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With numerous aspersions being cast upon mortgages and structured credit products in recent weeks we are going to search for some Good Credit - credit spreads. At the request of Jim and others we are going to set up the IVolatility.com Spread Scanner and look for some good credit spreads. But, first a few noteworthy market comments.

Head & Shoulders Top Update

For the week the S&P 500 Index (SPX) closed at 1331.29, down 64.13. We are still expecting a decline to the minimum measuring objective of 1225, now 106 points lower. We think it is unlikely that the S&P 500 Index has made a V bottom and we expect it will retest the 1270.05 low made on January 23, 2008 and then continue lower to the minimum measuring objective. Closes above 1425 would be required to change this outlook.

US Dollar Index (DX) 76.67, (cash) bounced off of the 75 support level once again increasing the significance of this support level. We are now beginning to see the formations of a bottoming pattern and we need to start considering the implications of the dollar turning higher. Has it discounted all of the negative news and is now looking forward? Perhaps it is discounting slower European economic growth and lower Euro interest rates. Again we say, keep an eye on the DX this week.

Market Breadth

The NYSE McClellan Summation Index, our market breadth indicator ended the week at –142.19, a one-week gain of 112.93 points, but the rate of increase has slowed.

Strategy

The strategy is to start looking for sectors and stocks that will rebound when the market turns. In the meanwhile commodity prices continue higher. If however, the dollar index continues higher we can expect to see some weakness in commodity prices as well. Watch the PowerShares DB Agriculture Fund (DBA) now 39.03, a new high, and with a 3.28% premium over its net asset value of 37.79.

Bearish Call Credit Spreads

We set up the IVolatility.com Spread Scanner in search of credit spreads. First we should explain bearish call credit spreads and what we are intending to accomplish. This is an Income Strategy that sells calls and protects the downside by buying the same number of calls with a higher strike price in the same expiration month. It is a limited risk and limited reward strategy. To ensure best results ideally both of the call strike prices should be out -of- the- money (OTM). As a practical matter we will have to accept a bit more risk by selling at- the- money (ATM) calls or we would not find many opportunities. The spread is done for a credit as the ATM calls are higher priced than the OTM calls bought for protection.

If the stock falls as expected then both calls will expire worthless and you retain the credit generated when the position was established. If however, the stock rises the break-even price is the lower strike price (the call sold), plus the net credit. The maximum loss is the difference in the strike prices, less the credit received. Set the Stop/Unwind (SU) at the break-even and buy back the short call, if the stock is gaining momentum or unwind the position if the stock price changes are erratic.

Since we are seeking a stock that will decline in price we need to consider if the market conditions support our assumption. We are expecting the S&P 500 Index to decline further so this would be consistent with the plan. We would want to exclude stocks in the consumer staple group as they have a tendency to decline less than the consumer discretionary stocks. We would want to exclude stocks in the groups that are showing relative strength, such as Agriculture and Mining. Finally we would want to exclude those that are potential takeover targets, such as YHOO and perhaps VCLK. The very best choices would be stocks that have just completed a counter-trend short term rally and are now resuming their longer-term downtrend.

The setting for the IVolatility.com Spread Scanner, using Friday’s closing data are:

Position Selection
Sell Mar08 Call, ATM.
Buy Mar08 Call OTM15%.

Position Criteria
Position IV ratio min. 1.25, max. Undefined.
Position cost Credit min. .75, max. Undefined.

Stock Selection
All USA.
Stock price min. 20, max. 100.
Option Volume 1000.
Options OI (Open Interest) 2000.

Show 50 records per page.

The scan results are CAT, EFA and ING. All are detailed below.

Caterpillar Inc. (CAT) 68.01. With three segments: Machinery, Engines, and Financial Products, Caterpillar, Inc. manufactures construction and mining equipment, diesel and natural gas engines, and industrial gas turbines.

DR: Income strategy with limited risk and limited reward. Declining market along with an economic sensitive declining sector. The stock is in a definable downtrend.

SU: At the break-even 70.77 (67.50 +3.27) buy back the short call or unwind the position.

Historical Volatility is 30.96.

• Sell CAT Mar 67 ½ call CATCU 3.35 IV 32.32 Delta -.5623
• Buy CAT Mar 80 call CATCP .08 IV 25.33 Delta .0356
  CR 3.27 Position Net delta -.5267

iShares MSCI EAFE Index (EFA) 68.34. The iShares MSCI EAFE Index Fund seeks to provide investment results that correspond to the price and yield performance, before fees and expenses, of publicly traded securities in the European, Australasian and Far Eastern markets, as measured by the MSCI EAFE Index.

DR: Income strategy with limited risk and limited reward. Declining market along with declining international markets. This ETF is in a definable downtrend.

SU: At the break-even 70.826 (68 +2.825 ) buy back the short call or unwind the position.
Historical Volatility is 25.99.

• Sell EFA Mar 68 call EFACP 2.975 IV 29.01 Delta -.5545
• Buy EFA Mar 79 call EFMCA .15 IV 23.01 Delta .0382
  CR 2.825 Position net delta -.5163

ING Groep NV (ING) 29.88. ING is a financial Services Company headquartered in Amsterdam, the Netherlands. They offer a wide range of services including insurance, banking, brokerage, mortgages, structured finance, credit cards and more.

DR: Income strategy with limited risk and limited reward. Declining market along with a disliked and declining sector. The stock is in a definable downtrend.

SU: At the break-even 31.76 (30+1.76) buy back the short call or unwind the position.

Historical Volatility is 50.54.

