The Option Investor Newsletter Monday 07-02-2001 Copyright 2001, All rights reserved. 1 of 1 Redistribution in any form strictly prohibited. To view this email newsletter in HTML format with embedded charts and graphs, click here: http://www.OptionInvestor.com/htmlemail/070201_1.asp Posted online for subscribers at http://www.OptionInvestor.com ****************************************************************** MARKET WRAP (view in courier font for table alignment) ****************************************************************** 07-02-2001 High Low Volume Advance/Decline DJIA 10593.75 + 91.32 10638.87 10467.38 1.11 bln 1600/1471 NASDAQ 2148.72 - 11.82 2181.05 2140.65 1.51 bln 1555/2234 S&P 100 639.96 + 7.94 642.08 632.02 totals 3155/3705 S&P 500 1236.72 + 12.34 1239.78 1224.03 46.0%/54.0% RUS 2000 498.39 - 14.25 513.28 498.25 DJ TRANS 2806.50 - 27.06 2836.63 2802.80 VIX 20.29 - 1.34 21.58 20.26 Put/Call Ratio 0.60 ****************************************************************** Economy over Earnings Is this a new dynamic? Positive economic news trumps negative corporate earnings news? About two weeks ago, I wrote about the market's rally off of positive data from the Conference Board, specifically its leading economic indicators. A similar situation developed Monday morning, when the National Association of Purchasing Managers released its index of manufacturing. The index rose to 44.7 during the month of June, from its May reading of 42.1. Estimates had the June reading pegged at 42.9, so market participants were pleasantly surprised this morning with the better-than-expected number. Still, a reading below 50 suggests that manufacturing is in recession - the index has been below 50 for 11 straight months ended June. Although manufacturing remains in somewhat of a slump, the recent rebound in the NAPM's index suggests that the worst may be over and better times lie ahead. In addition, the Commerce Department reported that consumer spending rose by 0.5 percent during April and May, which like the NAPM number, bested estimates. Fortunately, the dual dose of positive economic data overshadowed another major earnings warning. Minnesota Mining & Manufacturing (NYSE:MMM) guided second-quarter earnings estimates lower Monday morning, blaming its shortfall on weakness in the U.S. economy, overseas economies and the strength of the U.S. dollar. But, like many other companies that have warned recently, shares of 3M rallied throughout the day Monday, following its gap lower. In fact, the stock staged an $8 rebound from its opening lows and actually finished over $3 higher on the day. After the bell, further warnings surfaced in both the old and new economy. DuPont (NYSE:DD) issued a warning predicated upon the same issues as 3M had reported: weak domestic and foreign economies and the strong dollar. Although under illiquid conditions, shares were off by about $1 in the after hours session. The blow-up of the day belongs to Internet Security Systems (NASDAQ:ISSX), who issued a horrific earnings warning judging by the market's reaction in after hours trading. The company reported that it would sustain a loss of 2 cents per share from operations during its current quarter, while previous estimates had called for a profit of 15 cents. Shares of Internet Security shed about $17 in the after hours session, and its warning rippled across to its competitors, including Check Point Software (NASDAQ:CHKP) and Verisign (NASDAQ:VRSN). Additionally and unfortunately, Rational Software (NASDAQ:RATL) issued a warning, although it was not nearly as negative. The company reported that its earnings would fall to the low-end of estimates and that revenues would fall short by about $10 million. Shares of Rational slipped by about $3 in the after hours session. The slew of earnings warnings so far this week could keep the resistance in place across the major market averages. For its part, the Nasdaq Composite (COMPX) is having difficulty clearing the 2150 - 2180 range. Recall the head-and-shoulders pattern I had written about in early June, and it's clear why the COMPX is having trouble clearing that range. The neckline of that pattern had served as meaningful support prior to the COMPX's breakdown, and now that neckline becomes resistance. Should the COMPX decidedly advance above its current resistance range, it could retest its staunch resistance around the 2250 area. Traders can use any advance above the COMPX's intraday high around 2180 to confirm a rally attempt, as that level has served as very short-term resistance last Friday and again Monday. In terms of support, the COMPX has psychological