The Option Strategist HOTLINE Thursday, September 4th, 2008 Note: if you are viewing a text version of this report, click on the following link to see the charts: http://www.optionstrategist.com/products/advisories/hotline/charts.asp The broad market trading range has finally been broken -- on the downside. $SPX has oscillated between 1265 and 1305 for nearly a month. Now that it has broken through on the downside, we want to see the technical indicators confirm the bearish action. If they do, we'd expect to see a retest of the July lows (which are not that far away). In fact, considering just how oversold the market was at the July bottom, the ensuing rally has been pathetic. Many indicators, some of which were trumpeted far and wide in the media, registered historically oversold conditions in July. Yet all that the bulls could muster was an obviously weak-looking rally (see Figure 1). The equity-only put-call ratios are still in disagreement. The standard ratio (Figure 2) has remained on a buy signal since the July bottom, but now it is beginning to curl higher -- a move which would result in a sell signal if completed.. The weighted ratio rolled over to a sell signal about two weeks ago. It has wavered recently, and needs to clearly exceed the recent high to remain on a sell signal (see Figure 3). But, for now, our computer analysis program rates the weighted ratio as a "sell." Market breadth generated sell signals after the last rally attempt above 1300 on $SPX. At that time (late last week), breadth expanded enough to get overbought. That's okay as long as it stays overbought. But it did not, and breadth sell signals were issued by both oscillators early this week. Until today, even though the market was falling, these oscillators were not nearing oversold territory. So, they are not anywhere near setting up buy signals at this time. The volatility indices ($VIX and $VXO) broke bullish trend lines this week. When $VIX closed above 21.50 this past Tuesday, that broke the bullish downtrend line. Since then it has accelerated higher, confirming the new bearish uptrend in $VIX. As is often the case when a downturn begins, $VXO is racing ahead faster. The premium on the $VIX futures had been in a bearish state since August 12th. As is usually the case, the market eventually succumbs to this bearishness. Those high levels of premium have dissipated now, but the damage has been done. Currently, the front month September $VIX futures are trading at a small discount to $VIX, of 30 cents. The October futures are trading at a premium of 31 cents. Neither is significant at this time. The term structure of the $VIX futures has moved from an extended bullish (overbought) position to a more flattened position -- moving in a bearish direction. In summary, then, the breakdown by $SPX is significantly bearish. Market breadth oscillators and $VIX have confirmed this move, as they are bearish as well. It also looks like the put-call ratios are falling in line on the bearish side as well. In our opinion, this is a full-fledged sell signal which will test the July lows and likely has a good chance of exceeding them. Note: if you are viewing a text version of this report, click on the following link to see the charts: http://www.optionstrategist.com/products/advisories/hotline/charts.asp In last week's newsletter, we made a conditional recommendation. That has been elected on the downside, and SPY Oct 127 puts (SFBVW) should be purchased. + S522: Buy 6 SPY Oct 127 puts (SFBVW) Stop yourself out if $SPX closes above 1285. Covered Call Writes & Naked Put Sales Position CW234: ProShares Ultra Short S&P 500 (SDS) Put Sale Sell 3 SDS Oct 62 puts (SDSVJ) at 1.10 or more. SDS: 69.96 Oct 62 put: 1.10 SDS moves in the opposite direction from $SPX at twice the daily rate. So selling a put on SDS will make money if the general stock market moves lower. This acts as a small hedge to other "normal" naked put positions, which have risk if the stock market moves lower. This write works best for margin accounts (expected margin investment: $1,600 per naked put), but can arguably be used by cash accounts as well. The expected return is 22% on margin and 7% on cash. Futures, Sector, and Stock Sentiment There were new buy signals in BAC, ICEw, and