Option Investor

Daily Newsletter, Monday, 11/05/2001

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The Option Investor Newsletter                   Monday 11-05-2001
Copyright 2001, All rights reserved.                        1 of 1
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MARKET WRAP  (view in courier font for table alignment)
        11-05-2001        High      Low     Volume Advance/Decline
DJIA     9441.00 +117.50  9476.40  9326.20 1.19 bln   2045/1074	
NASDAQ   1793.60 + 47.90  1801.55  1768.29 1.70 bln   2131/1408
S&P 100   566.68 +  6.69   569.77   559.99   totals   4176/2483
S&P 500  1102.84 + 15.64  1106.72  1087.20
RUS 2000  437.54 +  4.47   438.24   433.07
DJ TRANS 2284.72 + 38.06  2291.78  2245.49
VIX        32.09 -  0.31    32.94    31.20
Put/Call Ratio      0.42

Waiting On The Fed?  Or Was It Cisco?

After the world made it through another weekend without any
meaningful developments on the war front (either good or bad),
market participants decided to continue the bullish move that
began last week.  The major indices moved higher at the open and
after stagnating in the middle of the day, rallied a bit more in
the afternoon session.  As has been the pattern recently,
Technology stocks led the charge in hope that Cisco Systems
(NASDAQ:CSCO) would have glowing things to say in their earnings
report due out tonight after the close.  We'll get into that
subject below, but first let's take a look at the broader market

The Industrials staged another triple-digit gain on moderate
volume, moving in for another attempt to break out of the recent
range.  This will make the fourth attempt to break out to the
upside, and if the bulls can't pull it off this time, it will be
hard to find the necessary catalyst to get the job done.  In
addition to the pending CSCO news, the markets are fixated on
tomorrow's FOMC meeting.  The Fed will announce their next move
on interest rates at 2:15pm ET, and given the recent slew of
abysmal economic reports, many participants are expecting
another 50-bp cut to go along with the other 9 cuts already in
place this year.  Could it be that the 10th time will be the
charm?  More than a few traders are clearly betting that is the
case, as shown by the solid gains posted over the past 3 days.

While volume was only moderate on the NYSE, the internals were
decidedly positive, coming in at a 2:1 ratio and bringing the
Dow Jones Industrials within range of a breakout over the 9550
resistance level.  The solid bullish move is particularly
impressive considering that the day started off with another
poor economic report.  The NAPM Services report came in at 40.6%
vs. the 47% consensus, and the markets rallied out of the gate.
Banking and Utility stocks led the charge outside of the
Technology sector and the outcome of this upward push would seem
to hinge on the outcome of the FOMC meeting tomorrow.  Traders
are hoping for a 50-bp cut as an aggressive antidote for the
worsening economic climate.  And waiting in the wings is the
economic stimulus plan, currently being debated in Congress.
Some of the reported issues (capital gains tax cut and repeal of
the alternative minimum tax) being debated could have an even
stronger positive effect on the business community than anything
the Fed can do.  It will take time to approve and then find its
way into the economy, but anticipation of this package could be
adding to the current bullish bias.

Over on the NASDAQ, Networking stocks led the charge higher with
a nearly 6% gain in the NWX index.  But the rally continued to
be broad-based, with Internet (+5.86%), Biotech (+4.55%) and
Semiconductor (+2.78%) stocks all posting solid gains.  Decent
volume and internals drove the Composite right up to the 1800
resistance level, but a mild pullback at the close kept the
bulls from posting a close over this formidable level.  But
there is no denying that the bulls managed a solid victory by
closing at a new post-attack high.

Getting back to the biggest factor in Monday's trading, let's
take a look at what CSCO had to report tonight.  Beating the
consensus estimates of 2 cents, the Networking giant managed to
deliver double that number, so on the surface it looked like a
great report.  But more than half the profits reported came from
interest and other income.  Don't you just love those pro-forma

Visibility is still murky (at best) for the current quarter,
with things improving slightly as we move into next year.
Judging by the nearly $1 gain in the after-hours session, this
is what traders were focusing on in the conference call.  CNBC
characterized the report as the "first solid positive news from
the Technology sector".  I think Briefing.com does a better job
of reporting the news and providing some rational commentary, so
I'm going to quote their interpretation of what CSCO had to say

"Using the company's assumptions, we can put together a Q2 model
as follows: revenues up 2.5% (company: flat-low single digits),
gross margins of 54% (company: mid-50s), operating expenses down
1% (company: flat to slightly down), other income flat (company:
flat), tax rate steady at 28% (company:28%), share count +70 mln
(company: +60-80 mln).  Using those assumptions, Briefing.com
comes up with a Jan qtr EPS estimate of $0.05 vs. the current
consensus of $0.03."

