UPDATE: I misspoke in the original post. The stock market is OPEN on Monday, October 13th.

Ye gods, what a couple of weeks! Starting on October 2nd, the market has been driven by sheer panic. The retracement has been over 40% from the October 2007 market high. If you recently put on covered call positions - using good stocks - without using the SuperPut structure, I sincerely hope you have not taken needless panic losses. Pretty much all the individuals in panic mode have sold, and we are starting to see a climax in institutional (hedge funds, etc.) selling.

This has indeed been a panic-driven selloff. The situation was never quite as dire as the administration painted it, but panic is self-sustaining. Pros sell at the top, buy at the bottom; amateurs do the opposite. So why have institutions - which have driven the panic - been selling out? Money managers will not be put in the position of explaining why everyone else got out and they didn’t. Many institutions saw the writing on the wall and got out, intending to get back in at a bottom. Indeed, many automated programs will start buying at about the 8,000 level on the INDU.

Unless you have lost all faith in the American economy and think it’s headed for the trash heap, it has all along been a matter of where the market ultimately finds support and rebounds. For this to happen, the selling must climax, which is likely, though not certain, to occur at a historical support level. Thus the bottom is unknown, as is the strength and momentum of a rebound. But we can look at some obvious support levels for the Dow Jones Industrials (INDU):

10,700 (2006) - blown
9.800 (2004) - blown
9,000 (2002) - blown
8,000 (2003) - being tested
7,500 (2003) - not in play yet
7,197 (2002) - not in play yet

The market is testing the 200-month moving average as the chart below shows:

As you can see, volume is headed towards a climax and capitulation point. This does not mean a bounce is right around the corner, since the market could easily look for the lower support levels. Much will depend on how much automated buying kicks in, and when. A decisive break below the 200-month moving average would indicate that the we’re going to test lower levels yet.

Volatility Indices
The CBOE volatility indices, which function as sentiment indicators and move inversely to the market (they’re high when the market is low) have all hit all-time highs; in fact, they keep reaching new highs:

$VIX - hit 74.46 today (previous high 49.53 - 1998)
$VXO (OEX volatility) - hit 99.65 today (previous high 72.13 - 1997)
$VXN (Nasdaq volatility) - hit 80.37 today (previous high 71.72 - 2001)

I’ve had to revise those highs skyward - twice - since I began writing this post. Those are 7, 10 and 11-year highs, at least based on the “official” indices. Note that the current VIX (tied to the S&P 500) was newly created in 2003. The “original” VIX was launched in 1993 (tied to the S&P 100), but was re-christened the VXO in 2003. Because it is older and S&P 100-based, and perhaps because VXO options are American-style, many market commentators prefer the VXO (old VIX).

NOTE: VXO (old VIX) data actually goes back to 1986, before launch. Using those numbers, the VXO would have hit a high of 152.48 on October 19, 1987 (Black Monday) and a high of 172.79 the following day. Source: VixandMore

Wrap-Up
The market will in all likelihood soon find a bottom and begin to recover. However, it may well be an intermediate bottom, with lower lows to come. In other words, are we going straight to THE bottom now, with a stronger recovery, or will we see only an intermediate bottom, with the market continuing the falling-range behaviour we saw from October 2007 through September 2008?

If the market does bottom soon, don’t assume the market gyrations and volatility are “over.” They likely won’t be. At the very least we will continue to see a lot of choppiness and volatility.

How strongly will the market snapback? Unknown, but programmatic buying will move the market smartly once the selling climaxes.

Covered call writers:
Use the SuperPut structure when you start writing again. Those long puts have a life of 6-8 months, and the likelihood of the market coming back down in that time frame is, um, reasonable. So don’t think you are throwing away the put cost.

On stocks that are down, do not write below your cost basis, or you will be forced to close those calls at a loss on a market snapback - and the magnitude of the snapback could be ferocious.

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.
—————-
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.

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.

A reasonable percentage of my posts are about the market, partly because I enjoy it and partly because that is what seems to be consuming everyone these days. I noted in recent newsletter articles that the stock market agains appears to have found the bottom trendline of the channel it’s been in since October 2007. On a weekly chart, the Dow Jones Industrial Average (INDU) indeed seems to have bounced off the channel bottom. It now must test the 200-week simple moving average (SMA), which is at about 11,712:

Note first of all that the upper channel line is almost the same as the (now declining) 50-week SMA. If the market rises that far, it will be simultaneously testing that average and the upper trendline. The prospect of a breakthrough there is not great, as I have discussed. The gray circle on the upper trendline indicates a possible point of intersection for that test. But will the market even advance that far?

