Option Investor

Daily Newsletter, Monday, 05/08/2000

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The Option Investor Newsletter                Monday  05-08-2000
Copyright 2000, All rights reserved.
Redistribution in any form strictly prohibited.

Posted online for subscribers at http://www.OptionInvestor.com

Also provided as a service to The Online Investor Advantage
MARKET WRAP  (view in courier font for table alignment)
       5-08-2000           High     Low     Volume Advance Decline
DOW    10603.60 +  25.70 10627.80 10522.10   786,188k 1,221  1,717
Nasdaq 3,669.38 - 147.44  3765.22  3669.11 1,142,396k 1,423  2,596
S&P-100  763.59 -   6.20   769.79   759.31    Totals  2,644  4,313
S&P-500 1424.17 -   8.46  1432.63  1417.05            38.0%  62.0%
$RUT     500.08 -  12.76   512.84   499.60
$TRAN   2935.87 +  59.76  2937.89  2874.12
VIX       31.12 +   0.73    32.16    30.93
Put/Call Ratio       .52

Buyers' Strike Continues

Just how many different ways can we say, "Investors' fear of FOMC 
rate hike keeps volume low and prices range-bound"?  Of course, 
there is slightly more to it than that.  For instance Cisco, 
Barron's front-page sacrifice of the week, lost $4.88 to close at 
$62.88 and made a big contribution to today's 147-point loss on 
the NASDAQ.  (The weekend publication penned a negative article 
noting CSCO's dependence on acquisitions to drive revenue growth, 
"questionable" accounting practices, and huge valuation.)  The 
fact is volume, having put in its lowest day of the year at 1.14 
bln shares on the NASDAQ and just 783 mln on the NYSE, is 
revealing a lack of liquidity in day-trading issues.  Most of us 
are finding it tough to trade our way out of a wet paper bag in 
this environment of widening spreads and market makers unwilling 
to take more than 100 shares on the bid.  

What do we mean by that?  A market maker will charge us more and 
pay us less to buy and sell a stock, requiring a greater move in 
the price just for us to break even on the trade.  Not only that, 
where they were once willing to buy 500, 1000, or more shares at 
a posted bid price, they are now willing to take only 100 shares 
before adjusting the bid downward.  Market makers need to eat too 
(and put their kids through Harvard, Yale or Stanford), thus they 
aren't going to buy something if they can't immediately resell it 
to another buyer.  Sellers unwilling to sell + buyers unwilling 
to buy = low volume and low liquidity.  That same market maker 
psychology applies to options too and makes profitable trading 
difficult.  From a market maker's perspective, why buy it if you 
can't sell it higher?  By definition, spreads widen in order to 
keep a liquid market.  Hopefully, that helps you to understand 
what we mean when we say it's hard to make money in a sideways 

Anyway, without a trend established, pros have temporarily taken 
to the sidelines until some economic news hurdles are cleared - 
same ones we highlighted before. . .the PPI on Friday and FOMC 
meeting on Tuesday, May 16th.  For the duration of the week, look 
for more of the same (sideways trading) in the overall market.  

Sadly for those of us with itchy trigger fingers, the market 
should remain in a tug of war with no clear-cut winner.  While we 
don't suggest which side of the fence to trade on (bull or bear - 
heck, we won't know ourselves until next Tuesday), make a note of 
the following arguments for each case in order to clarify why the 
markets are likely remain range-bound and choppy.  

In the bear camp, rising interest rates, light volume, high 
valuations, weak breadth and the Dow still under its 200-dma 
(10,808) all point to the down side.

In the bullpen, tech stocks have been resilient, sentiment is 
shifting as indicated by an increasing put/call ratio (contrarian 
indicator), uncertainty will lessen by May 16th, and this is an 
election year, all of which tend to support prices.

Now, let's take a peek at today's action.  The Dow looked like a 
cardiac patient with almost no pulse.  While today's trading 
range spanned 105 points, the index spent most of the day in a 
50-point range between 10,550 and 10,600, closing at 10,603 on a 
measly 786 mln shares, the lowest volume this year.  The next 
mild resistance is at 10,700; support at 10,400 from which we 
appear to be rebounding ever so slightly, but we won't 
characterize this as a trend based on the low volume.  What we 
have here is a 2-week neutral wedge formation with a technical 
convergence at about 10,550 to 10,600 on (surprise!) May 16th.  
It's not a prediction, just an observation.  That's about as flat 
as it gets, and makes for tough trading.  While 1700 decliners 
took it to 1223 advancers, surprisingly up volume outpaced down 
volume by 30%.  70 new highs squeaked by 65 new lows.  
Transportation, major regional banks, oil & gas drilling, 
airlines, tobacco, HMOs, auto parts, and drugs led the advancing 
sectors, according to briefing.com.

