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The word disaster's root is from astrology implying that when the stars are in a bad position a bad event will happen.

Disasters having an element of human intent, negligence, error or the ones involving the failure of a system are called man-made disasters. The failure of the man made system for allocating homebuyer credit in the US, and elsewhere, can only be described as a disaster.

In a report dated November 15, Goldman Sachs chief U.S. economist Jan Hatzius said a "back-of-the-envelope" estimate of credit losses on outstanding mortgages based on past default experience was around $400 billion.

Further he said, "The macroeconomic consequences could be quite dramatic. If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

The implication is that the credit contraction will have a significant impact on US economic activity.

See IVolatility Trading Digest™ Volume 7, Issue 25 Fakeout Breakout, dated July 30, 2007 and IVolatility Trading Digest™ Volume 7, Issue 27 Mortgage Minefield, dated August 13, 2007 for our homebuilders and mortgage finance company short list suggestions. If the mortgage induced contraction is as dramatic as implied by Goldman Sachs then some of these companies will most likely not survive as independent entities. Since market implied volatilites of the options for these companies are already high the preferred strategy is bear put spreads with three or four months to expiration.

Market Review

It is not surprising that market sentiment is poor and deteriorating. The volatility indexes are rising, short and long term interest rates are declining as Treasury instruments are substituted for riskier equities and other debt instruments. The McClellan Summation Index at –417.50 has now declined for five weeks and appears headed lower. The US Dollar Index (DX) 75.83, basis cash, made at stand at the 75 level by turning higher. Looking at a DX chart you will see a similar rally attempt that started on October 1, 2007 lasted 7 trading days. If we follow the same pattern we could expect to see DX turn lower again early this week, as Monday will be the 7th day of the current rally attempt. If so, expect gold and the gold miners to turn up again as DX turns lower once again.

If we are going to experience a lending contraction of the magnitude suggested by the Goldman Sachs economist it would seem to be an contradiction for gold to rise. The key is the US dollar. Refer to IVolatility Trading Digest™ Volume 7, Issue 33, Dollar Dilemma, dated October 1, 2007. As the Federal Reserve lowers interest rates to support the US economy the dollar will decline as a result of interest rate arbitrage, and gold will most likely continue rising.

Strategy

Reduce long exposure to only a few of the best sectors, such as China, dry bulk shipping, raw materials, seasonal natural gas and special situations that support stock prices. Otherwise again we suggest more shorts. In a rising implied volatility environment bear put spreads offer the direction without the implied volatility and time decay risk.

With market sentiment low and with economic prospects now looking bleak, perhaps it would be better to close all the longs and just be short or just close everything. On this thought we offer a quote.

"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets. The key to making money in stocks is not to get scared out of them". – Peter Lynch

Satellite Volatility

XM Satellite Radio Holdings Inc. (XMSR) 13.98 and Sirius Satellite Radio (SIRI) 3.52 are attempting to merge. This one is in the special situation category as their fate is not a function of the current equity market. The shareholders have voted in favor of the merger and now their future will be determined in the political arena. They require approval of both the Department of Justice and the Federal Communications Commission. Some are expecting a decision before the end of the year. This is exactly the type of uncertainty that causes high market implied volatility. For some added flavor it has been reported that hedge fund manager George Soros has taken substantial stakes in both companies. Look at the positive volatility spread in the volatility chart below.

With a total open interest of 893,320 options, of which about 330,000 are puts and 560,000 are calls the open interest ratio is 1.7 times weighted to the calls and the most recent put/call ratio is a very bullish .25 after the shareholders approved the merger. The current Historical Volatility is 71.57.

Trade Plan

DR: This is a special situation positive volatility spread trade that is entirely dependent upon governmental approvals. While the economic arguments for the combination make sense the stock would most likely return the previous support level just above 10 if the approvals were denied.

SU: A close below 10 would be the sign to unwind the position.

