You might think that high probability and high risk are mutually exclusive…and they probably should be…but hear me out.  There are 2 parts to this odd-couple trade: both high probability (and I say that without any empirical evidence), but one much riskier than the other.  The main idea is to hedge my directional portfolio that has been rotating through various short-term calls for some time now (tmw’s picks include:  APA, BRK.B, FCX, MUR, among others)…but I think it has some merit on its own, too, which is to short this tedious/insane/neverending rally.

It’s been over 2 weeks now since the the S&P 500 closed lower than the previous day!  That’s pretty fucking amazing.  11 straight days – certainly the longest streak that I can recall since I started actively trading a few years ago…

Not sure what the “odds” may be for 12 straight, but I’m willing to bet that they’re very, very low.  And even lower for 13…and so on and so forth.  So this is the “high probability” part:  certainly there’s a very good chance that we’ll have a few down days.  ”Soon.”

Specifically, this leg of the trade comprises of May’10 115. puts @ 3.55/contract.  Going out to May expiration does give us some leeway should the SPY’s “winning” streak extend into the mid-teens.

Converse to the SPY’s streak is the VIX’s “losing” streak.  Surely, this must end as well – more than likely, when the SPY does sell off, the VIX will produce a healthy bounce.  As of right now, it is approaching, if not already sitting at (strong) support around 17.

Playing the VIX is always tricky and playing VIX options adds just another layer to that.  Derivative of a derivative of a derivative (of a derivative?) “predicting” things 30 days out…it gets pretty fucked up.  I certainly avoid long VIX options…

Short options, on the other hand, can be quite useful – usually the “safer” choice (most options expire out of the money, afterall) and they do provide income up front.  In fact, the SPY put purchase was (mostly) financed by selling VIX puts, Mar’10 18.’s @ 0.35/contract, to be specific.  I do consider this part high risk (although inherently lower than any long Mar’10 option).  The VIX needs to finish the week above 18. for me to keep all the premium; above 17.65 to keep at least part of it.  Currently it sits at 17.58, so really, it’s anyone’s game.  But I’d like to think that the odds do favor my side.

Here’s an overall look at the risk involved with respect to the SPY.  The VIX line (red) is a bit of a best guess since its values do not necessarily correlate with any SPY reading.  My breakeven is in the mid-115’s.  Profitability grows nicely south of there, while the opposite is true at higher values.

Most of that overall risk is tempered by the fact that the VIX options do expire on Friday.  So even if they underlying does not go up, surely it won’t suddenly just plummet 50% (if anything, it’ll just continue the “slow death” that it’s been dying).  The risk on the SPY puts is capped at the initial price paid.  Profits are practically unlimited; technically capped at the SPY hitting 0.  That has about as much chance happening as the VIX doing the same.

We’ll check back on this trade towards the end of the week, especially as we get closer to Friday’s OpEx.

Late Night Mundane UPDATE:

This is surely a sign of the end of bullishness…the SPY 20-day sma finally crossed back over the 50-day AND the index put/call ratio ($CPCI) spiked high to 1.68, which I consider a contrarian long SPY entry.

Any other day, I’d be ecstatic for these signals…but after 10-days of “straight up” market action, I fear they will be proven wrong.

But if I can’t follow them blindly, what damn good are these indicators for anyway…right?

So:  long SPY at the open.  Also keeping CHK, ENER, STP, MON, PNRA, ESRX, VOD among others, on the radar…

____________________________

I just want to say one word to you…are you listening?

PLASTICS.

While banking some short term coin on AMZN & CREE, I ran across this news story…which immediately makes me want to load up on IBM in a long-term IRA.

IBM researchers on Tuesday said they have discovered a way to make Earth-friendly [biodegradable] plastic from plants that could replace petroleum-based products tough on the environment.

Now the key part isn’t even that it’s plant-based plastic instead of petroleum-based.

The “green chemistry” breakthrough using “organic catalysts” results in plastics that could be repeatedly recycled, instead of only once as is the case with petroleum-based plastic made using metal oxide catalysts.

The key part is that it’s (potentially) infinitely recyclable.  And not only that, it would allow us to recycle all our current (petroleum-based) plastics (using the same “organic catalysts”).

If that all sounds something like dividing by 0 (”infinitely” recyclable)…well it’s the future dammit.  (With jetpacks and telepathic communication!)

The future is still plastic, ladies & gentlemen…and if this technology becomes proven, IBM will be at the forefront of it.

Financial markets are gripped by the role derivatives have played in Greece’s debt crisis, but Italy also has a derivatives time bomb, and hundreds of cities are in the €24-billion blast zone.

Many local governments eager to cut financing costs for years rushed to sign up for complex derivatives contracts, even when the terms were in English. But some cities, facing big losses when interest rates go up, are now trying to pull out of derivatives and suing the international and local banks that arranged the deals.

http://www.theglobeandmail.com/report-on-business/economy/why-italy-faces-a-derivatives-time-bomb/article1497312

Indeud. Brother Jake has been a printing press (pun intended) for all of you fanboys out there. I believe he deserves a shout out for his acumen.  Basically, investments along side him in $SLW, $ANV and $RGLD will soon see you upgrade your diet from nightly feasts on Ramen Noodles to walking into Le Cirque 2000 in sweatpants and sunglasses, and still getting served, just “because you can.”

