We had some short offers in somewhat above the market yesterday, but the intraday rallies were too feeble to reach even these modest targets. Nor did it prove particularly helpful to have gotten the targets precisely right, as the nearly untradeable price action in the mini-S&P demonstrated. After the futures exceeded the previous day’s target, 1232.50, by a single tick, we shifted our enthusiasm to the next, 1236.00. The futures duly paused at 1235.50 yesterday morning, halting their gentle ascent; then, they spent the next three hours edging slightly higher, forming a double-top at 1236.50. Unfortunately, the biggest pullback that occurred from these highs during the entire session was a measly four points – barely enough to permit even the nimblest of traders to make lunch money, much less the cost of a trip to Disney World with the wife and kids.

(Click on chart to enlarge)

The lesson to take away from this is that we can probably continue to lay out shorts until the cows come home without fear of producing a serious loss. This is because our initial stops on futures trades are usually no wider than a single point (!), and in theory, operating in this mode, it would take three or four bum trades to generate a loss equal to the one we might expect from shorting the market after it has broken decisively lower. And why, you ask, the obsession with shorting? Very simply, because my gut is telling me that investor complacency has gone off-the-charts, making the stock market particularly vulnerable at this time. Granted, I did provide a bullish scenario for September/October in yesterday’s commentary, and although the analysis could indeed prove correct, it was inspired as much by sarcasm as by disinterested technical analysis.

Where the Excitement Was

Turgid as the markets were yesterday, the real-time Q&A session at Rick’s Picks was, as usual, pulsating with excitement. For those of you who were not privy to this latest installment of our weekly analytical orgy, let me mention that there were bullish comments and fresh targets presented for two mining-sector faves -- Royal Gold and Gold Fields Ltd. -- with a call-buying strategy for the former. Both will be archived by noon Thursday, there to remain for your perusal. There was also an interesting query from long-time subscriber Ben W. that I’ve reprinted immediately below, along with my response, which was intended to elicit a  pungent whiff of Wall Street’s back alleys. To wit:

"For the last week or so,’ the subscriber wrote, “I've been eyeballing the December 40 puts you had recommended in Citigroup. (I'd been hoping to steal them at a much cheaper price than you suggested, but they really have budged very little despite Citi's move upward). Today's volume numbers from the CBOE were pretty eye-popping if they are accurate (and I have no reason to think they were in error). These puts had volumes of less than 100 every day, until today. Today their volume was 17,000! If you don't get to check the numbers before they change them to zero tomorrow morning, I'll give you some perspective - in the Dec series, the 42.5 Calls had 6600+, and the 45 calls had just over 1000. No other strikes had volumes more than a couple hundred in the Oct or Dec series. The front month calls also had no strike with more than 1000 volume. However, the front month 40 puts and 47.5 puts also had volumes right around 17,000.

Meaning of Put Volume?

"Do you think this represents some sort of institutional interest in these options, and if so, what is the significance of all the volume being on the put side? Anyways, don't know if this has any importance or not, but I sure found it interesting."

My response:

I wouldn't read too much significance into this spike in volume, Benny. Most probably, options are being used here to facilitate the riskless delivery of a large block of stock at a later date. Using stock as an offset, puts and calls can be bought and sold in certain combinations by the tens of thousands with little or no effect on the stock. The premium paid for the options would be determined by the interest costs/income of whoever is long/short the actual stock.

That said, I should mention that, occasionally, a huge option trade will telegraph a block trade in the stock sometime thereafter. The firm traders are thieves, and they will steal from the public, and from market makers, at every opportunity. There are supposedly laws to prohibit front-running, but sometimes it seems to me as though no large block of stock is ever traded without having been front-run by someone.

How the Scam Works

To give you an example, a brokerage firm's floor broker will come into a trading pit to buy 10,000 call options at what seems to be a very rich price. Then, not two minutes after the sale is completed, a million-share block of stock will appear on the tape at a price $1 or more above the previous sale. It will turn out that the firm is the seller of the stock -- to its own customer -- and that the firm was simply hedging the sale, about which it had prior knowledge, by purchasing 10,000 call options ahead of it.

When the stock drops back to its previous price after the block transaction, the firm will short 10,000 puts at the same strike as the calls, locking in a "reverse conversion" whose payoff is the risk-free interest the firm will collect on the million shares it shorted to its own customer. Because the reversal will have been legged on at great prices, the annualized rate of return from this little scam will be a zillion percent.

The option market makers have no right to complain, though, because every Solly or Goldman broker who walks into a trading pit to effect such a humongous trade is like a belled cat. The market makers will have seen the firm's dog-and-pony show a dozen times and know they are being set up; but even so, few of them can resist the temptation to sell the call options at such a juicy price. As the old saying goes, you can't cheat an honest man.

***

A Rick’s Pick Event

Hidden pivots is the topic of my talk on tonight at 7 p.m. before the Denver Trading Group, the largest group of individual traders in the country. If you’d like to attend, further information can be obtained by  clicking here.