UPDATE - 10:50 am - Thankfully, the historic selloff predicted this morning by NYSE floor traders has not materialized, though the day isn’t over. I think President Bush’s address at 9:35 am helped, and the market seems to believe the bailout will happen over the oppostion of the House Republican Leadership and Main Street itself, which clearly does not understand either the magnitude of the problem or the bailout provisions.
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Treasury Secretary Paulsen hammered together a pretty good bailout plan in which Main Street will buy the bad mortgages - and benefit by the ones that pay. Warren Buffett says that 75% of the subprimes and Alt-A mortgages will pay. Not a bad deal.

Last night the House Republican leadership announced they will not support the bailout, demanding that the bailout be recast as a plan to insure the mortgages. How stupid. You don’t insure something after it goes toes up. Besides, Paulsen’s plan has an upside; taxpayers could conceivably come out not badly at all. The House Republican plan would mean 1) vastly greater cost to Main Street, and 2) mortgagees and mortgage lenders would have no incentive to minimize losses, since the insurance would provide a net. Maybe Congressmen should have to pass an economics test before being seated.

So - stock index futures are down today. The market, expecting a bailout, rallied a bit this week. Well, that’s about to change. Expect a horrible day today in the neighborhood. The selloff could continue into next week. NYSE floor traders were in tears this morning. They believe we will see history made today.

Forget technicals - this is bigger than technicals.

If the market tanks as expected, close the short calls. Beware of rolling the calls down, however, since some kind of bailout will occur soon - who knows what it will look like, or when it passes? You could become trapped in a strike below your basis. Only roll down IF the roll will result in a profitable trade if called. Our trade management calculator will calculate this for you automatically.

If really concerned about another Black Monday-type selloff, close the position.

Other alternatives:

1) Ideally, we would sell the stock and buy back the calls after the stock falls, but this would leave the short calls naked. Consider buying a higher-strike call (this turns the short call into a bear call spread), which will free the stock to be sold - IF you have spread-writing approval.

2) Create an OTM bear call spread (separate from the open covered call position), and close it profitably if the stock tanks.

3) Buy a long-term put and turn the CC position into a SuperPut. Puts might be, ahem, expensive today - even the long-term puts.

Stay frosty, and don’t panic. This, too, shall pass.

My negative thoughts and feelings of foreboding about the Financial stocks (mortgage, investment banking, banking) have not changed from those expressed on previous blog posts. I regard them as off-limits until further notice, since unknown problems can (and will) continue to pop up. If you are a trader, have at them, but an investment in financial stocks is highly risky.

WaMu (WM) may go into receivership, for example, and is desperately seeking Susan, or any other available suitor. Has a WaMu disaster been averted? No, but even if we were told it had, how would you or I have any possible way to know? WE DON’T. As one MSNBC commentator noted on-air, these financials will tell us everything is fine and then announce a couple of days later that they’re out of business.

Now, the Masters of the Universe at Goldman Sachs (GS) and Morgan Stanley (MS), proud, old names (really old) are going to turn themselves into bank holding companies so that they can borrow money from the Fed cheaply. They will then be regulated as BANKS by the Fed itself, not the SEC. And if you believe Goldman and Morgan are doing this to take advantage of great opportunities (instead of to survive at any cost), I have some land in South Florida to sell you.

You see, when Reagan ushered in the great wave of deregulation - including the tearing down of the Glass-Stegall Act, which forbid banks to be both investment banks and commercial banks - one of the senior partners at my old law firm predicted this sorry day would come. He understood greed. But no, I argued, the smart guys in Wall Street simply should be loosed to unleash their creativity, instead of being bound by unimaginative laws created as make-work by Washington’s legislative drones.

And so it did.

What my old partner Jack understood and I didn’t was that, because the Wall Street smart boys (and girls, these days) care about nothing but their bonuses and the size of their houses in the Hamptons, what we’d get one day is precisely what we got.

And these are the people Americans trust to manage their money? Good God!

Wall Street as we know it is changing under our feet. Lehman is gone and even if absorbed by Barclays it’s still gone as it existed before, Bear Stearns bought up, now Merrill Lynch bought up. There goes the last of the big investment banks. They’re GONE, people. A staple of American business, raising the money that fueled American business and thus American growth since before there even was an America… they’re gone.