To take advantage of the high implied volatility here are some suggestions:

• Sell XMSR Dec 12 ½ put QSYXV 1.450 IV 129.55 Delta .3127
  Or
• Sell XMSR Dec 10 put QSYXB .55 IV 130.89 Delta. 1510 (less risk, less reward)
  Or
• Sell XMSR Jan 12 ½ put QSYMV 1.95 IV 122.30 Delta .3128
  Or
• Sell XMSR Jan 10 put QSYMB .90 IV 122.84 Delta .1778 (less risk, less reward)

China Finance Online Co. Ltd. (JRJC) 28.80 was suggested last week in IVolatility Trading Digest™ Volume 7, Issue 39 as a special situation. They are scheduled to report earnings after the close on Tuesday November 20, 2007. The November 30 put at 1.675 was one of the suggestions. Since the stock closed below on 30 last Friday the sellers of the puts would now be assigned 100 shares of stock for each put sold. In this case consider the sale of the JRJC Dec 30 call JQJLF at 4.05 IV 124.88 with a delta of -.5415 against the now long stock. Chances are the IV will decline Wednesday after the earnings report, so it would be better to sell the call before the close on Tuesday. If the stock trades higher you would be selling the stock for 30, but your basis would now be 24.275 a tidy gain of 5.725 in 39 days. On the other hand, if the stock goes lower after the report, your basis is now 24.275 and the Dec 30 will expire worthless which means you could sell another call in January against your stock further lowering your cost basis.

In addition, consider this suggestion. The current Historical Volatility is now 129.36

• Sell JRJC Dec 20 put JQJXD 1.875 IV 172.41 Delta .1704

Baidu.com, Inc. (BIDU) 314.99. This rapidly growing company offers a Chinese language search platform, consisting of Websites and online application software with a network of third party Websites and software applications.

In IVolatility Trading Digest™ Volume 7, Issue 29, Beijing Olympics, dated September 3, 2007, when BIDU was 208.20 we suggested a Dec 210/220 bull call spread with a debit of 4.60. Now at 314.99 the spread is priced at 9.05 and if now closed the gain would be 4.40 after commissions for a 95.5% return in 77 days. If annualized this would be a 452% return. In the case of BIDU and some of the other China stocks this annualized rate of return may not be an unreasonable expectation.

Since BIDU has pulled back from 429.19 that it reached on November 6, 2007 perhaps it is time to look at another bull call spread. One of the real advantages of using spreads is that we are just buying the difference between the two strike prices allowing many of us to participate in the higher priced stocks that would otherwise not be affordable.

Consider this additional suggestion. The current Historical Volatility is 87.47.

• Buy BIDU Mar 310 call BDUCA 68.15 IV 87.58 Delta .6260
• Sell BIDU Mar 320 call BDUCC 64.50 IV 88.13 Delta .6030
  Debit 3.65 Position net delta .0230

One More Chinese Company

Focus Media Holding Ltd. (FMCN) 59.20. Shanghai based Focus Media Holding Limited operates advertising networks using audiovisual television displays consisting of commercial location networks, in-store networks, poster frame networks, mobile handset advertising networks, and outdoor LED networks. The commercial location networks includes flat-panel television displays placed in high-traffic areas of commercial buildings, such as in lobbies, near elevators, as well as in beauty parlors, karaoke parlors, golf country clubs, auto shops, banks, pharmacies, hotels, airports, airport shuttle buses, and in-air flights.

If you are thinking the correction is about over in the Chinese stocks then we should return to FMCN to see what we can find.

With a current Historical Volatility of 69.45 and a positive volatility spread consider this 9.20 points out-of-the-money put sale.

• Sell FMCN Dec 50 put QOHXJ 2.525 IV 90.10 Delta .2254

If the stock declines and the put is assigned your basis would be 47.475 and a quick look at the price chart shows that this level is below the breakout on the previous earnings report. For a long-term holder, say until the Olympics this summer, this would be a very desirable entry level.

