Option Investor
Market Wrap

Short Covering of a Different Kind

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Jim got called away at the last minute so I (Keene Little) will be covering for him tonight. I promise not to be too bearish (wink).

Opex weeks can be treacherous times to trade because the influence of traders' actions can have more to do with short term concerns rather than a longer term view of the market. We often hear of "short covering" and usually conjure up and image of traders who are short the market scrambling to cover (buy back) their short positions as the market rallies against them. It's what causes sharp, but usually short-lived, rallies during bear market declines.

During opex week if the market starts to drop and break support levels we can then get the opposite kind of short covering. Many professional traders are sellers of premium rather than directional traders who buy options for speculative plays. Selling calls above the market and selling puts below the market, hopefully outside the trading range, can net some nice steady income every month as those options expire worthless. But what happens when the market moves against many traders who are short these options?

If the market rallies above resistance and starts going against those who are short calls then those traders can either buy the calls back or they can buy the underlying stock/index to hedge their short call position. Both add buying pressure to the market. If selling breaks support levels then traders will either buy their puts back or sell stock to hedge their short puts. Both add selling pressure to the market.

Today was nasty. Look at the numbers in the table above. Volume was heavy and it heavily tilted towards selling. The number of new 52-week lows far exceeded the new highs. But also look at the put/call ratio. With a 1.05 ratio there were more puts than calls purchased today and that's so bearish it's bullish. When that many people are running scared and buying more puts than calls then you know we're probably at a short term bottom. At least the market is vulnerable to a real squeeze to the upside if somebody starts some serious buying (hmm, I wonder who that could be). The only thing I don't like when looking at the put/call ratio is that this is opex week and I have found that options activity this week tends to skew that ratio towards meaningless. But it's a warning for the bears.

Today's selling started breaking support levels with the DOW once again breaking the August low at 12518, this time a little more solidly than last week's quick break lower. SPX broke last Friday's low before the DOW did the same thing today and that may have had traders looking to cover their short puts now that we're into opex week.

And then with only 30 minutes to go in the trading session the "normal" short covering began. The bears who were pressuring the market lower all day were suddenly faced with some program buying that kicked in across the board and they started covering their short positions. The DOW jumped +100 points in about 15 minutes. This might have been aided by those who were covering their short put positions suddenly unwinding their hedge position (by buying back their short stock/index position).

But it didn't hold. You can see why opex week can get a wee bit volatile and trying to trade around the big guns doing all this can be hazardous to your trading account. We are the small plankton in an ocean filled with whale sharks. Personally, during times like this, I like to scurry under a rock and let my brothers get eaten. I know, where's my sense of loyalty to my brothers? Well, I guess I believe in survival of the fittest (wink). Besides, that's why I write these Market Wraps--my small contribution in trying to protect my trading brothers and sisters.

Citigroup got the blame for today's selling. As if it was a surprise. OMG, they really lost that much money? I had no idea! Sell Mortimer, sell! C declared a loss of $9.8B from further write downs and said they would cut their dividend 40%. They're raising $12.5B in new capital, $6.9B of which is coming from foreign investors including the Government of Singapore Investment Corp. (from whom we could learn a thing or two). They will also be selling $2B in preferreds to the public, all in effort to boost their capital base in order to meet regulatory requirements. It's scary to think how much more money they'll have to raise if (when) the next shoe drops--more loan defaults from construction loans and other shaky business loans. The collateralized debt obligations (CDOs) derivative mess hasn't even begun to rear its ugly head yet.

Merrill Lynch (MER) also announced that it was raising $6.6B, primarily through foreign investors--Korean Investment Corp., Kuwait Investment Authority and Japan's Mizuho Corporate Bank. These investors will receive mandatory convertible stock for their investment. It strikes me as sad that our powerful banks have had to resort to selling out to foreign ownership. I might be just feeling too parochial about this but it speaks volumes about the trouble we got ourselves into with all the Greenspan-approved "financial engineering".

After hours, after Intel (INTC) announced earnings and laid SB II (Stink Bomb number 2), futures sold off hard. While it looks like an ugly start to trading on Wednesday I'll issue the same warning I do every quarter after INTC announces their earnings. I don't know why it seems particularly true for INTC vs. the others but it seems the market acts opposite to whatever the futures did the night before after reacting to INTC's earnings. So be careful after the market opens on Wednesday.

INTC announced Q4 earnings of $2.27B, or 38 cents per share, on revenue of $9.69B, which was better than the $1.5B and 26 cents for the year-ago period. Revenue grew more than +10%. Sounds pretty good right? Unfortunately not good enough. Analysts were expecting 40 cents on revenue of $10.84B. I wasn't able to listen to their conference call but I suspect traders were not happy with their guidance either.

