A Trader Reflects on a Scary Week

WHERE THERE’S SMOKE, THERE’S FIRE

I thought it would be interesting to give a personal account of the events that transpired last week. Normally, I would tend to write more objective and less introspective articles, but these were abnormal deviations from anything seen before and, from my own perspective, it would be a way of venting the intense anxiety and stress levels that built up during the course of monumental and historic volatility. Even my own experiences didn’t prepare me for the intensity that I felt during these extreme volatile rides in the markets. The portfolio that I manage was stress tested to the maximum inflection point. And a feeling very unnatural and discomforting was settling in, a feeling that things were beyond what I could control and that the disastrous spiral of deleveraging was unwinding at an accelerated rate of speed, as if you were tethered to the end of a bungee cord without any elasticity left in it to bounce back and recover.

I had to to trust my own risk metrics and models that I use to mitigate portfolio deconstruction, but I have never seen volatility like this ever. While I wasn’t in the market on Black Monday of ‘87, most professionals that I know will tell you that the comparison doesn’t hold up–this was worse and, potentially, on the brink of being a global crisis not seen since the Great Depression. This was, in fact, the proverbial “precipice of disaster” with the credit markets actually freezing up and the arterial conduits of our economy seizing into cardiac arrest.

People not directly invested in the markets that mistakenly think Wall Street has nothing to do with main street, were about one or two days away from no longer being able to swipe their credit cards at the local grocery store to buy basic necessities, and the historical annals of long lines and rioting in the streets at the scene of bank runs was about to become history repeating itself. This was about a complete erosion of trust in the financial markets, a seismic shockwave causing instability and unrest to the fundamental basis of our entire global economy. Even the safety net of FDIC insured bank deposits were about to evaporate into thin air along with pension funds, money markets and retirement accounts. Sounds scary? It should be.

I think, even though we have no public transcript, this is exactly what Treasury Secretary Hank Paulson and Chairman Bernanke conveyed to make evidently clear to the leading bi-partisan panel of Congressional members that attended the emergency action meeting on Thursday night. Make no mistake about it, folks, this was a 3 a.m. moment. But Congress needs to follow through by supporting Hank Paulson and Bernanke’s plan and not politicize the required necessity of action with cries of “bailout” or “moral hazard” and other empty, rhetorical euphemisms.

I like to use this analogy: If you stand by and watch your neighbor’s house catch on fire while people are trapped inside and say, “it’s a moral hazard if you act because these are the consequences of playing with matches,” you are “immoral” to do nothing and not grab a bucket of water to help put out the flames. And to carry the analogy further, while you may think a fire in your neighbor’s house is not your immediate concern, once that fire spreads like a contagion, your house will burn down along with everyone else’s. Folks, “inaction” or being a spectator on the sidelines when you had the chance to act is immoral.

If you’re a firefighter or a police officer, it’s your job to act and do something, not make judgment calls on how the fire started. Can you imagine if a firefighter stood by because they wanted to teach a homeowner the lesson for not properly installing a smoke alarm? It’s the job requirement of elected officials and leaders to act when crisis occurs, not to stand by and moralize, or hold “hearings” after the fact. Before they blame anyone they need to look in the mirror first and hold themselves accountable. Of course, that won’t happen because that would mean not being reelected.

I’d be lying if I said I wasn’t scared. The whole week was wrought with sleepless nights and complete detachment and isolation from personal affairs. I was, literally, gargling the ol’ pink elixir, Pepto Bismol, like it was happy hour at the local corner tavern and pub. Like most others gripped and paralyzed with apprehensive displacement, I couldn’t walk away from the monitor for one minute because fortunes in the overall global markets were being erased tick by tick and the surmounting fear was palpable, very real and manifesting incarnate.

