BUMP - Lessons in Economics

I just wanted to highlight these videos on economic by Prof. Krassimir Petrov that I posted back in September. Now is a good time to review them.

Business Cycles, Part 1 of 4 - Introduction, Prof. Krassimir Petrov

Business Cycles, Part 2 of 4 - Business Cycle Indicators, Prof. Krassimir Petrov

Business Cycles, Part 3 of 4 - The Austrian Boom, Prof. Krassimir Petrov

BusinessCycles, Part 4 of 4 - The Austrian Bust, Prof. Krassimir Petrov

Each is over an hour and essential viewing for anyone interested in economic cycles.

Straddles the Safest Strategy?

I received this enquiry from one of the members of Aussie Stock Forums which I reproduce with permission:

Hi Wayne

You're an options man so I wonder if you'd mind answering a query. I'm relatively new to options and I've still got a lot to learn, but I've been going quite well with bought puts on US stocks. There's something I'd like to clarify. I've heard that the safest way to trade options is to buy a put and a call at the same time, i.e. a straddle or a strangle, effectively giving yourself a bet each way.
I can see the possible benefits of such a strategy if a stock is flat and there's an earnings report due and you're expecting it to jump one way or the other, but you're not sure which way. But surely the same strategy doesn't make sense if your stock is in a strong trend, has retraced briefly for a few days against the trend, and is now giving every indication that it's about to resume it's trend with a vengeance?
I mean, not only does it put your cost up considerably, but it also kills your profit to a some extent as one of the options would gain rapidly while the other one lost value rapidly (assuming that the stock does in fact make the expected trend resumption).
I guess you could unload the unprofitable one, but if the stock has made a decent move then the unprofitable option would already be showing a hefty loss which would eat into the profit of the other one. Furthermore, if you quit one of the options then it seems to me that you're removing your safety net if the stock was to suddenly reverse and move counter to the trend.
But on the other hand, would you really want to be in an option that was making money only because the stock was moving in the opposite direction to what you expected, i.e. against the trend? I mean, counter-trend moves tend to be short lived.
So, considering the above factors, my thinking is that just a single bought put is the best way to go if the stock is trending strongly but is currently retracing, yet showing sings of imminent trend resumption.

An example of what I'm talking about, the US stock BSC was downtrending strongly when it bottomed out on 9th January, then rallied for a couple of days before topping on January 11. The rally stopped near the Fib 38.2% retracement level, then BSC put in a small range inside day. According to my analysis, this was a good shorting signal if it traded below the inside day.
Now in this situation where the odds are heavily in favour of the stock resuming its downtrend, I can't for the life of me see any reason to buy a strangle or straddle, instead of just buying a single put. With just a single option, if it goes against me I can have a stop in place to minimise my loss. If it goes my way, it has the potential for considerable gains.
Is my thinking correct here, or am I, in my experience, missing something? I'd appreciate your views if you have time to give them.

It's a good question, and one that every options trader ponders as they go on their journey of discovery of this sometime bewildering trading instrument. There are a few concepts to deal with, perhaps if I cover with them one point at a time:

I've heard that the safest way to trade options is to buy a put and a call at the same time, i.e. a straddle or a strangle, effectively giving yourself a bet each way.

I get very annoyed when I see questions like this; not at all at the people asking the question, they are just trying to learn in what is quite a complicated subject. I get annoyed at the ersatz"experts" who spout rubbish like x is the safest strategy, or y is the best strategy.

There is no such thing as the safest or best strategy, there are only strategies that suit your market view, the way you like to trade and volatility conditions. The straddle and strangle are simply strategies for option traders to have in their armoury, to implement when they think it appropriate.

I can see the possible benefits of such a strategy if a stock is flat and there's an earnings report due and you're expecting it to jump one way or the other, but you're not sure which way.

Bear in mind that just about any option strategy intrinsically contains a bet on volatility. This is doubly so with the straddle or strangle. The expected move in the underlying must be greater that that implied by the options price, AKA implied volatility. To see what can happen with regards to implied volatility in this instance see my post - Nike Straddle - Just Do It.

