Option Investor
Market Wrap

Opex Pinning

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You will often find SPX get pinned near one of its multiples of 25 points--these are where you will typically find the highest volume and open interest in the options positions. Today we saw SPX get pinned to 1400, closing marginally above. While the important price for SPX options is the settle price tomorrow, many traders are squaring positions, including SPX, which tends to pin an index/stock around a level that has a large number of open positions.

Some times that level can be found at sites like http://www.iqauto.com/cgi-bin/pain.pl which gives you max pain levels. But I've found those max pain levels are not very good at identifying likely closing prices as we head into opex. Instead look for levels that have a lot of open interest as we get closer to expiration. And for SPX in particular look for levels around these multiples of 25.

The market struggled today. While the DOW was up much stronger, relatively speaking, the other markets struggled a bit more. The numbers in the chart above show the mixed performance. Volume was brisk at over 5B shares but up volume and advancing issues only marginally beat out down volume and declining issues. But 52-week highs continue to blow away new lows.

Bullishly the market remains firmly in the tight up-channels with no threat of breaking down yet. Bearishly I'm seeing some short term patterns that suggest this market is getting tired and is hitting some important levels that could be considered as upside targets achieved. I've shown my weekly SPX chart regularly at the end of this report, but I want to show the COMP here because I think it helps make a point about where we are and what may happen next.

Here's a weekly chart of the COMP:

Nasdaq chart, Weekly

Similar to the SPX weekly chart that I've been showing, the COMP has now rallied to the top of a parallel up-channel for price action since 2004. From a wide perspective like this I was thinking that the COMP might top out closer to 2400. The entire move up from the October 2002 low looks like a correction to the 2000-2002 decline. As such it should be something like an A-B-C 3-wave correction, which is how I've got this chart labeled.

If a correction is weak the C-wave will often stall at a level where it is 62% of the A-wave. That's the projection at 2395.78. But as the C-wave developed, particularly the last leg (5th wave) of it, it looked like we could form a parallel channel for it. A measured move is complete at 2452.43 which is where the leg up from July is equal to the move up from August 2004 to the January 3, 2005 high. And it's happening as the COMP is hitting the top of that parallel channel.

Now driving in a little closer to look at the daily chart we see that price has at the same time hit the top of its parallel up-channel for price action since July.

Nasdaq chart, Daily

This is the same chart as the one above but a daily. It shows price at the top of its two channels and tagging its Fib projection at 2452.43 (today's high was 2453.35). You can't see the daily candlestick because it's hidden in the trend lines but it formed a spinning top doji after gapping up today. Because of its gap up it could be considered a star doji. Either one signifies indecision and is often a sign of a top, especially if it occurs at resistance after a long run up. A red candle tomorrow would be confirmation that we are probably seeing a top being put in.

From a short term perspective I can see the need for a pullback and then a new high, or test of the high, in order to give us a 5-wave move up from November 3rd. That suggests a pullback into early next week followed by one more rally leg. But this final 5th wave is often a no-show as it's a highly unreliable wave (it can truncate which makes it difficult to tell if it's a 5th wave or just a correction to the start of a decline.

Therefore, based on this pattern I believe it's a good time to be legging into longer term short positions. Legging in means slowly building a short position; it does not mean spending everything you have on December puts. Long term means out at least to March/April if not LEAP puts, and it means buying a few puts at a time and then adding to your position when it starts working for you. If we start down soon I suspect you'll be taking profits in December/January and wait for the big correction back up before hitting it short again. At least that's what I would recommend.


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I may be jumping the gun again on thinking short in a market that is clearly bullish. Understand I like to call tops and have been a miserable failure at it the past two months (wink). Therefore, understand the risks and use proper risk management for your account. I want much more time in my options so that they don't bleed away from me if the market takes forever to roll back over.

Now let's move on to today's economic reports before getting back to the other charts.