MONDAY MORNING QUARTERBACKING

Monday’s 500 point drop was rather manageable and able to be adequately absorbed through hedging strategies that I maintain. It appeared, to me, like another “seen it before remake” of the same ol’ story. In fact, I began to lighten up on puts that, literally, quadrupled in value or more. Make no mistake, these are not bragging rights on returns, rather, they illustrate the offset to equity losses and neutralized the tremendous downside pressure on long-term holdings in the core portfolio. It was even tempting to fade the market that has worked so many times before because we were in an option expiration week, but discipline kept required short positions intact to balance out the portfolio.

With favorites like BHP Billiton (BHP) and Freeport McMoran (FCX) trading down to low 50’s and 60’s, respectively, I began to add back into existing positions and long-term holds. I waited for this opportunity for quite a while and, while it wasn’t presented to me under normal market conditions, following pre-planned strategies I added back into my existing holdings. They were simply too cheap on valuation basis for me to ignore and since the oil decline back in July, I had lightened up significantly on my commodity exposure because demand destruction and a rising dollar was putting undue strain on the entire sector along with oil prices. Not to mention, hedge funds were positioned in a very crowded trade around the commodity sector and were now undergoing a series of liquidations and forcible redemptions.

WEDNESDAY: THE SECOND FIREWALL WAS BREACHED

Quite honestly, this second concussion and major wave of selling caught me completely off guard. I really didn’t expect the continued selling pressure into Wednesday because, normally, expiration weeks begin to consolidate around strike prices, but this time the volume of selling was pushing absolute price dislocation in options as the VIX, or “fear gauge” on the S&P 500 index, pushed higher and was working its way past 40%!

It seemed with the saving of AIG and the rumored announcement of new short selling rules imminent that we had seen the capitulation and that a major rally was due, simply to cover existing shorts. As they say, timing is everything, and while this thesis may have been true in theory as the results verified later in the week, it didn’t reflect what was currently happening in the markets at all.

This wasn’t a consolidation around strike prices, this was everyone screaming fire and running through the door all at once and, believe me, the institutional sell side pressure was not being very gentlemanly because they were knocking down old ladies and little children to get to safety first.

Support levels and strike prices were being violated across the board and the markets were entering a systemic free fall. Chartologists and cult-like followers of trend and retracement lines were blowing into their rape whistles for help. You saw very little short covering into the close and the only thing stopping continued selling pressure was the clock running out at the end of the day.

Normally, it would be a compelling trade to fade the market and buy cheap upside calls with limited risk. But the premiums–even with less than 3 days until expiration–were trading at ridiculously high levels. This further increased my belief that the market was due for a snapback reversal because the market makers were unwilling to take the risk of a major short covering rally even as September out-of-the-money calls were due to expire imminently. The only way to take advantage of the sell off was to do it the old fashioned way–buy the underlying shares of stock! And to do so would be a gambler’s instinct without the absolute conviction that the selling was done. To tie up additional capital that may be needed later, with too many unquantifiable risks on the table, really forced discipline to keep and maintain unbridled gut instinct in check. If things continued to deteriorate then not having liquidity would be a major disadvantage.

I truly expected a bounce toward the close simply due to short covering because the markets were dangerously oversold, but that never came to fruition and left me very emotionally unsettled going into Thursday morning. To put it in perspective, Wednesday was a second concussion in the markets with another nearly 500 point drop. The portfolio was at maximum stress points. And while I did not have to sell any positions, I couldn’t determine if a third wave of selling could be absorbed adequately or not. I was relying on my own risk metrics and models that have never been tested to this point or beyond. An orderly sell off or decline in the markets is one thing, but when chaos and acceleration in selling reigns over sanity, professional traders and funds get blown out of the market. It was a very humbling moment of relying on theoretical models rather than tested risk management experience.

And for the first time, despite the entire year of extreme volatility, I felt scared. I had always hypothesized the “what if” scenario if things went to zero, but never did I actually believe it could happen because it seemed ridiculous to seriously contemplate financial Armageddon. For the first time, I actually felt what it was like to look over the edge and not see a bottom in sight.

I kept evaluating the risk mitigation in force to reassure myself that the downside was covered, but the natural emotions of fear were taking over and gripping me along with the sentiments of the entire market. It didn’t matter if my calculations looked right, because they didn’t feel right and that was panic inducing.