help at the 2100 level, with technical support lower near 2060. The S&P 500 (SPX.X) is having trouble advancing above the 1240 level as evidenced by Monday's three failed attempts to clear that area. In fact, the S&P has attempted to clear 1240 on four separate occasions over the past three weeks, but each time it has failed. Of course, a breakout above 1240 would certainly be a positive development for the broader market and may help the COMPX clear is resistance. On the downside, the S&P continues to gyrate around the 1225 level, which was its intraday low Monday and may continue to serve as support over the short-term. Below that level, however, the S&P has meaningful technical support at the 1210 level, which is reinforced by the equally significant 1200 level. We'll want to keep a close watch on the S&P's support levels this week. Meanwhile, the Dow Jones Industrial Average (INDU) is having problems hurdling resistance around the 10,650 level. Of course above that level lies the 10,700 level. But, the Dow continues to find support around the 10,500 level, where buyers continue to step in. As we turn to future, short-term price action, I'd like to opine that Monday's light volume pullback in the Nasdaq is not out of the ordinary in light of its substantial run over the last two weeks. In fact, it wouldn't be surprising to see the COMPX fall further this week to consolidate its recent gains, which wouldn't be all that disconcerting, at least from where I sit. What we don't want to see is the major market averages drift lower and subsequently break below key support levels, such as the S&P 500 and its support at the 1200 - 1210 range. If earnings warnings start to impact the broader market in a negative way, and support levels are taken out, we may witness a retest of relative lows, or even see a further pullback across the broader market averages. But earnings warnings haven't had much of an impact on price action recently, so that variable remains somewhat of a mystery. While I desperately want to have conviction one way or the other to better position my readers for profits, I must concede that it's difficult to definitively say which way the market is headed over the short-term. That's because several of the indicators I follow are telling conflicting stories. On one hand, the Nasdaq-100 is a few ticks away from a bull confirmed signal on the bullish percent chart. Should it be issued, I think that metric would add credence to the COMPX retesting the 2250 level in the short-term. Furthermore, the economic data recently released is showing signs of improvement, which has in turn discounted the myriad earnings warnings across the broader market. On the other hand, there are warning signals being flashed. I personally received an inbox full of e-mails this morning concerning the low level of the CBOE Market Volatility Index (VIX.X). For those who don't know, the VIX is a measure of fear among market participants, hence the "fear gauge." Typically, the lower the level of the VIX, the lower the level of fear among market participants. And when viewed contrarily, a low reading in the VIX suggests that market participants have grown complacent and portends a correction in the broader market averages. The two-year chart of the VIX below depicts that it's approaching historically low levels. And if readers juxtapose a broader market average, say the S&P 500, over each of the VIX's relative lows over the last several years a disturbing pattern develops. (Note the timing of each low.) I'm not smart enough to know whether or not the complacency displayed by the VIX is forecasting a correction in the broader markets. If history is any guide, however, that may very well be the case. But we must also remember that the VIX can always go lower if the broader markets work higher in the short-term. I think that the extreme reading of the VIX is a cause for concern, but it shouldn't be the final answer. Instead, I think the prudent approach is to incorporate it into your trading thesis. Finally, the markets will close early Tuesday, at 1:00 p.m. EST. And I hope all of our readers have a happy and very safe Fourth of July holiday Wednesday. Questions are welcome: eutley@OptionInvestor.com Eric Utley Editor Option Investor **************** MARKET SENTIMENT **************** Tech Sectors Test Resistance By Jeffrey Canavan The Nasdaq Composite tried to finish the day in positive territory, but was held down by biotechnology stocks. The Biotechnology Index (BTK.X) has been battling with the 200- dma for the past three days, and lost the battle today. The war can still be