The Option Investor Newsletter Tuesday 8-10-99 Copyright 1999, All rights reserved. Redistribution in any form strictly prohibited. Posted online for subscribers at http://www.OptionInvestor.com Published three times weekly, Sunday, Tuesday, Thursday evenings. ************************************************************ MARKET WRAP (view in courier font for table alignment) ************************************************************ 8-10-99 High Low Volume Advances Decline DOW 10655.15 - 52.55 10714.67 10549.08 836,280k 764 2,314 Nasdaq 2490.11 - 28.87 2521.65 2442.22 989,475k 1,343 2,684 S&P-100 665.41 - 6.33 673.36 658.23 Totals 2,107 4,998 S&P-500 1281.43 - 16.37 1298.78 1267.73 29.7% 70.3% $RUT 422.82 - 3.07 425.89 417.07 $TRAN 3137.54 - 82.91 3219.33 3104.44 VIX 28.30 + 0.31 31.09 28.21 Put/Call Ratio .78 ************************************************************* Don't buy it! The avalanche/decline line is picking up speed. The markets pulled another miraculous recovery from another capitulation event this afternoon but I am not convinced yet. The DOW was down over -150 points at 2:15 when buyers materialized out of nowhere. Analysts theorize that several buy programs were triggered when the DOW broke 10500 and the spurt of buying sent short running for cover. The Internets pulled back from the brink of another disaster with stocks like YHOO, INKT, EXDS posting strong gains after being strongly negative at midday. EXDS was down over -$7 but closed +5.00. YHOO was down over -6 but closed up +6.31. INKT gained over +$8 after starting the day negative. By all standards the huge rebound would be buyable BUT the most visible indicator is the avalanche/decline line. Advances are becoming few and far between with decliners beating advancers by 3:1 on the NYSE and 2:1 on the Nasdaq, and this is after the strong bounce firmed the numbers. Until the advancers pull ahead of the decliners you should not buy this bounce. The new highs also fell victim to new lows by 41 to 332 on the NYSE and 45 to 278 on the Nasdaq. This is not a buyable market. Another factor that could have sparked the bounce was the breaking of the 200 day moving average by the S&P-500. This was the first time the S&P has traded under the 220DMA since Oct-1998. Secondly the S&P broke the -10% barrier to officially signal a correction in the broader market. Either of these events can trigger buying by technical traders. This does not mean they are right. They are just playing the historical averages which favor a market bounce at these technical points. Even though the S&P broke the -10% barrier today the DOW is only down about -6%. The most widely watched and reported index is only comprised of 30 stocks and is weighted strongly to energy and cyclicals. There are 3100 stocks on the NYSE and the DOW cannot represent the true movement of the market. The cyclicals are defensive stocks and attract money when the other DOW stocks are selling off. The oil stocks are basking in the glow of high oil prices and are helping to hold up the index. Even with the bounce today the market is continuing to follow the pattern of lower lows and lower highs. On 8/2 the DOW low was 10615, 10614 on 8/3, 10565 on 8/5, and 10549 today. The highs were 10829 on 8/4, 10818 on 8/6, 10762 on 8/9 and 10714 today. This may seem boring to read but if the pattern holds we are looking at a retest of the DOW's real support at 10500 or even 10400 very soon. Our recent trading range is continuing to trade lower and it will continue until the buyers start winning the battle. The buyers are still waiting on the sidelines and there is still nothing to cause them to want to be in the market. The next earnings cycle is still two months away and this is typically a weak month in the market. This is not the time to be in calls. We got several emails last week about our call plays losing money. No kidding. Obviously some people are still not reading the commentary. We have been telling people for weeks NOT to play calls until the market trends change. As I have mentioned many times before, we list the call recommendations as possible plays WHEN THE MARKET RECOVERS, NOT NOW! If you must play calls we have recommended ONLY buying calls on a strong dip to the bottom of the trading range, like today, and then selling them on any bounce to the upper end of the range. As long as the range is trending lower you must sell quicker every time. This is a very risky strategy and I do not recommend it. I recommend waiting on the sidelines or shifting into put plays. Enough preaching but it really aggravates me to have someone blame us for losing money on calls when the market is tanking like we predict. The main reason analysts are blaming for the recent market drop is still the interest rate problem. Yes they will raise rates on the 24th and yes they will probably raise rates at the next meeting also. Live with it. The September FED fund futures are showing a 100% chance of a +.25% raise in August and the December futures are calling for another +.25 by December. Both of these raises are already priced into the market and we do not feel this is the reason for the current weakness. The market is weak because there are more sellers than buyers and I think the reason is the fear of history repeating itself from the last two years and Y2K fears. I was at a picnic on Sunday and two people in separate conversations, who did not know me were telling others they were selling stocks now to avoid the OCT Y2K rush. Multiply this by 100,000 picnics this weekend and you see why the advance decline line is accelerating downward. CSCO announced earnings after the close and beat the street by +.01 with a $.21 actual. CSCO traded up after the announcement and this positive tech event may help hold up the Nasdaq tomorrow. The Nasdaq needs serious help. The Nasdaq was down almost -80 points at midday before the Internet sector caught fire and pulled out of its death spiral. All of the Nasdaq majors finished negative. MSFT, DELL, CSCO, INTC, WCOM were all down. With the majors trending down the Nasdaq has an uphill battle to rally. MSFT may not be a contributor anytime soon with the Justice Dept now saying that they did find that Microsoft was a monopoly and did employ monopolistic practices in controlling their market. EBAY lead the charge for the Internet rebound after they reassured analysts that they had a handle on the outages and business was good. EBAY finished up +9.63 today but they had been beat up badly in recent days. Internet IPOs continue to flounder as Hotjobs (HOTJ) closed under its reduced IPO offering price. Blockbuster will be out tomorrow after also pricing at less than expected as a result of weak demand. Adding another match to the market fire, John Bollinger said today he had increased his cash position to 10% and planned to increase it to 30% in the next two weeks. Another bull bites the dust. Al Goldman from AG Edwards, lowered his bottom target for the DOW again today to 10,400 after the Richmond Fed reported that manufacturing and services were gaining momentum and wage pressures were adding to inflation. The DOW is not getting any help from the transports. All the stocks in the Transportation Index were down today except ROAD. The index closed down -83 after being down over -100 at midday. It is now trading under its 200DMA and is negative for the year. The Russell-2000 is also failing and is within two points of trading below it's Jan 4th starting point. It did bounce off it's 200DMA today. Remember the bear trap rally from last Thursday? The steel jaws slammed shut on us the very next day as the market continued downward. Also remember that NOTHING goes up or down in a straight line. 2-3 days down will bring a technical rebound. 