Option Investor

Daily Newsletter, Monday, 11/12/2001

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The Option Investor Newsletter                   Monday 11-12-2001
Copyright 2001, All rights reserved.                        1 of 1
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MARKET WRAP  (view in courier font for table alignment)
        11-12-2001        High      Low     Volume Advance/Decline
DJIA     9554.47 - 53.63  9606.10  9408.60  991 mln   1496/1561	
NASDAQ   1840.10 + 11.70  1848.00  1782.48 1.57 bln   1777/1770
S&P 100   576.13 -  1.86   578.31   566.41   totals   3273/3331
S&P 500  1118.33 -  1.98  1121.71  1098.32
RUS 2000  440.48 +  2.38   440.48   432.15
DJ TRANS 2272.60 - 48.09  2320.50  2241.79
VIX        31.26 +  2.50    33.06    30.92
Put/Call Ratio      0.61

Veteran's Day Volatility

With the Bond markets closed on Monday and significant progress
in the war in Afghanistan over the weekend, I awoke this morning
with the expectation of quiet trading day ahead, likely with a
positive bias.  Imagine my surprise to see the futures off
sharply ahead of the market open when I turned on my trading
screen.  Actually, you don't have to imagine my surprise, as you
likely saw exactly the same thing.

For those that missed the news this morning, shortly after 9am ET
American Airlines flight 587 crashed near Rockaway, New York
shortly after takeoff, prompting the closure of all New York City
area airports as well as tunnels and bridges leading to the city.
Despite the fact that there was no apparent connection to the
terrorist act that destroyed the World Trade Center, nervous
traders took some defensive action early on, sending the broad
market averages plunging at the opening bell.  So much for a
quiet day in the markets!

But what's this?  Rather than continuing to sell off on
irrational fear, the major indices fell right to the solid
support levels mentioned in the weekend Wrap, from which they
staged a steady advance throughout the day.  Internals on both
exchanged were almost dead even with volume light, just as we
would expect on a holiday.  By the time the closing bell rang,
most of the early damage had been erased from the DJIA and the
NASDAQ actually managed a positive close.

The wedge on the DJIA continues to narrow, and a breakout or
breakdown can't be far away.  9400 held as solid support this
morning (actually 9408), and we're starting to see support build
near 9550.  The next big test to the upside will be the
descending trendline at 9700.  Of course, eager bulls will want
to be on their guard with daily Stochastics pointing down again.
If this cycle causes a break of the ascending trendline (9350),
the rally will be in big trouble.

We've got a tenuous picture here as well.  Strength in the
overall NASDAQ has helped to push the Composite through the
38% retracement level and now the bulls are chipping away at the
50% retracement level at 1857.  A successful move through that
level will open the door for a run at the 62% level and possibly
2000 (dare we hope?).

As would be expected in the wake of such a tragedy, Airline
stocks were the biggest loser on the day, with the XAL index
giving up 5.75%.  But there were pockets of incredible
resilience in the broad market, with continued strength in
Networkers and Semiconductors.  One of the bright spots this
morning that likely helped the two Tech groups listed above was
the conference call from Ciena (NASDAQ:CIEN).  The company
updated its guidance for Q4 with the top and bottom lines
slightly better than the consensus estimates.  Not only that,
CIEN stated that it expects to be among the first to break out
of this tough environment.  Trading was heavy in CIEN, with
nearly 54 million shares trading hands (vs. the ADV of 20 mln),
and by the closing bell, the stock had tacked on nearly 10%.

Morgan Stanley added to the bullish sentiment in its pre-market
call on the Semiconductor Equipment sector, raising its price
targets on a number of names in the sector such as AMAT ($40 to
$50), NVLS ($40 to $50), KLAC ($45 to $60) and LRCX ($25 to 30).
Well, one man's treasure is another's trash, and it didn't take
long to hear the dissenting opinion as Needham and Co. proceeded
to downgrade shares of AMAT and NVLS.  The market is a voting
machine, and apparently the bulls had the winning vote today,
with all of the stocks listed above finishing the day with
fractional gains and the Semiconductor index (SOX.X) added 2.4%
to finish the day at $519, and just below the $525 resistance
level.  The Semiconductor sector was the best percentage gainer
for the day, but the Networkers weren't far behind with the NWX
moving up to close at $307, a new post-attack high, and just a
smidge below the $310 resistance level.

