Options Trader: Tuesday Wrapup

by: Philip Davis

I learned something today. My well-balanced portfolio has a limit and that limit is 13,400.

Although I thought I was very bullish, it turns out I wasn’t THAT bullish last week, when we were down at 13,100. Also, Friday’s sharp drop into the close caused me not to follow my plan of getting down to 60:40 bearish with my DIA puts into the weekend and we ended up 2:1 bearish - it’s never good to go off a well-thought out plan just because of a sudden market move!

I always tell the members it’s OK to lose money as long as you learn something but I got whacked for 10% of the STP’s gain (not value) today and that’s a pretty expensive lesson!

Also, rather than adjust quickly and go with the flow I stubbornly waited for the market to pull back before doing the bulk of my adjustments. And I waited, and I waited, and I waited… Needless to say the day did not go as I thought it would, the market took off right out of the gate and never really looked back, despite VERY disappointing Construction Spending (-0.4% vs. -0.1% consensus) and a fairly disappointing ISM Index at 52.9 although auto sales fell 2.8% and finally seemed to shake a little sense into the buyers.

Since the day’s numbers were worse than I projected this morning as well as worse than estimated, I was pretty surprised by the extent of the rally. We did get the tech leadership we’ve been looking for but, with oil racing up to $75, it was hard for me to buy the rally. By 9:58 I had capitulated on oil saying: "Oil puts - I’m stunned at the moment. I can’t imagine what data these guys are looking at. Seems to be the same old Bomb Iran crap we were talking about on the weekend. No new puts yet, that’s always a great way to die…. We just have to see where this takes us."

I never like rallies that are led by the energy sector and the 10 am economic data did little to give me confidence, but we turned our attitude around and I noted 1,480 was good going on the S&P and we placed other upside targets, looking for a Dow confirmation. At 11.17 I noted: "You can be bearish below 13,400 but above that you’re just being stubborn!" I simply didn’t want everyone to lose their heads (literally) ahead of the tomorrow’s Beige book and, as we discussed whether it was a legitimate rally or just low-volume manipulation, I pointed out: "Up/Down manipulation - it doesn’t “work both ways” when one of the upside manipulators is the $3T US government (that’s $2T they collect and $1T they borrow per year!)."

I still maintain that that borrowing by our government, along with their current policy of throwing money that they don’t have at the mortgage crisis they claim doesn’t exist, is not a fundamentally sound basis to build a rally on. This is especially true while the inflation they deny (food and energy) continues to climb and place a shadow tax on the people in a thoroughly disproportionate manner.

While we still have some work to do, we have made some serious progress. We need a strong move by the S&P along with the transports in order to keep us on the right track tomorrow. We also need the CAC and FTSE to join in the party and for the Nikkei to continue to act like it wants to go green as well. But can the Transports rally with oil at $75? Yes they can - because it’s a load of BS!

Oil at the NYMEX is currently in backwardation. That means that no one in the future is willing to pay the outrageous prices you are being charged for oil now. Some backwardation is normal but we have a pretty severe case at the moment where the front-month October contracts are trading at $75.08 but holding onto those barrel for November delivery will cost the trader .82 (1.1%) and holding on for December deliver drops the barrel price down to just $73.36. This continues all the way down through next December, when a barrel of oil can be had for just $70.56, even after today’s gains.

Additionally, the 90-day barrel count slated for delivery to Cushing, OK, a facility that can handle, at most, 40M barrels a month, is up to a whopping 668,485,000 barrels - that is more oil than can ACTUALLY be accepted by Cushing in the next 17 months! The average price paid for those barrels is $74.20 and in January the projected value of that oil is $72.70. By August ‘08, a barrel of oil can be purchased right now for $70.96 for guaranteed delivery but that would be a 4.3% loss even after paying for a year’s worth of storage, plus any interest due for putting up the money to tie up all these superfluous barrels in the first place.

As we predicted way back in the spring, a year of shoving barrels under the rug to simulate demand is finally coming home to roost. What is triggering this problem is the logjam of 189M barrels already under contract in December, as Decembers usually attract a lot of speculative buying. What has been happening all year is that the traders have rolled unused barrels back a month or two to get rid of them before the contracts were called due and generally they were rewarded with higher prices down the road. That may no longer be the case…

While it will be hard to predict when it will break down, it is now very unlikely that the solidarity (ie. cartel) shown by the NYMEX traders will last as each begins to lose more and more money as the quarter goes on. Without a war in Iran or a hurricane or some other horrible tragedy to cash in on, all these traders will have is a lot of very expensive barrels of oil that are costing them millions a month to store, and every month they stand to recover less than the month before. Much like a housing (or any other commodity) decline, all it takes is for one seller to start dropping prices and a real gunfight ensues.

While it may be a little frustrating hanging around with our oil puts and waiting for someone to pull the trigger, our members who were with us last fall can attest to the fact that it does indeed have a most rewarding conclusion!

We have only just started building our short oil positions, it is a process that may go on through the October hurricane season but I’m really starting to see the stars lining up for this one so get ready to have a little fun this fall. Being short on energy will also be a nice offset in case we get an unpleasant October surprise in the general markets as I certainly don’t feel we are out of the woods yet.

The dollar is not out of the woods either as it was harshly rejected from the falling 50 dma at 81 today. This should come as no surprise to readers who follow the global money scene as Iraqis have started to insist on getting paid in their own, more stable, local currency. More and more people would rather be paid in gold, and gold flew to break over $690, finishing the day strong at $691, this comes as no surprise to anyone who was here last Wednesday, when I said: "The dollar fell back to 80.71 but took a sharp bounce back of the declining 50 dma, which will be at 81 by the time it retests and gold hung out at $675, waiting for the other shoe to drop so it can break back over $700 in my opinion." Yes, it’s amazing isn’t it?

Well, we had little time to test the waters before being thrown right back into the rapids so let’s get ready for yet another very exciting week in the markets!