Unemployment Claims
There was little change in the data from the latest week. Initial claims were down 2K to 308K which was from an upwardly revised (I'm shocked) 310K. The 4-week average was up 2K to 313,750. Continuing claims were unchanged at 2.44M while the 4-week average fell 750 to 2.43M.

Inflation Data
CPI and core CPI data was out before the bell and it got the equity market all excited again as evidenced by the gap up in futures. CPI fell -0.5% for the 2nd month in a row while core CPI rose only +0.1%, the slowest gain in 8 months. A taming of inflation is what gives equity bulls hope that the Fed will start to lower interest rates.

As for Fed policy, the economic data since the last Fed meeting apparently does not entice the Fed to change their monetary policy. William Poole, president of the St. Louis Federal Reserve Bank, said to reporters following a speech in Washington, "There is no compelling need in the data that we see right now" to either raise or lower rates, Poole told. Poole said that the October consumer price data was "good news," but cautioned that it was only one number. He added, "I would not say that this number means we are out of the woods on inflation."

The bond market initially rallied on the CPI news but then did an about face and sank to new lows, driving yields higher. The Fed has made it clear that they will continue to fight inflation that is over 2% annualized and that's what we still have. So while bonds did an about face the equity market continues to live in lala land where everything is priced to perfection. The goldilocks economy that will make a cushiony soft-landing is what they want us to believe so that we'll keep buying stocks.

Right after the cash open there was a quick sell off in equities but then we got a gradual choppy lift into the afternoon. That choppy rise was actually bearish and it was the reason I had recommended a short play in futures this afternoon. We'll see if there's any follow through to the downside on Friday.

Industrial Production and Capacity Utilization
Industrial production rose in October, up 0.2% vs. the -0.6% decline in September. Credit was given to the rebound in utilities and the gains at computer and electronics manufacturers. The cooler weather increased demand for heat which is what boosted the utilities. The hope is that the uptick in computer manufacturing is not just a 1-month blip since the last quarter saw the weakest expansion in 3 years.

Output of consumer durable goods, including automobiles, furniture and electronics, fell 2.6 percent in October, after decreasing 1.8 percent a month earlier. Gains in production of home electronics partially offset the drop in auto output.
The slowdown in housing is hurting some manufacturers. Whirlpool Corp., the world's largest appliance maker, last month cut its 2006 forecast for shipments in North America. La-Z-Boy Inc., a home-furniture maker, cut its fiscal second-quarter profit forecast and predicted sales will be little changed from a year earlier.

Capacity utilization was up marginally to 82.2% vs. 81.9% in September. This is a number that is watched closely by the Fed. When capacity utilization becomes tight, and above 80% is that area, then pricing increases become more worrisome. When this is combined with wage increases then the Fed has to worry more about inflation. Right now we appear to be getting both of those and that would keep the Fed on a hawkish stance as far as the inflation picture.

The stock market focused on the reduction in PPI yesterday and CPI today and wants to believe that those indicate the Fed could be close to reducing rates. That's because the stock market is in a bullish frame of mind and will focus on only what it wants to hear right now. If people were in a more bearish frame of mind the market would be focusing on this data which points to inflationary pressures. It's all a matter of mood and right now the stock market continues to be in a bullish mood and will spin the news to fit its expectations.

Philly Fed Survey
Factory activity in the Philadelphia region improved for the first time in 3 months in November. The Philly Fed index rose to +5.1 from -0.7 in October and -0.4 in September. The new orders index fell to -3.7 from 13.4 in October while prices paid index fell to 26.7 from 32.0. The report showed that we have weakening demand in the area and only slight gains in production. The employee index dropped to 0.2 from 9.4, indicating slow job growth, which is the lowest it's been in three years. Manufacturers lowered their expectations slightly--the future index dropped to 12.4 from 16.7.

