We’ve All Seen the Statistic

The Careful Balance of Risk vs Reward

Dear Bottarelli Research Member,

It seems like we’re hearing it more and more each day: The fact that the market has never gone this long without a correction of at least 2%. As I write, we’re in the longest “calm” period since 1964, which is expressed graphically by the CBOE Volatility Index (VIX).

As you know, the VIX rises when investors believe risk levels are up. And it falls when investors believe that risk levels are down. Considering the fact that the VIX is woefully underneath its 200-day moving average — and cannot sustain anything above its 50-day moving average, it’s clear that investors are supremely confident about the current status of the stock market. But how long can this confidence last? That’s the big question.

In my view, the fact that this “calm period” statistic is being increasingly disseminated throughout Wall Street is acting as an early warning sign. For example, if we witness a day where the Dow opens 50 points lower, investors could quickly head for the exits in the attempt to sell before the big drop happens. And of course, this panic selling could have a snow-ball effect on the markets — as a seemingly manageable drop could quickly turn into an all-out sell-off that perhaps reaches the negative 250-point mark on the Dow (which would qualify as a 2% sell-off).

For this very reason, I’d like to maintain an equally-balanced ledger of both calls and puts. After all, no matter if we like it or not, we must continue to respect the market’s upside trend-line. That’s why I’d like to maintain our CELG March 55 Calls (LQH CK). At first glance, you’d think that the CELG upside is capped off at the 50-day moving average, but CELG has the ability to make strong upside moves, so I’d still like to be positioned to ride any future pops (just look at last October, for example). As you know, we entered these calls for $2.95 and they’re currently trading for $2.75, so if you don’t yet own this position, you’re getting a nice second entry opportunity today.

At the same time, I’d like to also maintain our downside put positions in both the PCU March 60 Puts (PCU OL) and the WBMD March 50 Puts (QWB OJ).In early trading, WBMD is going our way, as our puts have traded as high as $4.40 today. As you can see by the chart, any break-down will not find support until at least the $42 level, so maintain your WBMD puts.

Also, I’m still not convinced that PCU has any upside gas left. Today’s upside tick is slightly concerning, but if the stock fails once again at the $65 level, then we’ll be right were we want to be on this play. For now, maintain your PCU March 60 puts with $1.60 stop and let’s see if any profit-taking comes into play.

In other sector news, oil is continuing to climb — and looking to break past $60 a barrel for the first time in 2007. With wind-chill temperatures well below zero in most parts of the Midwest, it’s probably a good idea to establish an upside position in an oil service name. Two of the top off-shore drillers are Diamond Offshore Drilling (DO — NYSE) and Transocean (RIG – NYSE), and a look at each company’s chart paints an interesting picture:

Starting with DO, it’s clear that the stock has been engaged in a very strong up-trend that’s looking to break past the recent high set at $85. But when you look at the RIG chart, you see a very different picture:

Unlike DO, RIG has spent most of the last two weeks bouncing back and forth within a very right trading range — capped on the upside by the 50-day moving average and on the downside with the 200-day moving average. Now, if DO offers us any indication of the strength in the oil service sector, then I’d say RIG needs to play catch-up — which would equate into a rally that could take it all the way up to $82.50. In fact, if RIG can break through the $77.50 level, then we could see a quick shot up to the mid-$80’s. So to balance out our call to put ledger, let’s go ahead and establish an upside position in RIG. Here’s the play:

PLAY: Buy the RIG March 80 Calls (RIG CP) at or under $2.40, good for the day. Current bid/ask spread is $2.10 to $2.20. Place a protective stop loss at $1.20.

And lastly, the Dow Utility index continues to slowly push higher — negating the potential head and shoulders formation that occurred last week. As a result, our TXU February 55 Puts (TXF NK) have triggered their stop. So for now, close the position and we’ll look to re-enter on any forthcoming utility weakness. Until then…

Lock and load

Sincerely,