Japanese Yen futuresb. There are oversold conditions in CMEw, MAw, Cocoa futuresw, and Swiss France futuresw. There are new sell signals in BIDU, CHK, QQQQw, and $RUTw. There is an overbought condition in UBS. We are going to take a position that is bullish on the Japanese Yen. The most liquid way to accomplish this is to use the Yen options that trade on the ISE option exchange. On that exchange, currency contracts are inverse. In other words, they are in US Dollar terms. Specifically, the Yen contract uses symbol $YUK. As the Yen appreciates against the dollar (which is what we think is going to happen), $YUK goes down in price. Thus we buy $YUK puts to implement a buy signal in Japanese Yen futures options. Of course, one could just buy Oct JY calls on the futures exchange, but the $YUK options are available to all traders whether or not they have a futures account. Position PC964: Bullish position in Japanese Yen Buy 8 $YUK Oct 107 puts (UDEVN) at a price of 1.78 or less. $YUK: 107.08 Oct 107 put: 1.76 Stop yourself out on a close above 109. Volatility Trading There aren't many skews at the current time, but one that is very prominent is in GeoEye (GEOY). We already have a calendar spread in GEOY, although it wasn't available at our price for long, so many subscribers may not have been able to establish it. The reason for the skew is unclear. It could be related to the company's planned launch of a satellite on September 6th or 7th. In any case, a dual calendar spread involving Dec and Oct options looks attractive. Position E787: GEOY Dual Calendar Buy 6 GEOY Dec 30 calls (QZYLF) and Sell 6 GEOY Oct 30 calls (QZYJF) and Buy 8 GEOY Dec 20 puts (QZYXD) and Sell 8 GEOY Oct 20 puts (QZYVD) For a total debit of $1,050 for the entire position. GEOY: 25.93 Dec 30 call: 2.50 Oct 30 call: 1.80 Dec 20 put: 2.50 Oct 20 put: 1.75 Follow-Up Action: All stops are mental closing stops unless otherwise noted. Position CW214: FCX dropped sharply, and the stock is essentially in free fall. Cover all naked puts now -- even if you just rolled down. Position CW230: the COF puts (COFUE) should have been covered at 0.05, closing the position. Position F263: the Nat Gas long straddle. We want to speculate a bit with this position. Sell the Dec NG 90 put that is long now (hold the Dec 90 call). If Dec Nat Gas rallies, we will adjust the Dec 90 call later. As a defensive measure, however, if Dec Nat Gas falls below 79.50 at any time, then sell the remaining Dec 90 call and buy a March NG 80 straddle at that time. Position F332: the S&P put ratio spread. As the market declines, this spread is widening (which is good). The maximum profit area is between 1210 and 1230 at September expiration. Plan to remove half the spread if it can be removed for a credit of 5 points or more. Then hold the balance. Stop yourself out of the entire spread if Sept S&P futures trade at 1175 or lower. Position I298: the SPY/$VIX hedge. We are long puts on both SPY and $VIX, due to the large premium that existed on the $VIX futures. The position is marking down slightly. Make this adjustment: sell all the $VIX puts now, and continue to hold the SPY puts. Use a trailing stop at 127.50 for the SPY puts. Position I299: the VX futures calendar spread was established at 1.50 (Oct over Sept), as it actually traded much higher than that. The spread has shrunk now, so remove half the position at 0.60 or less (Oct over Sept) to take a partial profit. Position PC949: lower the stop for the Oct Cotton bear spread to 67.70. Position PC954: the GE calls (GEWLC) were stopped out today. Position PC958: the POT Oct 180-220 call bull spread was stopped out when the stock closed below 170. Position PC959: sell a quarter of the IBM Puts (IBMVE) now, to take a partial profit, and then lower the stop to 122 for the balance of the puts. Position PC961: the Monsanto calls (MFPJC) were stopped out when the stock closed below 109. Position PC962: the USO call bull spread (Oct 93-106) was stopped out when USO closed below 90. Position S516: the BBH calls (BBHIT) were stopped out. Position S520: the QQQQ calls (QQQIT) were stopped out. NOTE: if any position is not specifically mentioned, then its stop or other follow-up action is unchanged from the last published newsletter.