Semiconductors getting close to major resistance at 540.  Either
we get a breakout, which will undoubtedly lead the NASDAQ
through resistance, or a breakdown.  Look for a bounce in the
475-480 level to provide entries into plays in this sector.  A
fall below that level of support could prove unpleasant to the

Remember last week when the NWX cleared the 290 level?  The
support/resistance levels here are the same as last week.
Uncanny, isn't it?  Target bullish positions in the Networking
sector on a breakout over 310 or a renewed bounce from above

One predictable side-effect of the early plunge was a sharp
rise in volatility as measured by the VIX (for the S&P100) and
VXN (for the NASDAQ-100).  Both volatility indices spiked at the
open and then spent the day drifting back towards Friday's
closing levels as the major indices recovered their early losses
and fear-of the-unknown abated.  Volatility is still high, but
getting close to falling back into its historical 20-30 range.
Either that, or we are about to see it shoot higher along with
another large market selloff.  Either outcome is possible in the
near-term, but with the significant progress in Afghanistan and
the steady, measured market advance over the past several weeks,
I think the former case is the more likely one, at least over
the near term.

Since last Monday's Wrap, we got good news from CSCO, followed
by another 50-points interest rate reduction from the Federal
Reserve, and the markets took it all in stride, continuing their
steady advance.  Even the disaster this morning in New York was
reasonably well received by the markets, which continued their
advance despite other spots of less-than-stellar news.
Contrarian indicators like the VIX continue to show a healthy
amount of fear still in the markets, giving the bulls a wall of
worry to climb.

My personal bias says that we have some weakness ahead, and I
would expect the worst of it in the go-go sectors that have seen
the sharpest advance over the past 6 weeks.  But there are also
some powerful factors at work that could propel the market
higher in the near term, such as positive guidance from leading
Technology companies and of course a quick end to the war in
Afghanistan certainly wouldn't hurt.  Continue to play the long
side as long as it lasts, but protect your gains and don't get
greedy.  Keep a sharp eye on the leading sectors we've talked
about here tonight.  Breakouts in the NWX and SOX could breath
some serious new life into the current rally, while a breakdown
in either group will be hard for the bulls to digest.

As Jeff Bailey is fond of saying, trade what you see, not what
you believe.  You'll make more money that way!

Mark Phillips
Research Analyst

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To Spread or Backspread...That Is The Question
By Mark Phillips
Contact Support

Has this ever happened to you?  You are in the middle of a
dynamic conversation that periodically changes direction and
focus, when all of the sudden the question occurs to you, "How
in the world did we get on this subject?"  Well, that is
precisely what happened to me with our current conversation on
spread strategies.

It all started with my commentary in late October (just after
returning from vacation) that I was having a hard time finding
a trade that I liked.  That motivated several of you to write,
suggesting spreads and delta-neutral strategies and asking for
my commentary along those lines.  Of course, I jumped at the
idea, as the suggestion provided some variety to my column and
gave us all a chance to learn something new together.  Actually,
I am well-versed in spread trading, so I didn't expect I'd find
anything revolutionary to add to my knowledge base.  But I know
from long experience that every time I write about a topic, I
always learn something new about it.

The problem is that I didn't start our discussion in the most
organized manner, as I dabbled a bit in discussions of straddles
and some simple spreads, before diving into a detailed
description of the Ratio spread last week.  We used CSCO as our
working example for the Ratio Spread discussion, but I
deliberately used an example that did not offer an entry
opportunity after last Monday's article went to press.  Many
readers may have wondered why I did this, when my normal
practice when featuring a possible trade is to do so in such a
way that those of you following along at home can take advantage
of the opportunity as well.

But not everyone was in the dark, as demonstrated by some of the
emails I received.  One of the emails stated it so succinctly
that I decided to just duplicate a portion of it here for
everyone's edification.