As per my market wrap up–see yesterday’s post.  The same analysis and possible scenarios are still relevant given the benign action we saw today.

So the $VIX closed higher for the 2nd straight day, definitely ending that amazing streak of straight downward momentum.  The multi-year support around 17 has held strong.  And while it looks like it wants to bounce a bit more (which should bring some downwards market action along with it), the fact that it has failed to follow through on the last two morning gap-ups may put a kink in those plans.

But there’s no need to get anxious with any shorts.  I’d like to see it climb up past 20 (and its 20-day moving average, at the least), before I’d even consider switching over to the dark side.  Don’t snooze though…this bitch can move quick.

A few other OPTIONS MINUTIAE:

• The CBOE’s index put/call ratio actually flashed high on Monday (first time in over 2 weeks; highest since October)!  The reading of 1.87 resulted in the buying of several contrarian SPY long calls this morning…which are now up 10%.  A trailing stop should guarantee at least a few dollars out of it.  Today, the ratio is back in neutral at 1.13.
• HUGE volume in C 4.00 calls, with over 300k trading on the day at both Mar’10 & Apr’10 expirations; 150k in the Jun’10 ones.  BUY BUY BUY!!  Citigroup easily placed first in total options volume on the day, with 1.63 million.  That’s almost 3 times as much as the 2nd highest equity name (BAC) and 50% more than SPY, the usual leader.  Again, BUY BUY BUY!!!  (Unless it’s too late…)
• Yes, I did ignore WMT volume in the above bullet-point.  99% of WMT’s volume on the day were dividend plays and thus entirely useless for the purposes of trying to divine any additional insight…  The 800k+ traded in the Mar’10 52.50 calls is impressive though…
• “Government stocks” FRE, FNM, GE all at or near 2-year volatility lows.  The time is *now* if you’d like to bet long on volatility and general economic fuckery.  (Disclaimer:  the time has been *now* for quite some time…)
• Biotech lottery for your consideration:  AMLN.  Decision expected on/around March 12th.  Volatility already off the charts, but the Mar’10 ATM straddle is “only” pricing in a 25% move…

Personally, I’ve banked/scalped a few calls on names such as BIDU, BWLD, MA this week…but am still keeping things light.  An $SPX breakout (above 1150) and a $VIX breakdown (below 17) would convince me to man up and go long in size, while the converse would make me sit, wait, and continue to play “small ball.”

Market Summary

The $SPX rose 0.17% today to close at 1140, as we experienced another broadly flattish day of consolidation.  Certain underlying stocks saw some volatile swings today, and the marquee business in the world, $AAPL, broke out to all time highs. However, the overall market remains frothy and plagued by low volume.  The chart above shows that after the impressive run up from the February lows of 1043, we are now stretched fairly long as the RSI and Stochastics indicate a short/intermediate term overbought condition.  Moreover, we have successfully reclaimed all of the major moving averages without pulling back to test the underlying support of the move, as the 50 day moving average is down at 1111.  Above all else, though, the bears remain by far the most frustrated group because not only did the market fail to breakdown last July 2009 as well as this February, but the sharp rallies off of those bottoms have been followed by benign periods of consolidation to work off the overbought condition.  Some of the superstars of the previous bear market, including economist David Rosenberg, are making fools of themselves seemingly on a daily basis by cherry picking bearish economic data in order to prove why we must see the market drop 30% or more in short order.

Possible Scenarios

Successful trading is not so much about picking one thesis and sticking to it no matter what, so much as it is foreseeing several probable outcomes and knowing in advance how you will react when faced with them respectively.  In this particular market, the most probable scenario I see is a run up to the January highs of 1150.  I believe we will even make a marginally higher high.  At that point, all of the financial media will sing the praises of the breakout.  I believe we will then sell off sharply. One reason I believe in this outcome is because of how overbought on low volume we are.  So it makes sense that a continued drift higher on lower volume will eventually create an excuse for a sharp bout of profit taking.  Note also that this scenarios will create a bearish double top formation at 1150 or so and we could see an early version of “sell in May and go away,” whereby 1150 will be heavy resistance for a few quarters to come.

Another scenario I see is a sustained period of consolidation around the level we are at right now.  After several weeks of trading, the moving averages catch up to where we are now, and we also are able to work off the overbought condition without a sharp pullback.  This is a very bullish scenario and will lead to much higher stock prices over the course of the rest of this year.

A third scenario I see is a complete melt up in stocks, as the bears and underinvested bulls capitulate and buy stocks hand over fist.  They push the market up to 1250-1300 by May. This melt up is then followed by a sharp correction as investors truly sell in May and go away until Labor Day.

Strategy

Given my thesis that we are short/intermediate term overbought, I remain content to hold high levels of cash and $TLT as a way to play a flight to quality if we sell off.  I did buy $TRID for a swing trade today as I believe the stock has been decimated and is finally starting to act more constructive technically.  If we continue to melt up, I will hold my nose and sit out because I just do not see a favorable risk/reward profile to the long side right now.

