Financial Sense University ~ "A Market Meltdown is Possible" by Anthony Cherniawski 05/25/2005

This morning I’m going to take an approach other than charting to highlight the potential systemic risk involved in this market. We are very close to a potential market meltdown and, even though many are calling for new highs this summer, the Elliott Wave count and other data still support a major decline sooner rather than later.

The one thing that is very clear is that all of the stock indexes, both foreign and domestic, have the same bearish count. The EuroStoxx 50 index has completed five waves down and appears to be putting the finishing touches on wave (v) of c of wave 2, which could happen as early as today. The Nikkei index has five waves down and may already have completed wave c of 2 as of this morning. Folks, this is a worldwide phenomenon. The catalyst for this decline could be some overseas index taking the hit first. Even if this is not the case, any weakness in the U.S. markets could very easily spill over into the foreign markets. In either event, we will not be getting any help from the overseas markets.

It appears that big money is already ahead of us and has placed some huge bets on the market going down. The following is the volume of open interest for out-of-the-money puts on the SPX and the dollar volume of short trades that should be placed in order to adequately “delta hedge” the exposure of the sellers in the June put contracts. (Source: BigCharts.com, May 23, 2005 Option Chain for S&P 500 Index)

Options	June Open Interest	Volume of Shares (in $)
1175	82,098 contracts	$9.65 billion
1160	30,130 contracts	$3.50 billion
1150	99,770 contracts	$11.47 billion
1125	76,385 contracts	$8.59 billion
1100	111,420 contracts	$12.26 billion
1075	59,322 contracts	$6.38 billion
1050	133,186 contracts	$13.98 billion
1025	58,452 contracts	$5.99 billion
1000	22,507 contracts	$2.25 billion
975	27,358 contracts	$2.67 billion
950	69,780 contracts	$6.63 billion
900	115,023 contracts	$10,352 billion
850	26,499 contracts	$2.25 billion
800	42,584 contracts	$3.41 billion
700	60,588 contracts	$4.24 billion
600	20,195 contracts	$1.21 billion
500	60,603 contracts	$3.03 billion

The dollar volume of the open interest in all of these contracts except one is larger than the average single day volume in the entire NYSE exchange. In some cases, it is a magnitude of six to nine times the normal daily volume of the NYSE. So my argument is, rather than looking up to see how high the market can go, the longs might rather be praying that the S&P 500 not fall below the 1175 Strike Price (or the 50-day moving average, which is at 1172), just below where the first mega contract lies. At that point, the “black boxes” kick in with their automated sells for their hedge fund owners in addition to the sales being obligated by the outstanding put contracts.

The 200-day moving average is at 1162 (just below the H&S neckline at 1163.8 and another “black box” automated sell signal), so I noted the contracts outstanding at 1160, as well. Folks, this list is not the total of all the contracts. It is only the more noteworthy ones. The effect of the SPX going below these levels is to bring even more put contracts in-the-money, which would oblige more option sellers to short the index in order to neutralize their exposure.

A violation of the potential Head-and-Shoulders neckline at 1163 implies that the minimum decline will be to 1100. This example could lead to $61.3 billion of SPX contracts having to be sold short by options expiration on June 17th, if the markets are able to stay open. The 60-day exponential moving average of daily volume on the NYSE is just below $1.5 billion. The decline to 1100 in the S&P 500 index represents over 40 days of trading volume for the entire NYSE. There are two $2.2 billion dollar trades at 1185 and 1180, suggesting that when they are hit, there is a possibility of a strong down day at each Strike, which may ignite the decline.

More of my indicators have reversed into sell signals as of Friday’s close, although they are not yet unanimous. Today’s action is reversing down and erasing the positives that we saw at the open. You may have thought that I was being cavalier when I mentioned that we had a buy signal last week, but chose to ignore it. The fact is, the May options chain had a smaller but similar profile as the one above. We came within 4 points of triggering a potential meltdown at the close of Friday, May 13th. That, coupled with a zig-zag pattern, which is very unreliable, implied that “short” was the way to stay, even in the rally.

The other day, one of the talking heads on CNBC stated that one of the largest brokerage houses was recommending that retirees sell naked puts to increase their income from their investment portfolios. Heaven help those who took that advice!

In his 2002 Berkshire Hathaway letter to shareholders, Warren Buffett had this to say, “We try to be alert to any sort of megacatastrophe risk, and that posture has made us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Naked puts are potential uncollateralized receivables that could wipe out entire brokerage firms and those individuals choosing to sell them for income. Their magnitude is beyond anything I have ever seen before. On May 13th, those playing Russian roulette in the market found that the chamber was empty. Will the same happen for the June options expiration?

CONTACT INFORMATION
Anthony M. Cherniawski
President and CIO
The Practical Investor, LLC,
SEC Registered Investment Advisor
East Lansing, MI USA
Email

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.