Option Investor

Daily Newsletter, Monday, 10/29/2001

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The Option Investor Newsletter                   Monday 10-29-2001
Copyright 2001, All rights reserved.                        1 of 1
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MARKET WRAP  (view in courier font for table alignment)
        10-29-2001        High      Low     Volume Advance/Decline
DJIA     9269.50 -275.70  9543.40  9269.50 1.11 bln   1026/2067	
NASDAQ   1699.50 - 69.40  1767.97  1699.40 1.65 bln   1246/2364
S&P 100   553.34 - 14.64   567.98   553.34   totals   2272/4431
S&P 500  1078.30 - 26.31  1104.61  1078.30
RUS 2000  429.41 -  9.84   438.88   429.38
DJ TRANS 2218.96 - 28.62  2264.28  2218.72
VIX        32.39 +  1.86    32.70    30.95
Put/Call Ratio      0.61

Merger Monday

As the markets opened slightly weaker this morning, it looked
like the big news of the day would be the final resolution of
sale of GM's Hughes Electronics division (NYSE:GMH).  What has
been called one of the strangest mergers in recent memory was
finally resolved over the weekend, as GM decided to sell the
division to Echostar (NASDAQ:DISH), much to the chagrin of
Rupert Murdoch of NewsCorp. (NYSE:NWS) fame.  The $26 billion
deal creates the second largest television company in the United
States and creates a formidable competitor to the Cable TV
industry.  While the details of the deal filled the CNBC
airwaves early in the day, that quickly gave way to chatter
about the worsening decline in the broad market averages.

Within the first 30 minutes the DJIA had accrued a triple-digit
loss and it only worsened as the day wore on.  By the time the
closing bell rang, the Industrials had dropped more than 275
points from Friday's closing level, putting a damper on the
attempted breakout over the 9500 level.  Volume topped 1.1
billion shares, and advancers languished behind decliners by a
2:1 ratio.  With Stochastics rolling lower, confirming the
bearish divergence in the making, we have to look at the 20-dma
for support at 9250 and then down at 9100, which has been
holding as support since the breakout on October 10th.

The NASDAQ didn't fare much better, as it continued to pull back
from its attempt to break through the 1800 level.  Not only did
today's 70 point decline endanger the breakout through 1750 from
last week, but the rollover in the daily Stochastics confirmed
the emerging bearish divergence there as well.  Barring a
bullish reversal it looks like the 1640 support level is in
jeopardy, with a test of 1600 soon thereafter. Internals were
decidedly negative here as well, with decliners outpacing
advancers by almost 2:1, although volume was only moderate at
1.65 billion shares.

The Technology rally over the past month has been led by the
Biotechnology index (BTK.X), Semiconductors (SOX.X), Networkers
(NWX.X) and Internets (INX.X).  It is no coincidence that these
were among the loss-leaders today, as investors moved to lock in
profits and protect themselves from giving back their gains.
The SOX led the losers, giving up nearly 7%, while the INX and
NWX weren't far behind with 5.80% and 4.74% declines
respectively.  Even the BTK shed nearly 4% (actually 3.84%),
dropping back to the 555 breakout level.  What we have here is a
solid rally that is right on the cusp of reversing into a
bearish trend, and we'll need to see some serious bullish
support tomorrow to rescue these sectors before they roll over
even further.

Delving a little deeper into the movement in the Internet
sector, it is clear that the catalyst for this sector's decline
came from the annual Ebay (NASDAQ:EBAY) analyst meeting.  While
the stock was showing some mild weakness throughout most of the
day, the bottom fell out in the final hour.  Despite an upbeat
presentation, investors weren't wild about the forward guidance
provided by the company, as the stock fell from north of $56 to
$51.25 in less than 30 minutes before firming up somewhat ahead
of the closing bell.  For the record, EBAY guided analysts to
expect earnings in the range of 70 to 73 cents per share vs.
consensus estimates of 73 cents.  We've recently featured put
plays on EBAY on both the short-term play list, as well as in
the LEAPS column due to valuation concerns, and it appears we
were in the right place at the right time.