won, since support looks strong at 570, oscillators look oversold, and prices are above a rising 50-dma. A close above 625, and getting the bullish percent data off of bear alert status would help to clear up the picture. There are still some bullish stocks in the group, but overall the sector is neutral. Internet, software, networking, and semiconductors tried to put in a good showing today, but faded into the close. That could be because they are pegged at the their May downtrends, and the holiday-shortened week may lack the necessary volume to push these sectors through resistance. Muddying the picture even more are short-term stohastics that are suggesting these sectors are a little overbought, but longer-term MACDs and bullish percent data are oversold. A brief pullback before another attempt at the May downtrends could be the scenario that plays out for these sectors. The trend for energy stocks continues to be straight down, but pharmaceutical stocks were able to put a temporary stop to their skid, closing up 1.73%. The financial sector looks overbought, but continues to be the strongest sector, with insurance stocks doing especially well. *************************Sector Watch**************************** Weekly Daily Overbought Support Resistance Trend Trend Oversold DJIA Bearish Neutral Oversold 10,400 10,800 NASD Bearish Neutral Overbought 2,000 2,200 S&P 500 Bearish Neutral Neutral 1,200 1,250 Rus 2000 Neutral Neutral Oversold 480 500 Semis Neutral Neutral Neutral 545 660 Biotech Neutral Neutral Oversold 570 625 Internet Neutral Neutral Neutral 160 186 Networking Bearish Bearish Neutral 314 380 Software Neutral Neutral Neutral 210 241 Banking Bullish Bullish Overbought 640 670 Retail Bearish Bearish Oversold 840 880 Drugs Bearish Bearish Oversold 375 400 Percent Change Last 5 Days Last 10 Days Last 30 Days DJIA (1.0%) (1.1%) (6.6%) NASD 4.8% 8.1% (2.3%) S&P 500 1.5% 2.3% (4.3%) Rus 2000 2.9% 1.6% (1.6%) Semis 5.6% 5.9% (3.3%) Biotech 3.4% 2.8% (0.3%) Internet 2.5% 10.5% (13.4%) Networking 5.5% 7.9% (22.4%) Software 6.1% 11.9% (0.6%) Banking 1.4% 4.1% 2.9% Retail (0.4%) (0.8%) (4.4%) Drugs (2.1%) (4.6%) (6.0%) ***************************************************************** *********** OPTIONS 101 *********** Questions on LEAPS Covered Calls - Part 1 by Mark Phillips It was with amazement that I watched the results unfold last Tuesday night. Having penned the second of what I expected to be a two or three part series of articles on Covered Calls on LEAPS, I was hoping for a few emails that would encourage me to continue covering the strategy on a periodic basis. What I received exceeded my wildest hopes, with more than 25 messages cascading into my InBox by 8pm. I would start to answer one question and by the time I finished, there would be another 3-4 messages waiting to be read. By the time I went to bed that night, it was clear that I would need to start addressing the strategy on a regular basis just to answer the flood of insightful and prescient questions. Thank you to all that wrote in, requesting more information and a continuation of coverage on the AOL trade! While I will begin writing a column on the Covered Calls applied to LEAPS strategy every Wednesday (actually Tuesday this week, due to the holiday) from here on out (at least until there is no longer a demand for it), I thought tonight I would start to share some of the more popular questions. Complete with answers, this will allow all to benefit from the questions of the relative few. So let's get to it, shall we? Question: When you write a covered call on a leap is there any requirement on which strike price you sell the call on vs. the strike price of the leap you purchased? It sounds like you could buy an out of the money leap for cheap and sell the calls closer to the money for a bigger premium. Of course if the price of the stock stays the same or declines the leap would lose it's value, but you could eventually sell enough covered calls to pay for leap plus some. Answer: This was actually a popular question, and that should come as no surprise. After the tech decline of the past year, there are lots of investors that purchased LEAPS on fallen tech darlings to profit from the eventual rebound. Unfortunately, the 'bottom' where these LEAPS were bought was just a way-station on the trip to a much lower stock price. Investors that neglected to use a rigid stop loss on these positions could be FAR underwater right now, with little hope of getting whole before expiration in January, 2002. The ability to write Covered Calls against these positions seems tempting, but alas, it falls into the