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Daily Newsletter, Thursday, 08/01/2002

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The Option Investor Newsletter                Thursday 08-01-2002
Copyright 2002, All rights reserved.                       1 of 3
Redistribution in any form strictly prohibited.

In Section One:

Wrap: Watch Out For That Pothole Ahead
Index Trader Wrap: TORNADO MARKET   
Market Sentiment: You Mean Everything's NOT OK?
Weekly Manager Microscope: Green/Smith: Merger Fund (MERFX)
Index Trader Gameplans: THE SECTOR BEAT - 8/1

Posted online for subscribers at http://www.OptionInvestor.com
************************************************************
MARKET WRAP  (view in courier font for table alignment)
************************************************************ 
      08-01-2002           High     Low     Volume Advance/Decline
DJIA     8506.62 -230.00  8734.31  8479.90 1.91 bln   1224/1954
NASDAQ   1280.00 - 48.30  1326.10  1276.88 1.47 bln   1259/2140
S&P 100   444.32 - 14.55   458.87   443.12   Totals   2483/4094
S&P 500   884.66 - 29.96   911.62   882.48 
RUS 2000  389.21 -  3.21   394.47   388.00 
DJ TRANS 2308.26 - 61.08  2371.74  2307.58   
VIX        41.49 +  6.28    41.80    36.70   
VXN        60.35 +  2.49    60.93    58.80 
Total Vol   3,595.9M
Total UpVol   671.2M
Total DnVol 2,836.1M
52wk Highs   48
52wk Lows   298
TRIN        2.26
PUT/CALL     .76
************************************************************

Watch Out For That Pothole Ahead

The day's economic reports produced more of the same in the 
form of slowing growth and rising unemployment. The airwaves
were full of the arrest of WCOM executives and the promise of
more in our future. After the close it was announced that the 
Tyco CFO and General Counsel were leaving the company. This 
may be the prelude to the markets as we approach the August 
14th certifications. The economy is weakening and employees
at risk are fleeing sinking ships. 

Chart of the Dow


 
Chart of the Nasdaq


 

The big news this morning was the ISM report. This is one of
the most watched report cards on the economy and the average
grade today was a "D". Analysts were expecting a headline 
reading of 55.0 and got a 50.5 instead. This was down from
56.2 in June. All the internal numbers went the wrong way.

Table of ISM numbers


 

The numbers shaded represent weaker numbers than the month
before. New Orders fell from 60.8 to 50.4. Only 0.4 away from
shrinking instead of expanding. Order backlog did shrink to 
a declining number (over 50 expanding, under 50 declining) 
indicating that new orders have fallen below flat. These are
recessionary levels. The only component up for the last six 
months is the prices paid component and this indicates that
inflation is starting to creep into the economy. 

Analysts were trying to spin this report as "economy still
expanding" because the headline number was 0.5 over the flat 
line. Think about it. With all the warnings about falling
sales and orders going forward does anybody really think the
August numbers will be anything but negative? The 50.5 was 
the lowest number since January's 49.9 when we were just
coming out of a recession.

Construction Spending was also reported on Thursday with a
drop of -2.2% which followed last months -2% drop. This was
well below the expected +0.3% increase. Nonresidential
construction posted its fifth consecutive monthly decline
and residential its third monthly decline. This report was
seen as very negative as a drag in construction would also
be a drag on future GDP. This was the lowest level in six
years. 

Together with the weeks already announced GDP, Beige Book
and PMI, all showing declines, it is very hard to put 
bullish assumptions on the stock market. About the only
positive data out this week was the auto sales today which
showed a slight increase over last month. This increase in
sales came with the resumption of zero percent financing 
and discounts as high as $7,000 per vehicle. You can sell
anything if you give it away. Friday we will get the nonfarm 
payrolls and any reduction in jobs will be the final nail 
in the bullish coffin. Analysts are expecting 50,000 new 
jobs and an unemployment rate nearer 6.0%. A net loss of
jobs will be very negative. 

In stock news ADBE led the way with last nights warning
that revenue would be -10% below previous estimates. The
company lost -7.13 to 16.83 and took the rest of the software
sector with it. They said software spending was still very
constrained even for upgrades and sales had weakened in July.

After the close today Disney announced estimates that met
street estimates but then warned of slowing bookings for the 
current quarter by -6% and -10% for the fourth quarter. This
is a sure sign that the consumer is being more cautious and
should be a leading indicator that the hibernation has begun.

National Semi (NSM) warned after the close that weaker than
expected order rates for personal computer products and
related accessories like monitors would impact their estimates.
They did say orders for the following quarter were building
now that the merged Compaq and HWP were placing orders again.
This follows the NVDA warning earlier in the week and
could mean problems for Intel before the quarter is out.

After the bell Dow Jones reported that Tyco CFO Mark Swartz 
and General Counsel Irving Gutin are leaving the company. 
According to many analysts the CFO is the only one besides
ex-CEO Dennis Kozlowski who really knew what is happening
inside Tyco. Both men said they would remain at their posts
until replacements were found. I am going to bet that this 
scene will be repeated many times in the near future as life
in the hot seat becomes unbearable. With new criminal penalties
for financial misstatements the running of multidivisional
companies with far flung operations and having to certify
the accounting for thousands of employees is suddenly not a
highly sought after position. With officer salaries ready
to plummet in a fresh wave of stockholder unrest, the risk-
reward ratio is not what it used to be.

