Option Investor
Market Wrap

My Opinion? Who Cares!

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11-20-2002                High    Low     Volume Advance/Decl
DJIA     8623.01 + 148.23 8643.03 8439.06  1874 mln   1382/481
NASDAQ   1419.35 +  44.84 1419.64 1375.41  1200 mln   1524/194
S&P 100   466.91 +   9.30  467.40  456.61   totals    2906/675
S&P 500   914.15 +  17.41  915.01  894.93
RUS 2000  388.59 +   9.02  388.59  379.37
DJ TRANS 2281.37 +  11.55 2288.12  2263.91
VIX        28.66 -   2.70   31.46   28.66
VIXN       44.82 -   0.70   47.67   42.78
Put/Call Ratio 0.63

My Opinion? Who Cares!
by Steven Price

Talk about rangebound! The broader markets cannot seem to break out in either direction right now, leading to one headache after another for momentum traders. About the only market participants happy right now are those that started selling option premium when the Market Volatility Index (VIX) was still around 50 in the middle of October. Since then, we have seen a 44% drop in the VIX, and an awful lot of premium decay along with it. The current sideways movement is taking a toll on premiums and as we head into the holiday season and market action slows, market makers will be quicker to lower premium levels, rather than continue to purchase as the VIX falls.

The current market movement is a study in how option premiums are affected in upward trending markets, even if that upward trend is only an intermediate one. Many investors believe the VIX represents movement in the OEX and the overall market. While this is partly true, there is a little more to it than that. With a Dow that has not seen a trading range of less than 100 points since September 20, and only two since June 18, common sense says that volatility should still be near all-time highs. I'm sure there are many long option holders right now wondering why a $3.00 call went to $2.50, even thought the stock went up a dollar. In reality, implied volatility almost always comes down as the market goes up. The one big exception to that rule was during the internet boom of the late 1990s, when stocks were liable to gap up as quickly as they went down. However, that was the exception to the rule. There are a couple of reasons for this phenomenon. Under normal market conditions, stocks go up much more slowly than they fall. Additionally, the most common option trade is the covered write. This is when purchasers of stock sell out of the money calls against their purchase to reduce the price. While they risk having the stock called away if the stock rallies through the strike before expiration, therefore limiting upside potential, it still provides a winner on the rally up to the strike. This activity also provides a tremendous amount of selling pressure on options during market rallies, therefore leading to a drop in implied volatility, or the price of the option, relative to stock price. So if you are wondering what happened to the price of your options, this is the most likely culprit.

I mentioned in a couple of articles last week and this that the VIX does not drop from 36 to 30 in three days without some institutional selling. And institutions don't sell lots of options if they think the market is about to drop. It's a good bet that the same players that were selling premium, were also planning on buying some stock, or were writing calls on purchases at the very least. The fact that the VIX has now dropped under 30 looks bullish to me, since the big boys don't see immediate downside risk.

Chart of the Dow and VIX

Today's rally put at least a temporary halt to the head and shoulders pattern that had been developing in the Dow/SPX/OEX took a turn to the upside, rather than completing the right shoulder, as it appeared it would after yesterday's action. While we are not yet out of the woods on the downside, the Dow did take out the relative high, at 8636 on Monday, in intraday action, before falling back to close at 8623.01. The SPX hit the relative high of 915 and was turned back right at that level, finishing at 914. While these failures show that resistance is still in place, particularly in the SPX, bears need to be aware that we are still testing highs, as opposed to lows, which "feels" bullish for the moment. That doesn't mean I'm going full position long, as the bearish head and shoulders is still alive and well - as long as the Dow doesn't break 8800, or the SPX breaks 925. However, our new pivot point in the SPX for short term trades looks like 915.

Chart of the SPX

The Nasdaq also has yet to break the August high of 1426, which has served as resistance on several occasions now. However, the pattern beginning to emerge in the Nasdaq is a series of higher lows with the flat top. This is a bullish formation, and bears may want to switch teams if we get a breakout. While it is hard to imagine techs continuing this rally without a change in the IT spending environment, we are trying to capture moves for a profit, rather than funding our 401 (k) for the long haul.