Most economists felt the data to be somewhat disappointing and feel the housing industry has become a real drag. The new orders index is particularly worrisome. But that didn't stop the buying in equities. A slowdown in the economy? That's a good thing since it means the Fed can ease interest rates. When the mood turn sour on Wall Street many will look back, especially if they have losses on longs that they didn't exit, and wonder what the heck they were thinking about this data. How could it possibly have been bullish? And of course it's not.

Market Liquidity
I've talked often about the amount of money coming into the market from the Fed. They can create as much as they like since it comes from electrons and we all know we have an abundance of them. The US Treasury can also be quite active in this department through their repurchase agreements, repos for short. If they want more money in the system they simply offer more Treasury bonds for sale. A very likely reason to inject so much money into the system, which I've shown recently in charts of calculated M3 money supply (showing the recent spike up since August), is to help a slowing economy. The Fed will jawbone the market about how it frets about inflation, an overheated or underperforming economy and things like wage pressures as a way to influence the bond market to change their yields in order to get them, in effect, to do the Fed's job.

But it's what the Fed, and Treasury, does with money supply that has a real influence on the economy. Flood it with liquidity and the economy heats up (or fights the slow down) with all that available capital. Drain money out of the system and the economy starts slowing due to credit restrictions and lack of capital. For a couple of years now a favored way of getting money in and out of the monetary system is through its primary dealers--the mega banks such as Lehman, JP Morgan and Goldman Sachs. This has enabled these banks to "trade" the Fed's money and pile on with it (or get short if the Fed pulls money out).

This chart, which is a little hard to read since I had to shrink it for this report, is courtesy stocktiming.com and it shows the liquidity expansion and contraction since 2004 and compares that with how the stock market has performed.

Liquidity Expansion/Contraction, courtesy stocktiming.com

The top portion of the chart shows when money is expanding or contracting. This alone is good information if you use it to judge what the Fed is trying to do, and what they may be worried about. Based on the huge jump in liquidity expansion since June of this year I'd say the Fed is clearly worried about a slowing economy and a slowing housing market.

Not surprisingly anymore you can see by the lower chart, which is the NYSE, how stocks have benefited, or not, from the money flow from the Fed. After contracting sharply in May and June, followed by a steep market pullback, money has been flowing into the monetary system like there's no tomorrow and the stock market has clearly benefited. Don't fight the Fed has a whole new meaning when looking at this chart and it has nothing to do with interest rate policy. The big question now of course is what happens when the Fed feels the need to start draining off some of this excess liquidity. There goes the prop for the stock market when it happens.

I showed a daily chart of the VIX on Tuesday to show how price had broken out the top of its bullish descending wedge on November 1st and has since been sliding down the top of the broken downtrend line since then. Here's a little closer view of "price" action on the VIX.

VIX chart, 120-min

After breaking its downtrend line VIX came back for a test on November 9th and repeated tests this week. In its move down from November 2nd it has achieved a "measured move" with two equal legs down at 10.12. Today's low was 10.03, awfully close to finally going sub-10. At this point it's close enough and I started legging into some long term put positions today. The pattern of the decline in VIX yesterday and today is forming a very small descending wedge and this looks bullish--I expect to see it come roaring out of here very soon.

Another point about the VIX should be considered here: not only is the actual number low but the volatility around this number is also low. The Bollinger Band is getting very narrow. After a period of unusually low volatility, as measured by the BB, it's typically followed by an expansion of the volatility and it often happens quickly.

When the BB tightens you can never be sure which way it's going to break but in this case can we reasonably assume that the VIX is going to break down? I think not and therefore it's another sign that we should be prepared for a sudden burst to the upside in VIX which would very likely mean a break down in the stock market. Just more food for thought as we wait to find a top.

During past occasions when the VIX bottomed, it often came back for a retest of the low. When I look at the equities I get the feeling we're going to get a pullback soon, if not tomorrow, but that we could then get another rally leg that either retests the highs or makes marginal new highs. Therefore if you're feeling bearish here and you want to start building a longer term short position, do it carefully and leg in slowly. After the first larger pullback in the market you can be pretty sure we'll drive back up to retest the highs (and low in VIX).

