Option Investor

Daily Newsletter, Monday, 11/19/2001

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The Option Investor Newsletter                   Monday 10-19-2001
Copyright 2001, All rights reserved.                        1 of 1
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MARKET WRAP  (view in courier font for table alignment)
        11-19-2001        High      Low     Volume Advance/Decline
DJIA     9976.50 +109.50  9976.50  9870.40 1.30 bln   1955/1166	
NASDAQ   1934.40 + 35.90  1934.70  1905.36 1.88 bln   2234/1427
S&P 100   595.07 +  7.00   595.08   588.07   totals   4189/2593
S&P 500  1151.06 + 12.41  1151.06  1138.65
RUS 2000  457.71 +  6.40   457.71   451.31
DJ TRANS 2532.52 + 35.15  2541.13  2499.76
VIX        25.72 -  1.45    27.21    25.46
Put/Call Ratio      0.43

Who's Afraid of the Big, Bad Bear?

Apparently nobody, as the markets continue their advance, with
broad market indicators showing that fear is disappearing faster
than the Taliban front lines.  The CBOE Market Volatility index
continues its retreat into the historical range between 20-30,
as investors vote with their wallets that the economy will be
much healthier next year.  Coupled with 10 consecutive interest
rate cuts and hope of more to come and a sharp decline in energy
costs, many investors clearly believe the worst is behind us.  I
think the really important question is whether earnings are
really going to recover enough over the next 2-3 quarters to
justify the recent (and substantial) rebound in PE ratios.  It
will take a smarter man than myself to answer that question, and
as a trader, I'm thankful that I don't need to.

Pardon me a brief gripe, but it seems CNBC is becoming the
center for all news other than that which is market related.  Is
it just me, or have they forgotten that their viewers watch for
information on the markets, not every comment made by a resident
of the Washington beltway.  It seems like every time I'm watching
an interesting market-related story, the guests get pre-empted
for a speech by a member of the administration to one school
group or another.  It may be news, but what does it have to do
with the markets?  Wouldn't it be more useful for investors to
hear what is ACTUALLY moving the markets and what the attendant
risks are at this time?

I think what may actually be going on is that there isn't much
market-moving news going on right now, and that is being
exacerbated with a holiday-shortened week.  There was one news
item getting a fair amount of airtime on Monday and it was the
big oil industry merger between Phillips Petroleum (NYSE:P) and
Conoco Inc. (NYSE:COC).  This $15.2 billion merger of equals
will create the largest refiner in the country and judging by
the price action, investors liked the deal.  Both stocks spent
the day trading higher with COC gaining $1.68 and P tacking on
$1.53.  That's not bad, considering the pressure the oil patch
has been under lately, with the sharp declines in the price of
both crude oil and gasoline.  For the record, the December
Crude Oil contract traded as low as $16.70 today, a new 2-year
low.  That has helped the Airline index (XAL.X) to stage an
impressive 5-day, 37% rally, reaching a new post-attack high of
$89.55.  But even after such a stellar move, the XAL is well
below the September 10th level of $117, highlighting the
significance of the damage that is just in the beginning stages
of being repaired.

Housing starts were out this morning, showing a mild nationwide
decline of 1.3%, mainly due to the 17% plunge in the west.
While still 1.6% above the year-ago level, the 1.55 million
housing starts are 6.5% below the record peak (1.66 million)
posted in July.  The emerging trend of weakness in the housing
market points to further economic weakness ahead, but the equity
markets shrugged it off and all the major averages worked higher

Speaking of market action, it was another encouraging session
for the bulls, at least the ones that haven't already flown the
coop early for the Thanksgiving holiday.  (How's that for a
mixed metaphor?)  The DJIA inched ever closer to the
psychological 10,000 level and NYSE volume was downright
impressive for the beginning of a holiday week at 1.3 billion
shares.  Not only that, but the internals were solid too.
Advancers led the decliners by nearly a 2:1 ratio.  While much
hay is being made about the 10,000 level, a look at the DJIA
chart reveals that 10,200 will be a much more important
technical level due to the number of times it acted as support
in July and August.

Not to be left out, the NASDAQ Composite vaulted through the
1925 level for the first time since the September lows, closing
at the high of the day on nearly 1.9 billion shares.  The
advance decline line was positive here too, coming in at 11:7.
Who says there aren't any solid trading opportunities in 'quiet'
holiday weeks?

Last week, I mentioned that bulls would want to continue
monitoring two of the leading sectors, Semiconductors and
Networkers, to gauge the internal strength and longevity of the
current Technology rally.  I think it is worth reviewing the
charts from last week and then looking at the action since then.