2-3 days up will bring a profit taking session. Watch closely the internals of this market before committing funds to call plays or buying stock. The yield of the 30yr bond broke above 6.25% at midday. This is a level that has not been seen since Nov-97. It will lure cash out of the markets to the safety of bonds in the face of Y2K unknowns. Now after painting this bleak picture of the markets let me try another analogy. Visualize a face off in a hockey game. The ref drops the puck and each player tries to anticipate the drop and bounce on the ice. The winner may setup his team to score. Many stocks are like pucks this week. Traders with itchy mouse fingers are trying to decide when they will hit bottom so they can be the first to swing and chance a big score. The problem here is no one knows where the bottom is going to be. Traders swinging early will be penalized by having to sell quickly for a loss if the drop continues thereby increasing the drop rate. The player who waits too long is penalized by having to pay several dollars more than the lucky person that accidentally picked the exact bottom. This process causes many false starts and stops. Watch the internals NOT the stock to decide when to swing. We could see several more bounces before we see the bottom. Don't forget the PPI is due out Friday! Please, if you must play, pick your entry points carefully. Good Luck, Definitely, sell too soon. Jim Brown Editor *************** Market Posture *************** As of Market Close - Tuesday, August 10, 1999 Key Benchmarks Broad Market Bearish/Bullish Last Posture/Since Alert **************************************************************** DOW Industrials 10,500 11,320 10,655 Neutral 7.20 SPX S&P 500 1,330 1,420 1,283 BEARISH 7.30 OEX S&P 100 675 735 666 BEARISH 8.06 RUT Russell 2000 430 465 422 BEARISH 8.06 NDX NASD 100 2,200 2,468 2,164 BEARISH 8.10 * MSH High Tech 1,105 1,250 1,090 BEARISH 8.10 * XCI Hardware 920 1,090 971 Neutral 7.20 CWX Software 700 844 696 BEARISH 8.10 * SOX Semiconductor 450 535 499 Neutral 7.20 NWX Networking 550 625 529 BEARISH 8.05 INX Internet 500 580 381 BEARISH 7.20 BIX Banking 690 710 618 BEARISH 7.23 XBD Brokerage 410 440 352 BEARISH 7.23 IUX Insurance 645 660 580 BEARISH 7.23 RLX Retail 915 960 812 BEARISH 7.23 DRG Drug 370 400 333 BEARISH 7.20 HCX Healthcare 750 800 684 BEARISH 7.22 XAL Airline 180 190 151 BEARISH 5.21 OIX Oil & Gas 285 310 313 BULLISH 8.10 * Posture Alert Watching paint dry? Sector after sector continues a slow but steady pace south. With Tuesday's action, we have turned BEARISH on the Nasdaq 100 (NDX), Morgan Stanley High Technology (MSH), and Software (CWX). On a positive note, we have turned BULLISH on Oil & Gas, as it now is the only BULLISH sector on the posture board. A detailed description of our Market Posture and its applications can be found at: members.OptionInvestor.com/marketposture **************** Market Sentiment **************** Still going long? Over the last month, there haven't been many good opportunities to go long a stock or option. Many people refuse to short a stock, or buy puts, thinking that this is un-American. Just like in Las Vegas, many people will not put money down on the don't pass line, even if the table is obviously cold. Folks, it is un-American to lose lots of money or not take advantage of an opportunity when you see one. The best short-term opportunities lately have been taking advantage of down moves. For those of you who have been going short this last month, the equity in your brokerage accounts will do all the talking for you. For the rest of you, you may want to take advantage of the Volatility Index (VIX). Below is a chart of the VIX. If you recall last weeks one day reversal, you will see that the VIX broke above 30 and touched just above 32. This happened to occur at the absolute bottom of the market. If you happened to buy an internet stock (or anything in general on the Nasdaq), you could have made a huge percentage return on your money in just a few hours. You can see the big swing by the corresponding chart of the Nasdaq below. Today, we saw action similar to last week's one-day rally. Today, the VIX broke above 30, touched 31 and change, and closed at 28.30. While the VIX was above 31, the Nasdaq was at its bottom for the day. You could have, once again, done some nice fire sale shopping, as evidenced by the chart in Yahoo/Nasdaq below. There is no doubt that there is considerable weakness in this market. With the threat of a larger-than-expected interest rate hike (or numerous hikes), and Y2K looming around the corner, shorting is probably the best place to be right now. However, if you will only go long, try to use the VIX as a tool to help you with your trades. At times, it is very powerful and useful. However, as you can see below, the VIX can go a lot higher (i.e.54 for 1997, 60 for 1998), but for 1999, anything in the 30's has been a good buying opportunity so far. Market Volatility Index (VIX) Major Date Turning Point VIX October 97 Bottom 54.60 July 20, 1998 Top 16.88 October 8, 1998 Bottom 60.63 January 11, 1998 Top 26.38 March 4, 1999 Bottom 28.15 May 14, 1999 Top 25.01 July 16, 1999 Top? 18.13 * August 10, 1999 28.30 BULLISH Signs: Pinnacle Index: The Pinnacle Index for the OEX (630-670) is now reaching levels of extreme pessimism. From a contrarian standpoint, support is building in this area, and may indicate a short term base. Investor Intelligence: As a contrarian indicator, the percent of Bullish investors decreased 1.4% and Bearish sentiment increased 3.2%. Mixed Signs: None BEARISH Signs: Russell 2000: Broke below both the 50 and 200 day moving averages, proving very bearish. Interest Rates: The yield on the 30-yr Treasury broke out to new highs, which could spell potential disaster for this market. Peak Open Interest: The contraian put-call ratio clocking in at 1.0 suggesting bullish sentiment picking up steam. Market Posture: Several indexes have just rolled over, including the Dow, OEX, SPX, networking, and software. Market Posture 2: Several indexes continue on their bearish decline, including drugs, healthcare, brokerage, banking, airlines, Russell 2000, Insurance, and Internet. Advance/Decline Line: The A/D line has been rolling over, and will continue to prove Bearish if decliners continue to out-pace advancers in the weeks ahead. OTM Call Analysis As we move through the August expiration cycle, Pinnacle is tracking the level of call buying (OTM) between 710-780 among option speculators. As we have been documenting, excessive out-of-the-money (OTM) call may serve as overhead resistance. July Expiration Cycle OEX OTM Call Analysis (Open Interest July 680-750) Date Open Interest Change % Alert Friday, June 19 35,225 - Friday, June 25 63,342 +79.8% Friday, July 02 87,833 +149.3% Friday, July 09 99,855 +183.5% August Expiration Cycle OEX OTM Call Analysis (Open Interest August 690-780) Date Open Interest Change % Alert Friday, July 16 32,285 Friday, July 23 62,455 +93.4% Friday, July 30 74,895 +131.9% Friday, Aug. 06 113,258 +250.8% Market Sentiment at a Glance Friday Tues Indicator (8/06) (8/10) Alert Pinnacle Index (OEX): Overhead Resistance (715-745) 6.5 6.8 Overhead Resistance (680-710) 1.4 1.9 Underlying Support (630-670) 6.3 5.7 Put/Call Ratios: CBOE Total P/C Ratio .7 .7 CBOE Equity P/C Ratio .5 .6 OEX P/C Ratio 1.1 1.0 Peak Open Interest (OEX): Puts 620 650 Calls 700 700 P/C Ratio .7 .7 Market Volatility Index (VIX): CBOE VIX 28.30 Investors Intelligence: Bullish 52.20% * Bearish 27.80% * The Power of Sentiment Analysis It has often been said that the crowd is right during the market trends but wrong at both ends. Measuring and evaluating the sentiment of the crowd, therefore, can give savvy option traders a decided edge. (OEX) Pinnacle Index Friday Tues Benchmark (8/06) (8/10) Overhead Resistance (715-745) 6.30 6.78 Overhead Resistance (680-710) 1.41 1.86 OEX Close 674.13 665.41 Underlying Support (630-670) 6.50 5.73 Average ratings: Resistance levels 2.0 / Support Levels .5 What the Pinnacle Index is telling us: Overhead sentiment resistance is building at the OEX 720/750 level while the underlying support is holding at the OEX 645/680 level. Put/Call Ratio Friday Tues Strike/Contracts (8/06) (8/10) CBOE Total