But surely the same strategy doesn't make sense if your stock is in a strong trend, has retraced briefly for a few days against the trend, and is now giving every indication that it's about to resume it's trend with a vengeance?
I mean, not only does it put your cost up considerably, but it also kills your profit to a some extent as one of the options would gain rapidly while the other one lost value rapidly (assuming that the stock does in fact make the expected trend resumption).
I guess you could unload the unprofitable one, but if the stock has made a decent move then the unprofitable option would already be showing a hefty loss which would eat into the profit of the other one.

This illustrates my point about selecting strategies to suit your view and the way you like to trade. This trader has a clear scenario that he wants to trade and should it play out as envisaged, the straddle or strangle would be suboptimal. This trader wants a strategy with negative delta, not delta neutral like a straddle/strangle. This not to say that the straddle wouldn't suit another trader with a different view. It is a matter of understanding the strategy, the greeks, the risks, the potential reward, selecting and implementing a strategy that suits.

I mean, counter-trend moves tend to be short lived.
So, considering the above factors, my thinking is that just a single bought put is the best way to go if the stock is trending strongly but is currently retracing, yet showing sings of imminent trend resumption.

An example of what I'm talking about, the US stock BSC was downtrending strongly when it bottomed out on 9th January, then rallied for a couple of days before topping on January 11. The rally stopped near the Fib 38.2% retracement level, then BSC put in a small range inside day. According to my analysis, this was a good shorting signal if it traded below the inside day.
Now in this situation where the odds are heavily in favour of the stock resuming its downtrend, I can't for the life of me see any reason to buy a strangle or straddle, instead of just buying a single put. With just a single option, if it goes against me I can have a stop in place to minimise my loss. If it goes my way, it has the potential for considerable gains.

In this instance, with this view, a simple bought put could be the ideal strategy to suit this view. The long put is short delta, long gamma, long vega, perfect for a strong down move. The risk is that IV was already quite high and should the stock go against the trader's position, there would be some volatility crush as well. If this risk is acceptable to the trader, perfect.

My view and not to be considered as advice yada yada yada.

Goldman Sachs Tiptoeing Into The Bear Camp

Blokes like Mike Panzer, Peter Schiff & Stephen Roach have been bears for a long time and while it's nice to have such credible allies for the bear case, at times I wonder if we're all a bunch of fucking "glass half full" nutters and the economy will expand ad infinitum, like the mocking, smirking, asshole perma-bulls seem to think.

But when the likes of Goldman Sachs jumps the fence, it means there must be some substance to the bear view... and it must be close.

No need for further comment from me on this article which appeared in The Telegraph:

By Ambrose Evans-Pritchard
Last Updated: 5:43pm BST 27/09/2007

Goldman Sachs has abandoned its ultra-bullish view of the world economy, warning of a likely recession in Japan and mounting risks that US property slump could spread to parts of Europe.

In a new report, "The Global Economy Hits a Crunch", the US investment bank said it was no longer sure that Asia and Europe would be able to pick up the growth baton as America stumbled. It fears that turmoil is spreading beyond the debt markets to the factory floor.

"Much has changed since mid-July, when we wrote that 'the global economy continues to enjoy one of the strongest sustained expansion in modern history'. The mood in financial markets is clearly darker, and the economic data in the developed world is showing signs of wear," it said.
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"Japan's recovery is tottering, with the chance of an outright recession having risen to nearly two in three," said the report, authored by chief economist Jim O'Neill.

It is an abrupt change of tack for the bank known as the "cheer leader" of the global boom. Until now Goldman has insisted that Asia and the developing world are strong enough to shrug off an American slowdown, allowing world growth to keep racing ahead without missing a step -- despite subprime woes.

Often overlooked, Japan remains the world's second biggest economy and top creditor with some $3,000bn in net foreign assets.

Output had already contracted an annual rate of 1.2pc in the second quarter before the credit crisis hit.

There has since been a surge in the yen as speculators unwind carry trade positions, leaving Japan's margin-trading housewives and grannies nursing big losses.

Wages have fallen for the last eight months in a row. They are now down 1.9pc from a year ago, threatening to pull the country back into deflation.

Goldman Sachs feared it was now "inevitable" that consumers would batten down the hatches for a while.

The bank said Europe is now so weak after a clutch of dire confidence surveys in Germany, Italy, France, and The Netherlands that any further rate rises by the European Central Bank are "off the table".

It expects the euro to fall back to $1.35 against the dollar over the next year, and sterling to tumble to $1.88 as the Bank of England pushes through three rate cuts.