The NASDAQ fared worse shedding 147 points to close at 3669 and 
failing to break back above 3800, a critical level of resistance.  
Worse, support at 3700 failed, setting us up for yet another 
near-term test of 3600.  After that, start looking for 3500, then 
(gulp!) 3350.  We've noted before that we don't expect it to get 
that low only to hear the OOOGA-horn from Q-charts sound the 
alert.  It's still possible.  Yes, the lows are getting higher, 
but the highs are going lower too in (voila') another neutral 
wedge.  Again, not to sound like a broken record, but we won't 
know the directional breakout until it happens.  Unlike the 
lackluster Dow, the internals here stunk.  Decliners smoked 
advancers in a 13 to 7 ratio, and down volume was over 2.5 times 
that of up volume.  Tech stocks led by CSCO, who reports earnings 
tomorrow after the bell (-5.00, 62.754.75; see above), INTC (-
5.75, 117.63), SUNW (-5.13, 85.38), ORCL (-4.50, 72.31), and QCOM 
(-6.75, 103.00) dug today's NASDAQ crater.  73 new lows appeared 
today compared to just 36 new highs.  The lowest volume of the 
year today (1.14 bln shares) probably kept the selloff from 
getting worse, as the index remained between 3700 and 3750 before 
the breakdown at the end of the day.  One more time - tough to 
make money in that environment.

Any good news out there that might provide an air pocket of 
trading opportunity?  Yep.. Look no further than the Chase H&Q 
tech conference in San Francisco, where over 400 companies will 
be presenting to over 4000 investors this week.  Though today's 
presenters didn't fare that well (DELL, EMC, GBLX, TXN, and ORCL 
to name a few), collectively tomorrow's presenters (LU, MOT, 
JDSU, RMBS, EXDS, GTW, EMLX, LSI to name a few) could lend some 
support to the market and to individual issues that present a 
compelling story.  We still have earnings from some major 
companies too.  WMT reports before the bell tomorrow.  CSCO 
reports after the bell.  (And it better be good.  Otherwise, CSCO 
could lead another wave of tech selling and Barron's is going to 
gain a lot more credibility following last weekend's story.)  
AMAT reports Thursday and thankfully has Lehman Bros. pounding 
the table with a price target of $112.  Dell rounds it out on 

Just remember that the PPI is out Friday and could easily show 
signs of wholesale level inflation and that Greenspan and Co. 
will raise interest rates next week.  At this point though, it 
won't be much of a surprise to see a 50 bp increase.  Traders 
have come to expect it - its' almost a certainty - 80% priced in 
as of the end of last week.  You can confirm this in the 28-bp 
hike of the 30-yr. bond rate to 6.25% today.  So what's an option
trader to do for the rest of the week?  Go to the beach!

Seriously, if there was ever a time to step away from your 
trading screen to concentrate for a few days on clearing your 
head of all the noise, this is it.  Volume should remain low in a 
directionless, flat market with a greater probability of falling 
indexes than rising ones until traders become more certain of the 
future.  If you are going to play it anyway, you'll want to 
remain vigilant to find those needle-in-a-haystack opportunities, 
while watching volume for big clues on specific issues.  
Otherwise, consider sticking to defensive positions like puts, 
covered calls, or spreads.  If you are a buyer of time value in 
this market (as opposed to a seller of time value), lack of 
movement and time decay will cook your account into a meal for 
market-makers like a lobster slowly coming to a boil in a pot.  
Sell too soon; don't buy too soon, and don't be a lobster!

Buzz Lynn
Research Analyst

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Purchase Versus Pooling-of-Interests 
By S.P. Brown

Cisco Systems (CSCO) was sent reeling today courtesy of an 
article appearing in the latest issue of Barron's.  The 
article, written by Thomas Donlan, questioned the Internet 
switching and routing king's acquisition accounting methodology 
and how this methodology gooses the company's reported 

Cisco, like most high-tech companies, uses pooling-of-interests 
accounting when it books acquisitions.  Pooling has some 
distinct advantages over the more conservative purchase 
accounting method, the primary advantage being that assets, 
liabilities and equities of the companies are combined at their 
historic book values, meaning financial statements are reported 
as if the two companies had always been combined.  

