When looking at stock market performance at the midpoint of January, you’d have to wonder what could possibly incite higher stock prices.

Barring gold, virtually every sector has sold off. The sell-off that was occurring was a delayed reaction to the relative stability of last year’s fourth quarter. What has changed is investor sentiment from the recent normal slowdown/recession scenario — short in duration and infrequent — back to what we saw 20 years ago, longer recessions that occur more frequently.

Writedowns by Citigroup Inc. and Merrill Lynch & Co. Inc. in the U.S. and by CIBC in Canada don’t help — and justify yet another pound of flesh being extracted from share values. As a result, we are now in a period in which share values look cheap, relative to expected earnings. And because of this uncertainty, options premiums have risen.

Looking beyond the abyss, investors are asking: what will turn this around? One thing we know is that as of mid-January, fear is driving the market. We also know that standing at the edge of the abyss is a template for clarity. If clarity gains momentum, sentiment can shift back to the middle quickly.

Take Citigroup as a case in point. Investors looked at the writedowns as a glass half-empty. But you could say that Citigroup was airing its laundry and was, most likely, “airing” on the side of caution.

For that moment of clarity, we can thank the new era of corporate governance and the fact that Citigroup named Vikram Pandit as CEO and appointed Sir Win Bischoff as chairman on Dec. 11.

Neither of these men has responsibility for the current mess at Citigroup. So, their role is clear: communicate a worst-case scenario, leverage the news to slash jobs and cut the dividend (Citigroup slashed its dividend by 41% to US32¢ a share from US54¢ a share), find new sources of capital and begin to clean up the balance sheet.

To that end, Citigroup has lined up US$12.5 billion in new investments from sovereign wealth funds and existing shareholders, including US$6.9 billion from the Government of Singapore Investment Corp. in exchange for 4% stake in the company.

Other investors include Capital Research Global Investors, Capital World Investors, the Kuwait Investment Authority, the New Jersey Division of Investment, Prince Alwaleed bin Talal of Saudi Arabia (who is Citigroup’s largest shareholder), and former CEO Sanford Weill and his family foundation.

All told, Citigroup has raised US$20 billion in new capital over a period of two months. Same story, albeit in smaller numbers, for Merrill Lynch (about US$15 billion) and CIBC ($2.7 billion). This demonstrates, once again, the resiliency of big financial services institutions to access capital when necessary.

January was most likely the pivotal month for writedowns, as it has been almost six months since the subprime mortgage market began to unwind — more than enough time for managements to evaluate their exposure and write it off on last year’s books.

Next comes the U.S. Federal Reserve Board. Chairman Ben Bernanke will first jawbone the markets and then take definitive action. Through the first half of the year, the Fed will orchestrate a co-ordinated, three-pronged blitz with other central banks. This will include:

> frequent and significant rate cuts;

> infusion of liquidity; and

> moral suasion intent on easing credit restrictions.

The objective will be to shift investor sentiment, not only for those in the financial markets but also for those looking to enter the housing market.

This will probably stabilize stock prices. It will probably not stimulate share values, however. Replacing fear with clarity means you begin to focus on the outlook for earnings growth; and that probably won’t kick in until the third quarter. The equity markets will start to take notice in the second quarter. Financial services institutions will probably lead that parade.

In the meantime, the options market is responding to current sentiment. The Chicago Board Options Exchange’s volatility index (VIX) — which measures the volatility implied by options on the S&P 500 composite index — moved up to 28.46 just before options expiry in January.

Although this is still well below the 38.5 high the VIX hit in August, when the subprime crisis started to gain momentum, premiums are still quite rich, opening the door to some interesting option-writing opportunities — especially if you believe the market is unlikely to gain momentum until the second quarter.

@page_break@For Canadian positions, you might look at writing calls on the iShares S&P/TSX 60 (XIU; recently trading at $75.05). Canadian premiums, based on the XIU options, have risen to 24.5% implied volatility. Buying XIU and writing the March 76 calls, for example, would net a premium of $2.60 as of mid-January.

The return, if exercised, would be 4.9% for two months. If unchanged, it would be 3.5%.

In the U.S., you might want to look at Ultra shares on the S&P 500 (SSO; recent price, US$68.50) or on the Nasdaq 100 index (QLD; recent price, US$77.12). These securities provide leveraged upside exposure to the linked underlying index, with the leverage being two to one.

You can also trade Ultra short exchange-traded funds that reflect a bearish position on the market. For example, you could also buy Ultra short ETFs, such as SDS, on the S&P 500, or QID, which leverages the downside movement on the Nasdaq 100 index by a factor of two to one.

Taking this to the next step, clients can trade listed options on most of the U.S. products, although some are still in their infancy stage with limited liquidity. The options settle in physical delivery of the underlying shares. Which is to say, if the option is exercised, the writer is either obligated to buy (i.e., for short puts) or sell (i.e., for short calls) the underlying ETF.

This is useful from a tax planning perspective because the premium received when selling an option that offers physical delivery is taxed as a capital gain. This is not so with cash-settled index options, which are taxed as ordinary income.

Beyond the tax implications, there are some interesting option strategies using SSO and QLD. Because the ETFs are twice as volatile as the indices, the options are about twice as expensive — in line with the amount of premium one would typically get on an average individual stock. Yet, the ETFs are based on broad-based indices, which theoretically provides immunity to company-specific risk — albeit with two-to-one exposure to market risk.

Writing, say, the March 70 calls on SDS for a premium of US$4.75 will return 9.8%. If exercised, the two-month return is 9.8%; and if unchanged, it’s 7.4%.

With QLD, write the April 80 calls at US$7.50. The three-month return, if exercised, is 14.9%; and 10.8%, if unchanged. IE