January 2011 Options Review

According to the January Barometer, the stock market's returns during the first month of the year often predict the performance for the full year. The S&P 500 Index is on track to record its first January gain since 2007 and this bodes well for the remainder of 2011. Although the indicator failed in 2009 and 2010, it has been accurate 34 out of 41 times since 1950 for an accuracy rate of 83%. However, while the January Barometer is bullish for this year, the early gains in 2011 have been driven by a handful of sectors and significant event risk could drive higher levels of volatility in the months ahead.

Much of January's gains were erased Friday when fears about political unrest in Egypt and other parts of the Arab world sent the S&P 500 skidding for a one-day 1.8% loss. Still, it's on pace to add almost 2%for the month. Strong gains in the financials, industrial and energy names have driven the advance. The Energy Select Sector Fund(XLE) is up nearly 6% month-to-date. Shares touched their best levels since September 2008 Monday, fueled by higher prices across the energies. Crude oil (March) gained 66 cents to $90 a barrel today and, although down $2.85 year-to-date, crude has more than doubled during the past year. Natural gas prices are heating up. At $4.32 today, natural gas is up 5.4% since mid-December and hit five-month highs of $4.88 last week.

Shifting attention back to the equity market, the table below shows the performance of the Select Sector Funds. Collectively, these nine funds hold the five hundred S&P 500 stocksgrouped by economic sector. The industrials, which includetransportation, machinery and construction companies, have been strong. Financials and technology have also helped pace the market's advance in 2011. On a down note, almost anything consumer-related has been in the toilet. The basic material sector is showing a year-to-date loss as well.

One trend that has continued in the first month of 2011 is merger and acquisition activity. Massey Energy(MEE) shares are rallying 10% today after Alpha Natural Resources(ANR) made a bid for the coal producer. Other noteworthy deals announced so farin 2011 are AMB Property's (AMB) bid for Prologis(PLD) and Verizon's(VZ) acquisition of Terramark(TMRW). The trend is likely to throughout 2011, as large companies seek to boost revenues and profits through acquisitions amid sluggish economic growth.

While M&A activity is likely to continue, we might see an uptick in volume and volatility in the weeks ahead. Volume in the options market has picked up in late-January, driven by increasing activity in the exchange-traded funds. 5.6 million puts and 3.4 million calls traded across all ETF products Friday, as nervous investors stepped up demand for portfolio insurance and bought puts on names like the SPDR S&P 500 Trust(SPY), the PowerShares QQQ Trust(QQQQ) and the iShares Small Cap Fund(IWM). The heavy volume stands in stark contrast to the light volatility, low volume trend seen in December and throughout the first few weeks of 2011.