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Yesterday’s market selloff – and corresponding jag higher in volatility - came after a slow clobbering of bearish fundamentals was cemented with a below-the-belt hit from China on the primacy of the U.S. dollar. Today the fundamentals are little changed, but the market is two writedowns wiser (Morgan Stanley and AIG having coming clean about their bearish exposures). Fed chairman Ben Bernanke’s testimony before Congress confirmed the tight straits of an economy grappling with tandem inflationary risks and dour growth prospects, and a look at the price action in financial options shows option traders hunting for the next seat of bad news.

(XLF) – Financial Select SPDR – Shares in the financial services ETF are flat at $29.84 after making an auspicious break below $30 – a new 52-week low. The 270,000 options in play are trading 3 times as frequently to puts as to calls. Of interest here is a transaction involving some 45,000 lots in the December 29 puts, which traded at $1.22. Action in the January contract suggests that some traders may be wagering on some abatement to the financial sector’s current woes in January, taking advantage of the current 41% implied volatility level to sell volatility in the form of the 31/34 strangle.

(WB-OLD) – A look at the option positioning and implied volatility development in Wachovia shows option traders may be tipping the bank – which comprises just over 3% of the holdings in the XLF and is one of a raft of major financial institutions trading at multi-year lows today - as the next to report an outsize writedown. Our market scanners caught wind this morning of an unusual increase in implied volatility, up nearly 18% on the session to 57.6%. A look at developments in Wachovia’s implied volatility over the past two days shows the market expectation of share price turbulence increasing more than 56% in a matter of 48 hours. Option traders today have rushed to buy December 40 puts at a rate more than double the existing open interest. Elsewhere we were interested to see some 2,600 lots sell to the bid in the January 27.50 puts – action which on the surface looks to us like profit taking on a former position given the 33% increase in premium on this position.

(C)- The implied volatility reading in Citigroup continues to reflect a market still discomfited about the company’s prospects despite the recent exit of its beleaguered chief executive. Implied volatility rose 22% and is making a test of the 60% mark as shares continued their 4% freefall to read at $31.97 as of the noon hour. Traders have made a run on November puts at the now at-the-money 30 strike, which were bought on a volume more than 4 times the open interest, and on premiums up 200% on the session.

(BID) - Sotheby’s – Talk about under the hammer! Shares in art auctioneer Sotheby’s forfeited 28% of their value to $35.89 today as a trio of analyst downgrades coincided with the fizzling of a much-touted sale of Impressionist paintings in New York. The development has led some arbiters of taste to predict an end to the New York art boom, and options traders are staking their bets in kind. Options trading at nearly 6 times the average level today, as traders seek fresh longs in the November at-the-money straddle. At $5.75 the position costs some 16% of Sotheby’s current share price to enter – a reflection of the angry surge in volatility. Elsewhere it looks like a trader took profit on a position in the January 50 puts, which sold today for $17.90, having more than tripled in value overnight.

(GPS) – Gap Inc. – Today’s reported decline in October same-store sales for the everyman retail clothing chain was offset by profit guidance beating analyst estimates, and this was good enough for Wall Street today. Shares are up 4.8% to $19.03, and while options traders are swapping Gap contracts at nearly 5 times the average rate today, the positioning appears tied up in fresh buying in the March 20 puts, which are 19% cheaper today owing to the rally in current share price.

(CSCO) – Cisco Systems – Shares are down 7.4% this morning to $30.33 with more than 218,000 options in play, 3 times as many calls moving as puts. Heaviest liquidity is seen at the November 30 line, where call open interest had doubled this week ahead of last night’s earnings report. Much of today’s volume may be tied up in risk reversal trading with puts at the same strike, which are being heavily bought this morning. The November 32.50 calls have also sold off heavily, despite having lost nearly 94% of their value today in a choppy trading session for Nasdaq components.

Source: Thursday's Options Report: XLF, Wachovia, Citi, BID, Gap, Cisco