That up-down sequence for VIX would mirror the possibility that I see for stocks, as I had mentioned for the COMP above. I show that possibility on the DOW's chart:

DOW chart, Daily

The next level of the "stair-stepping" higher for the DOW is near 12400. In the move up from November 3rd the pattern would look ideal if we got a small pullback now followed by another push higher, and that's what I've depicted on the chart. The big thing holding this scenario back is the continued negative divergences I see as the market presses higher. RSI has not been able to recover above its broken uptrend line. Stochastics is clearly bearishly divergent.

But we can still get new highs with more bearish divergences--it will just get more bearish as time goes on if that's what we get. The trend is up and therefore buy pullbacks until the 20-dma and uptrend line break for good. Those are currently at 12120 and 12155, resp. It takes a break below 12075 and preferably below 11965 to confirm a break of the uptrend.

SPX chart, Daily

I added another parallel line to mark the top of the up-channel from 2004--the upper line is starting from the high in January 2004 and is the line I show on the weekly chart at the end of this report. SPX closed at the line today--right at 1400. Like the DOW I show a down-up sequence to finish the short term pattern but it doesn't have to happen nor does it have to make a new high. The bearish divergences will probably continue if we get a pullback and another new high. Start looking for the longer term short plays you'd like to do because we're now very close (really).

SOX semiconductor index, Daily chart

We had a very bearish shooting star candlestick at resistance yesterday but no follow through today so this actually looks somewhat bullish now. Price is breaking its downtrend line from January and getting back above its broken uptrend line from October 2002. If it can hold this gain then the 62% retracement of this year's decline at 492 could be the upside target.

BIX banking index, Daily chart

The banks are not confirming the rally to new highs for the DOW and yet they don't look particularly bearish here based on the corrective pullback. This looks like it will press higher and if it does then an upside target of 404-405 looks reasonable. If it instead starts to accelerate lower then what looks like a corrective pullback is actually a winding up of the EW pattern for a big leg down. In that case the 50-dma should get hit quickly.

There was a home builders' survey released today and it showed confidence in the U.S. market improved for a 2nd straight month. That was enough to continue some short covering in the home builders' stocks. It's had a sharp jump up off trend line support and so far looks like a classic bear market rally.

U.S. Home Construction Index chart, DJUSHB, Daily

The bounce up off support looks like it might be able to make it up to the top of its bear flag which is where its 200-dma is also located, near 724. Today price could not close above the high of its previous bounce in October. I also drew in a larger parallel down-channel for price action since its 2005 high and attached to the January 2006 high. The top of this down-channel intersects the top of its bear flag near 725. If that level is tagged I'd consider it an excellent short play setup.

Housing Market Index
This index improved to 33 in November from 31 in October. The index had dropped 8 months in a row so a small bounce in October has many claiming a bottom in housing has been found. Silly people. It's a dead cat bounce. The index shows that about one-third of builders are optimistic about the housing market--that certainly sounds like a reason to be bullish (wink). A year ago, the index was at 61 and it peaked at 72 in June 2005.

Builder confidence improved in the Northeast to a reading of 37 from 35 and it was up to 40 from 38 in the South. But confidence fell to a cyclical low of 34 in the West and matched a cycle low of 16 in the Midwest. It sounds like a draw to me. When I hear the home builders' executives say this is the worst they've seen and that the bottom isn't in sight yet I know who I'd rather believe. The housing market index sounds more like wishful thinking by the participants.

Oil chart, December contract, Daily

The drop in oil to a new low is a little surprising but not unreasonable if it immediately bounces from here. The pullback can still be considered part of a larger upward correction that started at the previous low on October 31st. It is only a 3-wave pullback and needs to stay that way if there are more bullish things ahead. It should find support at today's low which is at its broken downtrend line and the trend line along its recent lows.

