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Options Update – 5/16/10

 It was a volatile week that ended with the Dow Jones Industrial Average (DJIA) scoring a healthy TKO — thanks largely to Monday’s 400-point relief rally. The CBOE Market Volatility Index (VIX) reflected that volatility. Although it settled down from its readings in the low 40s the previous week, the VIX still ended the week at an elevated 31.24.

Mirroring the price action of the 1997 “Asian Contagion,” the S&P 500 Index (SPX) rallied powerfully from its 200-day moving average early last week, in response to a loan package from the European Union and the International Monetary Fund to the euro zone’s most heavily indebted nations. The rally pushed the SPX back above its 160-day moving average, situated at 1,120, and the January highs in the 1,150 area. But after an unsuccessful attempt to overtake its 50-day moving average in the 1,175 area, the SPX retreated 3.1% on Thursday and Friday. The SPX closed the week at 1,135 – below its January highs, but above the 160-day moving average, in a slight technical improvement relative to last week.

Levels of importance on the SPX include the round 1,100 level, which is not only the SPX’s 200-day moving average, but also represents about a 10% correction from the recent highs. Bernie also mentioned that we are keeping a close eye on the 1,167 level, as this is the site of the 160-month moving average, a trendline that acted as support at the bear-market bottom in 2002-2003. Moreover, when this moving average was breached in October 2008, it was a major sell signal. A month-end close above this level would support the notion that the SPX is in bull mode.

With the euro hitting fresh lows on Friday, it is evident that European worries continue to weigh negatively on investors in the U.S. market. The sell-off that began late Thursday and through Friday indicates there is a lot of fear about negative financial developments over the weekend. But a possibility this weekend would be government officials looking to implement a plan specifically designed to stabilize the euro, and this would be most effective if they can get U.S. cooperation. It is our belief that such cooperation is very plausible, as we don’t think Washington wants to see the dollar get overly strong from here.

Last week’s rescue package did nothing to stabilize the euro, and such stabilization is of very high priority over the short term. If in fact officials do something over the weekend to prop up the euro, we could see a huge equity rally on Monday. In the absence of such a plan, there could be follow-through selling.

Another potential catalyst this week is the expiration of May options. There is massive out-of-the-money put open interest on various indexes and exchange-traded funds that is getting set to expire. Should the market find any type of stability, whether technical or news-based, the unwinding of short positions related to the expiration of the out-of-the-money puts could create a tailwind for the stock market.

We are equally hedged in our portfolio as the early part of this week should bring quite a bit of volatility.  Sell into strength.  Investors have to be nimble in this market until a clear direction is revealed.

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