Last week's Semiconductor (SOX.X) chart:

It clearly looked like the SOX might be giving up its leadership
role after running into firm resistance in the $540-550 area.
Recall that the descending trendline began with the highs in
May, and the horizontal resistance line acted as support
numerous times over the past year before giving way in the wake
of the September attacks.  So let's see what the recent action
has to tell us.

So the SOX appears to be giving up its relative strength.  How
about the Networking sector?  Remember last week it was coiling
for a possible breakout over the $310 level and we were looking
for continued leadership here to help the broader NASDAQ to
push closer to the formidable 2000 level.

Last week's Networking (NWX.X) chart:

Sure enough, the NWX delivered in spades, following the breakout
over $310 with an advance through resistance levels at $322,
$335 and $345.  All this without so much as missing a beat.  The
NWX led the NASDAQ higher on Monday as well, pushing right up
to the $358 level with another 3.5% gain.  If the NWX can clear
$360, there isn't much resistance until $386 and then $405.

Pardon my optimism, but that looks like a setup for a sizeable
advance in select Networking stocks, which could drive the
NASDAQ up to challenge 2000 in fairly short order.  Take a look
at the Call list and you can see we are positioned to take
advantage of such a move with our plays on Juniper Networks
(NASDAQ:JNPR) and Finisar (NASDAQ:FNSR), also today's Play of
the Day.

Bullish bias aside, it is difficult to find an equity or index
(that isn't being plagued by bad news) that doesn't have an
overbought chart.  Does that mean that the current rally is
over?  Not necessarily.  Just as we saw charts remain buried in
oversold for weeks on end earlier this year, it is entirely
possible that we could see overbought charts remain so for
weeks to come.

Both the week of Thanksgiving and the week following have a
historically bullish bias, and if today's action is any
indication, the markets are in a repetitive mood.  My advice
is to continue to play the upside in those sectors that are
pushing the markets higher.  But keep those stops tight,
particularly as the DJIA approaches the 10,200 level and the
NASDAQ tests 2000.  Given the holiday-shortened week, I
wouldn't be surprised to see investors move to the sidelines
in the next couple of days, locking in gains and heading off
to enjoy some low-stress time with family and friends.  That
will certainly be my plan!

Until next time, I think Jim's advice to "Sell Too Soon" may be
the most prudent course of action.  Afterall, nobody ever went
broke by taking profits!

Mark Phillips
Research Analyst



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Call Ratio Backspreads - The Final Chapter
By Mark Phillips
Contact Support

We've been talking about the relative merits of the Ratio Call
Spread and Call Ratio Backspread for a couple weeks now, and
last week I made the case that the Call Ratio Backspread is
preferable due to the fact that it has limited downside and
unlimited upside.  In reviewing last week's article, I feel
there are some issues that need to be clarified.

This discussion has reminded me that it is important to apply
the correct strategy based on our expectations for the market
in question.  Let me briefly summarize when we would apply each
of the above strategies and what the benefits and disadvantages
are.  Refer to the graphic below (copied from last week's
article) for today's discussion.  Then we'll look at an example
of each, as we wind up our discussion of these particular

Ratio Call Spread: This strategy should be employed when we are
expecting a modest upward move, but you can see that a strong
rally can result in substantial loss.  We would initiate the
position when the stock in question is trading near 'A' if our
expectation is for the stock to be trading near 'B' at
expiration.  Since we want to initiate the position for either
a net credit or zero cost, we don't really have any risk if the
stock moves strongly in the direction opposite of our
expectations.  Where we can get into trouble is if the stock
rallies significantly above the point where the risk curve
crosses back below the horizontal axis.  If we are looking for
a strong rally, the Ratio Call Spread is clearly the wrong
strategy to employ.

Call Ratio Backspread: A more aggressive bullish trader that
wants to hedge their risks will be looking at the Call Ratio
Backspread.  While a muted positive move will have this investor
exposed to substantial risk, this position protects against the
possibility of a downward move, since we also place this trade
for either a net credit of zero cost.  In order to profit from
this strategy, we need a substantial upward move to overcome the
profit drag created by the sold options that allowed us to
finance the entire position.

