Index

1. Commentary
2. Financial Sector Takes a Beating
3. Options Versus Stocks
4. Current Trade Updates
5. Alcoa and Caterpillar
6. Schlumberger
7. Volatility Index
8. Mortgage Rates Drop Like A Rock
9. Closing Thoughts

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1. Commentary

Out with the old, in with the New Year. Wall Street couldn’t wait to put an end to 2008 and brought 2009 in with a bang. In a year that saw the Dow fall nearly 34%; the Nasdaq tank over 40%, and; the S&P 500 plummet 38%, 2008 was the market’s worst year since 1937. It was something that only happens “once every 100 years” and it was breath-taking to watch corporate America crumble right before our eyes.

For those of you who have followed the market over the years, you may remember the panic and devastation from the 2001 terrorist attacks that caused the market to tank or the Internet bubble that burst right before Wall Street’s eyes a year earlier. Those two events were astonishing and the collapse of 2008 was equally impressive. If not more so.

The market may have closed below 9000 to end the year but the Dow had a head of steam heading into 2009 and easily broke that level with Friday’s 258 point gain. The Dow’s close of 9034 came on a rally that saw intense buying throughout the day. The Nasdaq took out the 1600 level as it added double nickles (55 points) to close at 1632. The S&P 500 chipped in with a 28 point gain and finished at 931.

I mentioned in mid-December that all three of these resistance levels needed to be broken and held before any substantial rally can be considered. Are we there yet? It sure looks like it.

The market looks strong right now and some of this is built on Obama’s infrastructure spending plan to lift the economy once he takes office. The key for a sustained rally will be how the market reacts to fourth-quarter earnings and they will certainly be a mixed bag of tricks. However, earnings have been lowered so the bar isn’t that high.

The retail sector is going to stink it up but there will be diamonds in the rough. Energy is hot again as you will read about below and where is oil, gold, and the econony headed in 2009?

Back in June I called for a huge market drop as the bears came out in force to push the Dow to its lowest level in nearly two years. Back then I had four words for you that were leading the debacle: Oil, Banks, Housing and the Dollar. I mentioned these are the real “Four Horsemen” of the market right now and I think they still hold the keys for 2009’s outcome.

These are the questions that make up a major part of the market but as a whole there will once again be winners and losers this year. The key is to take advantage of these situations when they arise.

2. Financial Sector Takes a Beating

The new Dirty Dozen: AIG, Bear Stearns, Citigroup ($7.14, up $0.43), IndyMac Bank, Freddy Mac (FRE, $0.73, unchanged), Fannie Mae (FNM, $0.73, down $0.03), Ford (F, $2.46, up $0.17), General Motors (GM, $3.65, up $0.45), Merrill Lynch, Wachovia, Lehman Brothers and WaMu. There are more but you get the point.

It all started when news hit Wall Street that JPMorgan would be buying Bear Stearns for $2 a share back in March. The $236 million dollar price tag was just astonishing as Bear had seen its stock price fall from over $120 a share to $10. The Dow was at 12,500 and this “forced” deal that was assisted by the government and Wall Street had no idea this would be the snowball that would turn into an avalanche.

On 3/25/08 I had these comments concerning Bear Stearns:

“I have been warning you of a Bear Stearns collapse since early August (2007) when the stock was over $100 a share and as recently as January when the stock was over $80. Talk about “ruining a company” and Bear Stearns will now top many of those lists in a who’s who to blame. Those are just incredible numbers if you take a minute to fathom how an 85-year old company virtually ruined itself overnight.

From 1/23/08:

“I wrote about the company last August when the stock was at $115 and said that from the chart, “Bear Stearns looked poised to fall below $100 before buyers come back”. Three days later the stock hit a low of $99.75 and the August 110 puts I recommended at $4.00 traded above $12.00. No doubt a great trade and a great return.”

JPMorgan eventually agreed to pay $10 a share for a Bear, but as you can see, when the market panics there is an opportunity to make money when people are headed for the exits. Most investors tend to think you can only make money in the stock market if something goes up. It is often hard for them to see how short-selling works or how put options can be used when a stock is headed lower. Use this to your advantage.

