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In focus: Battle in a narrow range

Plus: Volatility projections and a conditional SPY trade

By Lawrence G. McMillan

The market can't go up or down -- at least for the moment.There is a ceiling at 1150, the daily high recorded on six of the last seven trading days. Conversely, there is a floor

at 1130, dating back to the last week of December. The low of the day has been near 1130 five times since the turn

of the year.

This doesn't necessarily mean that action is dull, as the entire range was traversed on each of the last three trading

days. Last Friday (option expiration day) was a fairly negative day, although a late rally "saved" the day. Then,

yesterday, the market rallied strongly, actually notching a new high for the Standard & Poor's 500

Index (INDEX:SPX) since March (but only by 4 cents, so it was hardly a breakout).

That rally was counting on a Republican victory in Massachusetts and good earnings from IBM (NYSE:IBM) . Both

of those occurred Tuesday night, and the market -- in its cycnical way -- sold off sharply on the news, trading all the

way back to 1130 this morning, before finding support on a modest afternoon rally. As long as $SPX is within this

narrow range, it seems that it is building energy for a strong move (40 points or so) once a clear breakout or

breakdown occurs.

The technical picture remains positive. $SPX is still above support at 1130, and that's also where the intermediate-

term trend line from the March bottom can be found currently. Thus a break below 1130 would not only violate

support, but would threaten the uptrend as well. There is further support at 1115 and 1100.

Equity-only put-call ratios continue to decline and that is bullish. However, they are now at very low levels on their

charts, which means they are overbought. The weighted ratio hit a new 14-month low yesterday. Of course, there

is nothing that says they can't go much lower. After all, ten years ago, these ratios declined into the 30's before

reversing upward. There is a lot more put trading in general, these days, so it might not be possible to get back to

the 30's, but it did happen before.

Wednesday, January 20, 2010

5:25 PM

 - ARM Spec notes Page 1

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Market breadth indicators are bullish, but somewhat overbought. The fact that three down days in the last six have

caused these indicators to be less overbought is positive. However, another day of heavily negative breadth

tomorrow would likely throw breadth indicators into a sell signal.

The volatility indexes (INDEX:VIX) (INDEX:VXO) continue to trend lower, although they have not hit new lows in acouple of weeks. However, a close above 20 by $VIX (it rose to 19.69 at today's highs), would threaten the

downtrend and issue in the possibility of a sell signal.

 - ARM Spec notes Page 2

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$VIX futures have been interesting this week. The January derivatives (futures and options) expired this morning inan "a.m. settlement." On each of the last three trading days, there were attempts to push $VIX higher -- either

coincidentally with falling markets or, more cynically, by traders hoping to improve their position prior to

expiration. Recall that there has been heavy hedging activity in this expiration, and those hedgers are long $SPX

puts, $VIX calls, and $VIX futures. Hence a rising $VIX (and falling stock market) are beneficial to their hedges.

The futures continue to trade at a large premium to $VIX. Meanwhile, the term structure continues to slope

steeply upward. These are bullish signs, although they do indicate that the market is overbought.

In summary, $SPX has had trouble breaking out above 1150, possibly due to overbought conditions as well as a

fulfillment of positive news expectations. Likewise, it hasn't been able to bread down below 1130 either, as the

"buy on the dip" crowd is still active. Eventually a breakout in direction or the other will occur, and after being

wound so tightly by the tight trading range, a breakout of at least 40 $SPX points should ensue.

Recommendation: Conditional SPY trade

In line with the market comment above, this recommendation is an attempt to put that market view into practice.

If $SPX closes at 1155 or higher then buy 6 SPY Feb 115 callsSPY: 113.89 -- Feb 115 call: 1.48 offered

Stop yourself out on a close below 114.

Or:

If $SPX closes at 1125 or lower, then buy 6 SPY Feb 113 puts

Feb 113 put: 1.74 offered.

Stop yourself out on a close above 114.

Trader's Insight: Volatility projections

$VIX is quite low now -- generally at about the same levels as it was in mid-2007 before the entire bear market

started. If one thinks that volatility will remain low, he therefore has a different market outlook from someone

who, say, thinks volatility has declined too much. Rather than just being a philosophical discussion, though,

volatility projections are crucial to option traders' strategies.

If you think volatility will increase, that is not a good profit projection for sellers of options, even in spreads. Thosewho think volatility will rise would rather concentrate on option buying strategies. That is one of the reasons why

we like the hedged $VIX/SPY positions -- they only involve long options and therefore would be aided, rather than

hurt, by an explosion in volatility.

Conversely, if you think volatility will decline even further -- as it did in 2006 -- you would be a seller of options.

Personally, that is somewhat like playing with fire, as volatility is so low that expected returns from option writing

strategies are unacceptably low -- unless you project volatility to go even lower while your option write is in place.

At this time, projecting lower volatility is acceptable -- even if you harbor bearish market thoughts -- but one must

be ready to abandon option selling strategies and bullish market aspirations if volatility begins to trend higher.

ARM Spec notes Page 3