Market Rally Fades At The Close...What's Next?
The markets opened higher this morning and continued to climb throughout most the day with new cash continuing to pour in despite the threat of future interest rates hikes. For a while, Greenspan's testimony to the House Banking Committee threatened to reverse the bullish trend but most traders were influenced by a Philadelphia Federal Reserve survey that indicated inflation remains in check. Since Tuesday's FOMC meeting, the market has struggled to break out of a narrow range as analysts and investors continue to weigh the possibility of higher rates and the negative impact they will have on corporate earnings. In today's speech, Greenspan skirted the subject of inflation, keeping his remarks focused on the global economy, but the deputy head of the International Monetary Fund voiced his approval of the activity, saying that the Fed should avoid raising interest rates until there are signs that inflation is actually rising.
None of that early morning optimism was present later in the day as stocks fell sharply in the last hour of trading. A wave of institutional program trading dragged the market lower and also accounted for much of the the late-day volatility. Worried investors rotated funds from semiconductors and other high tech stocks into utilities and smaller companies. IBM accounted for most of the Dow's drop and some of that money probably fueled the rally in small and mid-cap issues. It's obvious that smart investors are broadening their portfolio base and the lower priced stocks are expected to benefit from that rotation out of the market leaders.
There were some big issues in the health and drug sectors that rallied today. Merck moved higher on expectations it will win FDA approval this week for the pain-killer Vioxx; and Warner-Lambert and Schering-Plough both gained after rumors surfaced that the drugmakers are in merger talks. In other merger news, Healtheon soared $29 as it announced it will join with WebMD to create an Internet-based health care services company. In the technology complex, semiconductor equipment stocks suffered big losses after an industry report showed that a key financial ratio; orders booked to orders shipped, slipped significantly lower. Internet stocks also dimmed, with most marquee names losing ground; AOL, AMZN, EBAY and YHOO all moved downward as traders exited the high risk positions. The only Internet highlight was the Nasdaq debut of EToys. IPO shares of the online toy store soared from $20 to $76 on its first day of trading.
Optimistic traders received today's governments reports as some evidence that the U.S. economy is growing at a steady but not 'inflationary' pace. The Labor Department said the number of Americans filing new claims for unemployment benefits fell by 12,000 last week to 299,000 and the Commerce Department said the nation's deficit rose to a record high in March, led by a widening gap with Japan. The U.S. trade deficit is now one-third higher than the all-time record of $169.3 billion set last year as the global financial crisis continues to disrupt America's trade performance. Clinton has argued that the deficit represents a sign of our economic strength and the U.S. must continue to provide a market for crisis countries who are struggling to emerge from deep recessions. Try to explain that concept to the American steel worker!
Oil prices rebounded slightly from recent lows on Thursday even as booming oil exports from territories of the former Soviet Union undermined OPEC's supply restraints. Increasing Russian exports have reversed the recent rally that vaulted prices up from historic lows below $10 after world oil producers implemented March's supply cut agreement. Industry analysts expected the disruptions in Iraq's "oil-for-food" program to help efforts to reduce the supply quotas but the U.N. Security Council agreed late on Wednesday to extend sales for another six months without any changes to the current deal. The rise in crude values early in the year left refined product prices trailing, forcing refiners to cut back their operations and recent data from industry experts shows producers still have plenty of work to do to reduce the glut of spare oil present in world supplies.
One strange bit of news emerged from the oil sector. Energy company Enron is going to trade bandwidth, or communications capacity, as a commodity. Most companies now sign multiyear contracts with major telecommunications companies for access to a certain amount of bandwidth but Enron's plan is to let customers reserve Internet capacity, giving companies and other speculators the chance to trade bandwidth through a standard contract. The trading of bandwidth will change the industry by improving the provisioning and deployment of communications infrastructure. The first contract would provide for use of an Enron T-1 line, or digital transmission link, between New York and Los Angeles. The second is for capacity on a faster DS2 line, between Washington and California. It seems technology has no limits when traders are involved.
Fearless Friday forecast.
There are no major economic reports on Friday's agenda but stocks may be influenced by the expiration of stock and index options, the so-called double witching hour. The third Friday of the month is the last opportunity for institutional traders to close out May positions before the options expire worthless and that can lead to large buy and sell orders, making prices move erratically. On the positive side, the market seems to be established in a narrow trading channel and sometimes these can last for weeks at a time. Most investors are just waiting on the sidelines to see if there's any more bullish economic news out there that would scare the Fed into actually raising rates. As long as the fear of higher interest rates remains in check, market leaders will continue to rebound and move higher. On the negative side, when there is no good news, most people tend to worry more about bad news. In addition, two popular averages are forming some significant restistance at the top of the recent trading range and today's last hour sell-off is unlike the pattern of the last few days. Some analysts would say it confirms the bearish technical outlook. Take a look at these two charts and make your own decision...
My personal outlook; With futures currently flat (6:45pm EST), we would expect a slightly negative opening; a continuation of the downdraft from today's close. Tomorrow morning will set the stage for the day as this new slump will have to be met by vigorous buying from the market bulls. If this institutional interest fails to materialize, look out below! Without any leadership (or news), the usual upward bias of options expiration may not be enough to lure investors out of their inflationary doldrums. Even with a morning rally, I wouldn't expect a very strong session as traders do not want to hold many positions going into the weekend. If you must trade, avoid the impulse to buy the dip and wait for a solid, confirmed trend before playing.
BUYING THE RIGHT OPTION...
The #1 goal for most option traders is correctly predicting the future movement of the underlying stock or index. However, once the decision to buy something has been made, the average investor will have some difficulty determining which option to buy or sell. To be a successful trader, you must be able to select favorable option positions based on pricing and the time horizon of your play. Using call options as an example, an experienced speculator might purchase positions with only days or hours remaining until expiration. In contrast, an investor that uses fundamental analysis to make decisions would generally buy long-term options or LEAPS. The majority of traders fall somewhere in between, using technical analyis and market trends to generate short-term signals for the purchase of 15 to 75 day option positions.
After determining the correct time frame, you must still decide which option to purchase. In most cases, your results will be much better overall if you buy in or at-the-money options. If the stock moves up at all, you will most likely profit whereas an out-of-the money option might fall in value if that movement is only moderate or takes some time to occur. Another concern is the cost of time. As most of you know, the highest theoretical time value occurs in the at-the-money option and it decreases substantially the farther in the money we go. With in-the-money options, you spend less for time. Another advantage of using an in-the-money option is that it has a high delta. Delta measures the rate of change in an option's price compared to a one point movement in the underlying stock. That means an in-the-money option will follow the movement of the underlying issue closely, so even a small favorable change in the stock price will produce a profit. Some traders avoid in-the-money options because they are expensive but the truth is, the risk/reward ratio is better than most other positions.
The last and most difficult concept in option pricing is implied volatility. Many traders are completely unaware of the effects of this pricing component on their position. They continually overpay for options that are 'in demand' only to watch and wonder as the premiums quickly fade. The inflated prices are usually based on short-term potential such as mergers and aquisitions, earnings reports or split announcements. Position traders thrive on the disparities created by this effect, selling-off volatility for low risk, short-term gains. Market-makers profit differently but the concept is still the same; selling something for more than it is worth and buying it back for less than it should cost.
The nice thing about trading in the 90's is that we have plenty of low cost software and pricing models to help us choose the right positions. The problem is, there is an overwhelming number of products and services available to help today's investor. How do you choose the right one? I can't list my favorites in this article as we have affiliations with many of those companies, but drop me a line sometime, and I will tell you with which of those products I have had the most success.