This will severely crimp capital raising, don’t kid yourself. Who will underwrite corporate junk bonds now? Who will bring out deserving new public companies? Who will fund the hedge funds (hopefully no one)? Investment banks do these things (or did). Banks loan money to people who don’t need it, remember? Foreign money vendors will fill the gap to some degree, but they will cherry pick the best and safest.

Well, the good news is these Masters no longer will be able to engineer and loose upon us these toxic financial products that not even their creators truly understand. Banks, you see, are actually regulated, and bank regulators don’t find these things amusing.

If you agree with me about the dangers that inhere in the financials but nonetheless are squirming at the thought of missing their surge, buy some slightly OTM October calls, or ITM if you want better delta. Use a trailing stop if the trade is working, but set a reasonable sell-stop limit going in, to protect downside. And good luck with that.

The CBOE Market Volatility Index (VIX) is one of the stock market’s premier sentiment indicators, since it tends to move inversely to the market. At market bottoms (even bottoms that turn out to be only temporary, like a range bottom), the VIX tends to spike above 30, although above 35 is an even better sign. Please refer to my post yesterday for VIX and INDU (Dow industrials) charts, which illustrates the inverse relationship.

High spikes in the VIX tend to signal a market bounce off a support level, and the higher the VIX spike the better (low VIX readings are not very helpful in regard to market tops).

Yesterday, the VIX hit a high of 36.40, the highest reading since January 22nd of this year. Today it has hit 42.16 and is 39.25 as I write this - falling, so far.

Note that 42.16 is the highest level the VIX has hit since October 2002. Thus I think it it signaling a strong market advance off the bottom - which is forming as we speak. Like a farmer with sodden fields, I welcome the sun breaking through the clouds.

By the way, the MACD for the VIX has been climbing for several years and this year finally has risen to 1998 levels, as the following monthly chart shows:

In Dow Theory, simultaneous highs in both the INDU and the Transportation averages (still known to traders as the “rails”) is a bullish confirmation; simultaneous lows a bearish confirmation. The INDU appears to be bottoming, but the rails are up, which in Dow Theory parlance is a non-confirmation, meaning who knows?

But I think the VIX knows, because VIX spikes indicate panic, which is the stimulus point for the market to reverse course - because panic selling grows exhaused and the bottom feeders (like me) start rushing in.

Covered Call Thoughts:
What a great time for covered call writers (and call buyers) to look for trades! The best tactic will be to leg in, meaning buy the stock and wait to write the calls only after a price rise, which really makes returns take off. When you start to feel confidence in a snap-back, it is time to get in. If you can’t quite get a real confidence level, consider buying a long-term protective put (only those that are dirt cheap, with very little time value). When puts start to get cheap, what is that telling you?

If you have good stocks that are seriously down with the market, as opposed to being down on their own, don’t take a panicky loss here. The good ones should snap back.

If on the other hand the stock is Lehman Brothers, Goldman Sachs or AIG, to name just a few that have been wingshot (or gutshot), then a market surge can’t be counted on for much help.

The Good News:
I’m hoping the market tanks a little further to please the hard-core technicians, but we probably have enough to herald a strong market snap-back. I’m excited, friends.

UPDATE AFTER MARKET CLOSE: The Dow closed at 10,609, down over 25% from the October high; VIX closed at 36.14.

CORRECTION: the post stated originally that the INDU’s all-time high was 14,198 (what my QCharts platform shows), when it was actually 14,279. My apologies! I have corrected the post.

As I write, the Dow Industrials (INDU) have hit an intraday low of 10,660 in trading today, the lowest since January 2006. And we could see a lower low before the day/week is over. As the chart below indicates, this is a selloff over the preceding 12 months of 25.34% (3,619 points) from the October high of 14,279.

While amateurs and your dear Aunt Mabel are in panicky liquidation mode, savvy traders and investors know that the point to get in is here - or very near. First of all, the market selloff has been huge. There could be more to come, sure, as the lying scalawags of Wall Street are forced to disclose how bad things really are.

The Better News:
But an imminent market surge is on the way, as measured by the CBOE’s Market Volatility Index (VIX.X or $VIX), a premier sentiment indicator affectionately known as the VIX. It tends to move inversely with the stock market. Thus a significant market low will result in a spike in the VIX, as happened today.