P/C Ratio .66 .71 CBOE Equity P/C Ratio .54 .62 OEX P/C Ratio 1.10 1.01 (OEX) Peak Open Interest Friday Tues Strike/Contracts (8/06) (8/10) Puts 620 / 11,005 650 / 11,622 Calls 700 / 14,674 700 / 16,566 Put/Call Ratio .74 .70 VIX) Volatility Index Major Date Turning Point VIX October 97 Bottom 54.60 July 20, 1998 Top 16.88 October 8, 1998 Bottom 60.63 January 11, 1998 Top 26.38 March 4, 1999 Bottom 28.15 May 14, 1999 Top 25.01 July 16, 1999 Top? 18.13 * August 10, 1999 28.30 Investors Intelligence Survey Major Percent Percent Date Turning Point Bullish Bearish October 97 Bottom 22.0 48.3 July 20, 1998 Top 52.0 24.0 October 8, 1998 Bottom 38.5 42.7 January 11, 1999 Top 58.3 30.0 March 4, 1999 Bottom 49.1 32.5 January 6, 1999 58.3 30.0 January 13, 1999 60.0 30.0 January 20, 1999 61.7 25.9 January 27, 1999 60.7 28.2 February 3, 1999 60.0 26.7 February 10, 1999 61.7 25.9 February 17, 1999 55.7 28.7 February 24, 1999 54.1 31.5 March 3, 1999 50.9 32.1 March 10, 1999 49.1 32.5 March 17, 1999 52.6 17.6 March 24, 1999 55.9 29.7 March 31, 1999 55.6 31.6 April 07, 1999 56.4 31.6 April 14, 1999 55.9 30.5 April 21, 1999 56.4 30.8 April 28, 1999 56.1 30.7 May 05, 1999 58.1 27.6 May 12, 1999 56.9 31.0 May 19, 1999 60.9 28.7 May 26, 1999 61.6 27.7 June 2, 1999 61.6 27.7 June 10, 1999 58.3 28.7 June 16, 1999 58.8 26.3 June 24, 1999 57.5 26.5 June 30, 1999 55.8 25.7 July 07, 1999 52.6 27.2 July 14, 1999 55.2 26.7 July 21, 1999 54.1 27.9 July 28, 1999 53.6 24.6 Aug 04, 1999 52.2 27.8 * Please view this in COURIER 10 font for alignment ***************************************************** CHANGES THIS WEEK Index Last Mon Tue Week Dow 10655.15 -6.33 -52.55 -58.88 Nasdaq 2490.11 -28.99 -28.87 -57.86 $OEX 665.41 -2.39 -6.33 -8.72 $SPX 1281.43 -2.49 -16.37 -18.86 $RUT 422.82 -2.15 -3.07 -5.22 $TRAN 3137.54 0.42 -82.91 -82.49 $VIX 28.30 0.63 0.31 0.94 Calls Mon Tue Week SNE 123.00 -0.19 3.19 3.00 Merrill upgrade DELL 40.44 1.19 -0.56 0.63 Strong relative day INTC 71.75 1.88 -1.69 0.19 AMD chip worries LSI 53.44 0.94 -0.88 0.06 Strong sector AMGN 75.00 0.38 -1.81 -1.44 Dropped, broke 10-dma SLB 66.38 -1.00 -1.06 -2.06 New, hot sector NXLK 80.88 0.88 -3.50 -2.63 Have we hit bottom?? HGSI 57.25 -0.63 -2.63 -3.25 Use caution!!! TXN 138.50 -1.00 -3.00 -4.00 Where's the split run IBM 119.31 -1.31 -2.88 -4.19 Dropped, weakening HWP 106.69 -3.31 -1.00 -4.31 Potential split play Puts NITE 30.25 -4.88 -1.50 -6.38 Another rough day BRCM 104.88 -1.88 -3.50 -5.38 New, not recovering TAN 41.06 -3.88 0.25 -3.63 Retail sector suffering AMR 59.31 -0.56 -2.06 -2.63 Higher oil prices SCH 38.00 -1.31 -0.81 -2.13 Dropped, successful TBH 72.50 -1.13 -0.38 -1.50 Interest rate play U 31.06 0.06 -1.44 -1.38 Another 52-week low CMGI 76.19 -3.75 2.94 -0.81 The wild ride continues DH 57.81 -0.69 0.13 -0.56 Moving with sector MER 63.69 0.63 -0.81 -0.19 30-year bond pressure NKE 49.19 -0.13 0.25 0.13 Dropped, going nowhere MWD 83.31 0.31 0.88 1.19 Looking for support AMZN 91.00 -4.06 5.50 1.44 Internet rally today AXP 124.50 1.94 -0.50 1.44 Waiting for Fed SEPR 70.25 4.88 0.00 4.88 Flattening out DCLK 79.00 0.56 4.44 5.00 Dropped, strong day GNET 60.88 -3.50 8.56 5.06 Dropped, nice gains EBAY 89.25 -3.63 9.63 6.00 Bear trap rally?? **************** PICKS WE DROPPED **************** When we drop a pick it doesn't mean we are recommending a sell on that play. Many dropped picks go on to be very profitable. We drop a pick because something happened to change its profile. News, price, direction, etc. We drop it because we don't want anyone else starting a new play at that time. We have hundreds of new readers with each issue who are unfamiliar with the previous history for that pick and we want them to look at any current pick as a valid play. CALLS: ****** IBM $119.31 -2.88 (-4.19) Short but not that sweet. About the best we can say is that IBM found support again at $119. Remember, this play was predicated on the DOW remaining above 10,600, which unfortunately was pierced by an arrow just like an apple on William Tell's head. Yes, the market rebounded (which itself was not all that convincing, since the market still finished with a loss) but IBM did not participate at all. Also its volume remained average which is called relative weakness and isn't conducive to good call playing. If you followed the play from Sunday, you know we were waiting for volume to confirm direction and were not about to chase IBM for an entry. With that said, there should have been no reason to open a position thus we're dropping IBM from our call plays. AMGN $75.00 -1.81 (-1.44) Amgen has been in and out of its Narrow trading range that we spoke of last weekend. It has given us an opportunity to profit from its recent moves. Today it fell $1.81 on average volume and we believe it may be time to move on. It has ran up to the $80.00 twice only to pullback. It has spent to long basically going sideways, without any real conviction. The biotech industry has been trying to recover and may be trying to find a short-term bottom. Today AMGN fell very convincingly through its 10-dma leading us to believe there may be more to come. We will step aside for now. ***** Play updates continued in section two ***** ****************** FREE TRIAL READERS ****************** If you like the results you have been receiving we would welcome you as a permanent subscriber. The monthly subscription price is 39.95. The quarterly price is 99.95 which is $20 off the monthly rate. We would like to have you as a subscriber. You may subscribe at any time but your subscription will not start until your free trial is over. To subscribe you may go to our website at www.OptionInvestor.com and click on "subscribe" to use our secure credit card server or you may simply send an email to "subscribe@OptionInvestor.com" with your credit card information,(number, exp date, name) or you may call us at 303-797-0200 and give us the information over the phone. You may also fax the information to: 303-797-1333 ************************************************************* DISCLAIMER ************************************************************* This newsletter is a publication dedicated to the education of options traders. The newsletter is an information service only. The information provided herein is not to be construed as an offer to buy or sell securities of any kind. The newsletter picks are not to be considered a recommendation of any stock or option but an information resource to aid the investor in making an informed decision regarding trading in options. It is possible at this or some subsequent date, the editor and staff of The Option Investor Newsletter may own, buy or sell securities presented. All investors should consult a qualified professional before trading in any security. The information provided has been obtained from sources deemed reliable but is not guaranteed as to accuracy or completeness. The newsletter staff makes every effort to provide timely information to its subscribers but cannot guarantee specific delivery times due to factors beyond our control.