Laying Off the Action

Any time you are wagering on an outcome that has yet to be determined, you are gambling.  Often times, when you decide to gamble, your mind is made up and you make the commitment.  For example, if you play poker or blackjack for a living, you drive to the casino most days and will sit down and play.  Yet, one concept that is overlooked by many mediocre professional gamblers is the idea of laying off the action.  Just because there are enough people at the casino who want to play 100/200 limit Texas Hold ‘em does not mean that you should sit down and play a ten hour session.  To be sure, ego plays a large role in the decision many marginal pros make to never lay off the action if it is there. They think, “I’m a pro and a good player. Therefore I will win eventually if I play long enough.” For precisely this reason, however, many of those marginal pros go broke. They play when their edge is not there.   The winning pro, instead, may sit down briefly at the table. But, if the game is not particularly profitable or if the pro does not feel that he is playing that well, he will simply get up and leave.  An often overlooked benefit to being an independent gambler or trader is the ability to come and go as you please.  Many gamblers and traders make the mistake of feeling like they always NEED to be gambling/trading.

Trading stocks offers similar situations.  Let’s say you wake up and are ready to make a lot of money. You drink your coffee, read the news and monitor your scans of potential setups.  But, you don’t find much to see.  Many charts are overextended on low volume, and could get more overbought. Thus, you do not have much of an edge either on the long or short side.  In times like these, it is important to remember one of the great benefits of your chosen profession–YOU ARE ALLOWED TO LAY OFF THE ACTION.

Market Summary

Stocks put in an extremely low volume, flat day as the $SPX closed down 0.02% to 1138.50. By many metrics, in including the Mcclellan Oscillators and The PPT algorithm over at ibankcoin.com, we are very overbought and ripe for some consolidation of not an outright selloff.  However, as it usually goes in the investing world, Mr. Market will do that which frustrates the greatest amount of traders.  Right now, the most frustrated are the bears and underinvested bulls.  Today was actually a victory for the bulls because after the nice run up we have had, a benign low volume day helps to work off the overbought condition without doing technical damage to the now bullish charts.

Today, I sold most of my position in $BZ at $5.36 because the stock has had a sharp rise since I bought mostly back at $4.66.  The company also announced an offering which is dilutive to the current shareholders.  I still believe in the company and will revisit it on a pullback.

My top position right now is $TLT which I am substituting for being short.  My cash level right now is north of 60% and is easily the highest amount of cash I have held in a long time.  I must admit I am itching to put it to work, but I am just not seeing that many opportunities.  Many charts I see are parabolic in the short term and need to rest or pullback.

So, I will lay off the action until better opportunities develop.

Hollywood’s BIG night of auto-fellatio/cunnilingus “went down” earlier tonight, ending with a couple surprise spurts.  I guess we’ll have to start calling it the more PC auto-fellatio/cunnilingus thanks to Kathryn Bigelow’s upset victories.  I have yet to see The Hurt Locker, but I just might have to after seeing the ease with which it defeated the 10-foot Blue Aliens of Awesomeness.

Based on the movies that I have seen, I would’ve given the award to Inglourious Basterds.  But at least Christoph Waltz got his; not that there was ever a doubt about that.  That’s a BINGO!

Now, in options land, the best picture award would most certainly go to the hot-’n'-heavy $VIX Red Candle Diaries.  I brought this up a few days ago and since then it’s been nothing but even more red candles.  In fact, on Friday the $VIX closed at a fresh 21-month low of 17.42; not since May 2008 have we seen numbers this low!

There’s actually pretty strong support at this level extending back to mid-2007.  Should we break it, we would be back in full-fledged bull market territory a la 2003-2007 (that is, the $VIX readings would be back in the range evidenced during that run).

My guess, based on just the market’s run over the past month, is that we get a pause, or a pullback, or whatever you want to call it (’x’ amount of up-days in a row, and all that jazz).  But that’s just a guess, just like last week.  And just like last week, I remain cautiously bullish and will be looking to scalp some longs (has worked well so far this month; up a percent and a quarter).

A few other OPTIONS NOTES from Friday:

• The index put/call ratio ($CPCI) continues its inaction, correlating with the monotonous slide in the $VIX.  We’ve now gone over 2 weeks without an extreme high or low reading; longest since May.
• Strong call action in PDE – 9k in Apr’10 32.50’s alone (on 250 open interest).  No news that I could find, besides a corresponding increase in crude.
• EBAY also seeing good call volumes as it approaches its 52-week high.  Biggest volume (10k) in Jul’10 30. calls – betting on a 20%+ gain by then…
• Buyout rumor of the day:  NUAN
• Last but not least there’s ITMN, which finished a surprise 2nd in the daily equity options volume table.  But that’s what happens when biotech lotteries hit the jackpot.  Mar’10 ATM/OTM calls were the most active, with the 25’s trading almost 50k and the 30’s almost 40k.  Both of those are now out of the money, with the 30’s needing a 25% move in the next 2 weeks just to hit their strike…a lofty goal, especially with the impending volatility crunch…