Cataclysmic events like these are lifetime, monumental moments that truly reveal one’s character and discipline, a sense of oneself that might be easily confused with stubbornness and stupidity. At this point, I was beginning to question myself and my own strategies because this was uncharted water. Not because of the volatility, like I said before, volatility doesn’t bother me as long as I know the underlying fundamentals of the economy and the trust in the financial system works. What was disturbing was that real world macro-economic issues were beginning to bleed into the markets and this was less about professional institutions and hedge funds rocking and rolling the intraday volatility. But at the end of the day, I do believe in the capital markets and while, for a moment, I began to have doubts, I never thought they would allow the markets to collapse.

THURSDAY’S FLASH BANG AND RECOVERY

Thursday continued the selling pressure pushing volatility to an all time high for the year. No lifelines, no rescue boats, nothing. Margin calls were in effect and people were scrambling for liquidity.

This was a bank run like never seen before, exacerbated by the fact it only took the click of a mouse to push tremendous volumes of orders on the sell block. Morgan Stanley was on the brink of going under and Goldman was next. And after the investment bankers, next in line were the very last fortresses of our financial system, the banks like JP Morgan Chase, Bank of America, all considered “too big to fail.” It seemed as if no one was safe or immune from this financial contagion.

This was total and absolute market capitulation. Credit Default Swaps were trading at ridiculous levels, money was running into sub-zero yielding Treasuries and no matter how much liquidity the Fed was pumping into the banking system, the oxygen wasn’t reaching the brain and the markets were about to pass out and collapse under the weight of systemic leverage.

The institutions that wait for these moments with capital on the sidelines to buy weren’t jumping in because they’ve been burned before on these so-called bottoms. Rationally, we all knew this couldn’t continue, but emotionally no one had the confidence to believe there was an end to this madness.

You had to wait for a signal, some beacon of hope. Something. Anything…

And then, finally, news from overseas markets with imposed restrictions on short selling immediately in effect on financial stocks. The market didn’t follow through, but it was a hint of what was to come later that day and not a moment too soon…

All during the morning decline and sell off, I felt physically anxiety ridden, but I committed new capital to existing positions in the portfolio not because I wanted to, because I had to. It wasn’t easy to do and I certainly didn’t catch the exact bottom, but it was the discipline of not being distracted from sticking to a game plan by the rest of the market or chasing what other people were doing. This was strictly focused on my own existing strategies and metrics, like putting on blinders to the rest of what was going on even though I was well aware of the same emotional fear everyone else was. It made me sick to do it, like the concern of tossing good money after bad, but the valuation on a long-term fundamental basis was my entry point, irrespective of what the conditions were outside of my purview.

Having said that, I began to add Apple (AAPL) to my existing position around the 127 mark in the morning and watched it bleed down further, kicking myself for not waiting longer for my entry point. It’s sheer luck to dare call the exact bottom of anything, so there’s no reason to try but it still pisses you off to buy something and watch it drop further after you jumped in the deep end. But if you like the fundamentals long-term, then you should pick your range that you’d be willing to own shares even if the price action fell below what you paid initially.

To be fair, buying AAPL was the most difficult trade of all for me, and the reason is that I’ve been in AAPL for quite a while so even around the 130 mark, AAPL doesn’t seem undervalued and certainly not cheap. Having said that, I am a huge advocate of AAPL as a company on fundamentals but, when it comes to the way the stock trades, it’s a crap shoot. I think AAPL has tremendous upside, but it’s not cheap by any metric. AAPL remains one of the very few exceptions I have for owning high multiple stocks, as I tend not to prefer holding “hype driven” momentum trades. True, AAPL is more than hype though, and the earnings drivers are very real as it’s more than an ipod, or an iphone and, I believe, that analysts still don’t really grasp how significant and game changing their proprietary operating system is as they continue to threaten market share.

And in the uncertainty of markets like these, there are better trades to make if you are looking for stability in your portfolio. Adding into some of the other positions was not as difficult to do psychologically because to me, they were truly undervalued, but this was the second time this year AAPL has essentially “round tripped” from near highs of 200 back down to the 120’s.

