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Chaos Theory


At what point will the market shift its focus away from Iraq and towards our traditional metrics?


Total chaos--no mass confusion
Trades so hypnotizing known to call an illusion
Like a magician who draws a rabbit out a hat, son
I'm drawin' more, like a 44-Magnum


Good morning and welcome back to the twisting blitz. The wild ride continued yesterday as Hoofy's strong stateside stampede suddenly stopped and hightailed it back to Matador City. It was a surprising reversal of fortunes (no pun intended) as the bovine had seemingly cleaned up the sell-side pressure. As they began climbing over the 200-day moving averages, however, the flanking bears spanked the bulls and sent them slinking home.

The action illustrates a growing trend -- or lack thereof -- that's emerged in the market this year. The Minx, for all her movement and moxie, has been rather moody with her day-to-day dance. Once upon a time, savvy traders could "go out" long or short based on the previous night's price action. That's a been a dicey endeavor lately as the geopolitical landscape and two-sided risk has made for many sleepless nights in bed with Bloomberg.

The proliferation of hedge funds hasn't made the intraday much better. There are only a handful of good ideas floating around the tape these days and once they get sniffed out, they quickly crowd and cloud. That leaves many of us to our own devices in devising strategies that allow us to play while protecting our hay. For each of you, that means something different. For me, I've been trading some gamma. Here's how it works.

The first thing we need to do is find a vehicle to trade. There are many indices, sectors and individual stocks to choose from and you should find one that offers a familiar edge. That can mean that you're current of the fundies, you see something compelling in the technical levels, it's uber-extended (oversold), there's a relative disconnect between perception (where it is) and reality (where it should be) -- whatever "eyes" you choose to use.

Once you identify that underlying vehicle, you must find the appropriate option contract. For purpose of this example, let's say that we've chosen to buy QQQ and our desired contract is the May 27 puts. If we bought 1000 puts (delta of .53), our delta equivalent exposure is short 53,000 QQQ (.53 x 1000 contracts x 100 multiplier). Now,if we wanted to construct a delta neutral position (with positive gamma), we would simply own 1000 May 27 puts and 53,000 QQQ. From there, we could trade the underlying and "lean" one way or another.

Sound easy? It's not as straight forward as it sounds. There are a handful of variables involved and you're paying a premium for the right to own that gamma. The daily decay, known as theta, will drip every day (including the weekends!) and there needs to be movement in the underlying index (stock) to justify the volatility premium that you're paying.

It's a bit involved but I wanted to use some broad strokes and walk through an example with my fellow Minyans. We've got a stellar Derivatives Professor lined up for UMV and I know he's itching share his skill set. Options aren't easy and nothing we've discussed is intended as advice. It's important that you know the mechanics, however, and our community is committed to education.

We'll talk tape in a bit but, in the meantime, we've got breakfast with Beeks. Look for an unemployment rate of 5.9%, average hourly earnings of .2%, change in nonfarm payrolls of -35,000, change in manufacturing payrolls of -38,000, and average weekly hours of 34.2. I'll circle back after we see what we're working with today, my friends, keep your head up and your thoughts lucid -- we've got one session left.

Good luck today.

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