Best Investment

This column was originally published on RealMoney on Jan. 16 at 1:51 p.m. ET. It’s being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

The major indices are hugging the unchanged line at midday. Could this be a precursor to rampant pinning action for this week’s option expiration? I don’t play that game, so I won’t even venture a guess on pin candidates until midday Friday.

Despite the tight range, the VIX is up some 6% to 10.80. However, some of this lift is simply due to the “Monday effect” (though, in this case, Tuesday) in which the theta markdown that occurs on Friday afternoon basically prices in today’s decay, providing an underpinning for options during the morning hours. Also, with earnings and expiration on tap this week, traders were more likely to come in this morning as net buyers of option premium, as positions get closed or rolled ahead of the expiration.

The impact of expiration-related activity should also be taken into consideration when looking at the put/call ratios. The all-exchange ratio popped above 1.10 this morning, the highest reading in six weeks, but the equity-only ratio is still a subdued 0.62, in line with the 20-day moving average. The put/call on index products has jumped to 2.80, its highest level in two months, and that is lifting the overall reading. Much of the volume is coming in the form of rolling of out-of-the money puts from January into February and, as such, does not represent large directional or bearish bets.

The notable exception is coming on the Diamonds Trust (DIA) , which has seen heavy put activity in the March series. The $125 strike has traded 34,000 contracts against prior open interest of just 3,000, and the $120 strike has traded 20,000 contracts against prior open interest of 10,000 contracts. There is no corresponding volume in January or February expirations. However, the trade could represent a ratio spread in which someone is buying the $125 puts and selling the $120 puts for a net debit of $1.30 for the 2×3 spread.

I bring this up because some recent articles in The Wall Street Journal have been citing options strategists who recommend ratio spreads as a way of establishing downside protection at a minimal cost. In addition, some services such as OptionMonster.com are reporting an increase in frequency in this type of trade.

This is not a strategy I would suggest implementing if I was worried about a selloff. The risk/reward is not attractive, and the position’s price behavior will be exactly the inverse if the sharp selloff occurs.

With the Diamonds trading right around $125, a 2×3 spread would provide about 5% of downside protection, covering a move from $123.80 to around $118, yielding maximum a profit of $3.70 if shares are at $120 on the March 16 expiration.

But the position would start losing money if shares fell below $111.50, or slid 10.5%. Of greater concern is that the position would also be hurt by an increase in implied volatility, which would likely accompany a decline of 5% or greater. Lastly, even if the underlying price is at the max profit point, it is very difficult to pull off a ratio spread for a profit until you get to about two weeks before expiration. This means for the ratio spread to pay off, it needs to be just right in terms of the magnitude, velocity and timing of the price move. Basically, it’s a bet that the Diamonds will calmly drift 5% lower over the next three months. That doesn’t strike me as a high-probability scenario.

With options prices sitting near 13-year lows, I don’t see the sense in using a ratio — which gives only a narrow price range of protection, is exposed to unlimited losses and handcuffs the position to a three-month holding period — just to reduce the initial cost. I believe you’d be better off just making an outright purchase of the March $123 puts at $1.20 per contract. This has the same initial cost, but provides unlimited downside protection and, more importantly, the flexibility to trade around a near-term selloff and increase in implied volatility.

Oil stalled under the landmark $100 a barrel mark on Thursday, ending lower after remarks by U.S. Federal Reserve Chairman Ben Bernanke fanned worries about economic growth.

Gold ended higher but a slightly steadier dollar depleted its momentum without the expected $850-an-ounce test in futures trade at the Comex division of the New York Mercantile Exchange.

Nymex December crude settled down 91 cents, or 0.9%, at $95.46 a barrel, missing Wednesday’s $98.62 record high.

Crude prices have soared since August on the decline in the dollar, robust demand and tight supplies with trade becoming increasingly volatile approaching $100 a barrel.

It is now nearing the inflation-adjusted peak of $101.70 set in 1980 in the aftermath of the Iranian revolution.

December gold rose $4.00 to $837.50 an ounce, topping 20 cents below Wednesday’s 28-year record at $848. Futures hit a record high of $875 on Jan. 21, 1980.

Spot bullion’s late price in New York was $832.10/$832.85, off from $833.00/$833.80 on Wednesday, when it hit a 28-year high of $845.40, just below its all-time high of $850 set in 1980.

Gold is up more than 30% on the year, with troubles in the U.S. credit market and worries over global geopolitics and banking sending investors into safe havens, keen to hedge against a falling dollar.

Bernanke told U.S. lawmakers that the Fed predicted U.S. economic growth will “slow noticeably” in the fourth quarter of 2007 and the first half of 2008 because of credit market turmoil and the likelihood of an intensifying downturn in the housing market.

The dollar was last trading at $1.4676 per euro, down from $1.4643 late on Wednesday. It touched a record low of $1.4730 on Wednesday.

The Reuters/Jefferies CRB Index of 19 commodity futures fell 0.16%.

Comex copper for December delivery finished down 5.50 cents, or about 1.7%, at $3.2040. Earlier, it hit its lowest level since Aug. 22 at $3.1825 a pound.

At the Chicago Board of Trade, December wheat fell 25 3/4 cents to $7.62 per bushel.

It plumbed two-month lows on long liquidation and a low number for wheat in USDA’s weekly export sales report.

But corn and soybean futures rose, as did the ICE December arabica contract in New York, which settled up 1.45 cents at $1.2190 per pound.