The INDU nudged the 200-week average not so long ago and has pulled back. I nevertheless expect a full-on test of the 200 soon, in large part because so many expect it to occur and because a convincing failure there has not yet occurred. If the INDU breaks above the 200, a further advance to test the 50-week average may reasonably be supposed.

The market may, however, pull back to again test the lower trendline, as it did in March, which is noted on the chart above by the green circle. Another leap at the upper trendline is therefore quite likely.

To date, the INDU’s intraday low of 10,827 this year represents nearly a 24% selloff from the intraday high of 14,198. Put differently, the Dow has in less than a year lost nearly a fourth off its all-time high level in October 2007.

A fair question, one on many minds: if the current market is a correction to a major uptrend, when will this correction be over? No one knows, and the technical factors - while helpful - ain’t the whole story. There’s inflation, the economy, and other factors discussed at length by me and many other commentators. I think more selloff is necessary would be necessary to convince everyone that the correction has bottomed - a clear point of capitulation needs to occur.

But truly resuming a new uptrend will require a healthier economy and stronger corporate earnings. Will they be there? If so, the question of whither the market answers itself.

I am bearish now, as most of you know, but the market will in coming months - say by the end of October - make clear whether it is merely correcting a major uptrend still in place or if more bear is to come. I think a resumption of the bull this year or early next year is quite likely, especially given the election. We’ll soon know.

Quick Historical Note:

1. The correction of 2000-02 retraced approximately 38.2%, then later hit 50%, of the rise from 1990. Both are Fibonacci retracement theory numbers. In fact, the Dow declined to previous market top (support) levels from 1998.

2. The current correction already has hit 38.2% of the rise from the bull market’s 2003 beginnings. In fact, the first week of July 2008 saw a fall to 10,827, which is a 50% retracement. The current correction has already hit 2005 support (the INDU’s 2005 top) and has almost hit the 10,752 top from early 2,000.

3. Also on a positive note, the 200-week SMA has not yet turned downward. That downturn will be negative news. should it occur.

Feel better now? I know one thing: the more bearish more people become, the better I feel.

For call writers, of course, all of this is merely an attempt to answer the question of when is best to write covered calls. Right now is good, since the market has hit a (probably) temporary bottom and is gathering for a spring at the upper trendline.

Important Note: If we get another pullback testing the lower trendline, as in March 2008, don’t panic. It is not unlikely. Today’s pullback may indicate a retest of the lower trendline or may just be noise. And don’t forget: we’re in the doldrums time of year, and a lot of traders are on vacation now or not working their hardest.

Today is expiration Friday for the June 2008 equity options (tomorrow, Saturday, is actual expiration day). If you are short ITM options at or close to expiration and do not want to lose the stock, meaning have it called away, here are two techniques that allow you to keep the stock:

1) Buy back the short ITM calls, which will be down to parity (trading at intrinsic value) or close to it. If the stock has advanced, this is an expensive prescription, because the call’s intrinsic value will rise with the stock price. But this is a poor practice, because it adds to the cost basis in the stock. In other words, the stock price will be below the position’s cost basis. The only justification for closing ITM calls is an expectation that the stock will rise in the short term, recouping the cost of buying back the calls. If the stock pulls back, the stock will be below cost basis. Thus closing ITM calls should be reserved for those instances in which you have a short-term bullish outlook on the stock.

As a side note, the market may well have bottomed temporarily, as noted in my most recent issue of the Money Newsletter. If so, good stocks will be rising in the short term. Weigh this alternative with the one below.

2) Roll the calls out to the next month, meaning to buy back the short ITM calls and sell calls of the same strike price for the next expiration month. Because premium will be higher for the next month, rolling up should generate a credit, not a debit. The roll out allows you to neatly skip over assignment this month and defer it. If the assignment is presented again at next month’s expiration, you can roll out again.

You may be able to roll up and out to the next month for a modest debit (I personally don’t add debits unless they are nominal) - or roll up and out two months. In a strong bull market, this may make more sense, because stocks can rise for a long time without a meaningful retracement.

A frequent question I get about rolling out is: isn’t it just deferring the inevitable? Not really. Remember that YOU choose whether you are assigned or not. If we posited that the underlying stock will keep rising forever, then rolling out would indeed only postpone the day of reckoning. But that does not happen. Sooner or later the stock will retrace and give a breathing space to close the short calls. In a volatile or bear market (like the one we have now) a pullback is pretty much assured.

If you roll out, you can always close the new calls - that option always is on the table.

Russell Investments (www.russell.com), a subsidiary of Northwestern Mutual Life Insurance Co., provides some influential equity indices - the best known being the Russell 2000 Index - and Russell claims that over $4.4 trillion in investment assets is tied to them. There appear to be 120 index funds linked to Russell, of which 20 are Russell 2000 index funds.