category of "too good to be true". It turns out that the risk of the LEAP declining in value is the least of our worries. While such a trade can be entered, when selling a call with a lower strike than the LEAP that we own, the broker will consider it to be a credit spread and therefore will require margin to cover the additional risk incurred by taking on the position. The goal that we are trying to accomplish by writing calls against our LEAP is to reduce the risk of holding the LEAP, by reducing our cost basis. Selling a covered call with a lower strike than the LEAP actually increases our risk, because of the possibility that the covered call could expire in the money, while the LEAP is still out of the money. With a large disparity in strike prices, you can see we are coming very close to selling naked calls - the highest risk option trade I am aware of. It has limited reward and unlimited risk. In a word, UGLY! Let's go through an example to show why this is such a bad idea. Assume that we bought CSCO 2002 $40 LEAPS in January, as we expected that the stock would hold above the $35 level and then recover. Not believing there was much downside left in the stock, we neglected to set a stop loss. That was our first mistake as we watched CSCO get taken apart by the bears, dropping all the way to the $13 level. Now that the stock seems to have found a trading range, we decide to try to mitigate the damage by writing calls against the LEAP. We want time decay to work in our favor, so we will be using front-month options. In order to harvest any decent premium we need to be selling near-the-money options on a reversal from overbought. While we aren't there yet, it looks like CSCO will get close to $20 before reversing on this cycle so we target the $20 July Call. The premium we would receive as of Friday's close is a whopping $0.50. This hardly seems like much, but we're desperate to do anything to improve the balance sheet on this play. If we go to sell the call, our broker wants to protect himself against the worst case scenario by requiring us to maintain margin in our account to cover the risk. That risk amounts to a dramatic event shooting CSCO to $40/share overnight. About as likely as Alan Greenspan showing up to testify before Congress in a pink tutu, but possible nonetheless. That move would have the LEAP finally at the money, but the sold call would be $20 in the money, handing us a $1950 (($.50 - $20)*100) loss on that position. Sure, the LEAP would appreciate somewhat, mitigating the loss on the covered call, but not nearly enough. Put another way, we would take in premium of $50 (maximum reward) with a $2000 maximum risk. Those are not my kinds of odds! So while it is possible to sell calls in this situation, I don't recommend it. What we want to focus on in our trading is selling calls in such a way to reduce our risk. That means that we always want to sell calls with a higher strike than the LEAP that we already own, otherwise referred to as a debit spread. As long as we stick to this arrangement, our brokers should never require us to post any margin to initiate or maintain the trade. If at this point you are still interested in trading credit spreads with LEAPS, make sure you understand the margin rules and the worst possible outcome in the trade before embarking down that path. Each brokerage will have slightly different margin requirements, so check with your own broker to determine your specific requirements. Tune in tomorrow night, as I'll be addressing what was easily the most popular question received. Namely, "What do we do when the Covered Call is in danger of being exercised?" Another excellent question, and we will cover it in exacting detail. See you then. Mark Contact Support ************* NEW CALL PLAY ************* No new call plays tonight ************ NEW PUT PLAY ************ PMCS - PMC-Sierra, Inc. $30.18 -0.89 (-0.89 this week) PMCS designs, develops, markets and supports high-performance semiconductor networking solutions. The company's products are used in the high-speed transmission and networking systems, which are being used to restructure the global telecommunications and data communications infrastructure. Providing components for equipment based on Asynchronous Transfer Mode, Synchronized Optical Network, Synchronized Digital Hierarchy, High Speed Data Link Control, and Ethernet, the company sells its products to over 100 customers either directly or through its worldwide distribution channels. Bullish traders rejoiced last week when PMCS lowered its earnings estimates and continued to drive shares higher on hopes that the