The Option Investor Newsletter Tuesday 8-10-99 Copyright 1999, All rights reserved. Redistribution in any form strictly prohibited. DROPS CONTINUED *************** PUTS: ****** SCH $38.00 -0.81 (-2.13) A mixed performance for Schwab today but in the end, it was just another loss. SCH went lower out of the gates this morning before rebounding with the market midday. It was unable to hold its gains though and closed right on the afternoon low at $38. The entire sector was lower today amidst interest rate concerns. This group has seen an incredible pullback, in most cases over 50% from year highs. Even Schwab which is considered to be a more stable play is at a 50% discount. But we don't like to see the flattening out on the 200-dma that SCH has shown us for the last few sessions so we are closing out our play. The stock has dropped sharply since we recommended it and we feel that we are better off to take our profits and move on to another play. DCLK $79.00 +4.44 (+5.00) While showing some strength on Monday as the rest of the sector sank around it, today the Internet rebound really caught a hold of DCLK. While we did ride it down to its old support level of $70, the rebound was swift and sharp. We hope you had the opportunity to use a trailing stop on the way down, which would have stopped you out at a profit on the way back up. While the sector is still weak, there is also the possibility of a breather (or even further technical bounce) before lows are tested again. Having held up well into the close, we need to let the market give us a direction again before we play DCLK again. Thus we're dropping DCLK tonight, thanks to its relative strength. It also didn't hurt that AG Edwards initiated coverage with an accumulate rating or a $119 price target. NKE $49.19 +0.25 (-0.13) The fall in Nike shares may or may not be over. Technically looking at the chart, it is still pointing south. With the broader markets exhibiting weakness earlier today NKE, couldn't get out of its own way. Given the conditions in the retail sector the past two days, NKE should have joined the party. Instead it barely moved, leading us to believe this could be a short-term bottom or it may become range bound. Either way it is time to walk away from Nike. GNET $60.87 +8.56 (+5.06) Go2Net really did go today! So much so that we need to drop this for now. With all the high profile news that the stock has had, it was just a matter of time until analyst attention hit and today it did. News of a strong buy initiated by Piper Jaffery. Record earnings for Commtouch and D.G. Jewelry were also indirectly attributed to GNET's good job. The news rallied the stock above our resistance levels, so it's time to move on. The stock saw a price swing of almost $19 since our recommendation. Investors who watched this stock closely should have profited nicely during that time. PICK NEWS - CALLS ***************** SNE $123.00 +3.19 (+3.00) Sony rose Tuesday when the Japanese Nikkei index rebounded overnight but that isn't the big news for the stock. The big news is that Merrill Lynch raised their price target on SNE. Analyst Hitoshi Kuriyama said a higher target price was justified on three counts: Sony's first-quarter profit shrank less than analysts expected, cost- cutting efforts are working, and expansion into the high- yielding business of digital electronics will pay off. This helped SNE climbed on the New York exchange as the stock opened at $122.88. We had a fairly sideways day after that but considering the market weakness, it wasn't that bad. If we can get a broad market bounce tomorrow then Sony may be able to start a new uptrend. It was also nice to see the stock come back late in the day to end right on the day-high. Remember to confirm the direction if you are looking to open new plays. LSI $53.44 -0.88 (-0.06) The chip sector continued to show strength yesterday and LSI peaked at $55 to set its latest 52-week high. The news of Advanced Micro Devices (AMD) unveiling their newest speed demon, a 650 MHz Athlon microprocessor didn't hurt either. Today, LSI couldn't quite reach its newest resistance level as the stock price fluctuated throughout the day on strong volume. The recent volatility should continue to create entry points intraday for those who are looking to open new plays. Also, Banc of America Securities started new coverage with a "strong buy" rating. That should help to buoy the stock in this market. DELL $40.44 -0.56 (+0.63) The first 2 days of the week have been negative for the market but not for DELL. It's managed to eke out a gain so far this week. Technically, DELL showed strength today at $39.50, having lost only $1.50 while the NASDAQ was down 77 points. Then both the market and Dell rallied from there in today's action. Remember that we're playing DELL for a potential earnings run before it announces results on August 17 after the close. Yesterday DELL was upgraded by BancBoston Robertson Stephens from a "market perform" to a "long-term attractive" with a $48 short-term price target. This is because year over year revenues seem to have stabilized and unit growth looks respectable, at least according to BBRS analyst Dan Niles. We're still waiting for volume though. CSCO's results today may help the whole tech sector tomorrow, including DELL. Unless there's a meltdown, consider buying dips if it fits your risk profile. TXN $138.50 -3.00 (-4.00) TXN is staying on our call list thanks to its upcoming split on August 16. As we noted on Sunday there isn't much time for this play to work, just 3 more trading days. While it held up well yesterday, it's recovery this afternoon was weak compared to the market's. Banc of America Securities' today announced a coverage initiation with a strong buy and that may help tomorrow, though it didn't do much today. Even if TXN is so blessed, it needs volume to lift it up. No volume = no gain. Let us take this opportunity to suggest that you sit out if volume never materializes. Not much else has changed since Sunday. Remember our comments, "this market is still treacherous and unforgiving on call trades that go against us. After all, the trend is still down." INTC $71.75 -1.69 (+0.19) We are going to stay with INTC for now despite recent weakness. We would suggest if you are still in a play on Intel, that you move your stops up tight to pull you out of the play on any further decline. INTC is near the bottom of an ascending channel. It touched a new 52-week high at $74.44 again today but fell $2.88 in the last 30 minutes of the day. Volume as well picked up in the last hour today during the decline. But INTC did still close above its 10-dma and may bounce back tomorrow. In the news, Intel completed its acquisition of Level One today, which is valued at $2.73 billion. Shareholders of LEVL will receive 0.86 shares of INTC stock for every one share of Level One stock they own, based on Monday's closing prices. We are cautious about opening new positions in Intel but if the NASDAQ recovers Intel should be headed back to new highs. Remember keep your stops very close and let the market do the rest. NXLK $80.88 -3.50 (-2.63) There is a lot in the news that is affecting Nextlink this week. First, we have the interest rate scenario which needs little, if any, further discussion. Next, last month Sprint started a price war with their "nickel nights" on long distance service. Yesterday MCI WorldCom responded with its own version by extending its popular "5-Cent Sundays" plan to the entire weekend and weekday calls at night. With the current price war receiving so much attention NXLK Fell $3.50 today to close at 80.88. At the low of the day Nextlink was off by $6.00, hitting $78.38 about midday. The selling tapered off and some buyers did step up to the plate and brought NXLK back the last half of the day. We are going to stick with NXLK for another few days as technically, NXLK could be at or nearing a bottom. But use caution, we are not trying to pick bottoms here! It just looks like the current push down its lightening up somewhat. Now for the good news. Nextlink is due to announce the ex-date for a 2:1 split, probably around August 27th. We are looking for NXLK to begin a split run, which is why we are hanging on to Nextlink. Again allow Nextlink to prove itself before entering a new play with positive movement and volume. HWP $106.69 -1.00 (-4.31) HP was relatively flat today as the stock was down $1.00 to close at $106.69 on moderate volume totaling 3.35 mln shares. HP and Yahoo Inc. announced today a partnership that will assist companies in constructing Internet hubs. HWP said the new product will be named Corporate My Yahoo. It will be targeted to professionals and corporate executives. We still anticipate that HP will outperform most other tech stocks up until earnings are released on Aug 19 if the market calms down. It is probable that the stock will make a positive run over the next few days but we must confirm both stock and market