What that means in plain English is that the worst is behind for
this member of the Networking sector and that expectation (along
with hope for similar data from other leading Networkers) is
reflected in the recent trading of the NWX index.  Leading the
NASDAQ higher on Monday, the NWX cleared the $290 level for the
first time since the disaster in September and is now closing
in on strong resistance at $310.

No matter how you slice it, we're going to need to see continued
strength in the leading NASDAQ sectors (Networking,
Semiconductors and Biotechs) tomorrow if we are going to clear
the 1800 level and HOLD IT.  I would expect a positive open in
the morning due to the CSCO effect, but then the markets will
probably churn sideways until the FOMC speculation becomes news.
Then we'll see where investors line up, and that will be our cue
to take action.  Odds are good that there will be a dip after
the announcement, and the strength of that dip will determine
whether it is another bullish entry point or a warning that the
current rally is over.  Keep in mind that this may be the last
bullish factor to drive the market upwards for awhile.

My personal trigger levels will be 1735 on the NASDAQ Composite
and 9200 on the Industrials.  I would consider new bullish
entries on any solid bounce from above these levels after the
announcement.  Either that, or we'll need to see a volume-backed
rally through the 1830 level on the NASDAQ and 9600 on the Dow
before sharpening our bullish horns.  Remember that the markets
have had quite a run since the September lows, and without an
additional bullish catalyst, we may be due for some
post-announcement weakness.

On the other hand, if the rally fizzles near resistance, that
could be your signal to shift back over to the bear camp.  There
is a nice selection of Put plays on the playlist that could
provide some attractive entries if the broad markets fail to
follow through.

Regardless of your personal bias, make the markets prove their
intentions before committing to new positions.

Mark Phillips
Research Analyst

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More Details on Spread Strategies
By Mark Phillips
Contact Support

You asked for it, and now you're going to get it.  I received a
flood of email in response to last week's teaser article on
spreads, asking for more details and specific strategies.  It
seems like I may have stumbled on a topic that many readers have
an interest in.  So, I'll devote the next few articles to the
discussion of different types of spreads, their specific
advantages/disadvantages, and when to use them.

Just to make sure everyone is on the same page, we'll start with
simple spreads this week and move into some of the more involved
spreads such as butterflys, and ratio spreads.  As we mentioned
last week, we can take a non-directional position by putting on
a straddle, which consists of buying both a put and a call at
the same strike price.  That gives us the opportunity to profit
no matter which way the market moves, but they can be expensive
to put on, especially with historically high volatility like we
are currently experiencing.

For traders that are willing to take a directional position, a
simple spread can insulate them from the effects of both
volatility and time decay.  We can craft either a bullish spread
or a bearish spread, utilizing either puts or calls, depending
on our preferred strategy.  Let's start with a simple bull call
spread and expand from there.

Rather than focus on an attractive trade to take now, I want to
stay in an educational mode, as I think that will prove more
useful over the long term.  All eyes (at least in the Technology
sector) have been focused on Cisco Systems' (NASDAQ:CSCO)
earnings report, due out tonight after the closing bell.
Bullish traders that are expecting a glowing report might have
been leaning to the long side ahead of the report.  With implied
volatility inflating the option premiums, a spread might make
good sense for such a trader.  CSCO is currently trading just
shy of $18, with the $20 resistance level looming just overhead.
For the sake of example, we will focus on December contracts for
our discussion today.