"Looking forward to this series on spreads. Your material is
always educational and helpful.  However, you should, I think,
point out in your discussion of the 'ratio spread', that one is
reducing the downside risk by increasing the upside risk. In
your example, once CSCO moves above the sold call strike price
of $20, the investor loses money twice as fast as CSCO moves,
i.e., for every point that CSCO moves up, the investor loses two
points. A strong move by CSCO could be a disaster without a
quick exit."

I couldn't have said it better myself!  I'm sure many other
readers recognized the inherent risk, but for those of you still
in the dark, I've prepared a simple little graphic down below
that shows the relative Risk and Reward of a simple Bull Call
Spread, Ratio Call Spread, and Call Ratio Backspread.  The
horizontal axis represents the price of the equity, with
increasing prices to the right.  The vertical axis represents
the theoretical profit or loss of the spread position, with
potential profit shown above the horizontal axis and potential
loss shown below.

Let's do a quick review of each strategy, to determine its
relative merits and drawbacks:

Bull Call Spread: Involves buying a Call at strike A and
then selling a higher-strike call (at B) to reduce the
cost of the position, and hence the total risk.  The
reduced risk comes at a price though.  We also limit our
potential reward, and the position reaches maximum reward
(at expiration) if the stock is trading at or above the
sold strike (B).

Ratio Call Spread: This trade involves selling calls at
strike A and  selling a different number of calls at B,
and is best implemented when the stock is trading near A.
The advantage to this strategy is that we can select a
ratio of bought and sold calls that gives us a much
smaller downside risk, with the maximum loss if we are
wrong, equal to the cost of the trade.  So long as there
is a modest upward move in the stock, we will pocket a
profit.  But as my reader points out, a strong move in
the stock above the sold strike exposes us to increasing
losses due to the fact that we have sold more calls than
we bought.  Once we move above the point where the
risk/reward curve moves under the horizontal axis, losses
continue to mount.  So this strategy is a good choice
when we expect a modest upward move, but we must actively
manage our risk and may have to close the position prior
to expiration if the underlying stock enters a strong
rally.  Simply put, here we have limited reward, but
unlimited risk.

Call Ratio Backspread: The relatively narrow profit zone
of the Ratio Call Spread may have the risk averse trader
considering a slightly different approach known as the
Call Ratio Backspread.  We are still buying calls and
selling a different number of calls at a different strike,
but this strategy gives us unlimited reward, and limited
risk.  Doesn't that sound better?  Here, we would enter
the trade when the stock is trading near B and sell the
calls at strike A and buy a larger number of calls at
strike B.  Ideally, the trade would be put on for zero
cost or a slight credit, meaning that we win a little if
we are wrong and the stock drops, lose a little if the
stock goes noplace, and win big if the stock stages a
significant advance.

Both the Ratio Call Spread and the Call Ratio Backspread are
what are known as Delta-Neutral strategies, provided that the
position is put on for no net credit or debit.  Or put another
way, whenever you create a position that involves buying or
selling options with no net credit or debit, you have entered a
Delta-Neutral trade.  That doesn't mean it is risk-neutral, as
you can see by the risk-reward curves shown above.  As with any
strategy we wish to employ, we must understand the relative risk
and reward of the position before we put it into action.

So let's review.  The Ratio Call Spread can be used to place a
moderately bullish position with a small risk to the downside if
we are wrong.  The real risk comes in when the stock rallies
sharply as the larger number of sold calls can cause the
position to post a large loss.  If we are betting on a sustained
advance in a stock, the Ratio Backspread can prove to have some
significant benefits, specifically low cost to put on the
position, while retaining the ability to net unlimited reward
with limited risk.

There are a few criteria to look for when trying to find an
attractive Ratio Backspread trade.  First off, it is easier to
craft these positions in markets that have higher volatility
because options in these markets will have heftier premiums for
us to sell, offsetting the cost of the options we purchase.
Additionally, there are limitations as to which ratios (1:2,
2:3, 3:5, etc.) work best.  One other point to keep in mind is
that the Ratio Backspread (and Ratio Spread) can be created for
both a bullish (Call Spread) or bearish (Put Spread) bias.