• Sell ING Mar 30 call INGCF 2.18 IV 65.24 Delta -.4895
• Buy ING Mar 35 call INGCG .42 IV 51.91 Delta .1682
  CR 1.76 Postion net delta -.3213

Yahoo! Update

Yahoo! Inc. (YHOO) now 29.29, up .82 for the week. Yahoo provides Internet services to users and businesses worldwide. It also owns 39% of Alibaba, the Chinese B2B web portal.

Not surprisingly Yahoo rejected Microsoft’s unsolicited takeover offer, saying that it undervalues the company and they would not consider an offer below $40 a share.

Before Yahoo’s Saturday announcement the implied volatility of the options had declined during the week from 51.01 to 45.41. We think they will now start rising again. In the meanwhile, with a Historical Volatility of 126.92 and expected to be declining consider this near term put sale opportunity.

DR: Expect a long contest for Yahoo! Implied Volatilities should rise with each new report of a higher bid or expressing uncertainly or doubt about regulatory approvals.

SU: Setting a stop/unwind at this early stage of the process is difficult and may not be realistic since Microsoft is not likely to withdraw their offer so early in the process.

• Sell YHOO Mar 25 put .565 IV 55.52 Delta .1743

Options Upside Down

"Upside Down" is a song by Motown legend Diana Ross, a Pineapple cake, and the financial predicament of having negative equity status in a loan. We are going to add one more to the list, our own description of an options position that appears backward – which we are going to call “Options Upside Down”.

UltraShort FTSE/Xinhua China 25 Proshare (FXP) 98.20. This ETF seeks daily investment results, before fees and expense that correspond to twice (200%) the inverse of the daily performance of the FTSE/Xinhua China 25 Index.

If you are in the camp that believes the Chinese markets will not recover until the US markets turn higher here is a way to benefit from the continuing decline without shorting individual Chinese stocks. This ETF will rise twice a fast as the FTSE/Xinhua China 25 Index declines.

And if you want to limit your capital commitment here is a put sale strategy to get short. A rise in the FXY corresponds to a decline in the FTSE/Xinhua China 25 Index. So here is our “Options Upside Down” strategy.

DR: Low cost alternative for a short FTSE/Xinhua China 25 Index position.

SU: Buy back the short put on a close below 85.

With a Historical Volatility of 103.34, consider this put sale.

• Sell FXP Feb 85 put FXPNQ 1.875 IV 120.69 Delta .1799

In this case the positive delta corresponds to a negative position on the FTSE/Xinhua China 25 Index.

Refinery Time

This is the time of the year that the market begins to anticipate improving refinery gross margins as measured by the “Crack Spread”. Since we can estimate the amount of product that can be produced from a barrel of crude oil, and we can see the market prices for the products as well as the cost of crude we can follow the crack spread on a daily basis. Since it usually improves in the spring with greater demand for transportation fuels the equity market starts pricing the refiners higher before the crack spread starts improving. The obvious risk here is the possibility that due to a weaker economy the crack spread fails to improve. In that event, the equities will be ahead of themselves and subject to a downward correction.

In IVolatility Trading Digest™ Volume 7, Issue 41, Bearskin Jobbers, dated November 26, 2007 we first introduced Harvest Energy Trust when it was trading at 21.89.

Harvest Energy Trust (HTE) 23.81. Harvest engages in the exploration, development, production, and sale of petroleum, natural gas, and natural gas liquids in western Canada. They also engage in the refining and marketing of medium gravity sour crude oil. Upstream oil and gas production is weighted 70% to crude oil and liquids and 30% to natural gas, and is complemented by a medium gravity, sour crude oil refinery, located in Come by Chance, Newfoundland with current crude capacity of 115,000 barrels (“bbl”) per stream day (“BPSD”). HTE currently pays a C$.30 monthly distribution, or at an annual rate of C$3.60. At the current exchange rate the US amount is approximately $3.48 at an annual rate. At the current price this is a 14.62% return before the 15% Canadian Withholding Tax, or 12.5% net after withholding.

If you bought the November suggestion, your basis for the 100 HTE shares would now be 21.39 as the suggested December 22 ½ call sale expired out-of- the money. Your yield on this basis is now 16.27% before withholding, and a good bit above the current money market account rate.

What about the crack spread risk we mentioned above? What can be done about that?

Here is the plan:

DR: In order to keep the long stock for the dividend and protect the price risk we are going to suggest using a collar. Selling an out-of-the money call (against the long stock) creates the collar when the proceeds are used to buy out-of-the money put

SU: On a close below 20 we would sell our stock by exercising our put, for a total risk of 1.39 (21.89-20.00).

With a current Historical Volatility of 43.55 consider this collar.

• Sell HTE May 25 call HTEEE .875 IV 32.36 Delta -.3742
• Buy HTE May 20 put HTEQD .75 IV 43.07 Delta -.2254
  CR .125 Position net delta -.5996

In the event you did not follow the November suggestion then here is the trade based upon the current stock price of 23.81. If you think we will see higher gasoline prices this spring here is a way to hedge the added cost.

Buy 100 Shares of stock to collect the dividend.
• Sell HTE May 25 call HTEEE .875 IV 32.36 Delta -.3742
• Buy HTE May 20 put HTEQD .75 IV 43.07 Delta -.2254
  Net debit 23.685 Position net delta .4004 (1.000 -.5996)

The return on your position will be 14.69% before withholding, and a lot better than a money market account. If the stock were called away by a closing price above 25 on the May expiration your return would be approximately 9% in 14 weeks, still better than the money market account yield. The results may be further improved with some market timing by delaying the implementation of the collar until the stock begins to turn lower.

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