Putting on the bullish call spread could be done by buying the
$17.50 call (CYQ-LW) for $1.85 (ask) and then selling the $20
call (CYQ-LD) for $0.75 (bid).  This reduces the risk from $1.85
(cost of just buying the call) to $1.10 per contract, while the
unlimited potential return is capped at $2.50 (difference
between strike prices) should CSCO be trading north of $20 at
expiration in December.  Subtracting the cost of the position
leaves us with a maximum profit of $1.40 for a maximum risk of
$1.10.  By my calculations, that is a 1.27:1 reward-to-risk
ratio.  Not bad, but certainly not great.

We could do a similar trade utilizing only puts as well.  This
is referred to as a bull put spread and involves taking in a
credit that we anticipate keeping after the options in question
expire worthless.  Since our assumption is that CSCO should
rally on the heels of its earnings report, we'll buy the $17.50
put (CYQ-XW) for $1.55 and sell the $20 put (CYQ-XD) for $2.85,
taking in a net credit of $1.30, which is also our maximum
reward.  Our maximum risk is $2.50 (the difference in strikes)
minus the initial credit ($1.30), or $1.20.  That gives us a
reward to risk ratio of only 1.1:1.

I wouldn't be very excited about putting on either position,
especially not with the stock needing to clear such strong
resistance to give me that maximum reward.  The important point
here is that we can do essentially the same trade with either
puts or calls, so we would pick whichever trade gives us the
best risk reward ratio, in this case, the call spread.

At this point, I'm sure some of you are screaming "What about a
ratio spread?"  Fans of delta-neutral trading are familiar with
the concept of ratio spreads, where we sell a different number
of options than we buy, which adjusts our risk reward ratio to
a more palatable number.  Recall that delta is the measure of
how much an option will move relative to the move in the
underlying security.  An at-the-money (ATM) option typically has
a delta of approximately 50, meaning that the option will move
$0.50 for a $1.00 move in the underlying stock.

As of today's closing price, CSCO's ATM option would be the
$17.50 strike.  An out-of-the-money (OTM) option will have a
lower delta, maybe 30-35, while an ITM option will have a higher
delta, maybe 70-75.  For a delta-neutral spread, we want to buy
the same amount of delta as we sell, meaning that for the call
trade, we want to buy less of the ITM options and sell more of
the ATM option to craft a lower-cost trade with a greater
potential reward.  Ideally, this type of strategy will have a
zero cost and a total delta near zero as well.

Continuing with our CSCO example, we could create a ratio call
spread by purchasing 3 of the $17.50 calls at $1.85 for a total
cost of $5.55 and selling 5 of the $20 calls at $0.75 for a
total credit of $3.75.  This creates a position with much
greater potential for profit if CSCO closes at December
expiration near the sold strike.  Let's do some quick
calculations to see how we can expect this position to perform
for different closing prices for CSCO on December 21st.

Case #1 - CSCO closes at $19: The $17.50 calls will be worth
$1.50 each for a total of $4.50, and the $20 calls will expire
worthless.  So we pocket the $4.50 minus the initial cost of
the trade ($1.80), or $2.70.

Case #2 - CSCO closes at $20: This is the maximum reward case,
as each of the $17.50 calls are now worth $2.50, while the $20
calls will still expire worthless.  We sell our ITM calls for
$7.50, and after subtracting the initial cost of the trade, net
a total profit of $5.70.  That is a reward to risk ratio of
3.1:1, which is much better than the results for the simple
spread detailed above.

Case #3 - CSCO above $20: As CSCO moves above $20, we start to
lose some of our profits because the sold calls start moving
into the money.  Since we sold more of these than the lower
strike calls we purchased, there will come a point where the
play becomes break-even and then starts moving into the loss
column.  The key point is when CSCO trades at $22.85 -- at that
point the sold calls catch up with the combined value of the
purchased calls minus the cost of the trade.

So what does all this math tell us?  A ratio spread can give us
a better return than a straight spread and give us a fairly wide
profit zone (from $18.10-22.85 in the case of this example).  At
the same time, it limits our risk in the trade by offsetting our
initial cost through the sale of the higher-strike options.

I know there are a lot of details omitted from our discussion
today, but hopefully this will whet your appetite for our
discussion next week.  This CSCO example is not even close to
being an optimal example of the ratio spread strategy, but now
that we have covered the basic advantages of one of the more
complex spread strategies, I can delve into the details of how
to find an attractive candidate (or eliminate an unattractive
candidate), and how to select the best ratio for the spread.
I'll even attempt to find an attractive candidate where we can
put on a fictional spread and watch how it matures over time.
In addition, we'll define how to calculate the profit zone and
determine the break-even points.