ValueClick Inc. (VCLK) 22.23, sells clients online advertising campaigns and helps them increase their brand awareness. Advertisers are shifting their budgets online to take advantage of the growing popularity of the Web and the narrower targeting of advertising messages it permits. Recently the stock has reflected concerns about a Federal Trade Commission investigation into certain ValueClick websites which promise consumers a free gift of substantial value, the FTC wrote, "and the manner in which the Company drives traffic to such websites, in particular through email." ValueClick's Chief Executive Officer Tom Vadnais said his company is talking with the FTC about a resolution. He expects a fine, but one that wouldn't materially affect company finances. As a leading online ad serving company in a rapidly growing market this company remains an acquisition candidate.

For those who sold the November 25 or November 22 ½ puts based on the suggestion in IVolatility Trading Digest™ Volume 7, Issue 36, Bear Care, dated October 22, 2007, and are now long stock, then consider this follow-up trade against the long stock.

• Sell VCLK Dec 25 call QCSLE .975 IV 69.03 Delta .3404

The alternative is to sell more puts at a lower level increasing the position size. For example by selling the Dec or Jan 20 puts you cost basis would be below 20 in the event of assignment. It is hard to imagine that a price in the teens would last very long for a company in this sector. The current Historical Volatility is 69.93 and the IV Index for the puts is 68.69. While there is no volatility edge at this level the forecast volatility of both HV and IV are in the 50-60 range after resolution of the FTC issue.

• Sell VCLK Dec 20 put QCSXD .85 IV 67.34 Delta .2658
  Or
• Sell VCLK Jan 20 put QCSLE 1.45 IV 60.03 Delta .3404

IVOLalerts™

From IVolatility Trading Digest™ Volume 7, Issue 38, Solid Gold, dated November 5, 2007.

American International Group, Inc. (AIG) 59.12, a member of the DJ Industrial Average, provides insurance and financial services in the United States and internationally.

Rumors were that AIG would be the next to report massive write-downs from the aftermath of the mortgage and credit market problems when they reported third quarter earnings on Wednesday November 7, 2007. The estimate was for 1.62 vs. 1.53 year ago. The actual reported earnings were 1.44 per share and the stock declined 6 points down to the 55 level. It was also revealed that it has a $500 billion exposure to a portfolio of credit default swaps on loans made to borrowers who bought homes through its consumer finance unit. No further details have been released about Greenberg’s plans for management changes. Perhaps this was just hype release before the earnings report to bolster the stock price. The IV is now declining again and with a current Historical Volatility of 39.33 take a look at this put sale.

• Sell AIG Dec 50 put AIGXJ 1.20 IV 53.27 Delta .2081

While the stock could continue somewhat lower it will also respond to the expected decline in the Dollar Index (DX) that could come again very soon. The IV Index for the calls is 43.26 and 43.61 for the puts, while the HV is currently 49.19. Both volatility measures are currently high in a Type II pattern and we would expect them to decline back into the 30-35 range as the stock turns higher once again

Consider a near term put sale and a longer term bull call spread as follows:

• Sell NEM Dec 47 ½ put NEMXW 1.675 IV 43.95 Delta .3411

And

• Buy NEM Mar 55 call NEMCK 3.10 IV 41.81 Delta .4062
• Sell NEM Mar 60 call NEMCL 1.875 IV 42.13 Delta -.2788
  Debit 1.225 Position net delta .1274

Correction

In last week’s Market Review section we wrote that London’s FTSE index was off 17% since October 31, 2007. That was incorrect, actually the FTSE was off only 6.2 % as of the close on November 9, 2007 and is now off 6.4% as of the close November 16, 2007.

Reader Response Request

Once again we encourage you to let us know what you think about how we are doing and what you would like to see in futures issues. Send us your questions or comments, or if you would like for us to take a look at a specific stock or ETF just let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.

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