What's that I hear in the distance? I think it's Uncle Ben and his merry henchmen riding to the rescue. The market has dropped low enough (with the DOW now closing below the August low) and with bears now fully engaged it's time to fry the shorts. He might wait for a break of support for SPX (the August low is 1370) to pull the lever for the trap door and smoke the bears. Bears be forewarned here--Bernanke made it abundantly clear that he's ready to aggressively lower rates to help the economy. A declining housing market and a declining stock market could be his personal circuit breakers and a surprise rate cut is his modus operandi.

That's all speculation of course. We'll go with what the charts are telling us and interestingly they too tell me that we could be close to a very tradeable bottom. By the looks of the charts I'd be surprised by a Bernanke surprise tomorrow morning but that's why it's called a surprise.

First a quick review of this morning's economic numbers.

Economic reports
Retail sales, PPI, business inventories and the NY State Empire Index were the scheduled reports today.

Retail Sales
Retail sales were surprisingly weak in December but we had enough warning about this as we kept hearing how slow the holiday sales were. The housing slump and high gas prices is taking a psychological toll on consumers and this should not be a surprise. The only surprise to me is how long it's taking for the consumer to realize how much trouble they're in with their maxed out credit cards and empty housing ATM account.

Retails sales were down -0.4% after a downwardly revised +1.0% in November (originally reported as +1.2%). For all of 2007 retail sales rose +4.2% which is the slowest gain since +2.4% in 2002. As a comparison, sales were up +5.9% in 2006. Excluding sales of autos for December did not change the number but taking out gasoline had sales falling -0.2% instead (the price of gasoline dropped and further reduced retail sales).

Many people are now talking about the contraction in December likely meaning we're already in a recession. The official declaration is typically not made until six months out as two quarters of past data is needed to make the assessment. But obviously if market participants believe we're entering a recession and that we will see a resulting slowdown in corporate earnings then they've already begun the discounting process in stock prices. I'm reading more and more speculation now about how long the bear market will last, not whether we'll have one.

PPI and Core PPI
The headline PPI number dropped -0.1% thanks to a decline in energy prices. Food prices increased +4.3%. Thankfully none of us have to eat so the Core PPI came in at +0.2% (+2.4% annualized). This was considered a benign report and did not sway too many opinions as to what it means to the Fed.

PPI for the full year was up +6.3% which is the largest calendar increase since +7.1% in 1981. Core PPI was up +2.0% in the past year. So again, it's a good thing we don't need to eat or use energy products. Those on fixed incomes are certainly being penalized by the method used to calculate increases in their incomes.

Business Inventories for November
This is a rather old number so it's not exactly relevant to today's business conditions but U.S. businesses had a good November with higher selling prices and stronger sales at the retail level (which we now know is suffering). Sales were up +1.6% in November which was the strongest growth since a +1.8% jump in March. Sales as of November were up +8.7% in the past year (not adjusted for inflation).

NY State Empire Index
The index dropped to 9.0 in January from 9.8 in December (which was revised down from the originally reported 10.3). Expectations were for a slight increase so the report was further evidence of a contraction in manufacturing activity.

There's been a lot of selling in January and we all know the market is certainly short term oversold. That doesn't mean a whole lot since we saw an overbought market chug higher for months on end. But we need to stay aware that a short covering rally could catch fire at any time and really hit the buy stops. As I mentioned earlier, the charts show we could be nearing a good tradeable bottom, as long as that bottom doesn't suddenly drop away. That would be a crash and betting on one of those is never a good play (but consider yourself extremely lucky and shined upon by the trading gods if you happen to be short when it crashes).

DOW chart, Daily

The wave count for the move down from the December high calls for a minor new low to finish a 5-wave move down. That would set up at least a correction of that decline. As depicted, the bottom of a parallel down-channel for price action since the October high, currently near 12375, makes for a good downside target. The close today below the August low was a bit of a surprise--I thought surely "they" would prevent that from happening since a closing price below 12518 means more than a quick stab lower as it did last week.

Assuming we get the new low this week (it could chop its way lower and eat up another day or two in the process) then we'll have a setup for either a correction of the decline from December (dark red wave 2 at 13K in early February) or a slightly longer-lasting bounce into the end of February to perhaps the 13200 area. We won't know which bounce is playing out until after it progresses but regardless it would make for a nice trade to the long side. What happens after the bounce finishes is when the real excitement for bears will begin.

DOW chart, 60-min

The choppy price action since last Thursday's high had me thinking we'd see a sideways choppy consolidation, as I had mentioned during today's live trading session on the Market Monitor, but then we got a new low this afternoon. The choppy price action hasn't changed and now it's got me thinking we could be in a descending wedge pattern. This is a bit speculative but the multitude of 3-wave moves up and down is what has me thinking some kind of triangle pattern is playing out. Therefore another up-down sequence to a final low near 12375 towards the end of the week would be a good setup for the long play.