In turn, the reported earnings-per-share (EPS) of the new 
combination are generally higher immediately after the 
acquisition because the target's original accounting costs, 
less accumulated depreciation, usually are significantly lower 
than the current fair market value of the target's assets. 

Additionally, for subsequent periods, pooling allows the 
purchaser to avoid depreciating, or reducing from reported 
income, the full value of the amount paid for the acquired 

In contrast, under the purchase method, the acquiring company 
must write off the goodwill premium (market value over book 
value) it pays to the acquired company; these write-offs are a 
charge against earnings, which can amount to billions of 
dollars in mergers of large companies.  As a result, the 
reported earnings of the combined companies will appear lower 
under purchase accounting.   

Another significant advantage to pooling is if the acquiring 
company uses stock instead of cash to finance the deal, which 
is how most pooling deals are done.  The transaction is not a 
taxable event for the shareholders of the target company 
because it's just a swap of paper.  The stock of the acquiring 
company is used as the currency, and those shares are traded 
for the shares of the target company.  Furthermore, the cost 
basis for the new shares is the same as the cost basis for the 
old shares for investors in the acquired company. 

A purchase method acquisition, on the other hand, is generally 
a taxable event.  Selling shareholders do recognize a gain or a 
loss on the sale of their shares, even if they receive 
securities of the acquiring company in exchange.  

In an era of lax fundamental analysis and EPS as king, the 
pooling method has proven so valuable that many acquisitions 
are not completed solely because the transaction does not meet 
pooling requirements.

To qualify for a pooling combination, the merging companies 
must adhere to the Financial Accounting Standard Board's (FASB) 
rules, which state each of the combining companies must be 
independent, only voting common shares can be issued, no stock 
reacquisitions after the merger are allowed, there can be no 
planned transactions that benefit only some shareholders and 
there can be no disposition of a significant portion of the 
existing businesses of the combining companies.

Another reason a company may not want to use pooling is that 
it's more cryptic from an analyst's perspective.  The method 
provides the markets with less information than the purchase 
method.  Furthermore, pooling ignores the true market values 
exchanged in a business combination, while the purchase method 
reflects them. 

What's more, most knowledgeable analysts know that the pooling 
method overstates the purchaser's profits after the acquisition 
of a profitable business.  For example, if a company founded by 
an initial investment of $100,000 has grown so that it earns $1 
million per year, and is acquired by a public company for $10 
million in stock, pooling accounting allows the purchaser to 
continue to state $100,000 as the target's assets. 

Consequently, the purchaser appears to earn $1 million per year 
on an investment of only $100,000 instead of earning $1 million 
on the actual $10 million paid for the target, which translates 
into misleading higher returns on assets and equity.

On top of that, companies that apply the pooling method 
generally pay much larger premiums over current market values.  
In one study conducted by the Davis Group, companies that use 
pooling accounting on average pay 200 percent more than do 
purchase-method buyers, as the lack of goodwill amortization 
and the rising value of their stock allows them to pay more for 
the marginally better reported EPS. 

Now, though, it looks as if this little piece of financial 
alchemy might be coming to an end.  Last year, FASB unanimously 
voted to ban the pooling method, but the ban will not become 
effective until after the FASB issues a final statement on the 
issue, which is not expected to be before the end of 2000. 

The banning of the pooling method will most significantly 
impact technology and financial services companies, as goodwill 
traditionally encompasses a substantial percentage of the 
assets of these companies. 

Pooling is particularly well-suited to high-tech mergers 
because the relative asset value of many tech companies is 
small compared with that of industrial manufacturers, which 
have a large capital base of production facilities.  Without 
pooling of interest, acquiring software companies would incur 
large goodwill asset categories, which, in many cases 
(including Cisco's) would cause an unacceptable loss of 
shareholder value.

Proponents of the pooling argue that by eliminating this 
acquisition accounting method, FASB will retard merger & 
acquisition activity in the high-tech arena.  So, as a 
compromise, FASB will continue to allow in-process purchased 
R&D write-offs under purchase accounting rules to continue.  
In-process purchased R&D is basically a slush account that much 
of the goodwill incurred can be tossed into and then expensed 
in the year of the acquisition.     