In fact, the VIX hit an intraday high of 35.76, its highest reading since January of this year. The VIX strongly confirms a stock market move off this low level, which probably will be (at least) a market bottom. The market reverse on the last VIX spike, which barely broke 30. A reading over 35 is a horse of a different color. Look at January and March 2008 for an idea of what to expect.

I expect a strong snap-back in the next couple of months back up to test the upper range line (top chart), which also happens to be the 200-week moving average.

If the market breaks above the upper range line, you’ll hear a lot of idiot pundit talk in coming weeks about the new “bull market” - as if a bull market could spring forth from current economic conditions and falling corporate earnings. No, a bull market is not beginning, but we should have a couple of months of a rising market, which is a peerless time to write covered calls.

Consider legging in to the calls, meaning to buy the stock and write the calls only after the stock has risen (which really supercharges returns). If you’re really short-term bullish, consider buying ITM calls on great companies that have sold off with the market in past weeks.

What Could Go Wrong?
Of course, more catastrophic bad news on bellwether companies like AIG and Merrill might knock such an advance in the head, which would likely mean another stall-out in the market, sending it sideways, as happened after the July 15th “bottom”.

Expect another net down day today. The stock futures were heavily down. Giant insurer AIG is hanging on by its fingernails, and the NY Governor is desperately trying to keep it in business. It may file for bankruptcy protection.

Goldman Sachs’ Q3 profit was off 70%, and it didn’t make its consensus earnings projection (1.81 vs. 1.91). The purpose of this post, by the way, is not to paint a gloomy picture but simply to focus on what is happening.

We need a market swoon back to the DJIA’s 10,600 level or so, which was the bottom of a 2006 correction, before the market can resume its move up. I still think the market will bottom - at least temporarily - and make a new run north at the 200-week moving average.

But we first have to sort out the next few days. I look for the major market indices to fall over the next days or even couple of weeks to the lower trend line of the market’s falling range (see prior posts). We have lots of earnings reports yet to come, the news ain’t gonna be great, and we have to wonder how likely a market surge is while the drip-drip-drip of poor earnings results come in.

I am licking my lips at the prospect of the turnaround about to come. Seriously. Be looking for great companies that have sold off with the market in past weeks, which will come roaring back.

Covered Call Positions
Covered call writers, don’t despair here. See this market move for what it is - an opportunity. If you have been rolling calls down, it may well be possible to roll them down once more. But, I would close them for another profit if the market continues falling, then clear out any short calls. You don’t want to be caught in a low-strike call when the stock comes back (the assignment trap).

Right now is not the time to put on a covered call position. Wait a bit for even better prices. When the market snaps back, buy the stock but don’t sell the calls right away. Leg in, meaning to write the calls later after the stock has run up some.

I have been saying and writing for quite a while to stay away from the financials, including insurance. The reason is that (like kids diving into a murky pond for the first time), when it comes to the financials stocks we have no idea how deep the water is is or where the stumps are.

The stock index futures are down horribly this morning before the stock market’s open. The market will be slaughtered today, and the slaughter may last for much of the week.

Lehman Bros. (LEH) is gone, headed for bankruptcy. As an attorney, I understand this. Why make a deal to buy it now, when you can buy it out of bankruptcy court much cheaper and hose all the shareholders?

Bank of America is buying Merrill, Lynch. AIG, the insurance giant so beloved by Warren Buffett, is in deep doo. What do you think now of these hot-shot managers of the big financials, these smart guys with MBAs from Harvard and Wharton?

For all of you who wonder about my claims that ordinary people can - with covered calls - outperform the big boys, remember that the “big boys’” principal skill is pocketing fees, not making money. As Peter Lynch (a truly great money manager) once said, the average Joe who pays attention can achieve investment returns that beat 95% of the professional managers.

What to do today?

First of all, don’t freak out. The market is coming down hard today, as another financial shoe drops. Be prepared to close short calls as the stock falls, since it is likely that most stocks will be hammered today. Rolling the calls down may not be the best option, since the market is likely to snap back after it absorbs the newest financials fiasco.

If you are a down-day call writer, today may not be the day to write! The market could sell off for several days.