With futures down hard this evening, thanks to INTC, we could see the bottom of the parallel down-channel tested sooner rather than later and that would mean a drop to just below 12400. I would not be comfortable calling that the bottom (for a long play) since the pattern would not look complete yet. It could mean the final low (after another up-down sequence following tomorrow's low) will be closer to 12200. Use trend lines as I've done to help identify where the end of the pattern might be.


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As I mentioned earlier, if we get some follow through selling with tonight's depression in the futures, the fact that we're in opex week could aggravate the situation. Selling to hedge positions could add a lot of selling pressure to an already weak market. If you're in some short put positions (as part of a bull put spread for example), don't become a deer in the headlights tomorrow--have a plan for how you will exit/hedge or punt. Know how you will handle a big rally after you've hedged. Play it all out in your mind and then go on autopilot and leave your emotions out of your decision making.

Otherwise if we see a choppy price pattern that continues with the market working its way lower, watch for bullish divergences to appear near where you think support will come in and then carefully nibble on some long positions for what I think could be a strong rally next week.

SPX chart, Daily

The other indices look very similar to the DOW so I won't repeat myself. The August low at 1370 and then the bottom of the parallel down-channel closer to 1360 could act as support. The March 2007 low near 1364 is right in between. Tonight's futures, if the cash market drops the same amount, will have 1370 violated first thing in the morning. The upside potential for a bounce (too early to be thinking bounce though) is 1430-1440 by early February or slightly higher by the end of February, depending on which wave count we're in.

SPX chart, 60-min

As I mentioned for the DOW, if we see a selloff tomorrow, the pattern would still look best with another up-down sequence to finish the wave count. It could be a little tricky finding the bottom on this, especially if support appears to be breaking down. Use a short term downtrend line off the bounce highs to judge when the bottom has likely been found.

A look at the weekly NYSE, arguably a better market to watch for telltale signs for what's happening in the broader market, has turned bearish, especially if it closes below its long term uptrend line from 2003:

NYSE chart, Weekly

After topping out at the top of a parallel up-channel in July 2007, and almost retesting it at the October high, the NYSE has now broken below the up-channel. If it manages to recover back above 9315 by Friday's close then it will show a weekly close on support and leave us guessing, especially since a see a good rally ahead of us. So watch to see how the NYSE does on Friday and we'll see what kind of signals it sends us.

Nasdaq (COMP) chart, Daily

The COMP has been toying with the bottom of its down-channel and closed on it today. Slightly lower is the uptrend line from October 2002 through the July 2006 low. This is an untested trend line and therefore it's hard to judge how good a support level it might be. At about 2372 it's just below the August spike low near 2387. Certainly a break below both of those potential support levels would look bearish.

Nasdaq (COMP) chart, 60-min

I'm thinking the same thing for the techs as described for the DOW and SPX--a little descending wedge to finish the decline by the end of the week (maybe next Monday) would be a great setup for a long play into February. In the meantime, look for bounces to short if you'd like. Just be aware that the risk:reward ratio is shifting away from the bears' side.

Russell-2000 (RUT) chart, Daily

Like the techs, the RUT is bouncing around at the bottom of its down-channel and actually looks closer to potentially finishing its decline from December. I didn't mention it on the daily chart of the COMP, but I should note that I'm keeping a potential bullish wave count on the COMP and RUT chart to show that it's possible the 3-wave pullback from October is just a correction of the long term rally and once the pullback is complete we'll see a rally to new highs over the next few months. For the life of me I don't know what could propel the market to new highs from here but I'll let price rule that possibility out. First of all it needs to get back above 800 to even suggest that it's a possibility (with a heads up if the downtrend line from October is broken). Until that happens, if we get a bounce as depicted in dark red or pink and then new lows then the bullish (green) wave count can get thrown out the window (as I've already done for the DOW and SPX).

Russell-2000 (RUT) chart, 60-min

The RUT was holding up a little better than the others this afternoon has it refused to break to new lows while the others had no problem doing that. This one might be closer to finishing its decline and that's what I've depicted here--one more new low could set up the rally and it would be typical for the small caps to lead the way higher.

BIX banking index, Daily chart

I had mentioned last week that the wave pattern would look best with a little bounce and then another low in order to give us a 5-wave count down from the December high. The 5th wave (wave v on the chart) is the unreliable wave--it could truncate (not make a new low), test the low, or make a new low. So it doesn't have to make it down to the 212 area as I've depicted. It might only make it back down to the bottom of its down-channel, currently near 225. In any case, once the next leg down finishes (assuming we'll get the next leg down), it will set up a strong bounce in the banks so if you're short the banks, pull your stop down much closer now (I've got a key level identified at 267.26) and let the market prove it's ready to rally by taking you out.