For more savvy investors, the argument between the pooling and 
purchase methods is moot.  The fact is, economically, there is 
no difference between the two, for the cash flows are the same 
under both methods on a pre-tax basis.  

When it's all said and done, business combinations are 
acquisitions and should be accounted for as such based on the 
market value of what is given in the exchange, regardless of 
whether it's cash, other assets, debt or equity shares.  
Therefore, the purchase method should be mandated, if only 
because it makes the financial statements more accurately 
reflect true economic values.  


SEPR - Sepracor Inc. $104.44 +1.19 (+1.19 this week)

Sepracor develops and commercializes new, patented forms of
existing pharmaceuticals by purging them of nonessential
molecules.  The company's products can reduce side effects,
provide new uses, and improve safety, performance, and dosage.
Sepracor focuses its efforts on gastroenterology, neurology,
psychiatry, respiratory care, and urology.  The company is also
developing its own new drugs to treat infectious diseases and
conditions of the central nervous system.

Most Recent Write-Up

Feeling ill from the recent ups and downs in the market?  Perhaps
a dose of SEPR is just what the market ordered.  SEPR improves
existing, widely prescribed drugs, increasing efficacy and
reducing side effects.  SEPR works with the biggest names in the
industry such as Schering-Plough, Lilly, and Johnson & Johnson.
SEPR has been instrumental in improving some of the most popular
medications on the market right now.  Allegra, Claritin, and
Prozac are all beneficiaries of SEPR's technology.  SEPR is also
developing and marketing its own line of drugs through an
internal development program.  The program is expected to add to
SEPR's earnings stream, taking the company to profitability.
Since falling from its high of $126 in early March, SEPR bounced
and regained nearly 75% of its lost value.  We're looking for the
renewed momentum to carry SEPR higher, especially since the stock
just crossed the psychologically important $100 level.  SEPR
edged above resistance of $103 on Friday.  From here, the stock
won't face heavy congestion until $114.  Watch for a bounce off
support at $100 or wait for a strong move above current levels
as a confirmation that momentum is alive and well for SEPR.  A
rally on above-average volume would provide an additional


On what was an all-round bad day for the NASDAQ, SEPR managed 
to hang on to a portion of its gains.  Right out of the gates
SEPR went for its intraday highs at $109.75, continuing its
uptrend.  Yet, with such light volume on the NASDAQ, SEPR 
slipped later in the session as the broader market sold off.  
The chart looks strong with support around the current level 
of $105 and below at $100.  Look for SEPR to move higher, 
especially with the return of volume to the market.  Target 
shoot on intraday dips based on personal risk levels.

***May contracts expire in 2 weeks***

BUY CALL MAY-100 ERU-ET OI=425 at $ 9.50 SL= 7.00
BUY CALL MAY-105*ERU-EA OI=377 at $ 6.88 SL= 5.00
BUY CALL MAY-110 ERU-EB OI=151 at $ 4.75 SL= 3.00
BUY CALL JUN-105 ERU-FA OI= 37 at $13.25 SL=10.00

SELL PUT MAY- 95 ERU-QS OI= 13 at $ 2.75 SL= 4.75 
(See risks of selling puts in play legend)

Picked on May 7th  at   $103.25    P/E = N/A
Change since picked       +1.19    52-week high=$126.81
Analysts Ratings      5-4-2-0-0    52-week low =$ 27.50
Last earnings 03/00   est=-0.96    actual=-0.76
Next earnings 07-24   est=-0.55    versus=-0.56
Average Daily Volume = 1.09 mln


Money Management - Part two
By Austin Passamonte

I was intrigued with this money-growth multiplier from the 
first time I learned of it 15 years ago. Since then I have
run countless scenarios on trading models across the board.
Start with using only 25% of an account balance and then 
test 50%, 75% and 100% of each pending balance and see where
they take you. For curious types who can't bear to wait for
the answer, surprisingly enough it is the 75% multiplier that
vastly outperforms all others. 75%, 50%, 25% and 100% is the
order in which they finish profitably and the differences are
dramatic. Again, run these equations on the year-to-date
historical data for Skybox and draw your own conclusions. Just
pretend that each was a directional trade, and straddles were
never part of the program to verify which percentage works 

Keep in mind you cannot use a multiplier greater than 
50% when actually trading the Skybox due to the need for 
strangles at times. The only reason I suggest their data
is to test-run the strategies on actual trading scenarios.
We can use the 75% multiplier when trading the OEX in a 
directional manner as briefly described in Friday's OIN.

