Market Insider: Tuesday Look Ahead

It's the Fed's turn to sway the markets Tuesday, but stock traders will keep their eyes on the volatile oil and commodities markets.

The FOMC holds a one-day meeting and issues a statement at 2:15 p.m. The Fed is expected to leave the target Fed funds rate unchanged at 2 percent, but there is plenty of speculation about how it might tweak its statement. Many traders expect the Fed to show it is staying neutral on rates.

Miller Tabak chief bond market strategist Tony Crescenzi points out that the Fed noted in its last statement that downside risks to the economy had diminished somewhat. "They don't want to take that to the next step. They don't want to reinforce that too much," he said "if anything, they want to play it down.

Crescenzi noted the last Fed statement June 25 was before Fannie Mae and Freddie Mac became double trouble for the markets and received a back stop from the Fed and Treasury.

He said inflation should remain a concern and they are seeing that worry in consumer sentiment readings. "I think they're looking at what's happening on Main Street as much as on Wall Street," said Crescenzi.

"They don't like inflation where it is.. but they've got to stay vigilant on inflation because inflation is elevated," said Crescenzi.

The Fed's statement is the big economic event of the week. Also on Tuesday, ISM non manufacturing data is expected at 10 a.m. and a few major earnings are reported before the bell, including Procter and Gamble , Archer Daniels , D.R. Horton , Duke Energy , MGM Mirage , Molson Coors and Weyerhaeuser . After the bell, Cisco, News Corp and Whole Foods report.

Merrill Lynch is a stock to watch in Tuesday's session. CEO John Thain told CNBC's Maria Bartiromo on "Closing Bell" that the firm could not rule out taking more writedowns if it becomes necessary, but that the firm is now well capitalized and should return to profitability soon. He also said there are no plans to cut the dividend, and that a recovery for the financial markets is not expected until 2009.

Oil Smack Down

Oil fell more than $4 and was just above $121 in late trading. A lot of converging trends united to push down oil prices Monday including signs that Edouard would not be a major storm when it moves across the Gulf of Mexico oil production areas. Late in the day, the EIA said U.S. gasoline fell by 7.5 cents in the last week to $3.88 per gallon, the lowest price since May 19.

But in another important sign for the crude market, the Commodity Futures Trading Commission data showed that hedge funds were betting more on oil prices falling than rising in July for the first time in nearly a year and a half. Currency speculators, meanwhile increased bets on the U.S. dollar for the first time since June, according to CFTC weekly data from last Friday.

"The rally (Monday) in equities started late morning when we started having a sell off in crude. The rally in stocks ended when crude closed. The real play in that was crude versus the financial stocks," said Tim Smalls, head of equities trading at Execution LLC.

The Dow slid 42 to 11,284, but some of the selling pressure was reduced because of a big slide in crude. The S&P 500 fell 11 to 1249.01, and the Nasdaq was down 25 at 2285. Energy stocks were down 4.85 percent, while materials stocks were down 4.2 percent. Financial stocks were down just 1.3 percent. The best sector of the day was up 1.3 percent.

Smalls said crude was just the commodities market's "poster child" and there were steep declines across the board. "More to the point, look at copper. Copper was down almost four percent. silver down... gold down... natural gas was down 7 percent," he said. He said some of the market talk is focused on how commodities were in big demand ahead of the Olympic games, but the market is reminded that Chinese demand could now be slowing as the start of the Olympics approaches Friday.

Commodities and energy prices fell sharply amid rumors of hedge fund liquidations. The Reuters/Jefferies CRB index, a bench mark for major commodities, dropped 3.4 percent.

Gold fell a full percent to $900.10 per troy ounce. Copper slumped 4 percent, to $3.4875 per pound, a 14 percent decline from its July 2 high. Silver fell 2.2 percent to $17.1030 a troy ounce, its lowest close since June 25. Platinum was down 5.6 percent, at $1,563 an ounce.

The dollar fell about 0.3 percent against the euro and rose 0.48 against the yen Monday.

Smalls said the Fed statement will be the big key for the stock market Tuesday but it is not expected to make much news.

"They'll always matter. But on Thursday what the Fed says on Tuesday won't really matter. The Fed will matter for about 12 hours...The real kicker will be people looking at the statement to see what they're not saying," he said.

Then equities traders will get back to watching earnings and oil and the slumping commodities markets.

Weighing the Options

Rebecca Darst of Interactive Brokers pointed out in her daily note Monday that the type of trading in Freeport McMoran options Monday shows how traders are playing put spreads in reaction to the drop in commodities prices.

"Shares dropped 10 percent to $82.17 and at present we're recording implied volatility on all options at 76.8 percent versus a historic reading of 56.7 percent—that's a 27 percent spike on the session, a 52-week high for the reading all told, and suggests that options traders are pricing in 25 percent additional risk over the next 30 days than shares have shown historically," she wrote.

"With puts outmoving calls by a factor of 1.3, we saw brisk activity on both sides of the sentiment divide in the front month, while 4,000-lot long put spreads went through in the February contract between strikes 80 and 90, where the spread totaled $5.45 and in the January ’10 contract between strikes 60 and 70 where the spread was $4.15. Long buyers of the put spread strategy need to “earn back” the total amount of the spread with downside movement below the upper strike—which in this case suggests longer-term share price declines for Freeport McMoRan," she noted.

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