The one bright spot is the 'BRIC' quartet of Brazil, Russia, India, and China, all still firing on four cylinders, if slowing slightly.

In a separate report, "Rising Risks to the Global Housing Market," it said that much of global system had succumbed to a property boom that is in some ways more stretched than in the US, with real (inflation-adjusted) house price rises of over 100pc in France, 60pc in Italy, 55pc in Canada, and 72pc in Australia since the late 1990s. The bubbles in Spain and and Ireland have been more extreme.

"Such a widespread housing boom has little precedent in modern history. In those markets where prices have run up the most, and rental yields have fallen dramatically, the risks of a housing correction are likely to have increased materially," said the note, by Peter Berezin.

"The wealth effect for housing is about twice as large as for equities, with consumption falling by about two cents in the short run for every $1 decline in home prices," he said.

He expects US house prices to drop 7pc in 2007 and another 7pc in 2008, as mortgage lenders shut off credit to chunks of the market. "The US is often a leading indicator for what happens in the rest of the world".

Mr Berezin said construction booms usually lead to housing busts lasting several years. Residential construction in the US reached 6.3pc of GDP at the peak of the bubble, the highest since the baby boom in the early 1950s.

In Spain, it has been even higher, averaging 8.7pc of GDP since 2003, and in Ireland it has exploded to 14.2pc, leaving a overhang of unsold property. House prices are already falling in Spain, where 98pc of mortgages are on floating rates that have roughly doubled since late 2005.

Property prices have dropped for the last four months in a row in Ireland.

Mr Berezin said the Goldman's "decoupling" thesis was based on the assumption that the US housing slump was a "country-specific-shock" that would not spill over into other economies. This was now in doubt.

"The spread of global credit risks has introduced a new potential transmission mechanism. If home prices in the key economies begin to fall, this will have an adverse effect on global growth," he said.

Bears on Message

I've been totally slack about blogging the last few days. Partly because not much is happening from my economic perspective (in terms of things to write about) and partly because I am feeling a bit deflated/disappointed at the recent Fed actions. I really feel it is the worst thing they could have done for the health of the world economy in the medium term.

Anyway, while I recover some enthusiasm for writing shit on the internet, have a look at this video. It is Glen Beck interviewing couple of my favourite bears, Peter Schiff and Michael Panzer (who's blog, Financial Armageddon appears in my blogroll)

Rate Cut Post Mortem

As you know I have my own feelings about Helicopter Bens's rate cut. In case you haven't been following along, I think it was an extraordinarily bad decision and each member of the FOMC should be strung up by their balls. I've been dieing to comment from a bush economists point of view (and have been ranting and raving offline), but really wanted a more professional opinion for this blog.

As usual, Mick Shedlock delivers the goods with some excellent analysis in Bernanke's Bullet Misses The Mark. Here is a synopsis taken directly from the article:

List of What's Changed

• Perception has changed.
  
• Any perception of the Fed as being concerned about inflation went out the window.
• Any perception of the Fed as being concerned about the dollar went out the window.
• Bulls are happiest they have been in months.
• The stock market is higher.
• Gold is higher.
• Oil is higher.
• The Prime Rate dropped 50 basis points.

List of What Hasn't Changed

• Mortgage Rates. (Actually mortgage rates rose since last week as the chart below shows).
• Auto Loan Rates. Nearly identical to last week.
• Home Equity Loan Rates. Nearly identical to last week.
  
• The outlook for jobs. (If anything the outlook is weaker judging from the Fed's panic).
• Credit Card Interest Rates.
• The foreclosures outlook did not change. It is still bleak.

The Fundamentals Have Not Changed

• Massive numbers of foreclosures are still going to happen.
• Banks are going to be stuck in huge numbers of REOs.
• Home inventories are still rising.
• The economic ship is still sinking
  
• The jobs market remains grim

Please read the whole article as it makes a whole bunch of sense.

As expected & noted, there has been movement in the markets; The USD is taking it up the ass, and Metals, Oil and other exchange rate sensitive markets are flying. The really curious movement to me was in the long bonds, both in the US and Europe. Since the rate decision, the contracts I follow closely and trade, The Euro Bund and The 10 Year T-Note have been down strongly and in fact accelerating today in big one day moves.