A lot of money was made in Bear Stearns on the way down as some option trades returned 100%, 200% and even 400% (an AIG put option idea from the blog returned over 800%). However, money was also made on the rebounds when Bear Stearns was fighting off its demise. Some call option trades returned 100%, 200%, and even 300% in some cases.

Next came the meltdown of IndyMac which was shut down and became the biggest bank failure in history. Then Freddy Mac and Fannie Mae were seized by the government. If you stop and think about the magnitude of what was happening, it was easy to see that the stock market was going to struggle. By July, oil was racing towards $150 a barrel and the Dow had broken below 11,000 for the first time in two years. That was a 1,500 point haicut in five months. But it would get worse.

On 9/15/08, Lehman Brothers filed for bankruptcy. That day the Dow got hammered for a 500-point loss as the Dow closed at 10,900.

Here were my thoughts on Lehman back in July:

“Lehman Brothers Holdings (LEH, $14.43, down $2.87) continues to commit highway robbery. There’s no other way to explain it. It was exactly one month ago I mentioned the company had raised $6 billion through an offering of common and preferred stock. What was the name of that analyst who “upgraded” Lehman on the eve of the offering priced at $28? The stock was $30 at the time…”

The collapse of Lehman in September led to Bank of America (BAC, $14.33, up $0.25) closing a deal for Merrill Lynch. Bank of America had earlier walked away from a deal to acquire Lehman and both of theses news worthy events took place the same day. The deal closed last week and Wells Fargo ($30.00, up $0.52) just got Wachovia as well. That marriage was announced in October.

Merrill’s collapse was sad because the firm had been around for 100 years and was an icon on Wall Street. We were set for a drop below 10,000 for the Dow and October was right around the corner. Sure enough, by the end of the first week, the Dow had closed at 9,950. By November 20, the Dow had bottomed at 7,550.

Panic, fear, chaos, anxiety and confusion had set in when the initial $700 billion bailout failed but was later approved. We were getting 500, 600 and 700-point swings in the market and it was/ is mind boggling to watch how much money the government is throwing out to save corporate America.

3. Options Versus Stocks

One of the biggest trades I ever made in Google (GOOG, $321.32, up $13.67) was back on 10/20/05. The stock was at $300 the day before the company announced earnings and I bought two out-of-the-money call options for $10 apiece. The total cost of the trade was $2,000 and by 11/07/05 the calls had made me $8,000 as Google was trading for nearly $400 a share. Well, here we are three years later and the stock is right around the same level.

To buy 100 shares of Google it would cost over $30,000. I controlled 200 shares of Google by buying two call options at a fraction of the cost it would take to buy the stock. Yes, you could have made $8,000 on the stock when it ran from $300 to $380 during the aforementioned time frame but you would have had to put up $30K.

The clues were there though that Google was going to have a blowout quarter and although it’s risky to play these types of trades, they do work. The point I’m trying to make is let’s say you have an investment portfolio of $20,000. There is no reason why you can’t take 10% of that money and use it on “speculative” investments. Of course, everyone’s financial goals and risk strategies are different but with no risk there is no reward.

The point I’m trying to make is that buying stocks do not provide the homerun returns that options do. There are strategies with options that are considered safe that provide you with 8%-10% returns a month. We can teach you these types of iron condor option trades or if you want to play the e-mini’s we can teach you how to trade them as well.

I’m just not a big believer of stocks because I don’t like the amount of capital that you have to put up to make a decent return. Options provide more bang for the buck.

4. Current Trade Updates

As many of you know, from time to time I will profile option trades that are extremely risky in nature. Most of the time these trades can have wild price swings and if anyone decides to follow these trades, then know that you play at your own risk. I’m not a fortuneteller and I have no clue what 2009 will bring. If someone tells you they can predict exactly what the market will do day-to-day, run for the hills. My philosphy on the market is that I’m both a bull and a bear.

The one thing I find consistant with the market is that they are always certain sectors or certain stocks that are hot or cold. One minute a stock is rising like its hair is on fire, the next minute the stock is tanking like the Titanic. Understanding the market “Don’t Come Easy” as Ringo Starr would say. You have to read, research and study then be able to digest that information to your advantage.