We got started on this discussion after I received a number of
emails asking for coverage of delta-neutral spread strategies
in response to my comments that I was finding attractive
trading opportunities (read: high odds) to be few and far
between.  Since we began this series, the broad markets have
continued to power higher, contrary to my expectations.  I
looked at a LOT of possible candidates for both of these
strategies over the past couple weeks, and I must confess that
I have been unable to find a single candidate that I think
provides an attractive risk-reward ratio.  Part of this is due
to falling volatility (remember that these strategies perform
best with volatile stocks), but it is also due to what I
perceive to be the limited upside potential from current

Remember the basic rules of both of these strategies which are:

     1. Should be done for zero cost or a small net credit.
     2. The ratio between the bought and sold calls should be
        either 1:2 or 2:3 for optimal results.
     3. Recall spreads only deliver maximum return at
        expiration, so we want to give the trade time to work,
        meaning that we want from 60-90 days until expiration.
        This is a stronger rule for the Call Ratio Backspread,
        as we need the time for the large expected move to take

I think the best way to demonstrate the problems with initiating
these trades in the current market environment is to walk
through a couple of examples.  I have chosen the S&P-100 index
(OEX.X) for both of the examples, even though I don't think
either of the trades I am featuring here are attractive on a
risk/reward basis.  To make the math simpler, I will use 1:2
ratios for both types of spreads and then choose the strikes
accordingly so that we can put on the positions for as close to
zero cost as possible.  The OEX is currently trading at 595 and
change, so we will select the 600 strike as the ATM option.
While we are a little bit on the short side in terms of time,
I will use the January strikes for our examples.

Call Ratio Spread (1:2):
Buy 1 Jan-02 $600 Call for $21.30 Ask
Sell 2 Jan-02 $620 Calls for $10.80 Bid
Total Cost = $21.30 - 2($10.80) = $0.30 Debit

Using the Risk-Reward curve above, we can see that the maximum
reward will occur if the OEX is trading at $620 at expiration,
netting us a profit of $1970 ($20 difference in strikes x
$100 - $30 initial cost).  The sold $620 calls would expire
worthless.  That's not bad for a 60-day hold, but like we talked
about last week, we could really get in trouble if the OEX
staged a huge rally.  Since we are short more contracts than we
own, the losses can really mount if we don't employ a rigid stop
loss strategy.  If at expiration, the OEX were trading at $650,
we would be looking at a loss of $1030.  The long call would be
worth $5000, but the two short calls would each be valued at
$3000, so the math comes out to $5000 - 2 x $3000 - $30 =

And it would only get worse if the market rallied further, maybe
on a gap open on euphoria over the elimination of the 'bin Laden'
threat.  And a stop loss isn't going to protect us against that
kind of move.  While I think that type of move is unlikely, we
still need to take the risk into account, as everyone knows that
the market doesn't care one bit what I think.  Barring that type
of drastic new-related gap, prudence would demand that we protect
our position with stop loss order to close the upper position for
a profit at some point between maximum profit and the upper
break-even point.

So let's take a look at the Call Ratio Backspread to complete our
discussion.  Recall that in this trade we sell an ITM call and
buy a larger number (in this case 2) ATM calls, giving us a
position that profits in a strong upward move, but performs
poorly (read: loss) in a small upward move.

Call Ratio Backspread:
Buy 2 Jan-02 $600 calls for $21.30 (each) Ask
Sell 1 Jan-02 $560 call for $46.90 Bid
Total Cost = 2 x $2130 - $4690 = $430 Credit

Well, that starts out a bit better, as we pocket a little cash
when we put on the trade.  But we need to keep in mind that if
the OEX closes anywhere near where we initiated the trade, we'll
be racking up a significant loss.  Worst case, with the OEX
closing right at $600, we would realize a net loss of $7570.
Our long call would expire worthless, and the 2 long calls would
each have an intrinsic loss of $4000.  Subtract out the paltry
$430 net credit, and it would make for an unpleasant experience,
now wouldn't it?  We need that big upward move in order to
profit, but the question is (and we need to have this answer
before initiating the trade) how far does it have to move?

Well, for the 2:1 ratio the math is easy.  The OEX has to trade
at a level equal to the difference in strike prices ABOVE the
purchased strike price just to break even.  For this trade, that
means 600 (purchased strike) + 40 (difference in strikes) for a
whopping total of $640.  And that is for the trade to break
even.  Above that, we start to see profits, but you can see how
large a move is necessary to get us to that point.

You might ask yourself why the Call Ratio Backspread doesn't
look more attractive on paper.  There are two very simple
reasons.  The first is that there really isn't a lot of
volatility in the current markets, which makes it more difficult
to put together an attractive ratio to yield the net credit when
putting on the trade.  That creates the second problem by forcing
us to craft the spread with strikes that are further apart,
requiring a larger move before we reach that profit zone.  The
problem is further compounded by the fact that we have already
seen such a sizable rise in the markets, and the likelihood of
another substantial rally from current levels is markedly

I know you may be frustrated that we couldn't find a better real
world example for our discussion, but remember that our first
goal is education.  Take a look back in time to late September
and think about this Call Ratio Backspread trade.  We've had
more than a 100 point rally in the OEX since the September lows.
With volatility much higher at the time and the significant
potential upside, don't you think this strategy could have
performed beautifully?  The downside if you were wrong (and the
market melted down to zero) would have been zero, but you could
have positioned yourself for a nice profit over the past 60
days.  I don't have time to go through the math here tonight,
but I think you can see the potential.