worst is behind for the beleaguered Networking sector. Those bullish hopes appear to have been short-lived though, as the stock began pulling back midday on Friday and continued their slide today. A quick look at the daily chart shows that PMCS ended today's trading session below the 6-week descending trendline, currently $31.50. Combined with the 30-dma ($32.09) and historical resistance at $31, it seems clear that the bulls are losing their resolve, allowing the bears to have another day in the sun. Weakness appearing while the daily Stochastics haven't even entered overbought is just another strike against the stock's chances to work higher in the near term. Placing a retracement bracket over the stock's gains since mid-June shows the 38% retracement at $29 and the 50% retracement at $28, both levels of intraday support. A drop through $29 will provide for new entry points, especially if the Networking index (NWX.X) continues to weaken. Use intraday rallies as an opportunity to initiate new positions on a rollover at $31 or possibly $32.50. We are starting the play with our stop at $34, as a close above that level would be a strong indication that the bulls have not given up yet. BUY PUT JUL-35 SQL-SG OI=1192 at $6.00 SL=4.50 BUY PUT JUL-30*SQL-SF OI=1468 at $2.85 SL=1.50 BUY PUT JUL-25 SQL-SE OI=2325 at $0.95 SL=0.00 Average Daily Volume = 9.01 mln QCOM - Qualcomm, Inc. $57.87 -0.61 (-0.61 this week) Based on its proprietary CDMA technology, QCOM is engaged in developing and delivering digital wireless communications services. The company's business areas include integrated CDMA chipsets and system software and technology licensing. QCOM owns patents that are essential to all of the CDMA wireless telecommunications standards that have been adopted or proposed for adoption by the worldwide standards-setting bodies. Currently, QCOM has licensed its CDMA patent portfolio to more than 80 telecommunications equipment manufacturers around the world. Bullish traders have been giving it their all over the past few sessions as they struggled to push QCOM through the $60 resistance level. But the combination of the 50% retracement of the recent decline, historical resistance at $60 and the converged 30-dma ($59.23) and 50-dma ($59.66) was too much to overcome. The result was a pullback throughout the afternoon and QCOM just barely managed to hold above the 6-week descending trendline, currently resting at $57, also the site of the 38% retracement (actually $57.06). Falling through this level will provide an opportunity to initiate new positions ahead of a drop through $56, which will reverse the Point and Figure chart into a column of 'O's, setting the stage for a move back towards the $52 support level. Because of the strong resistance, we can place a tight stop at $60, keeping the risk in the play tightly controlled. If you are looking for a better entry point, consider selling any rally that fails to penetrate the $60 level. Increased selling volume will just help to confirm that we are on the right side of the trade. While QCOM may find buying support ahead of its earnings announcement, we don't need to worry about that right now, as the company isn't set to release its numbers until July 26th. BUY PUT JUL-60 AAO-SL OI=14456 at $4.10 SL=2.50 BUY PUT JUL-55*AAO-SK OI= 8400 at $1.85 SL=1.00 BUY PUT JUL-50 AAO-SJ OI= 9812 at $0.80 SL=0.00 Average Daily Volume = 13.7 mln QLGC - QLogic Corporation $62.53 -1.92 (-1.92 this week) Somebody has to make the equipment that lets your computer talk to all its peripheral equipment, and QLGC does it well. A leading designer and supplier of semiconductor and board-level input/output (I/O) management products, QLGC has been providing SCSI-based connectivity solutions to this market sector for over 12 years. QLGC's I/O products provide a high performance interface between computer systems and their attached data storage peripherals, such as hard disk and tape drives, removable disk drives and RAID (redundant array of independent disks) subsystems. The company is also the market share leader in Fibre Channel host bus adapters, a market segment that is receiving tremendous attention from investors. QLGC treated short-term put traders nicely a few weeks ago, and it looks like it is preparing to do so again. Although it was looking pretty strong as it pushed through the $60 resistance level last week, the bulls ran into trouble at the 200-dma (currently $66.27) over the past 2 days. With the daily Stochastics flattening out in overbought territory, and price pulling back from the upper Bollinger band, the odds are shifting back into the