The Lawrence Chan Blog

US Federal Reserve Open Market Committee (FOMC) made the announcement last Thursday that it is going to buy $40 billion MBS (mortgage backed securities) every month with no expiration date and that the low interest rate will be kept until at least 2015. As a market participant (i.e. trader) I do not really give a damn what that means on that day. I did not even read the exact statement until an hour after it was released. The market reaction to the announcement was wild and there was absolutely no time for in-depth analysis of the statement.

Over the weekend, I started to think about the implication of this FOMC decision. My conclusion of the reasons behind this decision is giving me very uncomfortable feelings and a sense of danger in the financial markets before US election in November.

Fed never made any bold changes to its policies right before election. This is the very first time that we get a shock like this. Many professional traders are surprised by this move from the Fed simply because of this. The truth is that I was one of those surprised. Luckily I have a plan B in place and that saved my day.

Giving Mr. Bernanke the benefit of doubt that he is not trying to boost Mr. Obama’s re-election chance, where does this Fed action led us to?

There is only one reasonable answer – very bad financial problem must be looming that waiting 2 more months will be disastrous.

Notice the action prescribed is specifically targeting the MBS, it is obviously a move to help the financial institutions to reduce the pressure on their books. I am not talking about just US financial institutions. I am talking about major European financial institutions as well. One or more of these firms must be in such bad shape that Fed has to act now.

Last time when Fed suddenly created the unlimited borrowing facility for the major banks, we had no idea why it was done. Until many months later that we learned many banks could not borrow money to support their daily cash flow. These banks could have gone under if not for the facility put in place right on time.

The question now is whether the crisis will be exposed or not. If it is not exposed like last time, all we are going to get will be a calm range bounded world markets until after the US election is over. If it is exposed, however, don’t be surprised that these coming 2 months turning into one hell of a roller coaster ride.

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Several days ago while Facebook was selling below $18, I was calling in my real-time chat that $17.50 should be the floor for the stock and that the goal is to print at least $20 and possibly $22 before option expiration. I also mentioned that Mark Zuckerberg will do something quickly right after to secure this low. Next thing we know, after market close that day, he announced that he will not sell his stocks within a year.

Why do I know that it will happen? Because I have seen enough of this happening again and again.

It is a great example on how chart reading, basic reading of option expiration bias, and common sense applied to analyze a stock objectively can give you a low risk entry. No need of voodoo magic like fundamental valuation where everyone can plug in their own preferred parameters, just pure understanding of market dynamics will do.

First, let’s talk about chart formations.

1. The 3 blue up arrows marked a regular 3 pushes down formation. (If you do not know what it is, look up the pattern 3 Pushes in my online eBook Crash Course in Chart Reading.) The pattern points to a retest of the price marked by the red down arrow on the left hand side. And it did it by late June (marked by the 2nd red down arrow to the left).

2. June is the first full month that Facebook traded. It is the reference month as stated in STOPD. The price range of Facebook in June is marked by 2 red horizontal lines. Once Facebook failed to hold the low of June, the 100% range expansion target (right below $18) kicks in. That was tagged several days ago.

3. The break down move started in end of July (marked by the magenta down arrow) formed a pocket zone. Pocket zones are retested almost all the time. The usual time span is within 2 times the original time period spent building the last bottom. In this case, the original time spent is about 2 months, so before year end, Facebook is likely to retest the pocket zone of $23 to $26.

Second, let’s talk about the option expiration factor.

Following is a screenshot of the Facebook put options expiring this and next Friday. I took the screenshot in the middle of the day.

1. Notice the open interest is significantly higher starting from $20 and peaked at $18. None of the higher strike prices, from $21 to $25, has comparable size in their open interest. Since option market makers are likely the writers of these options, do you thing they would just stand there and let these options turning into big fat losses?

Now take a look at the call options.

1. Which strike price stands out with the highest open interest? $22

2. Which strike price has double the open interest comparing to the next line below? $19

3. Again, it is reasonably safe to assume option market makers are the main sellers of these options. Why would they not defending their turf? If Facebook can print a close of at least above $19 and below $22 by option expiration, they stand to collect most of the premium. A job well done.

I have to clarify that the option market makers are not really manipulating the stock price here. Market participants are allowed to buy and sell at the price they want and at the time they want. Someone buying puts from the market makers, the market makers will somehow have to hedge the position or reduce the risk by transferring the position to someone else. In aggregation, as more puts are bought at a specific strike price, a hidden demand is created at the strike price. The dynamics is quite complex and will take several books to explain. So to cut it short, buying would show up in the underlying stock if there are enough put options written within a cluster of strikes.

Third, let’s talk about the often ignored common sense factor.

The Facebook IPO price is $38. Underwriters are still holding onto a huge inventory of the stock. To the retail public, these firms are sitting on a huge loss. But to the underwriters, it is just bad inventory. There is no point to unload the stock now because they will have to take losses and that will impact their quarterly results. So these firms do what they do all the time – trade it out.

Standard engagement for many market making firms would start to load up the stock at about 50% of the IPO price, right below $20. They would also talk to Facebook management raising their concerns about the stock price. The management has to listen and do something because, as a public company, Facebook still need the investment banks to handle their financing and related matters.

So, just like Fed chairman coordinating a rescue plan with European Central Bank, you get this series of planned "good news" to be fed out in sequence. The stock price can then rise steadily to the point where it is acceptable to the major players. Outlooks on the stock will be magically adjusted to the upside so that aggressive traders (they call themselves investors) would be lured to buy the stock from those who bought at the bottom. The cost of the bad inventories are then reduced.

As of today, 2nd good news is already fed out from Facebook. I wonder how many more are in store.

Conclusion

I am going to answer the title question myself here. No, it is not necessarily the absolute bottom. It is just a bottom put in place so that major players can force the hands of the shorts to cover so that a wait and see scenario can happen at $23-$26 area.

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Did it again. I promised myself not to pull anymore all nighters yet I did it again.

My research clearly told me that the advantage of riding trades from the evening to next morning after 9 am is no different from riding the same move from 7 am. Yet, the fear of not getting a part of this upside breakout still lured me to violate my own trading plan. I have  anticipated this move since the weekend … I am psych up to the point that I have to see it thru.

I am now facing the consequence – on my face that the statistics is telling the truth (again) and I am dead tired making it difficult to concentrate for the rest of the day.

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