Option Investor
Market Wrap

Market Wrap

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The stock markets began the week in a sour tone with the S&P 500 dropping 25 points to 1,266 and the NASDAQ Composite dropping 49 points to 2,365. Volume was very light on the New York Stock Exchange today with only 865 million shares traded. That is far less than the 50 day moving average of 1,328 million shares traded each day. The internals were weak on this late Summer Monday. There were 12 new 52-Week Highs and 101 new 52-Week Lows. Decliners outpaced advancers over 3 to 1 with 2418 versus 700, respectively.

As mentioned in last Mondays commentary, when the $TRIN closes above 2.0 the probability for a morning bounce increases significantly. The best way to trade the TRIN is to be prepared about 5 15 minutes prior to the close and place either a short put spread (bullish) on the S&P 500 (SPX) or S&P 100 (OEX) options or buy long the S&P eMini futures. With the options there is no way to have over night risk management on the options themselves but a trader with a futures trading account could have a stop order set to sell short the appropriate number of contracts that represent the cumulative Delta of the short put spread. For instance, you placed a short put spread on the OEX September 570/560 Put Spread for a net credit of $2.25 per contract and an 11 contracts. The position has a delta of 100.22 which suggests that the position will lose $100.22 per point decline in the OEX. Therefore, we can sell short 2 contracts of the S&P 500 eMini futures (the futures have a delta of 50 or a change in value of $50 per point in the S&P futures) to hedge the position if the futures drop below our overnight risk management level. So either way the TRIN long position can be hedged and have risk management. Our upside target is either closing the position at the open or at an 8 point profit target with a 4 point stop. By the way, last weeks TRIN trade did get stopped out.

Onto the NASDAQ internals, todays advance/decline had almost 4 losers to 1 gainer. The actual numbers are as follows: Advancing Issues = 632, Declining Issues = 2,228. There were 39 new highs versus 104 new lows on a very low volume day. Todays volume clocked in at 1,455 million shares versus the 50 day moving average of 2.08 million shares.

While I am on the internals I am going to cover the Open Interest readings as of today. The SPX closed at 1266.87 or about 17 points above the peak open interest (291,406 contracts open) strike price of 1250 on the September puts. The peak open interest on the calls is at the 1300 strike price with 218,628 open. The peak levels on the calls represent resistance while the peak levels on the puts show support.

As in most downtrends there are significantly more puts open than calls. This is because portfolio managers often purchase S&P 500 puts to hedge their portfolios. They do this according to their overall correlation to the S&P 500. For instance, if your diversified stock portfolio is $1,000,000 with a Beta of 1.30 then you would need to buy enough puts to hedge a $1,300,000 ($1 million X 1.30 Beta) portfolio. Hopefully those of you reading this realize that most option contracts represents 100 shares of stock or 100 times the value of the index. Therefore, the notional value of the S&P 500 at 1266.84 equals $126,684 per contract. A quick lesson in Deltas is necessary to figure the next part out. Delta is a theoretical value assigned to an option that represents the options potential change in price relative to a one point change in the underlying securitys price. For instance, assume we join the crowd and buy the 1250 September Put options for $19 per contract. Each contract has a Delta of negative 0.38 or profits $38 per contract for each point the SPX declines. By dividing the Beta adjusted portfolio value ($1,300,000) by the S&P 500 notional value ($126,684) we get a portfolio multiple of 10.26 or the Beta adjusted portfolios value per S&P 500 contract. To determine the number of contracts to buy to fully hedge the portfolio, we take the portfolios multiple and divide it by the Delta (0.38) to get 27 contracts. Therefore, we would buy 27 contracts of the 1250 puts to fully hedge the portfolio. In more stable markets we might see the S&P Open Interest Put/Call ratio to be skewed toward 1.0 suggesting that there are fewer put buyers protecting their portfolios and more call buyers adding positive deltas to increase their portfolios Alpha.

The NASDAQs open interest shows that there is support at 1850 as provided by the peak open interest of 12,211 contracts open. In addition, the absolute peak open interest is at the 1700 strike level with 17,725 options open. There is resistance at 1950 and again at 2100. But the 1950 strike price has the highest peak open interest with 17.960 opens contracts.

Today in Review

I believe that the market started off in a sour note this morning partly due to American International Group (AIG) having their third quarter earnings estimate cut to a loss of $0.86 per share by Credit Suisse. Fitch Ratings placed the insurance companys credit ratings on a negative watch. AIG dropped to its lowest level in thirteen years today and closed down $1.09 to $18.78.

The Financial Sector dropped about 3% today on the AIG news as well as news that South Korean regulators told the Korean Development Bank to be cautious about taking over any overseas banks. The Korean Development Bank expressed interest in Lehman Bros (LEH) last week. Shares of LEH dropped $0.96 to $13.45.


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The only three companies that posted a gain in the financial sector were Freddie Mac (FRE), Fannie Mae (FNM) and MBIA (MBI). The $2 billion debt offering by Freddie Mac was well received by investors. Fannie and MBIA apparently rose in sympathy as there was no news surrounding the stock.
The only economic news released today was from the National Association of Realtors existing home sales report for July. The report was mixed, but signals that a bottoming process in housing industry is taking shape. The number of home sales rose by a larger-than-expected amount, while home prices declined. In addition, the amount of unsold inventory rose to the highest level since at least 1999. July existing home sales rose 3.1% month-over-month to a seasonally adjusted 5.00 million annual rate; which is above the median economist estimate that called for 1.1% growth to 4.91 million.
Existing home sales are down 13.2% year-over-year. Existing home inventory supply is 11.2 months, compared to the 2007 average inventory supply of 8.9 months. The inventory of single family homes improved to a 10.6 months supply from 11.0. The decreased inventory time indicates that falling prices are helping to stimulate demand. Finally, the median sales price fell 1.3% from the previous month to $212,400 which is down 7.1% compared to last year. Not that it feels good but a 7.1% decline relative to the S&P 500s 14% decline isnt that bad.