bear camp in the near term. Adding to the bearish picture, we have the Point and Figure chart reversing into a column of 'O's today, opening the door for a retest of the $60 level, possibly as early as tomorrow's holiday-shortened session. Resistance gives us a nice location for our stop, which we are placing at $66. Use any short-term strength to initiate new positions on a failed rally near $65-66. Given the increase in selling volume this afternoon, the stock could be headed lower first, providing new entry points as QLGC falls through the $60 support level. Once the bears accomplish that goal they will work on driving the stock towards mild support at $58 and then firmer support at $54. BUY PUT JUL-65 QLC-SM OI= 402 at $6.00 SL=4.00 BUY PUT JUL-60*QLC-SL OI=2038 at $3.30 SL=1.75 BUY PUT JUL-55 QLC-SK OI=1487 at $1.80 SL=1.00 Average Daily Volume = 6.25 mln ***************** STOP-LOSS UPDATES ***************** BBY - call Adjust from $61 up to $63 BSYS - call Adjust from $56 up to $57 JNPR - call Adjust from $28 up to $29 MVSN - call Adjust from $64 up to $65 ************* DROPPED CALLS ************* RATL $27.45 -0.60 (-0.60) RATL issued an earnings warning after the bell Monday, which sent its shares lower by $3.45, or to $24 in the after hours session. This development is certainly discouraging for our play, but if the stock behaves similar to those companies that have warned recently, it may actually rebound early Tuesday morning. Keep a close eye on how the stock opens and use any strength to exit any open positions. *********** DROPPED PUT *********** VRSN $60.50 +0.49 (+0.49) Sadly, the unusual last hour of trading in VRSN on Friday turned out to be a precursor of what was to come this morning. Rallying strongly right from the opening bell, we immediately got confirmation that it was time to exit the play. Although the stock seemed to run out of steam as the day wore on, the fact that our $60 stop was decisively broken and held into the close leaves us no choice but to move to the sidelines. As of this writing, VRSN is being taken apart in the after hours session on the heels of the ISSX earnings warning, so traders that held on throughout Monday's session should still be able to manage a graceful exit on weakness tomorrow morning. ********************* PLAY OF THE DAY - PUT ********************* BA - Boeing $56.36 +0.76 (+0.76 this week) The Boeing Company is the largest aerospace company in the world, with its heritage mirroring the history of aviation. It is the world's largest manufacturer of commercial jetliners and military aircraft, and the nation's largest NASA contractor. In terms of sales, Boeing is the largest U.S. exporter. Total company revenues for 2000 were $51 billion. Most Recent Write-Up Growth in the airline sector is receding at an increasingly faster rate. High fuel prices, maintenance costs and slowing demand from air travelers are causing the major carriers to cutback on their spending. That in turn is causing shares of the world's largest aircraft maker to plummet. In addition, the extremely strong dollar is wreaking havoc on Boeing's overseas sales as currencies around the globe continue to weaken. After all, "Boeing is the largest U.S. exporter" as highlighted in the company description above. The slowdown in orders for the company's planes combined with the strong dollar-effect has shares of Boeing below its meaningful support levels as long liquidation continues to pressure the stock. We're looking for the weakness to persist over the coming weeks. Traders can look for new entry points into weakness early next week if BA declines below the $55 level on continued heavy volume. Conversely, any relief rally on light volume up to either the $57 or $58 levels may provide an entry point, provided the advance comes on light volume. We're initially setting our stop at the $61 level to provide the play room to work in our favor. Keep an eye on other aerospace/defense contractors such as Northrop Gruman (NOC) and Raytheon (RTN) we gaming entries into BA put plays. Comments Shares of Boeing popped above the $57 level Monday morning before fading into the close. Its light volume advance may have offered entries into this play. If it didn't, traders can use a breakdown below the $56 level on heavier volume to gain entry. For those who prefer confirmation, watch for a decline below the $55 level. BUY PUT JUL-60 BA-SL OI=6673 at $4.20 SL=2.50 BUY PUT JUL-55*BA-SK OI=5722 at $1.25 SL=0.75 Average Daily Volume = 3.32 mln ******************* 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. 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