If you don't happen to know what this means, it means that longer term bond yields, which mortgages and other long-term are priced off, ARE RISING, as indicated in the 10 year YIELD chart on the left.

I am on record as holding the view that rates should in fact be rising and I think that once liquidity is normalized somewhat, Bernanke will be forced to raise again. But on the long end of the yield curve at least, the market is doing what the Fed doesn't have the balls to do. Those who have painted themselves into a corner in the housing market won't be getting any relief and nor should they. (Though I do feel sympathy for how the market and mass psychology have compelled them to make unwise decisions. The psychology used by vested interests is very strong.)

In conclusion, the shipwreck is still on course, a .5% cut proves it. The only area where I remain bemused is why equity traders are bullish.

10 Priciples of Economics

"Mankiw's 10 principles of economics, translated for the uninitiated", by Yoram Bauman

This is a really good watch. :-) From Calculated Risk.

Goodbye USD!

0.5% is a very fucking lousy decision.

I'll let the real economists mull over than one, while ignoring the capitol hill sycophants.

At Last! A Voice of Reason.

Sort of. Katherine Mann says hold interest rates... but doesn't think a recession is on the cards. Hmmmmmm.....

The UK Mortgage Lender Implode-O-Meter?

By now just about everyone will know about the Northern cRock bank run on Friday and Saturday. I haven't posted till now for fear of merely regurgitating what is already posted in depth all over the freaking internet.

I have been amusing myself with pictures of queues outside branches like the one on the right... well, OK it's a photoshop job just for fun.

The only problem is that there are a lot of folks who won't be thinking the whole situation is funny at all. There will be hundreds of Northern Rock customers who will be having sleepless nights over the weekend, worried about the security of their investments; like the poor old lady below who stood in the queue for hours to get her money out, only to be turned away at closing time by the local constabulary. I feel for them.

Internet customers are having a hell of a time logging on and accessing their accounts amid suspicions that bandwidth has been deliberately restricted to stem the hemorrhaging of funds from the bank.

Of course everybody from the NR CEO, to the press, to the Chancellor of the Exchequer is saying that the bank is sound and that people funds are safe. But these parties are not known for telling the truth are they? Depositors obviously feel discretion is the better part of valour and taking their funds elsewhere. I can't say I blame them one iota.

Unquestionably, there is no way that NR can continue in it's current form, so basically the first mortgage lender in the UK will very shortly cease to exist.

That makes me wonder if some enterprising Englishman/woman has kicked off a UK version of
The Mortgage Lender Implode-O-Meter, because it might just be the first of many. Sub-prime lending in the UK has been rife and has been hidden by strong price appreciation to date and folks have been able to sell or MEW themselves out of trouble. But with the first month on month falls recorded, those days are over.

Regarding the future of the UK property market, I think there is a sound opinion here in the following video:



No matter what exactly transpires next, (I suspect governments and CBs will desperately try to prop up the boom) The world changed in August and things will be different and harder from now on.

The Myth Of The Perpetual Boom

In "The Age" today there was an article detailing how loan defaults have risen 30% in Australia over the last financial year. Read It.

That's not really what I wanted to concentrate on. There are literally hundreds of articles bringing to attention the signs of a world economy going over the falls. No need to regurgitate too much of that here.

The bit that caught my attention was this statement:

...And economists say consumers who haven't experienced a recession are upping their borrowing to levels more than double their income because they are confident the good economic times will continue.

This is something we bush economists of an Austrian bent have been commenting on for some time now. There are many folk that have either never experienced a recession, or who have forgotten that they can occur.

Only recently I was speaking to quite a successful small businessman who refused to concede even the remotest possibility of a recession... not just in the immediate future, but ever! LOL! Anyway, I changed the subject pretty smartly to conserve a friendship.

I notice even experienced economists who speak on Bubblevision seem to imply that recessions are just not on the cards anymore.

WTF?

I think the contrarian indicator is invokes waaaaaayyyyyy too early these days, (It's fashionable to go against the tide ). I often think it's a good idea to fade these "early" contrarians, but in these days where everybody knows about the contrarian indicator, and hence its inappropriate use, surely there must come a time to fade the faders who are fading the faders. lol.