direction first. Furthermore, the price of the stock is still holding above $100 and historically this is where the company likes to split their stock. If that is in the works and rumors begin to stir, we may just get the kind of earnings run we are use to. HGSI $57.25 -2.63 (-3.25) Today HGSI retreated with the market as investors protected recent gains but we did manage to stay nicely above support of $56. At current levels, any sign of market strength could provide us with a good entry point. Despite the negative market, HGSI showed some resistance at $57, almost like a spring being coiled for the bounce. But remember this is a speculation play, so caution is advised. Cambridge Antibody Technology group agreed to work with HGSI. This is a great combination that should speed results to developing useful medications for the future. PICK NEWS - PUTS **************** AMR $59.31 -2.06 (-2.63) Another rough day for the transports as oil spent most of the last 2 days north of $21.00 a barrel. Plus this was one of the hardest hit sectors in the market today and the technical picture is worsening. That is why we are seeing such a selloff in AMR. It's the double whammy. A weak technical outlook due to lack of support and a bad fundamental outlook thanks to high flying oil prices. We are now convincingly under the $60 level and have seen no end to the trend that started last Tuesday. It has been straight downhill since then. Keep your eye on the weekly inventory report for oil that is due out late Tuesday afternoon. This will give us an indication of which way oil prices and thus the airline sector will move tomorrow. U $31.06 -1.44 (-1.38) It's the same old story for USAir as investors keep their finger on the sell button. They tried to rally the stock on Monday but never made any substantial gains and it was right back to new lows on Tuesday. The temporary rally may have stemmed from news that they will be offering new routes from Atlanta to New York. But we keep talking about the overall sentiment for USAir and other airlines and until the momentum shifts, these rallies are nothing more than entry points. So keep the new 52-week lows coming and follow up the play with trailing stops to protect your gains. DH $57.81 +0.13 (-0.56) Investors who are still fearful of rising interest rates and tapering consumer spending are selling off their retail stocks as the economic picture grows more somber. On strong volume both days this week, DH traded below the $59 mark. This is a good sign because for the past three days it appears the 200-dma at $60 has been acting as overhead resistance. Put another way, the lower DH stays below this indicator the better. Be careful choosing entry points at this level since some indicators are showing oversold indicators. Look for entry points on the bounces and use stop losses. MER $63.69 -0.81 (-0.19) As the financial world of brokerage houses continue in its turmoil, MER is losing more ground. For the third day in a row, the stock has closed below its long-time bottom support of $65-66. Today, the stock pushed even further down and hit a daily low of $62. Pay close attention to the market sentiment. MER has been falling for weeks now and if this stock gets a strong market boost it may cycle upwards. In the news on Monday, MER was hit with a $75 mln lawsuit by Slovnaft, an oil-refining company. The suit alleges Merrill Lynch misrepresented and failed to disclose pertinent elements of 4 arranged loans between 1994 and 1997. Also today, Solomon Smith and Barney raised the 3Q EPS to $1.30 from $1.25 citing a strong show of retail volume (which may or may not hold true in the upcoming months). Either way if you have profits in this play in may be prudent to adjust your stops to protect those gains. MWD $83.31 +0.88 (+1.19) The financial sector is still in the dumps and the brokerages are first in line. MWD is consistently trading below its 200-dma of $87. Plus the stock has been pushing to lower-lows almost every day the past couple of weeks. Nevertheless we can never forget that nothing moves in a straight line, so always be prepared for those unforeseen bounces in the market. If the bond market recovers after hitting lows not seen in 2 years, we might be in for just such a relief rally. In the news, MWD's discount brokerage unit kicked off the week with their leading edge wireless trading! NITE $30.25 -1.50 (-6.38) What bottom? If there was one, this market maker fell right through it! On exceptionally strong trading volume NITE sunk $6.38 in two days, dropping it below the questionable $34-$35 level. Now let's not get too excited, too fast. There may very well be more room for profit. The falling stock market and potential regulatory issues are certainly pressuring NITE. In fact, insiders have sold off almost 1 million shares in the past week. Overall the sentiment is still very bearish but the stock has fallen so much that it is tough to pick new entry points so let's remember "caution" on this play. EBAY $89.25 +9.63 (+6.00) Is an Internet recovery at hand? Well, one day does not make a trend, but it can sometimes be a warning. Specific to EBAY, a couple of things may have contributed to today's almost double-digit advance. First, EBAY is naturally recovering from the sell-off on Friday and Monday. But unfortunately for us put players, there was an across the board rebound in the Internet sector today adding fuel to EBAY's fire. Also, some analysts believe that the appointment of Maynard Webb (a former Gateway executive who's known for his great organizational skills) to eBay's engineering and technological operations may have played a vital role in the stock's reversal (perhaps he can get the outages in check!). Plus the analysts' conference went well and, of course, they now are talking up eBay. Again one day does not end a play, but in this case leads one to caution. As you should know by now, EBAY = VOLATILITY + HIGH RISK! SEPR $70.25 +0.00 (+4.88) After making a little spike on Monday and coming in unchanged today, Sepracor's three week tumble is undergoing a slight stall. Despite this slight setback, investors continue to worry about inflationary fears and Greenspan's likely rate hike. We anticipate that these worries will continue up until the actual announcement on August 24. With the help of rate-hike worries in the market and the earnings loss reported by the company last month, we are hoping to get through this little stall and continue to even lower price levels. However use caution with this play. Conservative investors may want to hold off on opening new plays until the stock reconfirms downward direction. Remember SEPR has lost almost $30 in three weeks and may bounce as it approaches its support, so make the most of your stop loss orders. CMGI $76.19 +2.94 (-0.81) Nice attempt at recovery but CMGI couldn't get back above its weak Friday closing level of $77. Thus it stays on our put list despite the strong afternoon recovery. We all know that CMGI is capable of big swings. It actually touched as low as $68.25 today before adding back almost $8 by the close. If you had the luxury of watching today's action, setting trailing stops on the way down would have garnered exceptional profits. CMGI now rests precariously just below its support level of $77 (technically weak despite a big finish). While the possibility exists for a technical break to the upside, the overall trend is still down. Nonetheless, remember that Internets carry a high degree of risk and you need to plan your entry accordingly. Those with fragile tickers (hearts) should stay clear. AMZN $91.00 +5.50 (+1.44) In yet another sign of technical weakness, AMZN failed to close above its trading high of Monday, a day of wide market losses. Today's snapshot of strength in the final 2 hours can't negate that. While support is at $90, any further weakness in the sector (the bond rate is telegraphing that there will be weakness) could send AMZN scrambling back to the low $80's. After that the new floor