On June 27 Russell will reconstitute its indices for 2008, meaning that some stocks currently included will be ditched, and new ones added. Analysts expect over 300 new companies will be added to the small-cap index, including 40 or more companies dropping down from the 1000 to the 2000. The Russell 2000 is mostly populated by small- and mid-caps.

The managers of all those Russell-linked funds will have to adjust their holdings to follow the revamped indices. An AP article reports that hedge funds and others will try to take advantage of the changes, and that analysts are already war-gaming who’s in and who’s out.

Companies added or deleted, or downgraded, will experience some volatility as funds rebalance to adjust holdings. The volatility could be severe for deleted small-cap companies with significant institutional holdings when the big holders rotate out of them. And some companies will benefit.

Financials currently make up 20% of the Russell 2000, and some of them will be ditched, another reason to be very careful of them for July expiration. For reasons explained in my new book and in newsletter articles, I don’t write covered calls on, and don’t espouse the writing of, mid-caps very often and small-caps, never.

But if you do write or trade these, be aware that you could be bushwhacked on such stocks, even before June 27 - if the market decides a company is “marked.”

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As I (and others) predicted yesterday, the market sold off today. The DOW closed at 12,099 on Friday. On a weak open today, it swiftly sold off 460 points to 11,634 and is fighting to hold on to the 12,000 level. There were a huge number of sell orders from around the globe this morning, so the market was bushwhacked.

I remain short-term bullish; short-term only. The market should recover some of the lost ground, but this will only be a bear rally. The medium- and longer-term prognosis is not good. Don’t depend on the election year to save the market. I am not counting on the market to recover today, but it may begin a short-term recovery this week.

Some thoughts for covered call positions:

A lot of covered writers are in impaired positions. However, if you write covered calls on a market rebound, you will be caught in the assignment trap - forced to be called out at a loss or repurchase the short calls as the stock rises. It is usually better in this case to simply let the stock recover. If you are short calls at a strike below your cost basis, consider closing the calls and letting the stocks recover with the market.

When a stock recovers enough, consider taking profits on covered call positions or turning them into SuperPuts by purchasing the long-term puts, where the puts are cheap, with very little time value. It is advantageous to construct the SuperPut at a higher level. By example, if a stock ranges from $100 to $110, it would cost a lot to buy the 110P when the stock is $100 - we would pay $10 in intrinsic value, plus time value. But when the stock rises to 110, this is the time to buy the 110P, which offers far more protection.

Implied volatility being about the same, it will cost about the same to buy the 110P when the stock is $110 as to buy the 100P when the stock is $100. So it makes more sense to add the long put at the higher stock price. This is why I am more inclined to establish the SuperPut at highs, at range tops.

On the other hand, puts get pretty expensive when a stock is falling. We pay too much time value then due to high implied volatility. And when the stock stabilizes, the IV evaporates, diminishing the put’s value. A big key to the SuperPut strategy is not overpaying for puts.

If the puts are expensive (more than 2% monthly), it might be better to find another stock. As the stocks fall again with the market - and they will - the long puts will make it possible to write calls on the stocks (and close and trade the calls to generate additional credits) with impunity, since the long put provides a price guarantee.

I look forward to a brief market recovery and to establishing all SuperPuts at the higher price levels. Don’t be discouraged or freaked out by the market volatility. We are about to be in a terrific position to place SuperPut trades and laugh at further market decline, because the long put will make falling stocks someone else’s problem.

Yesterday (1/3) I put on some trades, since I like to write on market down days. I didn’t know today would be another market sell-off day, but who did? I want to do more this year of sharing my trades and thought processes with you. I won’t always be right, any more than you, but my goal is profit, not glory. I want to discuss one trade in particular: Amazon.com (AMZN):

I’ve done well with AMZN - it has been berry, berry good to me. The more I think about etailers, though (and AMZN is the big dog in etailing), the industry is a bit overbought, with a P/E over 100. So when the stock dipped today with the market sell-off, I decided to roll the calls down and out. I bought back the JAN 95C (-1.97) and sold the FEB 90 Call (+8.15). This lowered my cost basis to $86.02 in a stock that cost $97.00. Thus if called on the FEB 90C, I make roughly $4.00 a share, or 4.3%.

FEB expiration is on 2/16, which is 42 days out. If called, my return will be 3.1% normed to a month [4.3% / 42 days x 30-day month). This means that absent further selling off I will make a return that is at least 3% per month. I’m doing several contracts, so trade costs are minimal.

Should I have rolled down? Well, AMZN has started to come back a bit, but who knows? If there is bad news, I will be happy for rolling down-and-out. If it snaps back, I will not cry about leaving money on the table. 3% a month is not bad where I come from, and I’ll take it happily.