EU PU: Are Weak Hands Hedged Enough? ~ The Risk Averse Alert

Thursday, October 20, 2011

EU PU: Are Weak Hands Hedged Enough?

No doubt, a herculean effort appears necessary to sustain some semblance of a floor under the market...


Make no mistake, however. Elevated put option hedging of long equity stakes is not supporting strong hands with deep pockets. This fact was well-established not long after the market's counter-trend rally off March '09 bottom got underway.

Strong hands will manage their exposure taking profits as the market rises, while at the same time appropriately increasing their stake as the market's advance further develops. Such activity is reflected by an expanding volume of shares exchanged over the duration of a sustained market advance.

Contrarily, weak hands hold to their precious little gems in the face of rising prices, lacking both the wherewithal to increase their exposure, as well as the wisdom to increase the rate at which paper profits are booked. A market dominated by weak hands is revealed by a contracting volume of shares over a sustained market advance's duration. This, of course, precisely describes today's situation.

So, weak hands are behind the elevated measure of put option hedging seen over recent months, as well as currently. Their posture is not so disposed on account of an intention to drive the market higher with a fresh supply of capital which to bid prices up. Being still over-leveraged and flush with "assets" at grave risk of severe markdown, the best these weak hands can hope for is that their hedges will be sufficient enough to put a floor under the market should a bout of weakness develop from a growing need to raise capital.

Given the morally bankrupt, media-driven, psychological operation to which we among the fleas in the investment community are presently being treated with regard to a hopelessly insolvent trans-Atlantic banking system, the question of the sufficiency of hedging among weak hands is a very, very relevant consideration at the present moment...

Now, who was it that said for the market's advance off October 4th bottom to be sustained for as long as possible, the upcoming EU meeting might need be delayed? Oh yeah, it was me.

Am I alone in thinking appearances have been geared toward making a leveraged euro-zone bailout facility seem a sound preventative measure implemented as a precaution against potential contagion from a widening euro-zone debt crisis, rather than a swindle, a la 2008's TARP?

Apparently, then, judging by reality beyond the rumors, the memory of a terrible, hyperinflationary breakdown and its ensuing political chaos is not easily erased by what otherwise is increasingly perceived a wolf in sheep's clothing. One might suppose Germany also understands that, a beast with a voracious hunger for capital left unfed will be made weaker.

So, again, the question of whether today's weak hands are sufficiently hedged appears a most relevant one. Reiterating a point of view long ago put forward here, as the market craters and sinks indexes to levels last seen in the 1987-1994 period, the CBOE Put/Call Ratio is likely to see readings inversely proportional to those seen over the decades leading to the market's 2007 peak. A put/call ratio of 2-1 or more is not out of the question, and probably will be seen on more than one occasion — both during the market's pending steep fall, as well as during its initial turnaround.

Fast Money
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