I watched further selling in the overall markets and continued drop on Apple shares as a very interesting trade began to appear. Puts on AAPL that I had sold for $4 per contract were now trading upwards of $9. Only because I had just sold those same puts earlier is the reason why my attention was drawn to this trade, otherwise I wouldn’t have noticed it at all; probably because, once again, I was thinking how I could have held on for more and didn’t. And while I didn’t catch the absolute bottom of adding into AAPL positions or shares by buying in higher at a $127 range in the morning, I began to sell or write “naked equity puts” on the 130 contract with only 1 day into expiration, essentially reversing the position I held earlier in the same option contracts. The reasoning was that this was unquestionable chaos and believing in the fundamentals of our economy long-term, believing in the potential recovery of our markets, no matter how much it made me puke to do it, I sold into the ridiculous premium willing to be exercised and take possession of more shares of AAPL @ 130.

I don’t want to call it speculation because I only wrote the amount of naked equity puts I was willing to take possession of shares exercised against me. It wasn’t a huge or substantial trade as much as it was an interesting trade, with the market pivoting and those options expiring worthless on Friday–well, to be more accurate and precise, any profit was really an offset to whatever paper losses were incurred through equity collapses. To be clear, by selling or writing naked equity puts, you receive the entire premium collected held against the margin required to maintain your obligation to buy shares upon exercise. Writing naked equity puts ties up margin and equity because you are responsible for buying the shares–if exercised–at the stated contractual obligation of the strike price. It sounds like a risky strategy, but in all actuality, it is very conservative for a long-term investor if you are willing to own the shares.

It may be simpler for most people to just buy the shares when they are bullish, but this was a very unique opportunity because of complete market dislocation and volatility. Option spreads were out of line and the panic drove premiums to ridiculous levels. With less than a day and a half until expiration of the contract, it made sense as a risk to reward scenario. As stated previously, I really wasn’t interested in buying any more AAPL shares because I don’t think they were cheap enough to just run out there and buy across the board, especially when you are talking about a risk to reward relationship.

Of course, in hindsight, the better trade would have been to simply buy the shares and you would have made much more. Or to buy upside calls, but again, electing to use writing naked equity puts is a conservative strategy which limits the upside. But I already held positions in AAPL and added more to the portfolio earlier in the morning. I really wasn’t interested in adding more shares in that range, but I was willing to own more if naked puts were exercised against me. Turns out I didn’t need to and the trade worked relatively well but, as always, you know you could have done it better through the lens of hindsight.

The other trade that was less complicated was to add to existing shares of Boeing (BA) as it broke below 56, actually because it is a stock I hold I was watching it closely as it broke the 60 support level earlier in the week and well below its 52 week high. Boeing has been drastically oversold in my opinion and remains as one of my best recommendations for the long-term investor along with Lockheed Martin (LMT), which is another defense sector play that remains a part of my core holdings. If you chart the course of the last year, LMT has been, quite literally, bullet proof with a very low beta relative to the unprecedented volatility in the market.

I increased the share ratio of Boeing from 2:1, that is 2xshares of Boeing for every 1xshare of Lockheed Martin, to a 4:1 ratio, or 4xshares of BA to every 1x share of LMT. The reason I am comfortable with this ratio is because Lockheed Martin, which is a fantastic company with less headline risk than Boeing, remains fairly valued; however, the upside potential is greater for Boeing relative to Lockheed. To be sure, I wasn’t even looking for this trade but with a sub 9 p/e, this was the one trade I felt the most comfortable making amid the calamity of the market disruption.

Having said that, I’ve written an earlier article on the tremendous backlog of orders Boeing has and reasons to be bullish on the stock, but headline risk remains with a suspended refueling tanker contract, a separate helicopter contract pending and machinist union strikes. I believe that most of this headline risk is fully absorbed into the price action of Boeing if, and only if, they are able to bring the Dreamliner on a relatively close time table.