Until then, best trading wishes!

Mark Phillips
Contact Support


No new calls tonight


No new puts tonight


BRCM - call
Adjust from $34 up to $36


No Dropped Calls tonight


GDW $50.00 +2.85 (+2.85) We've been leaning on shares of GDW for
awhile now and it looked like the stock was finally ready to
break down for real.  But that was before the bulls took charge
this morning and pushed the stock steadily higher throughout the
day.  Our $49 stop fell early in the day and then GDW pushed
steadily higher into the close.  The late-day strength leaves us
no choice but to drop coverage of the stock tonight.  Use any
weakness ahead of the FOMC meeting as an opportunity to close
out any remaining positions.

SPC $49.20 +0.30 (+0.30) As of Friday's close, SPC had reversed
direction and was within a dime of taking out our $49 stop.
With bullish enthusiasm running rampant ahead of tomorrow's FOMC
meeting, it didn't take much to push the stock through our stop.
The fact that the rally came on much stronger than average
volume clinched the deal and we have no choice but to drop SPC
from the put list tonight.

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BRCM – Broadcom Corporation $40.26 +2.41 (+2.41 this week)

Sitting in the sweet spot between the Broadband and
Semiconductor sectors, BRCM is a provider of highly integrated
silicon solutions that enable broadband digital transmission
of voice, video and data to and throughout the home and within
the business enterprise.  These integrated circuits permit the
cost-effective delivery of high-speed, high-bandwidth networking
using existing communications infrastructures that were not
originally designed for the transmission of broadband digital
content.  Using proprietary technologies, the company designs,
develops and supplies integrated circuits for several markets
including digital cable set top boxes, cable modems, high-speed
office networks, home networking, and digital subscriber lines.

Most Recent Write-Up

It may look like BRCM didn't go anyplace this week, but those of
us that watched it closely were presented with a nearly perfect
entry point on Tuesday/Wednesday.  Profit taking drove the stock
down to bounce right on its ascending trendline, very near the
10-dma (currently $35.04) before the buyers appeared, helping to
propel BRCM back up to end the week with a fractional gain.
BRCM is once again nearing resistance near $39 and could easily
see a breakout that takes it through $40 to make a run at the
$45 level.  The key will be the broader Semiconductor sector
(SOX.X) which is currently testing descending trendline
resistance at $491.  Target fresh positions in BRCM on a dip
back to the trendline (currently ), so long as the SOX doesn't
violate its ascending trendline (now at $450).  Alternatively,
use a SOX rally over $492 to initiate new positions in BRCM as
the stock pushes above $39.  Keep stops in place at $34.


In anticipation of CSCO's earnings report tonight, shares of
Networking stocks and Communication Chip stocks staged an
impressive rally.  The buying pressure finally pushed shares of
BRCM through the $40 resistance level by the closing bell and
if the after hours trading is any indication, we should see more
upside tomorrow.  The Semiconductor index (SOX.X) finally poked
through the 500 level and could use the CSCO earnings as a
catalyst to charge towards the 535-540 resistance level.  BRCM
will likely move higher tomorrow as the bulls take aim at the
$42.50 level of resistance.  Use a dip to the $38 intraday
support level to enter new positions and raise stops to $36.
Consider harvesting some profits near the $42.50 level,
especially if the SOX and Networking sector (NWX.X) start to run
out of steam.

***November contracts expire in less than two weeks***

BUY CALL NOV-40 RCQ-KH OI=6211 at $3.10 SL=1.50
BUY CALL NOV-45 RCQ-KI OI=5534 at $1.10 SL=0.50
BUY CALL DEC-40 RCQ-LH OI=1895 at $5.50 SL=3.50
BUY CALL DEC-45 RCQ-LI OI=1413 at $3.50 SL=1.75

Average Daily Volume = 12.2 mln

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Does your broker offer Stop Losses on Options?

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Stop Losses based on the option price or the stock price.
Move your trading into the next millennium with PreferredTrade.

Anything else is too slow!



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