So without further ado, here is what we are working with going into 2009…

5. Alcoa and Caterpillar

From 12/9/08 (stock and option quotes are also from this day):

“The Alcoa January 10 2009 calls (AAAB, $1.20, up $0.55) were up 85% and the Caterpillar January 40 calls (CXJAN, $4.80, up $2.15) were up 80%. The December call options for these two companies did way better of course but there was heavy buying in the aforementioned options.” Key word here was the “heavy buying”.

Update from 12/11/08:

“The Alcoa January 10 calls (AAAB, $1.60, up $0.15) were profiled at $1.20 and it looks as though shares could make a run to $12 over the short-term. The stock appears to have bottomed and if we can get a push to $12 these calls will be worth at least $2.00 and that is the area we are targeting.”

“Caterpillar traded lower on Tuesday and hit a low of $41.26. It rebounded to finish flat but had a good day yesterday. The January 40 calls (CXJAN, $6.20, up $0.45) were profiled at $4.80 and could have been picked up cheaper than that.”

Current Update:

These trades did well on Friday as Alcoa (AA, $12.11, up $0.85) jumped 8% and Caterpillar (CAT, $46.91, up $2.24) added 5%. The Alcoa January 10 calls (AAAB, $2.32, up $0.68) are well above our $2 target so set stops there. The Caterpillar January 40 calls (CXJAN, $7.10, up $1.95) gained nearly 40% on Friday and stops can be set at $6.05. Both of these call options expire on January 16.

6. Schlumberger

Schlumberger (SLB, $45.62, up $3.29) had a huge day on Friday as expected, rising 8%. The February 45 calls (SLBBI, $4.30, up $1.30) could have been purchased last week for $2.00. Our initial target was $3.00 and I had mentioned I didn’t have a problem if you kept them open because momentum was building. Sure enough, the call options got a 43% pop on the 8% move in the stock. We now have over a 100% return.

These calls do not expire until February 20 so there is plenty of time for even bigger returns. However, set stops at $4.00 or $3.75 to protect these profits. Schlumber recently broke through its 10 and 20-day moving averages and is right at its 50-day average. The recent move could clear the way to a run at $50. That would put the calls at $6 or better and put our gain at 200%.

7. Volatility Index

On November 21, the Dow hit a low of 7400 while the Volatility Index (^VIX, 39.19, down 0.81) soared to a high of 90. The VIX has slowly trended lower over the past few weeks as volatility has somewhat relaxed. It also helps that the market has been in a bullish mood lately. A rising market brings the VIX down.

Remember, historically if the VIX is at 30 or more then it means the market is nervous. If the VIX is under 20, the market is confident. It’s not clear what the “new” standards should be for the VIX because the volatility has been so historic but techically speaking the market is still nervous.

Trading volume was light over the holiday and the market stayed in a tight trading pattern. However, all three indexes have their bull horns on and we could continue to see the VIX fall. Do keep in mind though that there are wild cards and jokers still out there and we have a lot going on in January.

8. Mortgage Rates Drop Like A Rock

Mortgage rates are now at historic lows (for qualified borrowers) with rates dropping below 5% in some areas of the country. The avearge 30-year fixed-rate mortgage is at 5.26%, down from 5.36% last week. The 15-year is at 5.07%, down from 5.23%. This is the lowest rate in nearly 40 years since Freddie Mac started its weekly mortgage survey.

Low rates will help the housing market and we will be watching these developments all year. Some of the housing stocks to put on your watch list include Toll Brothers (TOL, $21.59, up $0.16), D.R. Horton (DHI, $7.34, up $0.27), Lennar (LEN, $9.18, up $0.51) and Pulte Homes (PHM, $11.17, up $0.24).

Toll Brothers was at $15 in November, D.R Horton was at $4 and change, Lennar bottomed at $3.42 and Pulte hit a low of $6.50.

For those who of you who have followed my writings here were my thoughts concerning Lennar on 07/10/07:

“With the housing market showing no signs of recovery any time soon it may be time to take a look at some of the stocks in the sector that could be headed lower. While be may have arrived to the party late, I certainly don’t think the party’s over as the whole group could see continued new lows. Although it’s hard to predict where the bottom lies for some of these stocks, I believe they could still see another 15% to 20% drop. As such, if my forecast is right, Lennar ($34.86, down $1.45) could be headed below $30.”

To read the complete article click here.