There is also the cloud of suspicion for everyone currently
running a company until they certify. Tyco has already said
it could be months before they can swear to their statements.
A rumor that John Chambers, CEO of Cisco, was going to resign
rather than certify statements caused CSCO to drop -1.13 on
volume of 132 million shares on Thursday. There was also 
a rumor that the CFO Larry Carter had refused to certify 
their statements due to closet skeletons. Traders are also
worried that CSCO will announce a huge house cleaning with
their next earnings to dump some prior problems so they can 
certify for the next quarter. Cisco has a July 28th year-end
so they don't have to certify until October. Cisco said it
would not comment on the rumors. It is too early to tell is
they will or won't but comments reportedly from the officers
indicate they will probably sign. Of the 947 companies 
required to certify statements only 18 companies have said 
they would vouch for their books and the starting date is
only 12 days away. 

Tomorrow we will also get mutual fund flows and from the 
amazing resiliency of the markets this week I would think 
there was a slow down in withdrawals. Possibly even an 
small positive inflow. However after the negative economic 
news this week this is likely to be only a pause in the 
flood. Retail investors have had the double dip recession
picture painted for them in almost every conceivable way 
and many of those not hopelessly mired in the "buy the dip 
until broke rut" are going to pull money out next week. The
picture is clear. Despite the lowest interest rate in a 
decade and a Fed that is pumping money into the market by
multiple billions every day the economy and the markets are
still falling. According to the futures there is nearly a 
50% chance of another Fed rate cut at the August meeting. 
Will this be a desperation cut because the economy is worse 
than we thought? Definitely! The Fed will try to spin it as 
an "insurance" cut but not many would be fooled. Is another
-25 point cut really going to help now if an entire year of
cuts has barely put the economy back onto life support? 
This is a cyclical thing and everyone has to get used to it.
We had the longest bull market and economic expansion in 
recent history and now we are suffering through the 
obligatory bear market and recession. Just as our excessive
highs were extreme our bottoms will be just as extreme. The
current accounting nightmare is just another log on the fire.

How much farther can the market drop? Nobody knows. Merrill
Lynch cut their 12-month target on the S&P to 960 today. 
Think about that. The S&P closed at 883 today. Do you think
they are planning on a rebound to 1200 over the next 12 months
and a return to 960? I don't think so! They are expecting 
the market to drop to lower levels (not stated) and return
to 960 within 12 months. We all know that targets are rarely
hit but the thought process that went behind this is critical.
They had to analyze a lot of factors relating to the economy,
earnings and the impact on stock prices before deciding to 
go public with another lowered estimate. This impacts the buying 
habits of tens of thousands of Merrill customers. In effect
they are saying more bear market ahead, batten down the hatches.
Their previous target was 1050 and they would have gotten 
considerably less grief by just sticking to that number. 

Merrill's chief U.S. Strategist Richard Bernstein said his
indicators were deep into "sell" territory in a note to clients.
He said, "Even though investors are becoming increasingly aware 
of the problems confronting the stock market they remain far 
from the psychological state of capitulation that would signal
a bottom. Also, stocks are not cheap when considering low
interest rates and inflation. Investors are ignoring that the
S&P earnings growth is the least predictable and the most
variable as anytime in the last 60 years." Do I believe 
everything I see and hear? Heck no. However if only 25% of
what we hear about the economy and current accounting crisis
is true then there is a lower low ahead of us. I think these
high profile warnings are overly extreme but they should 
prompt traders to be more cautious about buying this dip.

I have wandered too far astray tonight so I am not going to 
cover specific market levels. Leigh does an excellent job
of that in his Index Wrap. (link below) I think the bulls
have one last chance to attempt a rally with the nonfarm
payrolls tomorrow morning. An upside surprise could cause
just enough confusion to get one more bounce before the 
negative economic news from this week begins to weigh even
heavier on the markets as investors withdraw even more money
from mutual funds. The question remains, "Why buy", and 
until it can be answered convincingly our future is not
bright. 

Enter Very Passively, Exit Very Aggressively!

Jim Brown
Editor


********************
INDEX TRADER SUMMARY
********************

TORNADO MARKET   
by Leigh Stevens

TRADING ACTIVITY AND OUTLOOK - 

IF we are in a bottoming process here at least in the NYSE 
stocks, its still going to still offer trading opportunities on 
the sell or put side of the market too - even if a bottom is 
trying to set up, it will likely be a "rolling" one - like a 
tornado that touches down, then goes up, touches down, etc. The 
havoc seems similar too! 

Adding to the bearish thinking resurfacing from the lower than 
expected GDP report, the ISM index of manufacturing activity, 
falling to 50.5% in July from 56.2% in June, was another 
indicator of slow economic/business growth. Add to that the 
earnings miss from ExxonMobil and sharply lower guidance from 
Adobe Systems - it's enough to make a wannabe bull cry for his 
momma.

