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A Bearish End to 2009?


Here's what you can do about it.

With the Standard & Poor's 500 Index up 47% from the lows it reached in March, many investors are feeling intense relief.

But with one or more institutional traders making bets that suggest a bearish end to 2009, the questions become: How do you read this information, and what do you do about it?

I'm struck by a sense of déjà vu.

In September 2007, there was a $900 million options wager that became known as the "Bin Laden Mystery Trade." Widely believed to be a massive downside bet on the S&P 500, it was a combination of options totaling 120,000 S&P call options contracts (SPY).

Because of its size and the way it was placed, the trade appeared to nervous investors as if somebody, somewhere "knew" something about the S&P 500 being in for a big tumble. Not surprisingly in this always-anxious, post-9/11 era, speculation about the trade took on a life of its own. In addition to lighting up the chat rooms and conspiracy hotlines, it quickly went mainstream. I recall being asked about it several times on various radio shows and at investing conferences around the world.

I wasn't a popular guy because, instead of playing to the conspiracy theories, I saw another explanation based on 20-plus years of professional investing. As it turns out, I was correct and the trade was some derivation of a "box-spread" options trade.

In case you missed the original article, here's a quick explanation. A box trade is a highly specialized transaction that professional traders or sophisticated institutional investors use on occasion to "box" in the market and guarantee a pre-set level of profits, an acceptable level of risk, or -- as may have been the case for that particular trade – the ability of an investor (institutional or otherwise) to obtain below-market-rate financing.

This time around, there's a slight wrinkle in that the options seem to be a so-called "put-ratio spread" that expires in December. This transaction calls for an investor to buy a number of put options and then to sell more put options of the same underlying stock and expiration date -- but at a different, lower strike price.

It's a limited-profit, unlimited-risk options strategy that's used when traders think the underlying issue -- in this case, the SPY -- will experience a little volatility in the near future.

According Andrew Wilkinson of Interactive Brokers Group Inc. (IBKR), an investor last month purchased a "ratio put spread" that expires in August. Wilkinson told that the investor established the bearish trade by using 120,000 "92" strike puts against 240,000 "80" strike puts, a 2:1 ratio established at the equivalent of 920 and 800 on the S&P 500. But as the markets rallied, this investor appears to have closed this trade in favor of a similar strategy involving December contracts.

According to Wilkinson, the trader then moved the long strike up to 95 (the equivalent of 950 on the S&P 500) and sold an additional 240,000 "82" strike puts that would have provided a defense against a market downturn of 14.5% at the time.

Clearly, there's a wide margin for error and a big zone for potential profits if the S&P 500 loses steam. (For reference, the S&P 500 closed yesterday, August 11, at 994.35).

In its current form, the options trade appears to have spread out to the point where the ratio spread is no longer clearly visible, or has morphed into an entirely different strategy. But the disproportionately large open interest of 182,157 contracts at 95 and 153,387 contracts at 80 in December seems to suggest that there's still a somewhat sizeable number of traders positioned for a potentially bearish end to 2009.
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No positions in stocks mentioned.
Fifteen trades. All profitable. Since launching his Geiger Index trading service late last year, Money Morning Investment Director Keith Fitz-Gerald is a perfect 15 for 15, meaning he's closed every single one of his trades at a profit. And he did this during one of the most volatile periods for the U.S. stock market since the Great Depression. Fitz-Gerald says the ongoing financial crisis has changed the investing game forever, and has created a completely new set of rules that investors must understand to survive and profit in this new era. Check out our latest insights on these new rules, this new market environment, and this new service, the Geiger Index.

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