I profiled a put option trade in the Lennar August 35 puts which returned well over 100% and is yet another example of how to play stocks when they are going down and everybody is selling. I only point these quotes and things out to you to help you try and understand the market not to toot my own horn.

I get a lot of questions on how I come up with my ideas and where to find trades and I thought I would share some of the quotes from the blog to help you learn. Believe me, I’ve had my share of clunker trades but when you apply some research to your trading ideas and study charts and trends, you will come out ahead.

Anyway, these stocks started rallying in November when the government said “we” would buy up to $600 billion in mortgages held by Freddie, Fannie and others. Of course, not everyone is benefiting from the lower rates, especially the home owners who owe more on their house than it’s worth because of the rapid decline in home values.

There will still be foreclosures but the new money and first time home buyers could be the first step to a much needed recovery. Here are some numbers for those of you thinking of buying a house. A loan of $165,000 would cost you a little over $900 a month so just plan for $1,000. These are enticing numbers and the reality of owning your own home is still doable.

The minimum wage rate, currently at $6.55, is going to $7.50 in July meaning a 40-hour work week still only nets the average American $1200/ month. I throw these numbers at you so you can see the disparity between what people make and what things cost. This was the problem with the housing bubble when people made $7/ hour and were getting a $200,000 mortgage loan on shoddy credit. We still need higher minimum wages of $10.00/ hour and houses to get to $125,000 on average before things even out in my mind but it all comes down to how people manage their money. It’s not how much you make, it’s how much you save and the returns you make on that money is what really counts.

Everybody is getting smarter about money which should help the housing sector. Yes, the rally started in November in some of the aforementioned stocks but there will be some trades out of the group.

Now, if you can’t wait for a trade in the home sector and you still think they go higher which one do you go with? The February calls will provide more time than the January calls and if you are really unsure and want some protection you could use a two-to-one ratio with both a call and put option. That would hedge your risk.

Here’s the short list:

Pulte could run to $13 but there wasn’t much action in the February 12.50 calls (PHMBV, $0.95, up $0.05) while the January 12.50 calls (PHMAV, $0.30, up $0.05) barely traded over 100 contracts. I don’t like either of those trades. D.R. Horton and Lennar are trading under $10 as well and playing options on stocks this low is tricky. That leaves Toll Brothers.

The Toll Brothers January 22.50 calls (TEPAX, $0.75, unchanged) saw 2,700 contracts trade hands on Friday while the February 22.50 calls (TEPBX, $1.80, up $0.05) traded under 100 contracts. There were over 1,000 contracts traded on the February 20 calls (TEPBD, $3.15, up $0.15) which suggests some exotic option strategies are already being deployed in Toll Brothers with the January 22.50 and the February 20 calls.

I’m not a fan on any of these trades but the February 20 calls could be played with a limit entry price of $3.00 (if you can get it) with a stop of $2.50 and an exit somewhere around $4.00.

9. Closing Thoughts

There’s an old wise tale that what the market does in January sets the tone for the rest of the year. Last January, the Dow finished the month lower and we already know the numbers for 2008. I don’t think the Dow will fall another 35% this year and I don’t think it will gain 35% either. So there’s my market prediction.

The Dow closed above 9,000 for the first time in two months. Wall Street is bullish right now and there is a pile of money on the sidelines waiting to buy stocks. Investors are either going to keep their money under the mattress or start putting it back to work. There is nearly $10 trillion in cash and money markets right now and stocks are at historically low levels as far as valuations go.

If we can get a continued rally then the rush could be on. However, we could be in the midst of a bear market bounce if the current rally fails and I would not discount the possibility of the Dow retreating and retesting its November lows. Especially if the commercial real estate market continues to deteriorate. The next few weeks will be critical in which way the market is headed over the short-term but I still expect some volatility. As option traders, that’s the number one thing we want to see.

Here’s to a New Year and a successful 2009. If you are new to options and would like to learn low-risk option strategies that return you 8%-10% a month or even more then take a look at some of our option training education courses on the right of this web page and click on a link that interests you.

If you want to invest in options, have a plan for 2009. We are in for another exciting year of trading and remember that options are the most powerful way to make a lot of money in the market due to their leverage. Yes, the risks are that much higher but if you learn how options work then you will be less intimidated and on your way to better returns.

Rick Rouse
Rick@OptionsMentoring.com

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