Short term, there probably isn’t any reason to recommend anyone jumping in until the markets calm down and we realize the full effect of a global slowdown, of which the main source of revenues for Boeing contracts are derived. But I am comfortable holding positions in Boeing for the long-term and really disregard the short-term “value trap,” if you will, on Boeing.

Lockheed Martin is definitely a better way to play the aerospace and defense sector but, more importantly, has remained incredibly stable during this entire crisis over the past year. A decent dividend, strong fundamentals probably make LMT a stock that I would recommend before Boeing based on consideration for other people’s risk tolerances.

I have to actually give credit to CNBC–who, 90% of the time, offer worthless infomercial-like analysis as do many other mainstream news outlets–and their excellent reporting during these tumultuous markets. I watch CNBC, not as an endorsement, but because you do really get some intelligent and objective people that stray onto the set once in a while in between the commercials–oops, I mean “objective analysis.” When it comes to intraday news that can’t be held back as an advantage to institutional investors, CNBC showed its value as their well connected reporter and correspondent, Charlie Gasparino, did an excellent job by breaking market moving news that a RTC-like bailout was imminent.

This was a whiplash movement in the market that saw panic inducing short covering and the moment we were waiting for as a much needed sign of relief. If your eyes were glued to the news, then you had an unusually fair shot out of the starting block once the gun went off and the race was on.

So, after continued selling and absolute capitulation to the downside, such as Morgan Stanley and State Street trading down to “going out of business” prices and reflecting the continued erosion of the capital markets, heavy volume flowed into the markets to end up over 400 points on the upside recovery. And, as mentioned earlier, the follow through was extra ordinary by confirmation of Hank Paulson’s intention to act in coordination with Bernanke and support of a bi-partisan Congressional panel. Add into the mixture imposed restrictions on short selling through monumental SEC interventions, and you’ve got a real bid on the overall market.

The reason I used the term “flash bang” is because when the concussion and shock goes off, you are left disorientated and somewhat frozen like a deer in the headlights. It makes you numb and your reaction time slow and nearly impossible to think coherently or behave normally. Trading is no different when events like these occur and this is why it is critical to have a game plan, so that you can react without dwelling on what to do before the moment passes you by. If you look at how fast the markets snapped back with the volume of buy orders pushed through the order flow, momentum was driving the stampede and there was no time to formulate an opinion or objective analysis. You either had a plan already or you were chasing momentum, either way it was a time for decisive action.

CLOSING BELL: BREAKING DOWN THE TRADES

After the run into the close on Thursday, I sat back and let it ride. And other than rebalancing some of my derivative positions, I didn’t buy or sell anything on the follow through during Friday session. I truly believe in the merits of being a long-term fundamental investor and positions that I added were based on existing holdings, the research was already completed and any previous buying was essentially dollar cost averaging to a portfolio. With the exception of a small, speculative collar trade I put on AIG and wrote about earlier in the week on Monday, I didn’t play or dabble outside of the existing portfolio.

I mention this because it in times of crisis you don’t want to be chasing stocks you normally don’t follow, and with little time to make rational decisions you have to fall back on what you know and hold in your portfolio. The main reason is because if someone takes a wrecking ball to the price action of stocks you own, you don’t want to be debating fundamentals against an argument about short-term, erratic market conditions, you should already feel confidence in your position if the story remains intact.

As for the financial sector as a whole, which really made the strongest recovery and will be the only way we can be led out of this crisis in the markets, I’ve written a previous article on “the only safe way to play the financials” that you can read on my website if you are interested. In this article, I’ve described how I would only recommend less credit exposed payment processors such as Mastercard (MA), Visa (V), and, perhaps, American Express (AXP) for entirely different reasons. Also, I included my reasoning to identify the exchanges such as Chicago Mercantile Exchange (CME), NYSE (NYX), Nasdaq (NDAQ), Intercontinental Exchange (ICE) as they tend to represent the same or similar business model by being, primarily, payment processors.

