If this won’t make Cramer spit out that coffee, not sure what will (hat tip Kieran in the comments)

Direxion, a pioneer in providing alternative investment strategies to sophisticated investors, announced today that it will execute a 1-for-2 reverse split of the shares of Direxion Daily Mid Cap Bear 3x Shares after the closing of the markets on Wednesday, June 24, 2009. MWN shares will begin trading on NYSE Arca, Inc. (NYSE Arca) on a split-adjusted basis on Thursday, June 25, 2009.

No one’s exactly sure why they picked MWN to reverse-split first. It’s a $33 stock, and it’s way off the radar. But the implication is that more popular names like our friends FAS and FAZ will reverse split as well.

Clearly though 2:1 won’t do the trick for them, perhaps 10:1 would make more sense. Or better still, issue new one’s from scratch. There was also some thought about creating new one’s with longer reset periods, like say one month as opposed to 1 session. But alas, that becomes problematic too as we saw a month with a greater than 33.3% gain in financials as recently as March. In fact last time we ran numbers, we saw that if Direxion had issued monthly FAS and FAZ when they issued the originals, FAS would be lower than it is now and FAZ would have gone under zero.

And in other news, Finra has officially requested that Ultra ETF’s now only sell with a warning label.

The Financial Industry Regulatory Authority has reminded brokers and registered investment advisers about their fiduciary duties when selling ETFs that offer leverage, are designed to perform inversely to the index or benchmark they track, or both. In a notice posted to its Web site earlier this month, Finra reminded the brokers and advisers that these instruments are complex and typically unsuitable for retail investors who plan to hold them longer than one trading session.

“While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis,” the notice said. “Due to effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective.”

It goes on to note that if your Ultra ETF is still up 4 hours after you buy it, consult a physician. Do not operate heavy machinery if you buy and hold these.

And no, I have no idea what is in that picture, although it looks like something out of Sleeper.

From The Daily Options Report by Adam Warner on the seasonal cycle of volatility.  It bottoms end of June beginning of July, then picks up in the summer for a peak in the fall.

For all the talk about “bottoming” the VIX, I would like to throw one little splash of cold water on it.

As per numbers I ran for my book, Options Volatility Trading: Strategies for Profiting from Market Swings(Amazon link) July cycle shows the lowest mean and median VIX readings. Early in the July cycle, really from June expiration into July 4th or so, is particularly bad, and in fact often is the low water mark of the year.

So with “cheap” options volatility already overpriced relative to realized volatility, and the last week of a cycle not a good time to buy options of the following cycle under any circumstance, I’d really refrain from “bottom fishing” July paper here. It will likely get cheaper in volatility terms.

Now none of this says anything about actual stock volatility this coming week. It’s expiration, anything can happen. I tend to think that if it’s non-volatile heading into expiration week, it stays that way. But you always have the chance of an event getting some names on the move. What it does say though is not to let a potential active day or two seduce you into buying July options. Treat it as a blip in volatility, not the start of a new trend up.

And none of this says anything about VIX futures, or VXX. Remember the VIX future just looks at a snapshot VIX reading for the day it expires. The pattern is ugly volatility early in the July cycle, but the VIX may very well rebound by the end of the cycle. Expect VIX July futures to keep a healthy premium to “cash”.

I don’t know.

I like to think as far forward as options expiration, next one is 20th June.   What is my best guess of what might happen until then and how can I make a few profitable trades.

I deeply respect people who can buy GE now and wait patiently for the economy to improve and GE to clean up its balance sheet and grow all its businesses.  I can’t do it.

My last boss at Millennium used to talk to floor brokers all the time and ask them, Why is the market up?  Why is it down?  The stories they told him satisfied him.  “Soros has split a large order among five brokers and it is getting executed …”  Something like that.

Trading shows how well aligned I am with reality.  I like models and finding and testing a trading strategy.  But all trading strategies bother me.  What is left out?  What are the hidden factors that are really driving the profit in the strategy?

In an up or sideways  market, you can do really well selling puts.   It is simple, and with a little technical analysis and no news to move the stock, like earnings, you can get some comfort that the put will expire worthless.  Also, you can use an options calculator to calculate the probability of success  based on the historical volatility.   That is comforting too.

In a down market selling puts will kill you.  So you have to know the difference short term, until the next expiration.

Don’t Over Fit

Part of his comfort with the methodology, I believe,  comes from his testing. He has tested his trade back over many years and sees how it performs.  There is a danger to creating trading strategies by backtesting.   There is a need to” improve” the parameters of the trading method so that the trading results improve.  This is a trap.  If the method works, it should work over a range of parameters.  If the parameters need to be fine tuned, that is a sign that they have been over-fitted.  They may have worked in the past, but probably will not work in the future.

One way to be sure to avoid this bias is to create your trading method over  say the past five years, but take out six months of three of the years.   Then once you have a method that you like, test it on the three six month periods that you did not look at.  That way if you have over fitted the parameters, the trades in the test periods won’t do well.

Juan has kept his trade parameters very simple and consistent.  That is a good sign.

How Does The Trade Behave?

He also has a very clear idea of why his trade does what it does. In other words, what are the hidden factors in the trade. Does it have an underlying bullish bias? Does it need volatility to increase to be profitable? What does time decay do to the trade? Does it profit from sharp moves or suffer?

Another piece of the puzzle is the time frame of the trade.  Are you most comfortable closing out all your trades every day?  Or every Friday?  Or do you want your trades to work over a month or two?  How are you most comfortable?

These are all important elements in creating a successful trader.