For example, let's say you were poised for a bounce near 
Friday's market open if Fed reports didn't tank the markets 
all day, in which case you'd remain bearish. We'd like to 
buy May 770 calls or 730 puts if either the above or below
triggers were hit in the only direction we're interested in
trading - in harmony with the market's flow.  

If one trigger we decide to trade is passed over by 3 points
and market signals look strong for continuation, we buy 
as many selected options we can afford using 75% of our 
allotted trading balance. A stop is immediately placed 2  
points below entry and the play is set. If market movement 
favors us and the trade meets your profit target, close out
and remain 100% in cash until the next opportunity. Your
balance has grown considerably and you can take the next
OEX trade using 75% of the new bankroll.

Losses are handled the same way. If you get stopped out, 
recalculate 75% of the remaining balance and take the next
trade using that. If you test-run this trading model, I think
you might suffer greatly from numbers dancing through your
head for awhile  
When deciding how many options you can afford to buy with 75%
of your chosen balance, always round the number down to the
point at or below 75%. As testing will prove, the sweet spot
in our bell curve here lies between 50% and 75% of the money
in play. Therefore, it is better to use 70% rather than 80%
to maximize results over long periods of trading.
Remember one very important thing: the money management system
allows you to win huge and gives staying power, but YOU MUST 
execute the win/loss percentage or it's all for naught. No
matter how good theory and projection looks, if you can't trade
the system to at least similar results, what of it?

When I began trading the OEX I used the 75% multiplier in
a modest-size account and ran it up 500% in six weeks working
the directional system described in Friday's edition. Then I 
got smart. That swollen account gave me an attitude and 
I had this OEX all figured out. No need for protective stops...
I know where the market is going. The index moves 20 -40 points
against me and my high-dollar options shrink to squat? That's
fine, I'll just wait for the market to return. No sense selling
out now when it's on the verge of turning around.

Have you ever waited for any market to return? If you're 
incredibly lucky it may come back close enough to let you
out for a small loss. It did that for me the first time, I 
guess it had mercy on a new guy. Not so fortunate the second
and third time. 

That's right, I did say third time. I bought 20 QQQs 
for 2 and didn't sell for 2 15/16 two hours later because 
I knew they were about to close out at 3. Rally time. I
was so sure the market would turn around just for me I held 
them long enough to sell sixteen at 1/2 while the other four 
couldn't ever find a home. You read it right, that is 1/2 with 
no whole number in front of it. How much is 20 x $293.50? 
Is there a difference between that and sixteen x $50? Does that 
help you understand why I'm fanatical about discipline & stops? 

The story ends on a happy note. Once humbled properly and
soundly by the markets, they have allowed me to run up the
aggressive account to new heights using strict discipline and
"trading scared". This success has much less to do with skill
than using proper money-play usage and strict discipline to keep
losses small. These strategies work just the opposite on a 
string of small gains and big losses - they bankrupt your account!

All of the money-management strategies in the world couldn't
save me from my own ineptitude. Don't think for one moment
anyone can out-trade stupidity, I proved that. Ignorance
defines without knowledge of, stupidity means in spite of 
knowing better. Good trading coupled with these strategies can
make you rich. Bad trading will shoot you down several times
faster. Remember, putting 50% or 75% of your chosen balance in
play with tight stops in place only jeopardizes the amount of
those stops. Trade naked, and you risk losing 50% to 75% of your 
account to severe market reversals. No question about what to do
every time a trade is filled - set those stops!
Again, let me finish by asking you not to believe anything I 
have written here on its face. Get out your calculator or 
spreadsheet program and investigate these yourself before 
committing your money to the methods. I know for a fact 
you'll believe your own math a whole lot better than you'll
believe mine. One thing is for sure, math is an exact science
that cannot lie, and I believe you're going to really enjoy
the truth it has to tell!

Trade the right direction in the right amounts.

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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 
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Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report and website should be independently verified.

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Option Investor Inc
PO Box 630350
Littleton, CO 80163

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