Next week, we'll move into what I think will be a more timely
topic, that of the Butterfly spread; perfect for a market that
is rangebound.  Depending on whether the spread is bought or
sold, we can profit from either continued rangebound action or
a breakout from the range.

Have a great week!

Mark Phillips
Contact Support

Correction: I made an error in last week's article when
discussing the Ratio Call Spread.  In the description of this
strategy, I wrote, "...this trade involves selling calls at
strike A and selling a different number of calls at B."  That
sentence should have read, "...this trade involves buying calls
at strike A and selling a different number of calls at B."  My
apologies for any confusion this may have created.


No new calls tonight


No new puts tonight


CHKP - call
Adjust from $37 up to $38

PDLI - call
Adjust from $32 up to $33.50

QCOM - call
Adjust from $54 up to $56.50

MXIM - put
Adjust from $59 down to $56


No Dropped Calls tonight


BRL $58.41 +3.22 (+3.22) We were looking for weakness in the
Drug sector (DRG.X) to push shares of BRL into another rollover,
and that clearly didn't occur on Monday.  Even with the DRG
index trading flat, BRL tacked on better than 5%, and that came
on volume 45% above the ADV.  That was enough to raise a red
flag in a quiet market, but with the stock shooting through our
$68 stop at the close, it is clear that we are on the wrong side
of the trend.  It's time to close our BRL play and take the
loss.  Use any weakness tomorrow morning to exit remaining open

WEBX $30.79 +4.36 (+4.36) Well that didn't take long.  We added
the play on expectations that a return to more normal travel
habits would pressure shares of the online meeting services
company.  That clearly didn't materialize on Monday as the stock
rocketed higher by 16.5% on more than double the average daily
volume.  We never got anything close to an entry point, and are
dropping the play tonight in acknowledgement that we missed the
boat on this one.

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FNSR - Finisar $13.55 +0.96 (+0.96 this week)

Finisar is a provider of fiber optic subsystems and network
test and monitoring systems that enable high speed data
communications over local area networks, storage area networks,
and metropolitan access networks.  The company is focused on
the application of digital fiber optics to provide a broad line
of high performance, reliable, value-added optical subsystems
for data networking and storage equipment manufacturers.

Most Recent Write-Up

Do optical stocks see the light at the end of tunnel?  It would
appear that way judging by the recent rebound in the group.
Heavy hitters such as CIEN, JDSU, PMCS, and JNPR have all
recently rallied despite the flow of negative news from the
sector.  Perhaps the worst is over for the group and demand is
about to return.  One of the smaller players in the field, FNSR
has been on a tear.  The stock is up by more than 200% from its
September lows.  It traded up to the 200-dma last Friday at
$13 and change, but could continue working higher over the
short term if the optical group continues advancing.  Traders
can look for a breakout above the 200-dma early next week and
confirm a rally attempt with an advance past the $13.50 level.
Beyond $13.50, FNSR doesn't have any resistance until the $16.
A more than $2 move in such a low priced stock can translate
into a solid gain in an option.  A pullback down to the $11
level and subsequent bounce would offer an entry on weakness.
Watch others in the group such as the aforementioned leaders.
Our coverage stop is in place at $10.50.


Networking stocks continued to rally on Monday, with the NWX
index rising right to the $358 resistance level.  That positive
movement helped our FNSR play to stage another breakout, pushing
through the $13 level as well as the 200-dma at $13.22.  Now
that the stock has cleared $13.50, there really isn't any
resistance until the $16 level.  Target new entries on an
intraday pullback near either $13, or even the $12 level, but
only if buying volume is strong on the rebound.  Alternatively,
continued strength above $13.50 can be used for momentum-based
entries.  Leave stops in place at $10.50 until FNSR solidifies
its breakout over $13.  Don't forget that earnings are set to
be released November 27th after the close, so we have less than
one full week to profit from the play.

BUY CALL DEC-12*FQY-LV OI=6668 at $2.15 SL=1.00
BUY CALL DEC-15 FQY-LC OI= 885 at $0.95 SL=0.50
BUY CALL MAR-12 FQY-CV OI= 251 at $3.50 SL=1.75
BUY CALL MAR-15 FQY-CC OI= 586 at $2.40 SL=1.25
BUY CALL MAR-17 FQY-CW OI= 424 at $1.65 SL=0.75

Average Daily Volume = 4.47 mln

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Anything else is too slow!



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