Option Investor
Index Wrap

An oil-based paint

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Let's hope any New Years Eve parties we might attend this year hold a little more excitement that what we've seen this week, at least from an analyst's point of view, as I'm running thin on any potential market moving things for traders and investors to be on the lookout for.

I'm calling today's trade an "oil-based paint" session, as today's activity was analogous to watching paint dry, with a late bid in oil offering some price movement to the U.S. Market Watch.

Aha! But these slow sessions also give traders and investors some time to look around, develop some further observations we might not otherwise get a chance to make when things are a little more active.

There was some downside action in the PHLX Defense Index (DFX.X) 257.19 -1.44%, which was one of this years best performing indices. As noted in today's Market Monitor and intra-day updates, the Pentagon reportedly is planning sharp spending cuts for its new F/A 22 fighter Jet program, where primary contractors Boeing (NYSE:BA) $52.07 -2.21% and Lockheed Martin (NYSE:LMT) $55.25 -2.66% fell sharply on the news. Of the 17 components that comprise the DFX.X, only Gencorp (NYSE:GY) $18.50 +0.05%.

PHLX Defense Index (DFX.X) Components - 12/29/04 Close

I would have to add General Electric (NYSE:GE) $36.56 -0.35% as a Dow component that may have been negatively impacted by today's news out of the Pentagon. I didn't see it as a component earlier today when I also made mention that United Tech (NYSE:UTX) $103.96 -0.74% may have also seen some negative sympathy trade.

I should note that I haven't verified all the YrNet% gains, but did make a correction to this years % change for L-3 Communications, which QCharts had shown as posting a loss for the year. Embraer Empresa (NYSE:ERJ) $33.15 -0.09% has fallen 6.48% this year.

If interested in seeing how the PHLX has weighted this index, you can visit the PHLX by clicking this link.

For all the bullish trades I profiled in 2004, I'm a bit embarrassed that I didn't pay more attention to this group of stocks.

I have to think to myself that as the Bush administration begins its second-term, and perhaps reviews both wars in Kuwait and now Iraq, air dominance came quick in both wars. I can't remember what military personal say, but I think it's something like "the initial battle is won in the air, but the war's outcome is determined on the ground."

Perhaps the Bush administration is taking measures to try and cap the record U.S. deficit and will limit spending for military aircraft, which so far has shown dominance in recent wars, and begins to provide greater focus on ground equipment, while also trying to limit some military spending on more expensive aircraft.

I'm thinking aloud here, something I'll do during a rather "uneventful" day.

Aha! But these slow sessions also give traders and investors some time to look around, develop some further observations we might not otherwise get a chance to make when things are a little more active.

U.S. Market Watch - 12/29/04

Tax gain and tax loss selling should now be complete for 2004. I was looking at the far right of our U.S. Market Watch and getting a look at just what has taken place this year. What might some investors be doing the past 5-days and 20-days as it relates to any tax strategies?

Semiconductors as well as miners might have been tax loss SELL candidates, to offset gains elsewhere.

Now take a note here, and think about this. At the end of a year, we'll undoubtedly see some gains/losses being offset, where the investor's plan is to try and get their capital GAIN as low as possible, as they get ready for April 15, 2005.

But the tax-GAIN selling may not be over. After January 1, an investor may actually look to SELL more profits where they have them early in the year, as they won't have to pay taxes on them until April 15, 20006.

"Tax selling" should never be the PRIMARY reason for selling and investment, but for those traders looking to ESTABLISH NEW POSITIONS, try to think about what the other investor (not yourself) may be doing in early January, when you consider putting on a new trade. Perhaps look at the 5-day, 20-day and annual net % change to try and determine if a stock/sector is being influenced by tax-GAIN selling.

Tax-LOSS selling in January? Not usually, as there's little benefit to be had until April 15, 2006.

While the Stock Trader's Almanac noted that December was historically bullish for Gold and Oil, my instincts from the 11/24/04 Index Wrap regarding something not "feeling/looking" right for gold stocks seems to have been correct. Oil stocks? Ugh! That's a tough trade for me to get my arms around still.

Now, as we enter the month of January, the Stock Trader's Almanac notes that Banking and Semiconductors experience some seasonal bullishness, while Natural Gas and Utilities tend to trade more bearish.

Look at the SOX.X again. Might be ripe for a bounce. No big gains for 2004 are there? Maybe tax-LOSS sellers have cleaned up their account, and tax-GAIN bears will be set to cover in early January.

One last note of interest. Look at how different this year's percentage change has been for the OEX and SPX. The SPX has almost doubled the performance of the OEX.