The drop in IT spending has been forecast because of a looming U.S. consumer recession, according to global investment bank Merrill Lynch. Research group IDC has predicted that global IT market growth will slide from 6.7 percent to a modest 5.5 to 6 percent in 2008–again as a result of the weak U.S. economy.

Advertisement

“The U.S. is on the precipice of its first consumer recession since 1991, which was the last time the market suffered from a confluence of high energy prices, weakening employment conditions, real estate deflation and tightening credit,” said David Rosenberg, Merrill Lynch chief North American economist in a statement on Tuesday.

Despite these concerns the bank has also predicted that the global economy will stay resilient in the face of turbulence in U.S. markets and embark on a “rebalancing” period, which could occur over a number of years.

According to Merrill Lynch: “Imbalances in the global economy, stemming from historic dependence on the U.S. consumer, have peaked and will unwind throughout the coming year… This ‘rebalances’ the growth within countries. At the heart of this rebalancing, which could occur over a number of years.

According to Merrill Lynch: “Imbalances in the global economy, stemming from historic dependence on the US consumer, have peaked and will unwind throughout the coming year … This ‘rebalances’ the growth within countries. At the heart of this rebalancing, which could last several years, is the growing power of consumers outside the US.”

The Asia-Pacific market is expected to remain largely unaffected by these changes. Analyst firm Gartner has predicted that IT budgets in the region “are expected to grow about 5 percent in 2008″, according to CEO Gene Hall, speaking at the company’s Symposium in Sydney a fortnight ago.

Marcus Blosch, research VP at Gartner, believes the US will go into recession but the relative strength of the Asian economies will help Australian companies survive.

“Personally I don’t believe the outlook is too great for America next year. With China and Asia, the economies are so strong that we will be able to weather the storm.

“The old joke is that if America sneezes, Europe catches a cold and the same with Australia because we are very tight. Hopefully what will happen is that America will go through its recession but many of the companies in Australia and New Zealand will be immune to it because they have got closer links to Asia,” said Blosch in a video interview last month.

Economic uncertainty in the US is one of a handful of “key disruptions” foreshadowing the predicted global IT market dip, according to IDC.

Other “disruptions” listed by IDC included open delivery, the growth of open source development and emerging markets.

“Disruptive technologies have been a persistent theme in IDC’s predictions over the past several years,” said Frank Gens, senior vice president of research at IDC.

“These technologies have been creeping into everything from enterprise software and hardware to consumer gadgets and telecom services, forcing vendors to rethink their offerings,” he said.

IDC’s latest announcement on the year ahead for IT markets falls closely in line with those predictions cast by Merrill Lynch for the global economy at large as Gens has indicated that what are currently considered “disruptions” will go through a normalising process in 2008 as market leaders “jump in with both feet” to these emergent trends, setting the scene for what the firm has dubbed as “the post-disruption marketplace”.

“In 2008, the era of experimentation will end as industry leaders get serious about transforming their products and services to take advantage of — and meet the challenges posed by–these new technologies and business models. The status quo is about to change,” said IDC’s Frank Gens.

WASHINGTON (AP) - Treasury Secretary Henry Paulson said Thursday that China is moving too slowly to overhaul its currency system and to crack down on copyright piracy, two factors that American businesses blame for the soaring trade deficit with China.

Paulson said the administration would continue to push China to move more quickly, but he cautioned that any protectionist backlash in this country would end up harming the U.S. economy.

“We must not heed the siren song of protectionism, trying to reduce the losses of the present by sacrificing the opportunities of the future,” Paulson said in a speech on trade delivered to the Economic Club of Washington.

Copyright 2007 Associated Press. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

For more information and to contact AFX: www.afxnews.com and www.afxpress.com

Two native bands are threatening to tie up the Ontario government’s long-range power plans using lengthy court delays.

In a submission to the Ontario Energy Board, people from the Saugeen Ojibway Nation Territories argued the province has not lived up to its legal requirement to consult with them on the plan’s impact.

The lawyer for the two communities, near Wiarton on the Bruce Peninsula, spoke earlier this week at board hearings into the Ontario Power Authority’sproposal for new energy sources.

Arthur Pape reminded board members of the Supreme Court of Canada ruling that Queen’s Park has a legal duty to consult with First Nations on the impact the power plan will have on their lives.

“There’s no way the Saugeen Ojibway could participate meaningfully with government to ensure that this part of the plan could be implemented in a way that protects their rights,” Pape told the board.

Pape says there’s still time to negotiate compensation that may be owed to First Nations for the impact of new wind farms, hydro dams and transmission lines on their hunting and fishing rights and way of life.

But he warned that if the government fails to negotiate, it could mean lengthy delays in getting the plan approved.

“If the government won’t work with them to find a way to accommodate those things, they may find themselves applying to the courts, and asking for the courts to not let this plan be implemented,” he told CBC News.

Neither the government, nor the Ontario Power Authority, which drew up the plan, would comment on Pape’s submissions.

TheOPA’s new plan, which calls for the provincial government to spend $26.5 billion on nuclear power plants, still requires regulatory approval.

The plan also proposes doubling the amount of renewable energy on the grid by 2025 and phasing out coal-fired generation by the end of 2014.

Several energy providers are considering building more wind farms on the Bruce Peninsula to bring power to the south of the province.

Much of that energy will require new transmission lines to be built.