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

As with the banks I've been looking for a little bounce and then a new low to finish the decline on the home builders. The next low, which I've got projected down to the 216 area, should do it for a while on this index. I expect a rally to follow that will break out of its down-channel. While I don't like the idea of recommending long plays in a bear market (a receding tide lowers all boats), I think nibbling long on one of the stronger home builders could work nicely (for a trade, not to hold long term, not yet anyway).

Oil chart, Oil Fund (USO), Daily

I like the bearish wave count as my preferred count on oil. The 3-wave move to the recent high suggests it's part of a larger correction. It calls for a drop down to around 64 (as wave c in dark red) before setting up another bounce (not to a new high) before another decline later this year.

Oil Index chart, Daily

With the drop in oil and a drop in the stock market it's no surprise to see the oil stocks getting spanked as well. This should continue lower and I'd look for potential support from its uptrend line from August, near its 100-dma at 817, and then its 200-dma near 774.

Transportation Index chart, TRAN, Daily

The Trannies got a little bounce from last week and now they too look ready for the next leg down to complete a 5-wave move down from December, perhaps down to the bottom of a parallel down-channel near 3900. From there it should consolidate sideways/up while (if) the broader market bounces.

U.S. Dollar chart, Daily

As long as the November low in the US dollar holds I'm maintaining the possibility for the dollar to turn around and rally higher (green). A rally back up to about 79 would be expected before potentially running into trouble. If the decline continues then I suspect the dollar will drop back down to the bottom of its down-channel by the end of the month/early February, below 74. If the dollar does manage to rally back up then that will likely depress the value of gold and other commodities. In fact the chart of oil supports the idea that the dollar will rally from here.

Gold may also have seen its high:

Gold chart, February contract (GC08G), Daily

The rally up to 909.50 has achieved the Fib projection for where the 5th wave equals the 1st wave in the rally from October 2006. It tried twice in the past two days to punch through this level but pulled back each day. Today's pullback held above its uptrend line from December so there's nothing bearish about this chart yet. But based on the Fib projection and potential completion of the wave count (although its short term pattern is far from clear here) I suggested a short today on the Market Monitor with a stop at today's high. I had mentioned that the Andrews Pitchfork (modified Schiff), as some like to use (wink), suggests higher but today's little selloff following the high might instead of have given the shiv to gold bulls. But if gold manages to push a little higher then watch for resistance at the top of its parallel up-channel near 925.

And speaking of parallel up-channels, the weekly chart of the gold ETF fund says bulls need to be careful here:

Gold chart, Gold Fund (GLD), Weekly

The Fib projection at 90.59, where the 5th wave equals the 1st wave, was missed by 24 cents today before selling off sharply. Not shown on this chart, a Fib projection where the 5th wave equals 62% of the 3rd wave at 90.27 was tagged today. Between these two Fibs it's a good setup for a short play if resistance holds. Plus you can see price is up against the top of the long term up-channel near 90. In my opinion this is as good a setup as you'll find to short something that looks like it only has blue sky and "lack of supply" above it. But if it can push higher again, the top of its short term up-channel is near 91.80 and I'd watch for weakness there.

Assuming we get some selling in gold next, the bigger question is whether we'll get just a pullback before heading higher again (green wave count) or if this is THE high that will last for quite a while. My preferred count is the dark red which calls a major high for gold here.

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

It's another busy morning tomorrow for economic reports and the CPI numbers could be troubling if they concur with the PPI numbers. The core CPI number is of course the one the Fed cares most about (whereas we care most about CPI which includes food and energy prices). Industrial production and capacity utilization are also important numbers that could affect the Fed's analysis about the economy and the need for further rate cuts (can you imagine if they don't cut?).

SPX chart, Weekly

SPX, like the NYSE shown earlier, has broken below its long term uptrend line from October 2002 (the bottom of its parallel up-channel). Confirmation of that break requires a break below the August low near 1370. The next possible support level is near 1364, the March 2007 low. As mentioned for the SPX charts earlier, it looks like we should be near the end of the decline from December and we should get a good bounce into February. That would leave a triple bottom against the March and August lows. Assuming we get the bounce, one can only imagine the number of sell stops that will be placed just below that level.

Tomorrow could be interesting, to say the least. The negative tone set by INTC in after-market futures may or may not carry over to the cash open. The bottom line is I think we could see some choppy price action over the next few days as the market works its way lower to finish its decline from December. Then it will be time to start looking for a buying opportunity (for a trade only but it should be good for at least a week or two).

Watch out for increased volatility as opexantics could make trading hazardous. Good luck and I'll be back tomorrow to see if we're a little closer to figuring out where the end of this decline might be.

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