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Putting the Odds in Your Favor





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March 2, 2012
Putting the Odds in Your Favor
News That Can Directly Impact the Size of Your Wallet
Today’s Laugh Line
This Day in Wall Street History: 1949: Soft-coal workers begin strike
Putting the Odds in Your Favor

By Ed Pawelec – Creator: Price Shock Trader

As traders and investors, we are all looking for something that tilts the odds in our favor, something that gives us an edge.  There are many successful methods of gaining an edge. 

As an option trader, odds are important because timing becomes a decisive factor and right now the broad market is on a very tight timeline.  The next two weeks can make or break the nearly 10% year-to-date rally in the S&P 500.

Week 1

Next week, the S&P is likely to start off in the 1365-1380 range that has bound it for most of this past week.   But the latter half of the week will bring the first high level leaks about just how well the Great Greek Debt Swap is going, also known as Private Sector Involvement.  No, it hasn’t gone away, but we are near the endgame for this chapter in the saga.

The success, perceived success, or even failure of this deal is critical for the near term stability of the financial markets, because there are far too many question marks if nothing is resolved.  The markets are not fans of uncertainty.  Even a worst case outcome of a “hard default” will be better than some new mechanism of kicking the can down the road.

But at this point, not knowing the outcome I started researching what the options were in an attempt to assign some probabilities to various end points.  Lo and behold, in my search I found exactly what I was looking for.  The following is the PSI Timeline Chart coming via Zero Hedge sourced from a BNP Paribas report from last week.

 

It has been about a week since the “You Are Here” balloon and we are week from March 9th.  So all throughout the coming week there will be sound bites and prognostications about just how well the PSI is going.  By the end of the week we will have the results and some decisions will need to be made, unless the best case scenario of a high participation rate occurs.

Week 2

What I like about the above chart is that it assigns probabilities to the four most likely outcomes and based on other research that I’ve done, I believe these numbers are pretty close to a realistic assessment.  What I am going to do is assign some S&P targets ranges for each outcome.

My only change is marginal increase in the best case scenario of a 95% participation rate.  BNP assigned a 6.7% probability to that outcome (top right box), but I think this deserves a little more because you should never underestimate the possibility of banksters and bureaucrats pulling a rabbit out of their . . . um, hat.  My average target bumps the probability of that rosy outcome to 7.2% while reducing the worst case (bottom right box) probability to 11.2%. 

The Odds are Posted

So let’s start with the top right box and its rosy scenario:

Everyone decides that this is the best deal ever and participates.  This is not as ridiculous as you first might think.  Large portions of Greek debt are held by the Greek banks and it certainly behooves them to participate because part of the next round of bailout money is already earmarked to help recapitalize them.  Whether this permanently resolves the issue is yet to be seen, but in the next two weeks it should be a positive for equity markets.  S&P target 1410-1420, 7.2% chance.

The next box down is not the worst case scenario, but it is not a good one.  The collective action clauses (CAC) that were inserted into Greek government bonds (GGB) to ensure participation by private sector holders are not only triggered in this scenario but becomes punitive and nobody gets anything, except of course credit default swap (CDS) holders whose insurance will pay off.  While this outcome may have wider, lasting ripple effects, over the next two weeks it’s likely to put some pressure on equity markets but is may suggest that a durable resolution can be achieved within the year.  S&P target 1290-1300, 8.2%.

The next box is the most probable outcome at 73.4%.  In this scenario there is 100% final participation rate with the debt reduction target achieved, but only as a result of triggering the CACs.  Despite the fact that the most recent estimates for the Greece is debt burden are well north of the 120% of GDP 2020 target in this scenario, it is what the market is expecting and is likely to produce a mild downturn on a sell the news type of reaction.  S&P target 1340-1350, 73.4%.

The lowest box on the right is in my opinion the worst case scenario because it brings the probability of a Greek exit from the Euro zone squarely into play.  It is also likely to result in some severe wrangling over just who is going to get paid what, including the European Central Bank (ECB).  The ECB recently had the Greek bonds it holds rewritten to exclude the collective action clause, but they cannot exclude themselves from a hard default where Greece literally goes out of business.  It’s always been my belief that Greece would be better off exiting the Eurozone and this would certainly set the table for that.  But over the next two weeks the markets are really not going to like this outcome.  S&P target 1250-1260, 11.2%.

Putting all four potential outcomes together yields an average target for the next two weeks on the S&P of 1335 to 1340.  Depending on exactly how we get there, this could be the long awaited pullback and a buying opportunity or a set up for further decline.  I’ll evaluate that in a few weeks.

The bottom line is that although you might miss the potential for about a 2% rally from current levels, that is a small probability.  The odds are favoring a mild to sharp pullback.  Over the last two days, Costas and Teeka told similar stories with the same endings.  If you haven’t taken long equity profits recently, you may still have a few days, but there will be most certainly better entry points ahead.

Let Us Know What You Think About This Article


Ed Pawelec
Editor, The Tycoon Report
Chief Investment Officer, Price Shock Trader

Ed Pawelec has been active in the options markets for nearly 2 decades. His interest in options began when he studied economics and finance at Washington University in St. Louis. At that time, options were a very new instrument among listed financial products.

He began his trading career on the Philadelphia Stock Exchange (PHLX) in 1993 as an equity options clerk, and quickly worked his way up, eventually becoming a successful market maker.

In addition to working as an options market maker on the PHLX, Ed also acted as portfolio manager on the buy side, and as an options execution specialist and strategist on the sell side.

At IFII, Ed merges his passion for financial education with his enthusiasm for options trading and passes along to individual investors tricks and secrets they usually have access to nowhere else.

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Today’s Laugh Line

The economy is so bad that I went to my bank to get a loan, they said, “What a coincidence! That’s just what we were going to ask you!”

(Got Jokes? Send your best jokes or funny videos to editor@tycoonresearch.com … if it makes us laugh, you might just see it in The Tycoon Report some day!)

This Day in Wall Street History:
1949: Soft-coal workers begin strike

1949: Soft-coal workers begin strike

On this day in 1949 the nation’s soft-coal workers, led by United Mine Workers chief John L. Lewis, hit the picket line to protest the recent appointment of Dr. James Boyd as the head of the Federal Bureau of Mines. The two-week walkout was another in the flood of strikes that cropped up in the wake of World War II.

Indeed, striking had become something of an annual ritual for Lewis and the miners: including the walkout in ’49, they had struck every year since the close of the war. And, though some of these strikes roused recourse from the mine owners and government, the workers were able to make some gains, including pension plans and a health fund.

Source: www.history.com

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