$$ Kyle Bass Tells It Like It Is - Part Two

Bass' Best Investment Ideas - CNBC.com

$$ Kyle Bass Tells It Like It Is - Part One

Ahead of the Money - CNBC.com

$$ Yesterday's News: China Sells. Today's News: Fed Buys.

Interesting headlines coming one day apart:

China Reduces Long-Term Treasuries by Record Amount

Fed Buys $2.551B Treasuries

$$ ARMS warning

I closed out of my shorts today based on the 5-day ARMS showing a deeply oversold condition combined with today's price action and a short term head & shoulders topping pattern on the VIX. 

Note the recent rallies after previous similar oversold ARMS warnings.  If we get a rally, I'll put my short back on because I am generally bearish on the market through October. 

$$ QE 2.0?

The FOMC meets on Tuesday.  Speculation persists that the Fed will announce a new round of quantitative easing at the meeting.  Ambrose Evans-Pritchard examines the topic in today's London Telegraph.  He concludes:

"Alabama Senator Richard Shelby has blocked the appointment of MIT professor Peter Diamond to the Fed Board, ostensibly because he is a labour expert rather than a monetary economist but in reality because he is a dove in the ever-more bitter and polarised dispute over QE.

The Senate has delayed confirmation of all three appointees for the board, who all happen to be doves and allies of Fed chairman Ben Bernanke. The Fed is in limbo until mid-September. So the regional [Fed chief] hawks who so much misjudged matters in 2008 [when the Fed only managed one 25 basis point Fed funds rate cut as America burned between March 19 and October 7, 2008] have unusual voting weight, and now they have a commodity spike as well to rationalise their Calvinist preferences.

Whatever Dr. Bernanke wants to do this week - and I suspect he is eyeing the $5 trillion button lovingly - he cannot risk dissent from three Fed chiefs: one yes, two maybe, but not three. He faces a populist revolt from the Tea Party movement, with its adherents in Congress and the commentariat. And China simply hates QE, which may or may not be rational but cannot be ignored.

Global markets have already priced in the next QE bail-out, banking the "Bernanke Put" as if it were a done deal. We will find out on Tuesday if life is really that simple."

$$ Hindenburg Omen

The Hindenburg Omen is traditionally defined when, on a given day, the number of NYSE new 52 week highs and new 52 week lows must both exceed 2.2 percent of total NYSE issues traded that day.  The Omen is a bearish sign.  Robert McHugh has studied the Omen in depth, and finds several other conditions helpful in predicting a downturn in the stock market:

1)  The NYSE 10-week moving average is rising the week of the Omen,

2)  The McClellan Oscillator is negative on that same day, and

3)  The number of new 52 week highs cannot exceed twice the number of new 52 week lows that day.

Omens often come in clusters.  The first time an Omen occurs, it's called an unconfirmed Omen. If a second Omen occurs within 36 days of the first Omen, the Omen is "Confirmed." 

McHugh's study has shown that Confirmed Omens have preceded all stock market crashes and panics over the last 25 years.  In addition, 75% of the time the market falls at least 5% after a Confirmed Omen.  These downturns have commenced within 1 day to 4 months after the confirmation of the Omen. 

From the up trend that started in March of 2009, we received our first Hindenburg Omen on Tuesday, July 6, 2010.  We'll be on the lookout for confirmation.  Today came close, but no cigar.  

$$ Option Strategies to Take Advantage of Price & Volatility Movements

Option prices are primarily determined by:

1.  Whether and how much the option is in the money (i.e. intrinsic value), and

2.  The time value of the option.

Time value is a function of several things.  One of the main drivers is volatility.  The greater the volatility, the higher the time value component of the option price, all other things being equal.   Volatility generally rises when prices drop, and falls when prices rise. 

During up trends, you might think that buying call options on price dips makes sense.  However, this strategy has a couple of problems:

1.  After a price dip, volatility will be relatively high.  So, you are paying a huge premium for the time value of the option.

2.  If you are right and the price of the underlying moves upward, your reward is sabotaged by falling volatility, i.e. falling time value of the option.  

Accordingly, I prefer to sell puts on dips in up trends.  This is a "premium collection" strategy.  My gain is limited to the amount of premium I collect. 

By selling puts when volatility is high, my premium is increased (because the time value component of the option price is increased).  If the up trend resumes as I expect and price moves upward (and volatility falls), then:

1.  The puts I sold become further out of the money, and

2.  The time value component of the puts I sold falls. 

Both of these things are good for me.  I want the puts I sold to expire worthless to the put buyer. 

IMO, selling puts on dips in uptrends is a far superior strategy to buying calls on dips in uptrends because with selling puts, I benefit from both price and volatility movement.  I prefer selling puts that are slightly out of the money with an expiration date 2-3 months out.  During a multi-year up trend, I hope to have ~3 opportunities to sell puts per year.   

In downtrends, on the other hand, buying puts on rallies takes advantage of both price and volatility movement.  After a rally, volatility will be relatively low.  Should prices resume their decline, volatility will rise.  All option buyers benefit from rising volatility.  And puts benefit from falling prices. 

IMO the best way to capture the benefits of falling prices and rising volatility is to purchase longer term (6 months to a year) out of the money puts.  You want some time left on your puts after the expected price decline occurs.  This way, you maximize the benefit of the volatility increase. 

Options are a complicated subject.  The foregoing is an oversimplified treatment, but the concepts are sound.

$SPY Market Breadth - Percent Above 50 DMA, 150 DMA

Let's take a look at a couple of charts showing the percent of S&P stocks above their 50 day moving averages, and 150 day moving averages.  First the 50 day chart:

You'll notice that we rarely drop much below the 20-25% range unless we are starting a new downtrend.  The May-June drop well below 20% is ominous in this regard.  It is my belief that we have begun a new downtrend.

In addition, you'll note that during downtrends, rallies don't make it past the 75-80% resistance zone.  Currently, we are sitting at 73%.  Based on this reading of the chart, we are very near a top.

Here's the 150 day chart:

Similarly, you'll note that breaks below the 35-40% range usually signify downtrends, while breaks above 60-65% are characteristic of up trends.   Up trends tend to find support at the 60-65% and 35-40% range, while downtrends find resistance at the 60-65% range.

Recently, we broke well below 35%  on the 150 day, and currently we are at 57%, both of which confirm the interpretation of the 50 day chart that we are near a top in a new downtrend.

If we manage to break through the resistance zones for downtrends (75-80% on the 50 day, 60-65% on the 150 day), the "new downtrend" will be placed in serious doubt.