Today, Linda Piazza and I were discussing the DIVERGENCE between the VIX.X 11.62 -3.16% and VXO.X 12.47 +1.29%, where at the open, the VIX.X gapped DOWN, while the VXO.X gapped UP.

It's not all that unusual to see some DIVERGENCE in these two volatility gauges, but what happened this year?

The OEX and VXO.X are more comparable as the index and volatility measure. The OEX represents 100 very large-cap stocks.

The SPX and VIX.X are more comparable as the index and volatility measure. We can probably see how the SPX gets "watered down" with some mid-cap, or "not as large-cap" as the OEX would represent.

Now look at those little buggers as depicted by the Russell 2000 Index (RUT.X) 653.34 -0.18%, which gained an incredible 15.86% over the past 52-weeks. Here we're addressing the trend of market capitalization. Large, to medium, to small.

Do you get a feeling, based on observation, even between the broader SPX and narrower OEX, how market capitalization was a "difference" in how a portfolio may have performed in 2004?

Next year (2005), I'm going to have to make some changes to the Beetle's Balanced Benchmark fund. I'm thinking of getting rid of the $HUI.X, and replacing it with the StreetTracks Gold Trust (NYSE:GLD) $43.66 -1.60%, which will give us a purer representation of gold (I'm still undecided on this change), but I'm definitely adding a small-cap asset class to the equity-side of the portfolio, give us an extreme "small cap" representation to the larger cap DIA/SPY/QQQQ.

Let's move on to a question I received from an index trader today and build on our "small cap" conversation. Let's also bring into the mix the POTENTIAL for tax-GAIN selling.

Question/thought: Jeff: I agree with you about not being long into Jan 3rd. Do you feel RUT will be capped then too. I don't know what to do with my IWN shares.

Response: Hoooold on there! I'm (Jeff Bailey) not sure that I said anything about not wanting to be long into January 3rd. If I thought that, then I wouldn't have profiled May call expiration for those Russell 2000 Growth iShares (AMEX:IWO) $67.74.

While the trader's question addressed the Russell 2000 Value iShares (AMEX:IWN) $193.61 -0.05%, here what I'm looking at, and other traders might want to also.

Let's review from the start (see 10/28/04 Index Wrap) when we first started looking at a bullish seasonal trade in the small caps. I eventually decided on the IWO as an indexed security to trade, but I had set up some "tests" that the IWO needed to pass in order for us to initiate bullish trades. The IWO trade I'm talking about is still profiled as being OPEN in my Market Monitor Profiles.

The following discussion will be predicated on a trader owning two (2) of the IWO May $63 calls (IWO-EK). I've marked the two separate dates where I profiled the first entry point for 1/2 bullish position (11/08/04) as the IWO passed my first test for seasonal bullishness. I also point to the second entry date of 11/10/04 as the IWO quickly passed the second test for strength.

That was the "easy part," as it always is. Buying is easy, selling, or closing the trade is the most difficult part.

Russell 2000 Growth iShares (IWO) Chart - Daily Intervals

It's taken just about two months for the "small caps" to have reached their historical average gain of 12.9% from November-May! Time flies, as have the small caps. But remember! The average gain of 12.9% is an average. Some years have produced larger gains, while others have been less, or found losses.

One note I make, is that last year, the IWO had risen 48.7% for the year (by 12/31/03), but still tacked on an additional 9.6%. My thoughts/observations here are that after this review, I wouldn't have minded being long into January. But let's use the 9.6% additional gain as a POTENTENTIAL future reward for assessing what type of DOWNSIDE risk we take from tonight's close.

Proper trade management at this point, even when holding May expiration, is that I wouldn't want to risk much more than 5% to the downside from $67.74. Risking 5% from here, to further POTENTIAL 9.6% reward (like last year) gets the trade back to a risk/reward of roughly $1/$2. Now, a 5% risk in the underlying IWO would be $3.38, or risk to $64.36.

How do YOU feel about that?

Where does $64.36 put the IWO should it fall that far? See where I place the text "MINIMUM stop?" Just under $64.78.

What did we FIRST note in the 10/28/04 Index Trader wrap, when it came to "counting levels?" Once above a level, then NEVER traded BELOW two levels lower.

If the IWO were to trade TWO levels below $67.74, then that would be BELOW the $64.78 level. There... boom, done, closed out.

Another strategy is to SELL 1/2 of the position. Pay yourself what is now a MAXIMUM gain at a TARGET, follow the other 1/2 position with your stop just below $64.78. This LIMITS current RISK in the trade. Yes, it may also LIMIT future reward/gain, but there's no rule that says a trader has to sell EVERYTHING at once.