Chart of the Nasdaq

One of the big reasons for the rise in the Nasdaq is chip stocks. The Semiconductor Sector Index (SOX) once again tested new relative highs today. This morning saw an upgrade from Soundview, which said evidence is growing that the first quarter could be a turnaround in the order picture for the semiconductor equipment industry. It raised price targets on several stocks in the sector, including KLAC, TER, NVLS and LRCX. This followed last night's earnings release from Analog Devices (ADI), which met expectations, but warned that it could miss consensus estimates for next quarter. The company did say, however, that a slow August order rate improved in September and grew significantly in October. The SOX not only ended the day on a new relative closing and intraday high, but closed near its high of the day, as well. The strength in the sector, in spite of more warnings than I can count on the entire OI staff's fingers and toes over the last couple of months, cannot be ignored. It has now set a series of higher highs and higher lows and bounced from a previous resistance level at 310, which could now be viewed as possible support. We still haven't seen a shift in capital spending, and even Alan Greenspan said yesterday that there are "very high hurdles" to capital spending that must be removed before investments in new technologies resume. However, investors are betting that it will come back and are scooping the sector to prove it.

Chart of the SOX

After the bell, Hewlett-Packard released earnings that beat estimates by $0.02, tripling its year ago number from 0.8 to 0.24 per share, prior to the Compaq merger. If we combined Compaq and HP results from last year, the company would have been over $500 million in the red in the year ago period, which makes the number even more impressive. The stock was trading $18.50, up $1.65 (9.7%) after hours. This may help boost the Nasdaq through that August resistance, but we won't count our chickens just yet. We have seen sentiment change overnight many times, so we'll wait for the actual breakthrough before declaring a rally.

There was conflicting data today from the housing sector. The number that got the most attention was the 11.4% drop in housing starts in October. It was the largest drop since January 1994. In fact, the annualized pace dropped to 1.603 million, which matches the number of units started in 2001. This was a drop from last month's annualized rate of 1.81, which was a 16-year high. The decline was also worse than expected; economists were expecting a rate of 1.72 million. The number that got less attention, but helped lead to a rally in the Dow Jones Home Construction Index (DJUSHB), was the The Market Composite Index of mortgage loan applications, which measures mortgage loan applications for purchases and refinancings. The index showed an increase of 21% in the week ended November 15, and a 22% increase over the same week a year ago. There were also increases in the Purchase Index and Refinance Index. This also marked the seventeenth straight week the Refinance Index was above 4000. The data was accompanied by news from Hovanian Enterprises (HOV), currently on our call list, which raised its guidance for full year 2002 earnings and said new home orders in November remain strong.

The bond market seems to be confirming the switch from bonds into stocks. In fact, for all the talk of a bearish head and shoulders formation in the Dow and S&P, a look at the ten-year bond shows a similar formation during the recent equity rally. Today's bond sell-off seemed to just about complete the right shoulder. If this H&S breaks through as the Dow rallies, then the bulls may be in business.

Chart of the Ten-Year Note

It seems that I switch sides on a daily basis, but in a rangebound, bouncing market, that is what tends to happen. If you were to pick one direction and simply stick with it, you'd see an awful lot of whipsaws. While that may not make much difference to long-term traders, short-termers better be willing to change sides as quickly as needed. Today the trend is up, but we are right at resistance in the broader markets, so we could be due for another rollover to the bottom of the range. If we see a fall in the morning, then I'm jumping on for what could be only a short drop. However, if we break through 915 in the SPX, then I'm jumping on long for the next 10 points. Then it will be time to reassess again at 925. If the Nasdaq breaks 1426, then I'm in until I see a rollover. Get the point? We need to be willing to get in and out quickly in this choppiness and leave our opinions out of the equation.

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