Reasonably Thinking

Two months ago, I proclaimed that the market was up and therefore time to sell.  At the time, I shorted SSO (an ETF that positively tracks the S&P 500 performance).  The market has since fallen from 1,115 to 1,052, equating to a 5.7% drop.  Today, I took profits by covering this position.

Consider the rationale…

Long term, I remain bearish on both the US economy and S&P 500.  However, in the short term, the newswire is bursting with bad news–housing sales plummet, Greece debt auction is weak, consumer sentiment falls, Yen rises against USD, Ireland debt rating is downgraded–how much worse can the wire get?  I’m not entirely sure, but I would feel too greedy for having been correct on this trade and not taking some profits.

Keeping score, this two month trade netted me a 9.7% return of $164.

In other news, here is a great link as to why the housing consensus was incredibly wrong this morning.  The consensus predicted home sales of 4.65 million.  The author predicted a very low 3.95 million homes sold.  Actual sales came in at an even lower 3.83 million homes sold.

One last musing…  the relationship between commodities and bond yields disturbs me.  Although oil is starting to look attractive in the low $70s, I am intrigued by the paradox of high gold prices concurrent with low yields.  Perhaps more on this later.

Here is a great post by Diana Olick suggesting that housing prices will succumb to massive inventory.

I agree.  My previous trades and current positions, betting that housing prices will fall, can be found here.

Today’s 2% stock market rally resulted from quarterly bank data and momentum, neither of which changes my underlying thesis.  I still believe that economic fundamentals are worsening, which is a point I described in last month’s article:  Housing, Economy, Banks–A Three Legged Stool With Three Broken Legs.  Furthermore, I agree with those who view the market as overvalued (I’m primarily thinking Hussman/Hester and Schiff).  As such, today’s market action provided an opportunity for me to increase my overall short exposure.

The Trade:

Sold 4, SDS put spreads, at interval 28/36 (+/-), that expire in January 2011, for $5.12 each.  (Remember, SDS has an inverse correlation to market performance; as the market falls, SDS will rise).

Maximum loss = $1,152 is SDS < $28

Maximum gain = $2,048 if SDS > $36

Breakeven = $30.88

(Calculations exclude a $14.95 commission)

(Image from OptionsXpress)

In making this trade, I am betting that SDS finishes (in January) above $30.88 and would benefit from the maximum gain above $36.  The market is pricing in a 27% probability of >$36; this seems a little low for me.   On the other end of the spectrum, the market is pricing in a 41% probability of <$28; this seems very high.  In other words, the market is pricing in a 41% chance that I’ll lose the maximum $1,152 on this trade.  I doubt this will happen as I readily bear this risk.

The probabilities of payouts are structured as such:

41% SDS < $28

32% $28 < SDS < $36

27% SDS > $36

(Image from OptionsXpress)

The tactics of this trade is very similar to a trade I made in March.  Back then, I sold 3 SDS put spreads at 26/33 (+/-), expiring in September.  Today’s trade replenishes this established position while substantially increasing my exposure for the next two months.  Since March, the economy has not improved (independently from increased debt) and the market has nudged marginally higher; hence, it makes sense to keep both positions here.

Also…

Volatility has fallen the past two months, so I purchased 35 shares of VXX at $21.60 per share.  I think volatility has the potential to explode, so I am just building my position here.  I now own 100 shares of VXX.  For a recent article on volatility, read Claussen’s “Why trade the VIX.”