I think it is instructive to look at the INX index as a way to
measure the current situation in the broader Technology sector.
As you can see from the chart above, the INX reversed from the
$120 resistance level and by the closing bell had fallen right
to the $108 support level, also the site of the converged 20-dma
and 50-dma.  The bullish trendline that has been in place since
early October has been solidly broken, and we'll need to see
some concerted buying near current levels if the Technology
rally is going to continue.  While the support levels and moving
averages are different, similar patterns can be seen in the
daily charts of the NWX, SOX, GSTI Software index (GSO.X) and
GSTI Hardware index (GHA.X).  In a nutshell, the rally is in
trouble, and barring a solid bullish reversal tomorrow, it looks
like the odds will favor more downside this week -- namely puts.

In terms of sentiment, we're starting to see a bit more fear
creep into the broad market, as the VIX moved higher for the
first time in the past 8 sessions, ending the day at 32.39.
Daily Stochastics are just starting to poke out of oversold
territory, indicating that we could see more fear prompt a
significant market retracement over the next several sessions.

With earnings season winding down, investors are once again
focusing on the economic reporting calendar, and there isn't
likely to be much positive news available from that quarter
until the Fed delivers their next decision on interest rates on
November 6th.  For this week, we have Consumer Confidence
tomorrow morning at 10am ET, followed by the 3Q GDP numbers on
Wednesday.  Anyone think those numbers are likely to provide a
boost to the markets?  Me neither!  Without a tangible bullish
catalyst, I'll be leaning towards puts, but cautiously due to
the underlying bullish sentiment caused by traders afraid of
missing the end of year rally.

Remember to trade what you see, not what you believe.

Mark Phillips
Research Analyst

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Coping When Market Direction Is Unclear
By Mark Phillips
Contact Support

After my wandering commentary last week, I received several
emails expressing the same level of confusion about the current
market behavior that I was trying to express and work through
in my article.  Additionally, I received several questions
inquiring as to delta-neutral or non-directional strategies.
Below is a typical question, and I think it makes a good
launching point for our discussion this week.

"...I am not clear as to why you do not refer to non-directional
or delta-neutral trading opportunities."

On the surface, it would certainly seem to make sense.  If we
don't know whether the markets are headed up or down in the near
term, then we ought to be able to craft a strategy that profits
no matter which way they go.  So let's work through some of the
possibilities and see what the pros and cons are, with an eye
towards finding that attractive trading opportunity.

There are numerous strategies that can be employed, from simple
to complex spreads, to straddles and strangles; all of which
have their optimum times for application.  If we want to take a
market neutral position, we might consider a straddle or
strangle that positions us to profit if the market breaks
strongly in either direction.  A straddle consists of buying a
put and a call at the same strike price, where we expect one
side of the trade to become profitable when the market or equity
in question breaks in that direction.  The advantage of such a
position is that we don't have to pick a direction  -- just put
on the position and wait for the market to tell us which
direction was right.

Unfortunately, there is a downside to this strategy that must be
observed.  Straddles only make money if the underlying equity
makes a big move.  In the meantime, we are holding a deflating
balloon.  Part of the cost of the options that make up the
position is based on time value and underlying volatility.  As
time marches on, the time value of the options we purchased is
slowly (or quickly, depending on the amount of time until
expiration) bleeding away.  To make matters even worse, there is
a lot of volatility (compared to historical norms) in option
premiums right now, and as that volatility drops, we are faced
with losing premium on that front as well.

So straddles are great when we don't have a strong bull/bear
bias, but dangerous if the underlying doesn't move.  That leaves
us with a wasting asset, and the longer the equity remains
rangebound, the worse it becomes due to both time and volatility
collapse.  Therein lies the beauty of spread trading.  We can
craft a spread with a bullish bias, bearish bias or neutral
bias, but the one constant is that we can shield ourselves from
the deleterious effects of volatility collapse.

Rather than buying both a put and a call, a spread involves both
buying and selling options, with the net effect that we are
buying and selling both time and volatility.  The types of
spreads available range from straight bullish/bearish spreads to
ratio spreads, back spreads, butterfly spreads, and other, more
complicated combination positions.  The one constant here is
that you must decide before trading, which direction you expect
the stock to trade; up, down or sideways.  There is a spread
available to take advantage of all three directions, but we do
have to make that decision in advance.

We don't have the time to go into the details of any of these
combination strategies here tonight, but if there is enough
interest, I would be more than happy to delve into any type of
spread or other combination position you have an interest in.
Just drop me an email to the address below, and I'll dive in
with my educational hat firmly attached.