Technically, the failure of the S&P and Dow indices to hold above 
their 21-day moving averages suggests that the correction has 
taken hold and that there will be further downside in NYSE stocks 
in the near-term. The Nasdaq was the "weak sister" (would 
"brother" be more politically correct?) on the rally and is in a 
deeper correction. The S&P and Dow was trending as much sideways 
as lower - more on that in a moment.

Speaking of politics someone mailed me and suggested that I leave 
the political decisions to the Pres - vis a vis invading Iraq.  
Well, it is being much talked about lately as an economic issue, 
not solely as a moral or stopping potential aggression issue. 
Mark Whistler, on our sister stock site, Premier Investor.com 
asked readers to chime in on the topic and he'll publish what our 
"public" is thinking.  

The S&P pattern on the hourly chart is looking a lot like a 
"rounding top" pattern - that chart is further on.  I was 
starting to thing "rectangle" - now when does a round shape look 
like a box? 

Trying to think outside the "box" - I was looking at the 
possibility that the recent sideways move in the indexes, was 
setting up a trading range that COULD be a type of consolidation 
called a "rectangle".  But a rectangle pattern can sometimes be a 
REVERSAL formation and act as a top.  

The key is which way it breaks out.  The idea that we're seeing a 
basically SIDEWAYS consolidation, before another push higher, is 
unlikely unless the S&P and Dow rally on the opening and don’t go 
any lower that the final hour today. I thought I'd look at the 
pattern for those interested in these sort of things. 

When there is a sideways move after a move, where the highs and 
lows are in a similar price area such that you can then draw 
horizontal lines across the highs and lows, the shape is a 
rectangle - the width is always longer than the height (between 
the tops and bottoms). I'm talking about how the hourly charts on 
OEX, SPX and DJX were looking - less so with the weakness on the 
close, but here's the pattern I’m referring to: 



 

A move below the lower end of the trading range (885 in SPX, 445 
in OEX; 85 in DJX) NEGATES the consolidation/rectangle idea and 
suggests a near-term TOP instead. The indexes would have to break 
out above the upper end of the rectangular pattern (87.6 in DJX; 
458 in OEX; 912 in SPX) to suggest a breakout and signaling a new 
up "leg" - this is seeming less likely as bearish forces get more 
of a grip on the market. 

S&P 100 (OEX) Index - Daily/Hourly charts:    


 


Someone asked me if I had "played" with (drawing) UP trend price 
channels. NO, because the downtrend channel is still very much 
intact. Definition of a downtrend - a series of lower highs and 
lower lows. We have to get above a prior important (up) swing 
high to suggest that the trend might be reversing.  What we have 
above is not that. More or less we have a "double top" so far in 
OEX. You'll see in the SPX (S&P 500) hourly chart below that the 
(downside) reversal was right AT its upper trend channel 
boundary.  

Near support still looks like 443-444 and in danger of breaking, 
with 427-428 as a downside target with a break of 443. Such a 
move would put OEX back to where it started the rally at the 
beginning of the week and will be bound to disappoint the bulls - 
stay tuned! As to buying calls in that area - maybe - I favor 
buying into oversold markets and you'll note that the daily 
stochastic is up nearer overbought territory. 

The low 420 area is a 50% retracement and "normal" for a 
correction. "When in doubt stay out", is the saying and old 
trader's truth that I'm feeling. Markets making transitions, if 
that's what we have here, are tricky and easy to give back hard 
won profits from when the market trend had a more definite 
direction. At least the options premiums are more reasonable now.   

S&P 500 (SPX) Index - Hourly chart:


 


Are we starting the next downward slide?  If I look at the trend 
and the channel, I would have to say YES.  At least until SPX can 
take out its prior high at 912, then 919.   

I was thinking that near support was 884, which SPX is almost 
through - next is potential support down in the gap area at 855. 
No longer so far away!  I would look for 855-850 as a next 
downside target zone.  If short, that would be my objective and I 
would consider an exiting "stop" point at just over the upper 
trend channel line at 906. 

Can't say that I would buy in the 850 area, if reached, ahead of 
watching how the market behaves tomorrow.  I always look for some 
"basing" action before buying and am unsure how this current move 
will play out. The talk of a double dip recession is making me 
less bullish each day.  The optimism didn't lass long! 

Dow Index (1/100: $DJX.X) - Daily/Hourly charts:


 
 

No bust out above DJX resistance yet as you can see. The DJX 
stopped right at the top of its channel and has put in a double 
top to boot. What we're not seeing is a sharp down move like we 
might have expected two weeks ago after a rally "failure" - well, 
stay tuned - accelerating (downside) momentum may be next. 

Next estimated support is at 82.8-82.5, the area of DJX's upside 
chart gap - from Monday morning. If we get back to the Monday 
opening the week will be complete and they go out where they 
started.  Well that's a bit different than past weeks when the 
indices went out way under the week's opening. Bullish progress! 

Nasdaq 100 Trust Stock (QQQ) Daily/Hourly charts:


 


The only thing I was reasonable "sure" of was that the Nasdaq 100 
and QQQ would "fill" their upside chart gaps.  So far, a nice 
downside trade if you were lucky enough to have shorted the top.  
Actually, luck was not what was needed as much as absolute faith 
that there would be NO channel break out - or, trading as usual 
in tech land. These stocks are still too "expensive" relative to 
the S&P! 