would be $60. We're not trying to poke holes in AMZN. After all, it has a fine brand name that offers a good shopping experience and conjures up all kinds of positive images. Unfortunately they don't look like $$$ signs. In fact, in a briefing.com article today it was pointed out that brick and mortar retailer, Wal-Mart has a higher profit margin than AMZN. Wasn't that supposed to be the beauty of online retailing? Anyway, look for continued sector weakness, but be mindful that even on their way to the cellar, they still take the stairs, not the slide. It's a volatile play so exercise caution. Also note that they have settled their dispute with the New York Times over use of the words "Best Seller List". TAN $41.06 +0.25 (-3.63) Has it hit the floor yet? On Monday, Shares of Tandy fell another $3.88. Volume on the decline was more than twice the norm, with 2.48 mln shares exchanging hands. The retail industry has really been getting kicked around recently. Many company's are still reporting increases in same store sales with earnings beating analysts estimates. This was the same story last quarter except investors rewarded the retailers. This quarter interest rates are a bit higher and investors are drop-kicking many of the retail companies like a football. The retail sector did find some strength today after Walmart reported earnings and led the industry to a gain. Is this the bottom? We will let the markets tell us for sure. However one day does not a trend make. At its low of the day TAN hit $37.38, down $3.43 for the day. The last hour it did regain its composure, coming back to close at $41.06. If you are in Tandy and didn't take your money off the table today, move your stops down tight. We would be cautious about entering a new play on TAN at this time, given the strength it exhibited near the close today. TBH $72.50 -0.38 (-1.50) Telebras was down $0.38 on Tuesday to close at $72.50. Volume today was a little on the heavy side with 1.97 mln shares changing hands. It appears market sentiment is favoring an interest rate hike by the Fed on Aug 24. With the South American economies being heavily influenced by U.S markets, higher interest rates will likely drive TBH lower over the next couple of weeks. If you were to look at two six month charts, one of the DOW and one of TBH, it is astonishing how TBH mimics the DOW as economic or monetary concerns effect the market. Historically, we can expect Latin American ADR's to be volatile as interest rate uncertainty continues. Moreover, unless the Fed decides that one rate increase is not enough, we will see more losses in TBH. AXP $124.50 -0.50 (+1.44) Not much movement today on AXP. This fact makes caution necessary since a lot of the market's move today were based on interest rate concerns and the yield on treasury bonds. Financial stocks were affected for the most part but, AXP held up quite well with an afternoon rally off it's low of $123.06. We are still holding below resistance of $127 though and any sign of market strength may move AXP up so set your stops. Yesterday analysts were confirming that the financial sector is oversold so watch for investors jumping in on bargain hunting. But if we get more market weakness, we could see $115 as our support. Be cautious before starting any new AXP plays. NEW CALL PLAYS ************** SLB - Schlumberger Limited $66.38 -1.06 (+3.06 this week) Schlumberger is one of the world's largest and most diversified oil services firms, operating in more than 100 countries. Its Oilfield Services unit provides practically everything needed for finding oil, including interpreting seismic data, drilling rigs and services, wireline logging, constructing wells and project management. Its Measurement & Systems unit, which makes smart cards and other measurement and transaction systems, is a world leader in gas, water, and electric meter manufacturing. With investors anticipating an interest rate hike by the Fed on August 24, many are running from those sectors of the market that are most affected by higher interest rates into others that are safe havens. These worries that have existed for the past few months have made oil stocks the place to be. In the short-term, we expect continued selling of interest rate sensitive securities and more buying of stocks like SLB. We picked SLB as a play because of the fact it's an industry leader and is positioned well to make a nice move ahead. The stock recently broke through its resistance level at $65 and should be on track to go even higher considering the current market conditions. Oil has recently closed above $21 for the second day in a row, which is a great sign for a stock that lives or dies by these prices. Each Tuesday there is a report from the American Petroleum Institute showing oil inventories. Today's release indicated that draws on oil were higher than expected for the week and that should help the sector. Like always place stop orders to protect yourself if oil prices change directions on us. In the news, Schlumberger said Monday it restructured its joint venture with UK.-based Cable and Wireless Plc. to make their Omnes communications company a Schlumberger unit. This joint venture would help Schlumberger provided wireless communications to companies in remote regions. BUY CALL AUG-60 SLB-HL OI=9305 at $6.75 SL=5.00 BUY CALL AUG-65 SLB-HM OI=9399 at $2.69 SL=1.25 BUY CALL SEP-65 SLB-IM OI= 648 at $4.38 SL=2.75 BUY CALL SEP-75 SLB-IN OI= 705 at $1.94 SL=1.00 Picked on August 10 at $66.38 PE = 78 Change since picked 0.00 52 week low =$40.06 Analysts Ratings 7-9-8-1-0 52 week high=$67.63 Last earnings 07/99 est 0.25 actual 0.63 Next earnings 10-22 est 0.26 versus 0.13 Average daily volume = 3.2 mln Chart = http://quote.yahoo.com/q?s=slb&d=3m NEW PUT PLAYS ************* BRCM - Broadcom Corp. $104.87 -3.50 (-4.13) Faster, Faster, Kids say while spinning! We big kids want faster as well, just faster online connections. BRCM is the company helping us as they focus on products that give us high speed transmission over our existing phone lines and cable systems. This technology allows users to more efficiently use voice, data, and video streams. BRCM's detailed focus on system design allows this speed and efficiency to be offered in MPEG devices for the cable TV box, Cable modem's, Ethernet networks, home based networks, digital broadcast, and XDS markets. Broadcom has thus captured a large share of the cable modem market and acquired customers like 3Com, Cisco, General Instrument, and Motorola. Revenues have almost tripled to $96 million due to expanding markets, and the companies effective management. August 5th took BRCM to a new 6 week low of $101.50. The stock has been unable to recover and looks poised to head lower on continued market weakness. Currently our 10-dma is serving as resistance at $115, with support at $98. Any market correction should prove profitable to support. The company may be currently overvalued with a relatively high P/E, and this should also help put downward pressure on the stock as the market corrects. Because we have seen several sessions of profit taking, do not enter until you are sure of the market's direction and the stock is also continuing down. There is not a lot of news on Broadcom however there is one report Monday that confirmed BRCM's weakness. It cited that while many other chip makers were experiencing strength in shares, BRCM was declining due to interest rate fears. The stock also seems to be trending with the Internets, another reason to play this one short. BUY PUT AUG-105 RDZ-TA OI= 430 at $4.75 SL=3.33 BUY PUT AUG-110 RDZ-TB OI=1293 at $7.75 SL=5.87 Average Daily Volume = 2.19 mln Chart = http://quote.yahoo.com/q?s=brcm&d=3m ****************** FREE TRIAL READERS ****************** If you like the results you have been receiving we would welcome you as a permanent subscriber. The monthly subscription price is 39.95. The quarterly price is 99.95 which is $10 off the monthly rate. We would like to have you as a subscriber. 