However, outside of these mentions, and in the context of the greater banking system, I was pleased to see the overall financial sector recover with the rest of the market, but I didn’t see any reason to add more positions at this time.

I did watch the remarkable recovery by Morgan Stanley (MS) and Goldman Sachs (GS) which would have been outstanding buys at the low, but I have remained on the sidelines even though I like them both as companies and franchises. I think Bank of America (BAC) will be very interesting going forward if they remain well capitalized and maintain their dividend, but I don’t own it. Over the course of the next several years, some of the biggest and best trades will be in the financials such as these remaining banks and brokers, and those that bought the banking stocks at bankruptcy-like prices. And to those that made these trades, I applaud you. There is no question that the most dramatic returns will be made in the most feared and hated sectors of Wall Street.

AIG, which I don’t feel comfortable recommending, will most likely do well once they downsize and get the toxic paper off their books with this new plan. It’s interesting because, unlike Fannie Mae and Freddie Mac that essentially went into a receivership, this new potential plan by Paulson makes their entire entity viable again.

I traded AIG with a specific reason due to dislocations in option premium and I hold a small position of shares speculatively. I am not recommending it for anything other than speculation, but they may turn out to be one of the best trades going forward. What happened to AIG should not have occurred and this Paulson plan directly effects their outcome. That 80% collateral in warrants may not end up being the huge share dilution that everyone expected if alternative financing steps in and pays back the bridge loan, especially if amended accounting rules on mark-to-market occurs or bad assets are taken off their books.

I really don’t care if the markets continue to run much higher at this point. I think I would, along with many others, prefer stability first and the ability to make rational decisions. There were things, in the predictable safety of hindsight, that I could have done better and traded more successfully. Doing so is a futile exercise, no different than thinking the winning lottery ticket held the same numbers we knew we could have picked. But I will do some reflecting, especially as I recognize with absolute humility that these markets will do what they want, when they want and we have no say in the direction they ultimately go.

THIS WAS A RESUSCITATION, NOT A RALLY

In closing, this was, as I like to say, witnessing history. These are extra ordinary events that have transpired. Is the bottom truly in the market? Are all the problems, somehow, magically disappearing before our eyes? No, balance sheets still remain at risk, real estate, the primary source of equity and retirement for most Americans is still far from recovery. For all intents and purposes, we are in a protracted recession, despite what economists will argue on the basis of flawed or skewed statistical data.

In summation, you’ll hear a chorus of people say through the protective lens of hindsight that at the end of the week the markets remained relatively unchanged by the calculation of all our major indices. But this is a woefully inaccurate statement and mismanagement of facts. This was about being on the brink of total and systemic financial collapse.

Yes, this was the biggest short squeeze ever in history. But I wasn’t buying into it like it was all clear or things were no longer problematic in the financial sector, I was simply relieved as so many others were to see assets begin to recover. Rally? I don’t think so. Only if you had never invested in the market and this was your first day putting new capital in at the very bottom. For most people who were already invested in the market, this was about stability. It may look pretty on the headline news with sensational images of 300-400 plus point moves, but if you look at the facts and the underlying shares of your portfolio it was more about returning to fair value.

It truly is testament to the resiliency of the American economy and the global financial markets working in coordination with one another, and why it is essential in the 21st century that we continue to forge allies that share the same risk of capital deterioration by not being on the same page. Our economy is different than anytime in history in terms of the global reach, technology, manufacturing efficiency and the potential for a new wave of job creation if we dare to allow real leadership to transform naive optimism into reality.

This was, for me, an illusionary experience of time dilation, where so much seemed to happen in a compressed amount of segmented and very fractured moments. Consider, all these events transpired in less than 5 business days. Major institutional firms went under or were absorbed through orchestrated government liquidity. The markets were clearly getting hammered that began a domino effect of forced liquidations and wholesale asset devaluations. The bankruptcy of Lehman Brothers and the surrender of Merrill Lynch to Bank of America was staggering, only one week after Fannie Mae and Freddie Mac were bailed out by the Treasury. Next in the crosshairs was AIG which had systemic ramifications to the entire financial system. This was a viral outbreak in the entire financial system with no signs of abating.