I am bullish in Nasdaq from about the low end of the channel and 
an oversold reading to about the high end of the channel and an 
overbought reading.  Now the question becomes do we make a new 
low in the Q's as per its "usual" bearish pattern.  

The action in Cisco, Intel, Microsoft, Qualcomm and others in 
Nasdaq is not encouraging for hanging in around recent lows.  
bellwether stocks Cisco and Intel look like they could go to new 
lows. That means the Q's will too. The 22 area will be key - it 
looks like QQQ tests its prior low (21.6) at a minimum.  Stay 
tuned.  

Leigh Stevens
Chief Market Strategist 
lstevens@OptionInvestor.com 


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****************
MARKET SENTIMENT
****************

You Mean Everything's NOT OK?
by Steven Price

The bad news keeps coming.  This morning's economic data showed 
initial jobless claims rose 20,000 to 387,000, which was higher 
than the forecast of 365,000 to 375,000.  The Institute of Supply 
Management (ISM) report came in at 50.5%, which was lower than 
the expected 55.3%.  Construction spending was down 2.2% versus 
an expected increase of 0.2%.  These numbers, combined with 
yesterday's disappointing GDP and Chicago PMI data, have given 
the market a downward push.  The Dow was down over 200 points 
today, however it has found support at 8500 once again.  Although 
we traded as low as 8479.90, the bulls pushed the group back over 
the 8500 level to hold the close above support. With more data 
out tomorrow, this level may not hold if the news is bad.  We'll 
be getting the unemployment rate for July and if this morning's 
initial claims number for last week is any indication, this is 
bound to disappoint.  We will also be seeing non-farm payrolls 
for July, personal income for June and factory orders for June.

We headed into last weekend on a positive note after the market 
held its levels after an incredible rally.  The market has held 
most of this week's gains, however several factors could combine 
to send us into this weekend in negative territory. Three 
straight days of bad news (if Friday's data is no more 
encouraging than Wednesday's or Thursday's numbers) could speed 
up weekend profit taking for those investors who have become 
nervous about hanging on to recent gains. They may look at the 
recent market surge as a gifted opportunity to dump issues they 
had been holding on the way down, and today's 200-point drop may 
put a scare in them. If the Dow breaks back below the 8500 
support level we have seen the last couple of days, the decline 
could speed up as short-coverers move out of the way and longs 
look to get out.  The feeling of heading into the last trading 
day of the week after a three-digit down day "feels" much 
different to investors than coming off a 5 point give back after 
an almost 500 point rally, as we had last week. 

The technology sector received more bad news last night, as Adobe 
lowered both earnings and revenue estimates, citing "a difficult 
global business environment," which led to weaker than expected 
sales, particularly in Japan and Europe.  The stock was 
downgraded this morning by Goldman Sachs, Merrill Lynch and UBS 
Warburg, and subsequently hammered by investors, trading down  
$7.12 to $16.84.

There was a bit of good news, as July U.S. sales were up 24% for 
GM and 1.5% for Ford.  These stocks have been hard hit in recent 
months and can use the boost.  Psychologically speaking, this is 
the only good news investors have seen this week. 

This morning's arrests of former WorldCom execs Scott Sullivan 
and Dave Myers, may serve to instill confidence that the 
government is "doing something" about company executives who are 
looting the shareholders.  However, the looming presence of the 
August 14 deadline for companies to certify their accounting 
statements could continue to keep investors on the sidelines 
until they are sure who is willing to back up the numbers.  
Overall, the market is feeling awfully heavy, and Friday's trade 
could bring another pullback.  Keep an eye on 8500 in the Dow and 
885 in the S&P 500, as these levels have been repeatedly tested 
the last few days.  This level was violated by the S&P, which 
closed 883.05.  The 8500 level in the Dow, however, has proved 
resilient.  If they go south together tomorrow, stay out of the 
way until new support levels are in place.


----------------------------------------------------------------

Market Averages

DJIA ($INDU)

52-week High: 10679
52-week Low :  7702
Current     :  8506

Moving Averages:
(Simple)

 10-dma: 8278
 50-dma: 9162
200-dma: 9774



S&P 500 ($SPX)

52-week High: 1226
52-week Low :  797
Current     :  884

Moving Averages:
(Simple)

 10-dma:  859
 50-dma:  971
200-dma: 1083



Nasdaq-100 ($NDX)

52-week High: 1782
52-week Low :  896
Current     :  938

Moving Averages:
(Simple)

 10-dma:  938
 50-dma: 1064
200-dma: 1369



-----------------------------------------------------------------

The Semiconductor Index (SOX.X):  So much for the bottom in the 
SOX.  the index continues to slide to new lows as bad news keeps 
coming.  KLAC Tencor released earnings which showed a 64% 
reduction in earnings and 38% reduction in revenue.  This helped 
the bears pile on this sector and drive it to new 52-week lows.  
There is a significant downward trendline pointing this sector 
toward the 300 level, which it could see as early as tomorrow, if 
the economic data being released in the morning weighs on the 
overall markets.