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The Option Investor Newsletter Tuesday 8-10-99 Copyright 1999, All rights reserved. Redistribution in any form strictly prohibited. PLAY OF THE DAY *************** U - USAir Group Inc. $31.06 -1.44 (-1.38 this week) As one of the top 10 airlines in the U.S., US Airways Group is the holding company for US Airways, Inc., Shuttle, Inc., Allegheny Airlines, Inc., Piedmont Airlines, Inc., and PSA Airlines, Inc. As a certified air carrier, they are engaged primarily in the business of transporting passengers, mail, and property. USAir is still trying to emerge from a rough decade which has included low-fare competition, labor disputes, and early retirement by more than 300 pilots. Currently one of their more popular routes comes from Shuttle, Inc. which operates the US Airways Shuttle between New York and Washington. Sunday Write Up It's hard to believe that we started this week with such a spike in optimism in USAir's stock. When Tiger management, USAir's largest shareholder, announced that they had filed with the SEC to explore merger/alliance deals for USAir the stock spiked up $4 in a matter of hours. What an entry point for those of us that weren't fooled by the hype! In hind sight that news was probably nothing more than a chance for Tiger to unload some of their shares which total 22% of the company. The rest of the week was nothing but down for U's stock. On Friday they filed their quarterly report for Q2 with the SEC. It read like a shareholder horror story. It was filled with labor problems, Y2K concerns, shrinking cash positions, court battles, revenue and economy worries, higher fuel prices and increased competition. We got depressed reading it and we don't even own the stock. It is no wonder the stock hit another 52-week low today, closing only .06 cents off the day-low. But like we have been saying for weeks now, entry point is the name of the game. The stock only moves a few dollars a week but premiums are extremely low. So plan your moves before opening new plays. US Airways said Friday it has had to cancel a rising number of flights because of pilot training problems, bad weather and the work of integrating new aircraft into its fleet. This portion of the 10-Q mentioned above was summarized after the close on Friday by Reuters. The company said they don't have an ETA on when the problems will be resolved. Just another log being thrown on the fire for USAir. Tuesday's Update It's the same old story for USAir as investors keep their finger on the sell button. They tried to rally the stock on Monday but never made any substantial gains and it was right back to new lows on Tuesday. The temporary rally may have stemmed from news that they will be offering new routes from Atlanta to New York. But we keep talking about the overall sentiment for USAir and other airlines and until the momentum shifts, these rallies are nothing more than entry points. So keep the new 52-week lows coming and follow up the play with trailing stops to protect your gains. BUY PUT AUG-40 U-TH OI=697 at $9.50 SL=7.00 BUY PUT AUG-35 U-TG OI=254 at $4.38 SL=2.75 Average Daily Volume = 859 K STRADDLES ********* Well traders, breakouts to the downside are in full force. The Index Averages have helped just about any consolidated stock to breakout to the downside. The good news is that looking at the different markets by sector tells me that there is more room for not only breakouts to continue, but there are still several markets that have not broken out yet. Sectors that I am looking at right now that are consolidating include the oil and gas sector and some stocks in the financial data services sector. Stay tuned! Did anyone take a look at the straddles published just a few days ago? The two that interested me the most were Whirlpool and Maytag. Same industry, different market directions. You can look at the fundamentals all you want, but what the consumer sees is one company (Whirlpool) selling quality appliance products at competitive prices, while another company (Maytag) sells quality products, but at a higher price. Maytag is of appliances as Michellin is to tires. Problem here is this company is relying too much on top of the line products. Maytag has washers and dryers that retail for $1000 or more each. This is similar to the braun shaver offered by Gillette. Shaving your face has the same affect with a 99 cent razor as it does with a $200 electric shaver. Now I know I will get some argument here, but the result is basically the same. The same goes with washers and dryers. Why spend $1000 on a washer when you can basically get the same affect for $300? This seems to show with Maytag, as inventories are building. Get ready Maytag, Christmas is only 130 days away. Most of the stocks that were published as breakout stocks did indeed breakout. HoneyWell (HON) has broken down out of its classic wedge and shows a clear selling pattern. Its down about 4 points from Friday, and the latest news is that it is proposing a merger with Allied Signal. Avery Dennison (AVY) broke down and is now 2 points ITM from Fridays price. No news here, but the stock is down 3.5% which is great for the put side of a straddle. Zion Bancorp (ZION) is nowhere from last week as the wedge continues to tighten. They are involved in merger talks which can be a risk to straddle traders if they happen to be bought at today's stock price. Centocor (CNTO) is one of those stocks that looks like watching paint dries. CNTO was downgraded yesterday, but the stock hasnt moved on any news since the takeover rumors of last week. If these rumors don't surface into reality soon, CNTO should get tagged to the downside soon. Maytag and Whirlpool were both mentioned above, and are moving apart, with MYG leading the way, with nearly 5 points of intrinsic value in the puts since Friday. Straddle Mailbag I have gotten several questions asking what a straddle is, the elements to creating a straddle, and placing the straddle order. I also got a question wanting to know how you make money with a straddle. Keep in mind that in the OIN / OPTIONETICS seminar series, I cover this strategy in more detail. I will answer the above questions in order. What is a straddle and what are the elements to creating a straddle? A straddle is basically a call option and a put option, at the same strike price, using the same expiration date for each option type. These strikes can be anywhere you like, as long as the call and put are the same strike price. Keep in mind that I like to enter all my straddles using strikes as close to the underlying asset as possible (at-the-money). If the stock is trading at 98, and the strikes that are closes are the 95's and 100's, I will go with the 100 strikes as they are closer, or I may decide to wait a day or two for the stock to reach a strike, making that strike price "at-the-money." How do you place a straddle order to your broker? Well, this is not as tricky as you think. First of all, a straddle order is a spread order, meaning that this order can be placed and filled on one ticket. When I first started trading straddles early in my career, I first had to look for a broker that would take my straddle order on one ticket, and fill it as a spread. An example of outright fills versus spreads would be as follows: OPTION STRIKES SPREAD (COMBINED PREMIUMS) XYZ DEC 100 CALLS FOR 8 XYZ DEC 100 STRADDLE FOR 15 XYZ DEC 100 PUTS FOR 7 Getting this order quoted and filled at a spread price does 2 things. First, I don't have to get quotes for each and add them up in my head. Second, and most important, I know that if I am filled, I am filled on the entire straddle, not just one side of the trade. I always enter my orders as a straddle spread and get filled as a spread to insure I am in on both sides. Here is a few more tips and tricks that I use when entering a straddle. Like Jim Brown lives by, I avoid placing straddles during the opening hour. Even though spreads are more tolerant to directional risk, the spreads are often wider during "amateur hour." The other thing that helps me is that I always use a "limit order" when entering the straddle. This just helps me to keep from overpaying for the straddle. Like I always say when it comes to the bid and offer, I am glad to give the floor trader a little spread, but I don't want to put his kids through college. Tom Gentile COMBINATION PLAYS ***************** Delta Neutral Trading Techniques There are many ways to take advantage of theoretically mispriced options in the retail market. Most traders will buy or sell a concurrent (and possibly opposing position) in the underlying issue or open a spread with options on the same instrument in a similar series. Those who wish to participate in delta neutral strategies may choose to trade options which are theoretically equivalent. Spreads with this type of "hedged" outlook generally fall into the category of "volatility" plays. Two of the more advanced volatility spreads are the "Back-spread" and the "Ratio Vertical Spread". The first thing one notices about these two techniques is they have many common characteristics: 1. Both spreads are initially "delta neutral". 