I hope that historians and academic professors accurately describe the events that transpired not on the end result of how we navigated out of a crisis, but by a measure of how close we came to a complete financial disaster. These are the lessons of history that often fail to teach those that refuse to listen.

However, to truly fix or address the problem they do need to approach this systemic problem from many angles above and beyond temporary short selling rules and regulate the OTC market of CDS (Credit Default Swaps) and other illiquid, complex derivatives. I’ve mentioned this before in a previous article, but the problem also has to do with dark liquidity pools and off exchange volumes of order flow that push the price action without needed fair market transparencies. I think they need to have regulation that keeps the major exchanges such as the CME, NYX, NDAQ and other global exchanges as the primary conduit and only way stocks, options and futures are transacted. Crossing networks and opaque block transactions off exchange are nothing less than manipulation. Fair and orderly markets can only exist when there is total transparency to the routing and processing of order transactions.

Conversely, if an institution with a short bias wants to commit a bear raid on a stock, they can continue to slice and dice large block orders through the system to keep hitting the bid over and over, absorbing any reasonable upside momentum and trapping the uptick until the price collapses. And this isn’t even discussing the absurdity of these, seemingly untraceable, “naked short positions” that remain unsettled by normal clearing requirements.

I’ve heard a lot of people on television and media crying about reinstatement of the “uptick rule” which would help, true, but they are wrong to believe that is the sole reason why markets were in a free fall. The truth of the matter is, once again, the high volume of orders that flow anonymously off the exchange in these dark liquidity pools. Algorithms and dark liquidity pools are probably the main reason why there is so much volatility in the markets, which account for at least 2/3 of all daily trading activity.

As I mentioned, there were serious dislocations in the bid and ask spreads of options which is attributable to market makers unwilling to take on the risk of unhedged positions due to newly imposed short selling restrictions. I am sure there will be an amendment to the SEC intervention that will provide an exclusionary clause for market makers to sell shares short as needed to neutralize risk.

For those that don’t understand how this works, when you buy put protection and a market maker sells you that contract, they must, in turn, short the underlying shares to hedge their position. And the same is true if you sell a call and a market maker buys the option contract, they must short the underlying shares against the position. In effect, they are creating a neutral position that offsets risk in order to create tremendous liquidity in the markets and tight spreads on the bid and ask. They do this over and over again throughout the day to create liquidity and, essentially, utilize “gamma scalping” of premiums through very minute and precise arbitrage.

I am concerned, however, that there are market makers that also trade for their own firm’s interest. I would hate to think that this exception to the short selling rule for market makers is just another “back door” for institutions to short sell stock and drive prices down further. A lot of firms that do their own proprietary trading with their own self-serving interests also provide liquidity as market makers which could, potentially, be a severe conflict of interest. I have no problem with market makers shorting for the exclusive reason to provide liquidity in the markets, but if it becomes a loophole around the intended effect that is, whether you like it or not, working to blow out professional short sellers and hedge funds, then you tell me who has the bigger fix in the game.

As addressed earlier, I essentially added to existing positions that have been fairly resilient throughout this calamity. Of course, as any investor you must remain nimble and adapt to any market changing conditions. I would say I am optimistic, but cautious. And who wouldn’t be cautious when our trust has been betrayed by frayed balance sheets and one sacrificial lamb after the other calling out the bottom prematurely.

I maintain offsetting hedges and believe, perhaps, hope that this was a declarative bottom. For how long who knows, but there has been a clear green light put in by our government to go out and buy stocks. But a disciplined trader never trades without the ability to accept being wrong and I have been wrong on many things so, please, make sure you know where the exit signs are if they start to ring the alarm again.

It would be correct to attribute a lot of the move in the markets to be a massive “short squeeze,” but if you factor the more intermediate effects that extend into next week, professional short sellers have been, literally, “put” out of business for the time being. I don’t think the market is necessarily overbought, for the same reason that I won’t characterize this a rally as much as a recovery. Call this a resuscitation, not a rally, ok?