If you feel like this discussion is progressing too slowly, I
apologize.  Just keep in mind that there are numerous seminars
available that take 2 entire days to cover Delta-Neutral
strategies.  Given the limitations on the time and space we have
to work with, it is my hope that I can give you enough knowledge
over the course of several discussions that you can continue to
add to your arsenal of trading strategies.

Now that I've hopefully laid out the framework of the type of
trade to look for in a more organized manner, next week we can
focus on a specific Ratio Backspread trade that we can all
follow together and hopefully profit in the process.  Next time,
we'll define some of those criteria I mentioned above, as well
as list some possible candidates and show how the trade is
structured with at least one concrete example.

Stay Tuned!

Mark Phillips
Contact Support


CHKP - call
Adjust from $31 up to $32.50


No Dropped Calls tonight


CVTX $37.30 +2.62 (+2.62) We jumped into our CVTX play just
before the bottom fell out and the stock plunged all the way to
the $32 level, and those that played the stock netted a nice
gain on the drop.  Recall that we recommended taking some
profits last Thursday due to the sharp drop.  As it turns out
that was the smart way to go, as buyers have been active the
past couple days, driving the stock through both the descending
trendline and the 10-dma today on volume that nearly tripled the
ADV.  Although our $39 stop is still intact, it looks like the
tide has shifted in favor of the bulls, so we'll drop CVTX

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PMCS - PMC-Sierra $20.57 +1.05 (+1.05 this week)

PMC-Sierra designs, develops, markets and supports high
performance semiconductor networking solutions.  The company's
products are used in high speed transmission and networking
systems, where are being used to restructure the global
telecommunications and data communications infrastructure.

Most Recent Write-Up

The networking sector has been on the mend recently thanks in
part to Cisco Systems.  The Networking Sector Index (NWX.X)
has been reflecting the renewed bullishness in the group.  The
NWX broke above the 300 level last week and is poised to work
higher next week if the Nasdaq continues its march to higher
highs.  PMCS is a key supplier to Cisco, which is why shares of
PMCS have been rallying in recent weeks.  The stock is
approaching the key $20 level again.  It actually broke above
that level briefly last week, but pulled back on profit taking
late last week.  The stock has very little resistance above
the $20 level.  The closest area of congestion is around the
$24 level, which is a nice $4 move away from current levels.
Traders looking for the breakout above $20 should keep a close
eye on the NWX early next week.  An continued advance in the
NWX would support a breakout in PMCS above the $20 level.
Traders should also keep close tabs on the Semiconductor Sector
Index (SOX.X).  A good set-up would be strength in both the
SOX.X and NWX.X in conjunction with the move we're looking for
in PMCS.  Stops are initially in place at the $17.50 level.


Despite broad market weakness this morning, it didn't take long
for shares of PMCS to find support and move into the green.
After pushing through the $20 resistance level during the lunch
hour, the stock dropped to that level, found support and headed
higher for the remainder of the day.  The $20 level was an
important milestone, as it had turned back the bulls on each of
the prior 4 trading days.  With a close over $20, PMCS is now
in position to work higher, and has little in the way of
overhead resistance to hold it back until reaching the $23.50
level, also the site of the 50% retracement of the stock's
decline since being added to the S&P500 in early August.
Target pullbacks to the $19.50-20.00 level or possibly stronger
support near the 6-week ascending trendline near $18.25.  Keep
stops at $17.50.

***November contracts expire this week***

BUY CALL NOV-20*SQL-KD OI=4530 at $1.55 SL=0.75
BUY CALL NOV-22 SQL-KX OI=1795 at $0.60 SL=0.00
BUY CALL DEC-20 SQL-LD OI=2399 at $3.60 SL=1.75
BUY CALL DEC-22 SQL-LX OI=1099 at $2.55 SL=1.25
BUY CALL DEC-25 SQL-LE OI= 985 at $1.55 SL=0.75

Average Daily Volume = 10.1 mln

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