosted largely for traders to rack up profits in options, as expressed above, and the last two days of trading have both ended up losers. Since the indices had been pumped quite a bit higher in a relatively short period of time, there may be a lull in the action for the next 2-3 weeks, but then earnings and guidance will begin to dictate the direction and it's not likely to be very good. Also, there's surely going to be more money being thrown around, scandal, and other disruptions, so the mini-bull we've experienced over the past two weeks may fade fast.

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