Most stocks are well off their 52 week highs and are trading at relatively low valuations. I hope politicians don’t forestall the needed action because a volatile economy helped them bounce in the polls, like those that root for a weak economy with glee because it benefits their political careers and agendas. I would hate to think that a bad economy and volatile market benefits one party over the other because, if politicians exploit the suffering and impact of massive asset deterioration, they should be remembered come election time how they fumbled the ball.

I will say that in order for this “recovery” to be sustained, Congress on both sides of the aisle need to stop politicizing this financial crisis and support Treasury Secretary Hank Paulson and Chairman Bernanke. The two men, singlehandedly, have been actively saving not only our American financial system, but the entire wealth effect that extends into the global economy. I’ve made it clear in previous articles how much I respect and appreciate these two men of action and, unless things change, they continue to make heroic gestures to save our capital markets. This is a 3 a.m. moment, folks, and as far as I can tell they have been the only ones answering the call.

DISCLOSURE: Author holds positions in AAPL, FCX, BHP, LMT, BA, MA, V, AXP, NYX, NDAQ, AIG

Comments

[Zekeko:]

Many people were scared last week. I like your position in Lockheed the most going into an election year and uncertainty in the world. I think that is your best trading idea.

I'm not sure if financials of any kind are a wise investment now, even the credit cards like Visa and Mastercard will face shrinking payments process if the the economy pulls back.

Your perspective on the market makers is very revealing and I do agree that they could be a back door to violating short selling rules. Overall, a long but well thought out article

2008 Sep 22 05:11 PM

[pairsarb:]

I enjoyed everything except the drivel about specific trades. We are all traders and usually nobody cares about those specifics. I could care less what you traded, only if you are profitable. The generalities, however, are interesting.

Last week didn't seem about "stability," but more about panic. The artificial floors the two men in question attempt block the markets from trading where they truly need to in order to weed out the sick and weak companies. Ban on short selling....ridiculous. Today those same financial dropped arguably more than in history as a group, reflecting in the short term the true demand for these companies. Certain market makers did not perform their duties today because of the short sale ban, and they were well within their rights as their own power was breached because of this ban. The markets are there to reveal true price. The actions of Paulson and Bernake should have been worded "in the efforts to avert true price discovery because we don't like the prices being discovered....."

The long bias this author has clearly puts him in favor of these rescue attempts. We are not talking fires and neighbors lives here, we are talking about money. There are no lives lost if insolvent companies die in a financial fire. There may be a period of panic, but the new and existing strong models will grow through the ashes of the dead models.

Any attempt to delay the important initial pain and suffering lengthens the time to healthy recovery. It's unfortunate for the long term that those who have been unthinkingly indoctrinated to be biased on the long side unconditionally have the power and means to delay important financial purging. If the author wants to use a better fire analogy, look to nature. Natural burns preserve and renew. It's only when these natural burns are prevented by man that we have catastrophic wild fires that are far worse than nature, by itself, could have engineered.

2008 Sep 22 07:11 PM

[iNVestorUnrest:]

Another nice read, so far so good. I don't necessarily actually agree what some of your positions but it's interestin' to see how you decided to trade a wild week

I did notice that your plays on BHP and FCX moved up a lot. Is that sustainable or just because the dollar fell

AIG was also a huge winner on a down day today

2008 Sep 23 01:39 AM

[wise invest...:]

i just hope we don't revisit that volatility and lows of last week because it seems as if things are hingin completely on Congress--and that is a bad thing.

2008 Sep 24 04:11 PM

[mister_x:]

Wow, thanks for sharing that. That exactly mirrored my experience last week, on a smaller scale of course. I'm an investor with a long term bias too and had FCX (among others) in my portfolio and went through the same emotions as you, except I had no puts. I added to my positions all the way down and the short covering rally was a major relief.

Lesson learnt: If you are long stocks, always buy puts when the markets rally and puts are "cheap". That's avoid some stomach churn and the urge to throw in the towel and sell.

2008 Sep 28 11:35 PM