In other words, in the quote above, is there a "genuine" contrarian signal? There sure are lots of bears about at the minute, but the great unwashed masses are still unrelentingly bullish.

Riches to Rags In The City

In the last few posts I've been speaking about the now well known problems in the credit markets, and how this is starting to affect London property prices. Of course yje property perma-bulls refuse to concede that falls in prices are possible; real estate only ever goes up don't you know?

History and a few deft keystrokes in Excel disprove that, but for falls to become a reality, there must be vectors that exert downward forces. I've mentioned the vanishing bonuses, but how about unemployment? I'm not talking about factory workers and builders any more, I'm talking about suits.

Check out this blog from the BBC's Robert Peston LINK:

Scything the City

• Robert Peston
• 13 Sep 07, 07:45 AM

The humungous bonuses trousered by many investment bankers may seem a trifle de trop.

But it’s not a stress-free existence. They live in an eat-or-be-eaten world and are in work for as long as they are economically productive - and barely a second longer.

So brutal redundancies are now only days and weeks away, as it becomes commonly accepted that the turmoil in financial markets will depress certain lines of business for months if not years.

The boss of one investment bank tells me he expects a first wave of job cuts that will see individual banks reduce their headcounts between 5 and 15 per cent.

And he says he wouldn't be surprised if that was followed just a few months later by a second wave of similar or even greater magnitude.

First out the door will be many of the creators of the current crisis: the manufacturers and traders of assorted asset-backed securities that you can hardly give away right now; all those debt whiz-kids who engineered the poisonous collateralised debt and loan obligations; the banking servants of a hedge-fund world that’s shrinking fast and of a private-equity industry in cryogenic storage.

Should we weep for their plight? Some of you will scoff at the thought. It’s a big hello to schadenfreude.

Actually, there could be one or two benign consequences from the slaughter of the not-so-innocent, such as a deceleration in the rampant inflation of central London property (okay, I know this is not a universal good).

But don't think we'll get away scot-free.

The economy called Britain is built on financial services (though more by accident than design). Something over a third of our overall economic growth has been generated in recent times by the City and financial services.

Lean times in the City means slower growth, less wealth to spread around and a substantial dip in the Treasury's tithe.

When the bubble is pricked, no umbrella is big enough – we all become a bit damp.

There are still corpses to float to the surface in this whole credit crunched scenario IMO. Bearing in mind the gravity of what happened in July-August, things are just a bit too quiet to be real.

What Are Gold & Oil Telling Us...

...if anything?

Well yeah, it's partly to do with the dollar doomage, but I think there is more to it than that. Both gold and oil are threatening, or threatening to threaten multi year highs. In the case of oil, all time highs.

First gold: There is the gold is money argument, so it's natural that gold will rise as the dollar tanks. I don't go along with that 100% but what I think matters nought. If enough folks with enough capital think so, it is so. Perception is reality. Add to that the speculative froth once the public gets onto the bandwagon and in the current environment we could see some real boomage here. To a certain extent, I think this could be starting to happen. The gold bugs are certainly starting to froth at the mouth on all the trading forums.

weekly continuous gold

In recent months it's been grinding sideways frustrating the crap out of all but option writers, but this move is starting to look fair dinkum.

On the the other hand, oil is threatening to take out its all time high. There are probably plenty of bullshit fundamentals to justify this, and if of an apocalyptic bent, one simply must be a crude oil bull.

weekly continuous west texas sweet crude

The $64,000,000 question is the future of the price of oil in the medium term, presuming the world economy goes into recession. It would be expected that a recession would lessen oil consumption and result in declining prices, sans any killer 'canes obliterating the Gulf of Mexico or similar.

Long term, you just have to be a bull.

I'm glad I have some rudimentary charting skills because the fundamentals are often too full of biases, bullshit, short term considerations and rigs getting blown over.

An all time high in pretty short shrift seems like a high probability in the near term.

Back to the question posed at the beginning. Is this trying to tell us something? Something other than the purely native fundamentals of these two commodities? If it is, I suppose it will be loud and clear in a relatively short space of time.

The Streets of London

For a couple of years now, there has a been a growing crowd that have become bearish on the UK property market. The bulls cite a number easily disproved fallacies as to why they think property prices will rise well beyond inflation ad infinitum. Shortage of housing, we are an island, high immigration etc etc etc, all of which were cited in the last boom did nothing to stop the bust when it came in the early 90's.