52-week High: 657
52-week Low : 311
Current     : 311

Moving Averages:
(Simple)

 10-dma: 337
 50-dma: 402
200-dma: 505


-----------------------------------------------------------------

Market Volatility
The VIX spiked back up over 40 today, on a big drop in the 
overall markets.  With unemployment and payroll data out 
tomorrow, premium remains high.  The Dow and S&P 500 are testing 
recent support levels, and fear of a big drop has led to higher 
option prices ahead of the economic reports.  Look for a drop 
back into the 30s if the reports are good and the market 
stabilizes, or goes up. If we have a drop, the VIX may spike 
higher, but in any case should settle down from intraday highs 
before the close, as traders try to avoid holding excessive long 
premium positions over the weekend.

CBOE Market Volatility Index (VIX) = 41.49 +6.28
Nasdaq-100 Volatility Index  (VXN) = 60.35 +2.49

-----------------------------------------------------------------

          Put/Call Ratio  Call Volume   Put Volume
Total          0.76        552,185       420,798
Equity Only    0.57        417,503       238,647
OEX            1.14         24,437        27,838
QQQ            0.24         64,113        15,532

-----------------------------------------------------------------

Bullish Percent Data

           Current   Change   Status
NYSE          30      + 1     Bull Correction
NASDAQ-100    31      + 0     Bull Confirmed
DOW           23      + 0     Bull Alert
S&P 500       28      + 3     Bull Alert
S&P 100       27      + 1     Bull Alert

Bullish percent measures the number of stocks in an index 
currently trading on a buy signal on their point and figure 
chart.  Readings above 70 are considered overbought, and readings 
below 30 are considered oversold.

Bull Confirmed  - Aggressively long
Bull Alert      - Cautiously long
Bull Correction - Pause or pullback in upward trend
Bear Alert      - Take defensive action if long
Bear Confirmed  - High risk if long, good conditions for shorting
Bear Correction - Pause or rebound in downtrend

-----------------------------------------------------------------

 5-Day Arms Index  1.17
10-Day Arms Index  1.25
21-Day Arms Index  1.24
55-Day Arms Index  1.36

Extreme readings above 1.5 are bullish, and readings below .85 
are bearish.  These signals don't occur often and tend be early, 
but when the do, they can signal significant market turning 
points.

-----------------------------------------------------------------

Market Internals

        Advancers     Decliners
NYSE       1229          1890
NASDAQ     1216          2065

        New Highs      New Lows
NYSE         17             60
NASDAQ       67            135

        Volume (in millions)
NYSE     1,976
NASDAQ   1,544

-----------------------------------------------------------------

Commitments Of Traders Report: 07/23/02

Weekly COT report discloses positions held by small specs
and commercial traders of index futures contracts at the 
Chicago Mercantile Exchange and Chicago Board of Trade. COT data 
can be found at www.cftc.gov.

Small specs are the general trading public with commercials being 
financial institutions. Commercials are historically on the 
correct side of future trend changes while small specs tend 
to be wrong.  

S&P 500

Commercials increased both longs and shorts, however increased 
long contracts totals by an additional 10,000 contracts more than 
shorts. Small traders continued to get longer, while adding 2,800 
net longs to their position.


Commercials   Long      Short      Net     % Of OI 
07/09/02      396,321   456,164   (59,843)   (7.0%)
07/16/02      388,943   464,162   (75,219)   (8.8%)
07/23/02      405,969   471,704   (65,735)   (7.5%)

Most bearish reading of the year: (111,956) -   3/6/02
Most bullish reading of the year: ( 36,481) - 10/16/01

Small Traders Long      Short      Net     % of OI
07/09/02      145,017    71,402    73,615     34.0%
07/16/02      157,370    67,247    90,123     40.1%
07/23/02      166,713    73,778    92,935     38.6%

Most bearish reading of the year:  36,513 - 5/01/01
Most bullish reading of the year: 114,510 - 3/26/02
 
NASDAQ-100

Commercials added contracts both long and short to their 
positions, maintaining approximately the same ratio, however 
increasing their positions by approximately 8,000 total 
contracts.  Small Traders added to their short positions reducing 
their net by approximately 400 contracts.


Commercials   Long      Short      Net     % of OI 
07/09/02       31,227     39,592    (8,725) (12.3%)
07/16/02       33,152     39,866    (6,714) ( 9.2%)
07/23/02       37,204     43,601    (6,397) ( 8.0%)

Most bearish reading of the year: (15,521) -  3/13/02
Most bullish reading of the year:   9,068  - 06/11/02

Small Traders  Long     Short      Net     % of OI
07/09/02       12,520     8,348     4,175     20.0%
07/16/02       12,816    10,774     2,042      8.7%
07/23/02       12,756    11,152     1,604      6.7%

Most bearish reading of the year: (10,769) - 06/11/02
Most bullish reading of the year:   8,460  -  3/13/02

DOW JONES INDUSTRIAL

Commercials added 2,000 contracts to their long position, while 
adding only 671 to their shorts.  Small Traders increased both 
sides of their position, however added almost 2,000 more short 
contracts than long contracts. 