Is there more upside? The point and figure chart still has a bullish vertical count to $72.50 associated with the chart. From tonight's close, that would be an addition POTENTIAL $4.76, or 7.02% gain. Remember, the point and figure chart bullish/bearish vertical counts are to be used to assess POTENTIAL longer-term price objectives. They can be met, never met, and sometimes exceeded!

Since our PINK seasonal retracement level of 100% ($67.74) has been achieved, here's what I did yesterday. In the above chart, the conventional (blue) retracement, while useful for support at this point, is of no help to try and establish any further upside levels of resistance. It stinks to be long in stocks/securities that are trading 52-week, or all-time highs isn't it?

Here's a chart I put together last night. The BLUE retracement on this chart is conventional from the IWO all-time high of $86.50 to the all-time tweezer-bottom lows of $33.50 found on 10/09/02 and 10/10/02. The PINK retracement is the always helpful "fitted 38.2%."

Has anyone noticed some 50-cent increments showing up for peak highs and lows in the IWO? Almost like a computer is trading this silly thing.

Russell 2000 Growth iShares (IWO) Chart - Daily Intervals

The conventional (BLUE) retracement was to large of a range to fit on the IWO, but I've shown what I can. The PINK retracement was anchored at 0% to the low close of $52.25 in August, then I "fit" the 38.2% at $60.80 and the 10/06/04 relative high close.

Now, I also experimented with a fitted 38.2% with the same anchor point, but attached to that other relative high peak just below the 200-day SMA, and I would note that its 100% result also comes very close to the currently HIGHER $70.35 level, but that fitted wasn't getting the trade correlation that we see with the currently displayed fitted 38.2%.

I also LIKE the 100% (as a rosy eyed bull right now) at the currently derived 100% of $74.62, which would be a 10.1% further POTENTIAL gain from tonight close. If the IWO is going to exceed its bullish vertical count, then $74.62 gives a further level of resistance to target into May, even January. One never knows for certain.

Outside of what you, or I believe the economic conditions are, we might also want to go back to just "why" some seasonal patterns into May can still provide further bullishness.

With some of the major indices at all-time highs, some at 52-week highs, supply of stock may be very limited.

As the economy looks to be in a second-year of (using October 2002 market lows as end of contraction) we could see improved job growth have some favorable impact into the April 15 tax deadline, as investors make decisions on their yearly funding for retirement accounts. Recently released consumer confidence indications may provide some bullish undertones to such thought.

Anyway, I spend a little more time in tonight's wrap on trade management, for an index trade that I profiled, where hopefully more than one trader grasped the concept for bullishness, traded a previously defined trading plan, and with target achieved, now wonders just what to do.

I (Jeff Bailey) do NOT know for certain that similar gains will be found this year, as to that observed, and now mentioned from last year. But depending on YOUR comfort levels for RISK of PROFIT at this point, you've got some tools, and new information on where YOU might want to place a profit stop.

Traders and investors might also find it helpful to continue to follow this trade, even in the Market Monitor nightly archives. Even if you DID NOT trade this trade, it can perhaps give some insight as to what the small cap market is saying.

Traders/investors will ask me "why are you so bullish?" One reason is that I keep challenging trades like the IWO to prove further strength, or show weakness. So far, all I see is strength, even when monitoring for weakness.

There are several indicators that have been suggesting "bearish divergence" since early November. Be alert to those indications, but don't let it keep you from trading bullish, with a protective stop.

Market Snapshot / Internals - 12/29/04 Close

Volumes increased toward the close, and that was enough to have today's volumes at both the NYSE and NASDAQ almost identical to yesterday's. Earlier in the session, volumes looked very light. Holiday-like volumes, not everyone is trading, and tough to read too much into things.

I don't know. Oil's sharp rise in the couple of hours sure doesn't look to have spooked equities, almost as if destiny calls for a bullish tone into Friday and the end of the year. Usually a bullish tone, so not overly surprising.

The Stock Trader's Almanac does note that Friday, the last day of the year has seen the NASDAQ up 29 of 32, but has been down 3 in a row. Dow has traded down 7 of last 11.

Pivot Matrix -

The NDX/QQQQ and SOX.X are the first equity-based indices to achieve a higher trade at their WEEKLY R1s. No small feat considering negative breadth at the NASDAQ all day.

I did check in on the Computer Technology Index (XCI.X) 723.95 +0.01% today, and this large-cap tech index has been trading sideways the past 5 days and hugging 720 as support and 726 as resistance.

If the OEX is going to show further 584 correlations within the DAILY pivot matrix, to combine with WEEKLY R2 and MONTHLY R2, and have me on the floor by Friday, then tomorrow has to be an upside trade in order to have Friday's DAILY R2 moving up and revealing 584 again.

There's another test for strength I'll throw out there.

Jeff Bailey

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