Oil Index chart, Daily

The drop in oil spooked some longs in oil stocks but it was ready for a drop anyway. I'm looking for this to drop back to its 50-dma and then hopefully have some for clues in the price pattern as to what will be next.

Transportation Index chart, TRAN, Daily

The Trannies finally got their, um, act in gear and charged to a new high for the move up from September. It closed marginally above resistance by its downtrend line from May so if it can hold above (vs. this just being a head fake break above) then it's possible for this to rally up to the top of its up-channel near 5000. But first it will have to get through so upside Fib targets at 4900-4925.

U.S. Dollar chart, Daily

The US dollar found resistance at its 20-dma today and then just above that is its 50-dma at 85.90. If the dollar can not get through 86 and then drops back to a new low (breaking its uptrend line in the process) then that will be confirmation that the dollar finished its upward correction in October. In the meantime I'm looking for it to bounce back up to the top of consolidation pattern near 87.

Gold chart, December contract, Daily

Gold is just the opposite to the US dollar. It has pulled back from its broken uptrend line from August 2005 and should proceed down to the bottom of its consolidation pattern near 560. But like the dollar, but mirrored, if gold finds support at its 50-dma and then hits a new high for this bounce then the low for the pullback correction will have been it October low, in which case gold should start heading for new highs in 2007. I expect new highs in 2007 anyway but not until after it finishes its downward correction.

Results of today's economic reports and tomorrow's reports include the following:

After a bullish week for the home builders it will be interesting to see what the reaction is to Friday's Housing Starts number. If the home builders' index pops up to the 724-725 area, pick on your favorite (weakest) home builder and short it. If we get a pullback on Friday it might just be part of the upward correction so it wouldn't necessarily be immediately bearish.

SPX chart, Weekly, More Immediately Bearish

Daily, weekly and monthly charts are overbought and SPX is hitting the top of its long term channel. VIX is at record lows. Can it go higher? Absolutely. Would you be willing to buy it here? Me neither. I've started carefully legging into some long term short positions and will add to them when they start working. Be careful since we have no idea how high this could go if we get an honest to goodness blow-off top.

While we had a bullish opex week, which had been anticipated based on the recent pattern of watching the Thursday prior to opex week--it has been a pretty good barometer for the following week. If you trade opposite to what the previous Thursday does you'll make money. Of course now that that pattern has been identified it'll stop working.

But opex week wasn't a particularly volatile week and that raises the question what to expect for Friday. If I'm correct that we're going to get a pullback and then a final rally leg into Thanksgiving then a flat choppy day on Friday would be appropriate. We might even pull back hard but again that could be just part of a correction so don't get married to positions if your doing short term trading. Takes your money and run, as often as you can.

I've mentioned potential turn windows and that November had several things pointing to a top in the market this month. Turn windows are just that--they don't tell you which way the turn will be and it's not until you're heading into the turn window do you have a good guess which way it will turn. Since we're rallying into November we can expect a turn back down. But caution here--sometimes turn windows turn into acceleration windows and in this case that means a blow off top in the making. Several Fibs pointed to November 3-17 for a turn window. The Bradley Model points to the end of November. So it's a wide enough window to not be helpful from a timing standpoint and that's why I'm watching the price pattern. If we do get a pullback and rally into Thanksgiving, maybe even after, then the Bradley Model may prove to be right on the money (November 30th if memory serves me).

As has been a typical recommendation lately, trade light and trade fast since choppy price action rules. If you're waiting for a swing or position trade I think we're close. If you position trade start looking at some short plays now. The risk is a blow off top so be aware of how it could go against you badly. The more conservative trader should wait until we have evidence of a break in the up trends and then get short on a bounce that retests support-turned-resistance. You'll have plenty of opportunity to catch a ride on the southbound train so you don't need to be a hero and catch the top.

Good luck over the next couple of days. I'll see some of you on the Market Monitor on Friday and I'll be back here for the Tuesday Wrap.

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