Commercials   Long      Short      Net     % of OI
07/09/02       20,761    14,122    6,639     19.0%
07/16/02       20,357    14,074    6,283     18.2%
07/23/02       22,369    14,745    7,624     20.5%

Most bearish reading of the year: (8,322) -  1/16/01
Most bullish reading of the year: 15,135  - 10/16/01

Small Traders  Long      Short     Net     % of OI
07/09/02        6,831     6,623       208     1.50%
07/16/02        8,524    10,133    (1,609)   (8.62%)
07/23/02        9,101    12,604    (3,503)   (16.1%)

Most bearish reading of the year:  (8,777) - 10/12/01
Most bullish reading of the year:   1,909  -  1/16/01

-----------------------------------------------------------------


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WEEKLY MANAGER MICROSCOPE
*************************

Green/Smith: Merger Fund (MERFX)

Investors seeking a stock fund with a good long-term record and 
low correlation to the market may want to have a closer look at 
the style/strategy that Frederick Green and Bonnie Smith use in 
the Merger Fund (MERFX), a unique equity fund that seeks growth 
by investing in companies that are involved in announced merger 
and acquisition activities.  

"That strategy might sound risky," Morningstar says in its fund 
opinion, "but it isn't."  Morningstar continues by saying, "The 
fund shoots for a 10% gain a year," adding, "and its volatility 
is extremely low for a stock fund."  In other words, this stock 
fund aims to produce annual returns near the historical average 
for stocks with considerably less risk (or volatility) than the 
market.

Indeed, Merger Fund has one of the lowest risk scores over the 
past three years, a volatile period for the stock market.  The 
fund's 3-year annualized standard deviation figure of 5.91% is 
pale in comparison to the average hybrid fund (10.87%) and the 
average domestic stock fund (21.14%), according to Morningstar.

Since the co-managers can and do invest a portion of assets in 
cash or cash equivalents (28.6% of assets as of Dec. 31, 2001), 
Morningstar classifies the unique offering as a domestic hybrid 
fund not a domestic stock fund.  Lipper calls the Merger Fund a 
specialty diversified equity fund.  The fund prospectus says it 
is non-diversified (28 stock holdings as of Dec. 31, 2001).  So 
this is one offering that doesn't compare easily to other funds.

Merger Fund (MERFX) has current net assets of $936 million, per 
Morningstar, and requires a $2,000 minimum initial purchase for 
both regular and IRA accounts.  The fund is no-load, and may be 
purchased on a no-transaction fee (NTF) basis through the major 
NTF fund networks, such as Schwab's Retail OneSource service or 
TD Waterhouse NTF.  The fund's current expense ratio (1.34%) is 
average for stock mutual funds, perhaps a little high for mixed 
equity funds (hybrids) and includes some 12b-1 fees.  There are 
no initial, deferred or redemption charges (loads).

Effective October 5, 2001, the Merger Fund was reopened to new 
investors.  The mutual fund has reserved the right to close to 
new investors at any time.  You may receive more information or 
fund prospectus by calling Merger Fund at 1-800-343-8959.

Managers' Background

Prior to January 1989, the fund was known as The Risk Portfolio 
of the Ayco Fund and operated under a different charter.  Since 
January 31, 1989 (listed as the inception date in Morningstar's 
fund report), the fund's day-to-day portfolio management duties 
have been handled by Frederick W. Green and Bonnie L. Smith.

Frederick Green is President of Westchester Capital Management 
(since 1980). He also serves as the President and a Trustee of 
the Merger Fund.

Green's bio states that he specializes in merger arbitrage and 
spent eight years as a portfolio strategist with Goldman Sachs 
and Kidder Peabody prior to joining Westchester.  Green is a 
member of the Association for Investment Management and Research 
(AIMR) and the New York Society of Security Analysts.

Bonnie Smith has co-managed the fund since January 31, 1989 and 
is a merger arbitrage specialist.  Smith has been Vice President 
of Westchester Capital Management since 1986, and also serves as 
the Vice President, Treasurer and Secretary of the Merger Fund.  
Ms. Smith is also a partner at Grace & Green Associates.  

Westchester Capital Management, Inc. is based in Valhalla, New 
York, and has been a registered investment adviser since 1980.  
The company also manages merger arbitrage programs for other 
institutional investors, including offshore funds and private 
limited partnerships. 

Investment Style/Strategy

Per the prospectus, the Merger Fund seeks to achieve growth of 
capital by engaging in merger arbitrage.  Under normal market 
conditions, the Merger Fund invests at least 80% of its assets 
principally in the equity securities of companies involved in 
publicly announced mergers, takeovers, tender offers, leveraged 
buyouts, spin-offs, liquidations and corporate reorganizations.

As stated earlier, depending upon the level of merger activity 
and other economic and market conditions, the Merger Fund may 
temporarily invest a substantial portion of its assets in cash 
equivalent (money market) securities.  It may also invest fund 
assets in corporate debt obligations, as part of its arbitrage 
strategy or otherwise.

Like other merger-arbitrage strategies, Mr. Green and Ms. Smith 
purchase the stock of the targets of announced acquisitions and 
occasionally short the acquirer's stock.  If the deal is closed, 
the fund makes money.  Before making an investment, the two co- 
managers research the strategic rationale behind the merger, or 
acquisition, etc. 