2. Both spreads are affected by changes in the underlying issue. 3. Both spreads are affected by the passage of time. 4. Both spreads are affected by changes in implied volatility. First, the Back-spread: A back-spread exists when more long positions are purchased than those which are sold (2x1,3x1 etc..) and all the contracts expire at the same time. In order for a call back-spread to be delta neutral, the purchased calls must have a higher exercise price than those which are sold. A put back-spread requires just the opposite; the purchase of puts with a lower exercise price than those which are sold. The primary characteristic of a profitable call or put back-spread is an increase in volatility; a move away from the long (purchased) option's exercise price will increase the value of the spread. Depending on the type of back-spread, movement in one direction will be preferable to movement in the other direction. In a call back-spread, upside potential is unlimited and a put back-spread has unlimited downside potential. Traders should choose the type of back-spread that reflects their opinion about future market direction and avoid this strategy during stable cycles. In most cases, regardless of direction the strategy requires movement. If the underlying issue remains in a small range, a back-spread will rarely profit. One way to ensure profit from a volatile market (regardless of direction) is to open the position for a credit. That means the amount of money received from the sold options is greater than the cost of those which are purchased. If the market collapses in the case of a call back-spread, or explodes in the case of a put back-spread, all options will expire worthless and the play will profit from the credit of the initial transaction. Ratio Vertical Spread Some traders refer to the opposite of a back-spread as a ratio vertical spread or front-spread. This position consists of more short (sold) contracts than long (purchased) contracts, with all contracts expiring in the same month. A ratio vertical spread will realize the maximum profit at expiration if the underlying issue finishes at the short (sold) option's exercise price. The value of the position will decrease if the underlying contract moves away from this exercise price. While the ratio vertical spread will generally profit in a stable market, the type of position (bullish/bearish) should still be based on the future outlook for the underlying issue. Since the ratio vertical spreader assumes the opposite risks of the back-spreader, the amount of loss is unlimited on the upside in a call ratio vertical spread, and just the opposite in a put ratio vertical spread. With the current market outlook in mind, we will focus on the bearish form of this strategy; the ratio call spread. The ratio call spread is a neutral strategy in which one buys a number of calls at a lower strike price and sells more calls at a higher strike. This type of play offers a large probability of making a limited profit with low downside risk and a relatively small investment. It is one of the more attractive delta neutral spreading techniques since the trader is buying mostly intrinsic value and selling a relatively large amount of time value. The ratio call spread has a defined range within which a profit can be made at expiration. If the spread is initially established for a credit, there is no downside risk. The profit or loss at expiration is constant below the lower strike price because both options are worthless in that area. Maximum profit occurs when the issue finishes exactly at the strike price of the sold option. The greatest risk in a ratio call spread lies to the upside, where the loss is theoretically (although not realistically) unlimited. Many delta-neutral traders prefer ratio call spreads because the downside risk or gain is predetermined in the opening ratio and therefore the position requires little monitoring in a bearish market. The margin investment required for a ratio call spread is fairly nominal since (on the long side) one is buying a call rather than buying the stock. The actual position is really the combination of a bull-call spread and a naked call, thus the net investment is equal to the collateral required for the naked call plus (or minus) the net debit (or credit) of the spread. As in many spreads, there is more than one way to implement the strategy. The most common philosophy is that ratio call spreads should be established for credits so that there is no chance of losing money on the downside. Traders that use this method want the underlying stock to be below the sold strike price when the spread is established. The further the stock is below the strike, the more attractive the spread will be. Once again, this type of position has no downside risk; even if the stock collapses, the profit will be equal to the initial credit received. The trader that plays both debit and credit (ratio call) spreads will generally have a better selection of candidates to choose from and will also be able to assume a more neutral posture on the underlying issue. Those who trade only credit spreads will generally return smaller profits (when the price of the security remains relatively unchanged) but will not have to worry about risk with a declining market. If the stock price falls significantly after the play is opened, a downside follow-up is not required when the initial spread was for a credit. If the initial spread was a debit, the trader may want to roll-down the written calls. The follow-up action for an upside move usually consists of buying additional long calls to reduce the ratio in the spread. Eventually, the goal would be to adjust the spread ratio to 1:1 (a bull-call spread). In addition to these defensive actions, ratio call spreads can also be closed early to take profits or limit losses. The most common situation occurs when the stock price is close to the higher strike price and the time value on the sold position has eroded significantly. Another alternative is to re-adjust the ratio to reflect any new opinion on the underlying security or to re-establish a neutral profit range. Our new associate, Tom Gentile, is an expert in the art of delta-neutral trading. With a little bit of reader interest, we may be able to convince him to provide some ratio spread candidates in a future newsletter. Good Luck! ray@OptionInvestor.com ****************** FREE TRIAL READERS ****************** If you like the results you have been receiving we would welcome you as a permanent subscriber. The monthly subscription price is 39.95. The quarterly price is 99.95 which is $10 off the monthly rate. We would like to have you as a subscriber. You may subscribe at any time but your subscription will not start until your free trial is over. 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