George Washington delivered the first State of the Union address on January 8, 1790 and later this month George Bush will use the occasion to tell us how he views the US economy, the number 1 political issue among presidential hopefuls. We expect a bullish outlook to be conveyed, confirmed by government statistics. However, our confidence in some of these statistics is dwindling (that’s a nice way of putting it!). Phil has often discussed in the past that when unemployment figures remain the same or rise slightly, it is not necessarily reflective of a healthy economy when the reason the numbers change only fractionally is due to workers transitioning from higher-paid to lower-paid work. Additionally, when industrial production, employment and real personal income turn negative, it’s best to “Think For Yourself” as our pal Tom2oc likes to say, rather than trust blindly the messages and spin conveyed in the media.
In recent weeks the stock market has suffered a relatively big downturn. Many indexes and stocks are precariously perched on key support levels and Friday’s close did not inspire confidence that they will hold. So, we decided to return back to the 2000-2002 bear market to view the context of the decline over the past few weeks. In the chart, you can see that the decline in recent weeks is somewhat insignificant relative to the huge declines earlier in the decade.
Will such massive declines occur again if the recession Goldman Sachs and others have portended does occur? We doubt it very much. The declines in the early part of the decade followed extremes of bullish sentiment. However, we do believe that when traders look back on 2008, the one word that will sum up the year is ‘volatile’. This next week might be a prime example. CPI, PPI, earnings reports, options expiration (hey when the Fed first made a substantive rate cut, wasn’t it during options expiration?….didn’t Bernanke refer to such a ‘substantive’ cut in his last speech and isn’t much of the mainstream media questioning why he didn’t make the cut during his speech?…We will be especially alert this week, particularly Thursday for any news coming from the Fed). So, with the possibility of further substantial declines or massive rallies, how do you play the next week, the next month and the next year?
The straddle protects the options trader against shocking and unexpected moves in a given direction by hedging both directions. With a straddle or strangle, it doesn’t really matter which direction the stock moves, provided it moves far enough. When you have little certainty regarding the direction that a stock will move, it becomes imperative to protect your virtual portfolio against violent moves that can be catalyzed by unexpected daily events.
Sometimes straddles/strangles are considered delta-neutral trades, which can be interpreted to mean simply that when a stock rises or falls, the opposing instruments offset each other. For example, if a stock were to rise $1, the long call would gain but the long put would lose the same amount. This is often true for straddles and strangles in the short-term for immediate moves. Remember that, as stocks rise, long calls continue to make money whereas long puts can only lose a fixed amount. Similarly, as stocks fall, long puts continue to profit in the downtrend while long calls only lose a fixed amount, the debit spent. As a result, neutrality is only maintained for a short duration. If you have experienced a painful start to the year, are eager to minimize account volatility and yet still participate from market volatility, this is a strategy that is well worth considering further!
Stay Safe!