The Merger Fund prospectus comments that merger arbitrage is a 
highly specialized investment approach - generally designed to 
profit from the successful completion of such transactions.  As 
compared with conventional investing, Westchester Capital Mgmt. 
considers the fund's merger arbitrage investment returns to be 
less volatile than overall stock prices.

The principal risk associated with this fund's merger arbitrage 
investment strategy, per the prospectus, is that certain of the 
proposed reorganizations in which the Merger Fund invests may be 
renegotiated or terminated, in which case losses may result.  It 
is not a "diversified" fund within the meaning of the Investment 
Company Act of 1940, meaning it may invest assets in a relatively 
small number of issuers, making it potentially more volatile in 
the short-term than the average general equity fund, let's say.

The Merger Fund prospectus states that the fund is not intended 
to provide a balanced investment program.  Rather, this fund is 
intended to be an investment vehicle only for the portion of an 
investor's capital, which can appropriately be exposed to risk.  
They say that each investor should evaluate an investment in the 
Merger Fund in terms of their own investment goals.

Fund Chart

Below is a 6-month chart for the Merger Fund (MERFX) showing a 
net asset value (NAV) of $13.08 as of July 31, 2002.  It would 
appear from the chart below that Merger Fund is bouncing off a 
six-month low.   



 



In the next section, we discuss the fund's risk and return over 
various time periods, plus how the independent fund raters such 
as Morningstar and Lipper grade Green's and Smith's performance 
on a risk-adjusted relative basis compared to other stock funds.

Fund Risk and Performance

Again, keep in mind that when we go through this data, that the 
Merger Fund is classified by Morningstar as a "domestic hybrid" 
and rated against other hybrids, while Lipper groups the Merger 
Fund in with other specialty stock funds and grades it relative 
to the broad equity fund group.  Value Line puts Merger Fund in 
its "growth objective" fund group.

Considering risk first, below is how the three independent fund 
trackers grade the Merger Fund's risk.


 Morningstar: Low (all trailing periods and overall)
 Value Line Risk Rank: Low
 Lipper Preservation Score: 1 (Lipper Leader)


You can see that whether compared to mixed or full equity funds, 
the risk level of the Merger Fund is graded as "low" compared to 
other stock funds.  Earlier, we quantified the fund's volatility 
("standard deviation") and showed that its risk was almost half 
that of the average hybrid fund and significantly lower than the 
U.S. equity fund average over the trailing 3-year period through 
July 31, 2002.

Morningstar grades the fund's return "high" in all trailing time 
periods and overall except for the trailing 10-year period.  For 
the trailing 10-year period as of July 31, 2002, the fund gained 
8.91% per year on average, ranking in the top quartile (top 25%) 
of the domestic hybrid group.  However, its total return is 1.2% 
below that of the S&P 500 index and more than a percentage point 
below its 10% annual return goal.  The Merger Fund achieved its 
goal on a gross return basis over the past decade, but not after 
the deduction of fund expenses.  

Overall, Morningstar rates the fund's return as "high" compared 
with other domestic hybrids.  The Merger Fund's trailing 3-year 
annualized return of 3.84% through July 31, 2002 and its 5-year 
return of 6.7% score in the category's top decile (top 10%) per 
Morningstar.

Note that the fund's relative rankings on an "after-tax" return 
basis are slightly lower than on a "pre-tax" basis as reported, 
but still at or near the cutoff for top decile performance.  It 
is not necessarily designed to be tax-efficient, but due to its 
strong relative performance, it still ranks among the top funds 
in the category on an after-tax basis.

Summary

The Merger Fund is obviously not for everyone but investors who 
are looking for a unique and largely successful merger arb fund 
have an appropriate choice here.  Between 1995 and 2001, Merger 
Fund met its 10% annual return goal five out of the seven years.  
In 1998 and 2001, when it failed to make 10% for investors, the 
fund co-managers still produced positive returns.  So, over the 
past seven calendar years, the fund has posted positive results 
for investors.

That streak is currently in jeopardy, with the Merger Fund down 
11.44% on a YTD basis as of July 31, 2002.  While negative, the 
fund still curbed 8.57% off the S&P 500 index's decline through 
July 31.  Compared with the average stock fund, Frederick Green 
and Bonnie Smith have excelled at preserving capital during the 
market downturn, while offering potential for long-term capital 
growth.


Steve Wagner
Editor, Mutual Investor 
steve@mutualinvestor.com


***********************
INDEX TRADER GAME PLANS
***********************

THE SECTOR BEAT - 8/1
by Leigh Stevens

Highlighted sectors below are Gold & Silver (XAU), Health Care 
(HMO) & Oils (OIX). These sectors are either having significant 
price moves of late or are subject of reader interest. Health 
care providers (RXH) have also been strong of late. The Oil 
sector got crushed today after a recent recovery rally. And, hope 
springs eternal in the hearts of the gold bulls. 

The Oil Service sector (OSX) was weak also as a giant in the 
industry, Schlumberger (SLB), fell over 7% following a downgrade 
from Morgan Stanley to an "underweight" rating. 