A study of business cycles and a few columns in Excel will quickly dispel the mathematical absurdity of the perpetual boom. Indeed, regional England has been seeing price stagnation, and even falls in some areas. Even Northern Ireland has apparently hit a wall as desperate vendors drop asking prices to shift their overvalued hovels.

Ahh but London, that paragon of all that is coveted in this bourgeois ego infected planet; Harrod's, Covent Garden, Mayfair, the West End and so on, has been stubbornly, defiantly rising in the face of all rationality. There have been two main reasons for this. The UK's favourable tax treatment of non residents has seen billions of pounds pouring in from wealthy foreigners, snapping up all the fashionable real estate. Most recently, this has been coming from the Russian oligarchy. The second factor is the absurdly oversized bonuses financial sector employees have been receiving, due to the recent credit and equities boom.

I mean, what do you do with a Christmas bonus that would make the GDP of a small African nation look like pocket money? Why, buy real estate of course!

We bush economists have been wondering though, how the recent credit market heart attack would effect the City boys. The answer came via the Financial Times:

City bonus fears hit prime market

By Jim Pickard and Sharlene Goff

Published: September 7 2007 20:16 | Last updated: September 8 2007 05:18

Property purchases are coming under pressure in the wealthier London districts after gloomy forecasts for end-of-year City bonuses.

Estate agents have reported some deals falling through, while mortgage brokers have seen a number of active buyers put their property searches on hold, for fear they will not receive the bumper payouts they had hoped for.

House prices in areas popular with City professionals, such as Mayfair, Kensington and Chelsea, rose at their slowest pace for a year last month as the impact of the credit crunch took hold. FULL STORY

While the article states that rises have merely slowed down and no falls recorded, it can't be long before there are MoM falls as the credit crisis plays out.

Now things get interesting. The signs of an impending Austrian bust are everywhere and the ball is in Bernanke's hands, though the general consensus is that he can only provide a rear-gaurd action, giving the smarties enough time to get the hell out of the way.

Sub-Prime Mess Contained

A leading economist said today that there is no evidence that the sub-prime contagion will spread beyond the stratosphere. Meanwhile, the credit crunch is starting to involve the cheap tat buying public.

Families have been warned of a looming credit drought as banks and building societies stop handing out cards and overdrafts to hard-pressed households

Industry experts have said that lenders are clamping down on debt applications for fear that borrowers default as the economy worsens.

It is the latest evidence of how the financial markets crisis is affecting households and follows news that mortgage companies are primed to increase their interest rates, causing more hardship for hundreds of thousands of households due to renew their home loans in the coming months.

Equifax, a company that provides credit checks, said households would find it increasingly difficult to borrow money in the coming months, as lenders started to refuse more and more applications. FULL STORY

I think this will have a quantum effect on retail sales... perhaps even accelerate mortgage defaults. I know plenty of folks who are doing the credit card boogie to make their over-committed ends meet, all the while building more and more debt. Another signal we bush economists take note of.

Jobs

So Wall Street economists were expecting ~+115,000 on the NFP number.

Really?

The building industry is hemorrhaging jobs from the great gaping hole in its aorta and I suspect there would be a few real estate broker sending CVs around at the moment too; and the NFP was a shock?

"It's a major shock to the market," said Peter Cardillo, chief market strategist at Avalon Partners. "If the job market continues to weaken, fears of a recession will continue to accelerate, calling into question corporate earnings."

You have to wonder about economists. I mean I have an interest in economics and though no formal degree, I would consider myself what would be termed here in Australia as a "bush economist". This is someone who basically has been fucked by not knowing about business cycles before and has learned to "sniff out" when things are starting to get out of whack.

We bush economists have been worried about sub-prime, stretched asset values and rampant malinvestment for a couple of years now while the smirking Wall Street assholes have been bullshitting on about Goldilocks economies.

We have also been wondering how long birth and death models and other such nonsense could disguise the real state of employment. When you get an actual drop of 4,000, it's time for folks to pull out their CVs and polish them up for a potential mass mail out.

But look and the bright side, it's another factor for Uncle Ben to justify a rate cut.

The logic goes: slowing economy => rate cut => bullish => market rally

Yep, Goldilocks rules... along with other fairytales