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Don't think price, think risk

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Last night's OptionInvestor.com Index Trader Wrap mentioning of the NASDAQ-100 Bullish % ($BPNDX) reaching the 70% level and now longer-term "overbought" level along with this morning's 09:00 update and same mentioning has triggered multiple e-mail regarding "what to do now."

Our first "concern" is for the protection of bullish profits and there are various ways to protect gains at a higher level of risk.

First lets take a look at the NASDAQ-100 Bullish % ($BPNDX) and what's taken place in another bullish cycle since the reversal up on March 17th to "bull alert" status, which had bears covering short/bearish positions and turning bullish.

NASDAQ-100 Bullish % ($BPNDX) Chart - 2% box size

The bullish % "field" or maximum range is always 0%-100%, but levels of more "oversold" conditions are found at 30% and below, while levels of more "overbought" conditions are found at 70% and higher. Similar to a thermos that keep hot things hot and cold things cold, the NASDAQ-100 Bullish % has once again given an alert to strength after March 17th's reversal up into bull alert status. I make note in the above chart that the recent reversal cam from similar levels of bullish % found back in February (red 2) of 2002, which then saw the bullish % rise to 70% by roughly mid-March (after red 3, before red 4). We see similar levels of bullish % action during the recent bull cycle.

I've said before, that the bullish % isn't necessarily a "great" tool for establishing price objectives, simply because the MARKET will cycle its price, but the cycle is determined more by RISK than anything else. For instance, during bull markets found in the late 1990's, the NDX moved higher and higher. Yes, there were pullbacks, but bullish % followers simply found the pullbacks come after the bullish % rose above 70% and RISK, even in a very bullish market environment became to high. Then at a higher low, the bullish % would reach "oversold" and despite the higher low another surge higher would take place.

The past couple of years, the trend of the NASDAQ-100 ($NDX.X) has changed to a series of lower highs and lower lows, but amazingly, the bullish % continues to resemble market periods of "overbought" levels and "oversold" levels.

If you were a big buyer of tech or NDX/QQQ for that matter in when the bullish % were 70% or higher, chances are you didn't make a lot of money as the bullish % fell as the market systematically reduced risk. If you were a big shorter of tech when the bullish % fell below 30%, chances are bears didn't make a lot of money near-term on the reversal back higher (at least the past couple of years) as an oversold rebound took place.

One interesting e-mail that I got today comes from a trader that is LONG the QQQ Jan 25 04 LEAPS (bullish) but has also written calls (sold) the May $26 contract. He's wondering if he should be "nervous?"

Heaven's no! Not with the bullish % up at 70%. You're "nervous" with regard to your May $26 calls, and while I'm not certain, I would guess that you sold them in mid-April. I'm just guessing. But by owning the Jan $25 2004 LEAPS, you're protected. I would DO NOTHING with this trade at this point and let things play out until May expiration, which is on May 16th.

The "only thing" wrong with the above trade perhaps is that the covered calls was written a little "soon." But without knowing for certain when each trade was initiated, I'm thinking worst case right now is a break-even if not slightly positive result from the trade.

Traders with similar situation, but only holding the bullish side of the longer-term LEAPS, might also view the selling of a covered call as advantageous as an opportunity to work down the cost basis of your longer-term bullish trade.

What has "usually" been the disadvantage of covered call writing is that as your index position has profited as the bullish % and indexes rebounded, we usually find option volatility at lower levels and there's not a lot of premium associated with the selling of covered calls. Compare this to periods when a market has declined and higher option premiums are found.

Option traders associate this with the NASDAQ-100 Volatility Index ($VXN.X) 32.98 -1.2%, which was near 50.00 in March (do you make the tie with the bullish % at 30% in March and VXN.X at 32.98 when bullish % is at 70%)?

Here may be a "lesson" to market volatility traders that try and time the markets based on "low" and "high" levels of volatility. A couple of weeks ago, we noted that the VXN.X was breaking to historic lows. For some "bears" that was the reason to be BEARISH and buy puts. However, the bullish % were nowhere close to being "overbought."

I'm not suggesting that the BULLISH % by itself is the BEST indicator compared to the VIX.X or the VXN.X, but combined they give a somewhat "cloudy" view of just how well these volatility indicators serve as a contrarian indicator. But together, the bullish % and VIX.X or VXN.X are a great indicator.

Anyway.. I thought the subscriber "dilemma" was a good one. I like his strategy, and I can't critique his entry on the selling of the covered call. You've got to do what you've got to do on a particular day when assessing risk in your account. Still, I think a good and prudent strategy is to sell some covered calls. The more "protection" a trader looks for in a covered call, the more IN-THE-MONEY he/she would sell.

Stock traders will implement various strategies with a covered call. Often times, the first trade is to sell an OUT-THE-MONEY current month expiration (out the money is if the stock is trading $27 and you sell a $28 call option). Then, if the stock declines more than 5%, you'll find the out the money call option you sold, declining in price (remember you sold the call high and can buy it back now for less). Then, the trader will either wait until option expiration and just let the OUT-THE-MONEY option expire worthless, or buy it back for cheap, and then SELL another OUT-THE-MONEY call option at the $27 strike. All the time, keeping and eye on the appropriate bullish % for the type of stock you hold longer-term bullish thoughts for.

Current market action has the Dow Industrials (INDU) 8,486 -0.19% lower by 17 points, the S&P 500 (SPX.X) 917.76 (unch), the S&P 100 Index (OEX.X) 466 (unch) and the NASDAQ-100 Index (NDX.X) 1,108 -0.72% off just 8-points, with the NASDAQ-100 Index Tracking Stock (AMEX:QQQ) $27.57 -0.57% lower by $0.16.

Sector action leans to the positive side on an index-by-index count, with weakness found in the Semiconductor Index (SOX.X) 333 -1.81%. Since we're discussing the NASDAQ-100 Bullish % ($BPNDX) today, we'll discuss the sector bullish % for the semiconductors. According to Dorsey/Wright and Associates, the Semiconductor Bullish % (BPSEMI) is still "bull confirmed" status at 50.82%, which is a cycle high for this sector bullish %. In March, the semiconductor bullish % fell to 22%, before reversing up into "bull confirmed"" status at 28% in early March (red 3 on a point and figure chart). Do you make the tie with this sector bullish % and what took place in the NASDAQ-100 Bullish %?

Upside sector action has the S&P Insurance Index (IUX.X) 260.67 +1.3%, Health Provider Index (RXH.X) 259 +1.3%, HMO Index (HMO.X) 581 +1.64%, Oil Service (OSX.X) 85.21 +1.44% and Gold/Silver Index (XAU.X) 65.74 +2.15% leading today's sector gainers list.

Last night, Kent Barton asked me what I thought of the "insurance" stocks. One thing that "makes sense" to me for their recent bullish action is something I had made some scribble notes on in prior commentary. Insurance company's have been BIG buyers of corporate debt in recent months. Corporate bonds have done will in recent months too, which not only gave insurance companies some attractive YIELD at the time, but has also built in some rather impressive capital gains, which they have been reporting. These bond portfolios among insurers are funded by the premiums you and I pay for insurance, but the incomes from these bond portfolios then are used to pay claims. When the bond portfolios do well then Insurance companies tend to do well. If claims are LOW, then the gains can be exaggerated to the upside and this can build to a more bullish stock price of the underlying insurance company's stock.

Jeff Bailey

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