As I pointed out last week, when you (or I) can't make a
decision on market direction, sometimes the best decision is to
stay on the sidelines until we can develop a tradable bias based
on the charts.  This is especially important when we are faced
with the volatile markets we now have.  It becomes critical to
have a good knowledge of what drives option pricing when
constructing combination positions, because profitability will
be even more dependent on picking the right options and avoiding
those that are excessively expensive.  Before my early-October
absence, we had started a series on understanding the Greeks,
which are the basis of option pricing.

The question posed at the top of this article provides a great
launching point for continuing our discussion in that vein, so
tune in next week and we'll start off with a detailed discussion
of Delta and Gamma, and how they influence both the option we
select and the best strategy to employ.  From there, we can get
into the real meat of option pricing (in my opinion), which is
the world of Vega and Theta, volatility and time value

Until then, trade only when it is profitable to do so.

Mark Phillips
Contact Support


No new calls tonight


No new puts tonight


AIG - put
Adjust from $86.50 down to $85

EBAY - put
Adjust from $60 down to $56


JNPR $24.00 -1.00 (-1.00) Despite the heavy buying volume that
propelled JNPR as high as $27 last week, the bulls have been
gradually losing their resolve over the past several sessions.
Monday's action was firmly oriented to the downside, and now
that the Stochastics have rolled over and JNPR has closed right
at our $24 stop, it looks like it is time to move on.  The close
at $24 has turned last week's breakout into another broken
pattern, so we're moving the play to the drop list tonight.

VRTS $29.63 -2.05 (-2.05) That didn't last long!  We added VRTS
to the call list on its breakout last Thursday, and the sellers
have been on the warpath ever since.  Friday's close just over
the $31 level looked like a possible entry point, but the
persistent weakness throughout the day on Monday made it clear
that we have another failed breakout on our hands.  With a
broken stop at $31, we're dropping VRTS tonight.  Fortunately,
we didn't receive a tradable entry point, so we'll admit our
error on move on to more attractive plays.


No dropped puts tonight

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AIG – American International Grp. $81.00 -2.80 (-2.80 last week)

Engaged in a broad range of insurance and insurance-related
activities through its subsidiaries, AIG's primary focus is on
its general and life insurance businesses.  Additionally, the
company is growing its presence in financial services and asset
management.  Other operations include auto insurance, mortgage
guaranty, annuities, and aircraft leasing.  With operations in
130 countries, AIG generates more than half of its revenues
outside the United States.

Most Recent Write-Up

If you've been looking at the Insurance sector (IUX.X) for a
possible put play, then you aren't alone.  After such a sharp
rebound from the post-attack lows, the IUX is looking vulnerable
to a bearish attack, and a drop below the pivotal 700 level
would just get the feeding frenzy started.  AIG is looking
similarly weak after rolling over near $86 and beginning to
build a bearish trendline over the past couple weeks, currently
resting at $84.  A rollover in the IUX would likely pressure AIG
back down towards its 200-dma (currently $81.49) and open the
door for the stock to close back under the critical $80 support
level.  Aggressive entries can be taken based on failed attempts
to rally through the descending trendline, although the more
cautious approach will be to target new positions as the stock
drops through the 200-dma, or even the $80 support level on
increasing volume.  Daily stochastics have been rising in agony
for the past week, despite the continued price weakness.  When
the oscillator does roll over, it will likely drive price down
towards the $76 level, the next probably level of support.  Our
stop is initially set at $86.50, just above the recent highs.


It looks like the Insurance index (IUX.X) is getting ready to
break to the downside, and once it prints below $700, we'll be
looking for a significant decline in the sector.  As a proxy
for the IUX, AIG had a rough time on Monday, shedding nearly $3
and falling to its lowest closing level in over 2 weeks.  The
stock is now resting just above the $80 support level, and when
it falls below there, it will open the door for a drop into the
mid-$70s.  Without even reaching overbought, the Stochastics are
once again rolling over, heading back to oversold.  We're
lowering our stop to $85, and would consider any reaction bounce
into the $83-84 level as an attractive entry point.  Otherwise,
wait for the stock to break the $80 level before taking a

BUY PUT NOV-85 AIG-WQ OI=14449 at $4.90 SL=3.00
BUY PUT NOV-80*AIG-WP OI= 7524 at $2.00 SL=1.00
BUY PUT NOV-75 AIG-WO OI= 1202 at $0.80 SL=0.00

Average Daily Volume = 7.00 mln

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