Tomorrows Reasons for Moving

Tomorrow morning the August consumer confidence reports will be released at 10:00 AM. It is expected to be 53 versus last months 51.9. Also at 10:00 AM the New Home Sales report will be released which should provide some additional insight into whether housing remains weak overall. The August 5th FOMC minutes will be released. Usually, the equity markets are fairly quite ahead of the release. However, currency, credit and equity markets become volatile following the report.

Most of the stocks reporting earnings tomorrow are international stocks that I dont trade. Frankly, I dont many of the stocks reporting tomorrow. I used to trade Chicos FAS (CHS), Corinthian Colleges (COCO) and LTX Corporation (LTXX) many moons ago. There are a few consumer discretionary stocks reporting tomorrow including AEO, BIG, BGO, CHS and JCG. Consumer Staple stocks include SFD and SAFM.

The S&P 500 (SPX)

Today the SPX closed down more than 25 points at 1266.84 on light volume. The lighter trade suggests that the day was not a distribution day. Another reason for the light volume was that many traders are taking their vacation the week before Labor Day.

In this weeks newsletter, I am using a different background color and layout for the charts. The chart shows three moving averages, the 50, 89 and 200 day Simple Moving Averages (SMA). The longer term moving averages aid in determining the overall trend of the underlying security. The SPX is obviously in a long term downtrend as indicated by all three moving average intervals. As the chart above shows the market appears to have peaked short term at 1313.15 on August 11th. I have drawn a Fibonacci retracement from the July low to the peak. The SPX has been maintaining just above the 50% retracement level as it tries to break above the 50 day SMA, currently at 1278.82 (green line). If the SPX breaks below Last Wednesdays low of 1261 then the 50% retracement is the target line. But we need to see a breach of that level (currently at 1256) and a hold of the 61.8% Fibonacci level before taking a long position. A breach of the 50% level could be traded with a partial position with the 61.8% level, less a couple ticks, the stop loss. There are a number of ways to trade the SPX which include SPX options, futures, the S&P SPDR (SPY) and the Ultra Long Proshares (SSO). The next price level support after 1261 is at 1247 which is the August 4th low. Money Flow remains steady in the 50s but took a dip lower on todays decline in the market. The Money Flow Index shows that if the market begins to decline that there is still a lot of room for the indicator to fall before suggesting a selling stampede.

As of the close the 8 day Exponential Moving Average (EMA) closed just above the 21 day EMA. A breach of the 21 day EMA by the 8 day EMA would therefore suggests a negative bias. As a trader, when this bias shifts to negative short trades should be placed on the initial breach as well as when the price tests the 8 day EMA. For instance, a short trade on the SPX would be entered at the closing confirmation of the moving average cross over. Then a buy stop would need to be placed at a break of the recent high or some other parameter that meets your risk appetite. The Bollinger bands are squeezing together which is a reflection of the recent bit of lower volatility. The low Bollinger band is providing support at 1249 while the upper Bollinger band has the resistance at 1307. Slow Stochastics ticked down but hasnt confirmed a sell signal. That will occur once the Stochastics line closes below the moving average (green line). RSI is falling fast bust has support at 34. A break below that will suggest further weakness in the SPX.

The Russell 2000 (RUT)

I want to look at a different market this week. The RUT has held up stronger than the Dow Jones Industrial, S&P 500 (SPX) and the NASDAQ (NDX). As the charts below show the RUT did dip down quit a bit in March and July but have had phenomenal relative strength versus the SPX and Dow.

The RUT has posted a higher low and higher high since the July 15th low, barely. Stochastics appear different on the RUT chart when compared to the SPXs. For instance, the RUT is still on a long confirmed because the Stochastics line is above 20 after re-emerging from below 20 and the Stochastics line is also above the moving average. However, RSI isnt confirming the long as of todays close. The Lower Bollinger band is indicating the uptrend and is providing support at 700. There is also support neat 700 from the early August lows. We need to watch the 8 day EMA as it is approaching the 21 day EMA. A cross would suggest weakness in the small caps.

The RUT came down just below the 200 day SMA (719.99) intra day but closed just above it at 720.54. In addition, the 38.2% Fibonacci retracement at $719.88 provided support today. A break of the 200 day SMA and the 38.2% level would suggest the 50% retracement level and coincidentally the 50 day SMA as the next support level. Even though the RUT is showing decent relative strength it remains in a slight downtrend overall.

The Healthcare sector has been the darling of the Select SPDRs so far this year. However, the XLV closed below the 21 day EMA which suggests rotation into another sector may be occurring.

The Consumer Staples SPDR (XLP) is the only sector represented in the Select Spiders that is still above its 50 and 200 day SMA. One could buy the XLP on dips and sell short the weaker Sectors like financials (XLF) and materials (XLB) on spikes. Trade the trends direction. If the trend is down as indicated by the 50 or 200 day SMA sell the sector short on overbought signals. Cover the position at a risk level that you are comfortable with. For instance, if the ETF closes above the 21 day EMA or the 8 day EMA closes above the 21 day EMA. Another method may resemble a Turtle by placing a stop at the break above the 20 day high. Another stop may be relative to volatility of the security. For instance, on a short trade, one could set a stop at a break of 150% of the 20 day ATR on an up bar. Theses are just some examples. Good trading!

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