UP on Thursday - 


 
     
DOWN (the most) on Thursday - 


 

   
SECTOR TRADE RECOMMENDATIONS & REVIEW -

NEW/OPEN TRADE RECOMMENDATIONS -

Long SMH at 27.35 
(Semiconductor HOLDR's)
Stop at 24.50


 
TRADE LIQUIDATIONS -

NONE


SECTOR HIGHLIGHT(S) -

Gold & Silver Sector Index ($XAU.X)
STOCKS: ABX; AEM; AU; FCX; GOLD; HGMCY; MDG; NEM; PD; PDG; SIL


 

The gold stocks are continuing to try to climb out of an oversold 
condition.  "X" marks the spot of an upside target that I have in 
the 65 area - the sector may get to around 67 where there is 
small downside gap.  70 is a major resistance overhang currently.  

Not much upside potential from its 63 close, but I see some.    
UPDATE: 8/1

Healthcare Index; Morgan Stanley ($HMO.X)
STOCKS: AET; AHG; ATH; CAH; CI; FHCC; HUM; MME; OHP; OPTN; 
PHSY; TGH; THC; UNH; WLP


 

The Healthcare Index has had a steady rebound from its recent 
low.  I could see HMO getting back up to 580, a 50% retracement 
of the last downswing, or to around 590, resistance implied by 
its 50-day moving average.  However, 590 is the "best" recovery 
type potential I see currently - its not the start of a new 
uptrend in my estimation.   
UPDATE: 8/1

Oil Index; CBOE ($OIX.X) - 
STOCKS: AHC; BP; CVX; KMG; MRO; OXY; P; RD; SUN; TOT; UCL; XOM.


 

Exxon Mobil (XOM) fell over 8% after its Q2 earnings missed 
estimates - the company indicated Q2 net income of $2.67 billion 
(39 cents a share), down over 40% from $4.46 billion (65 cents), 
in the same period a year ago. XOM's profit came in 7 cents under 
consensus estimates. 

XOM set the tone for the Oil (OIX) sector index, which "failed" 
or reversed at resistance implied by prior lows, before its last 
downswing.
 
It's possible OIX can retreat all the way back to its recent lows 
in the 245 area.  Whether it retests this area or not - failure 
at its first key resistance resulted in a continued bearish chart 
picture. 

UPDATE: 8/1


Leigh Stevens
Chief Market Strategist
lstevens@OptionInvestor.com


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The Option Investor Newsletter                 Thursday 08-01-2002
Copyright 2002, All rights reserved.                        2 of 3
Redistribution in any form strictly prohibited.

In Section Two:

Dropped Calls: EFX, CHKP, LLY, WMT
Dropped Puts: None
Daily Results
Call Play Updates: ADP, BAX, LTR, MMM, MSFT
New Calls Plays: None
Put Play Updates: BBOX, DD, JPM
New Put Plays: DHR, CCMP, KLAC

****************
PICKS WE DROPPED
****************

When we drop a pick it doesn't mean we are recommending a sell
on that play. Many dropped picks go on to be very profitable.
We drop a pick because something happened to change its
profile. News, price, direction, etc. We drop it because we
don't want anyone else starting a new play at that time.
We have hundreds of new readers with each issue who are
unfamiliar with the previous history for that pick and we
want them to look at any current pick as a valid play.


CALLS:
*****

EFX $21.02 -0.18 (+0.39) Although it was looking good earlier
this week, our EFX play seems to have run out of gas.  After
running up north of $22 on Monday, it has been a slow, but
consistent drift lower, and the bulls seem to have lost their
enthusiasm.  EFX close 2 cents above our $21 stop on Thursday
and could bounce tomorrow if the broad market tone is favorable.
If so, take advantage of that strength to close open positions
at a more favorable level.

---

CHKP $15.87 -0.91  (+0.17 for the week) Checkpoint looked poised 
to break above recent highs above $17.50.  The last three  days 
have shown several attempts to break this level, with no success.  
Once the stock dropped below $17.00, intraday movement showed 
this as a new ceiling.  This new resistance, when combined with 
yesterday's warning from Adobe regarding the current business 
environment, has convinced us to close this play. 

---

LLY $55.00  -3.42 (+1.30 for the week)  In our most recent write-
up we suggested conservative traders take profits in our target 
area over $58, as the stock traded as high as $59.24.  We raised 
our stop on this stock, which was originally picked at $53.70, in 
order to lock in profits on a pull back.  A downgrade based on 
what we consider to be old news, which is the possible delay of 
drug approvals due to manufacturing problems, pushed the stock 
down yesterday, only to see it bounce back.  However, this 
action, combined with downward pressure on the broad market, led 
this stock to our stop loss on today's close.  

---

WMT $47.40 -1.78 (-0.78 for the week)  Wal-Mart looked strong 
throughout the first part of the week, as it fought off poor 
consumer confidence and retail sales numbers to forge ahead, 
trading as high as $49.65 on Monday.  Comments from the company 
regarding sales coming in below expectations last week, and 
steering future guidance toward the low end of its previously 
estimated range, eventually combined with weakness in the overall 
market to turn this stock down from $50.  With poor economic data 
the last two days, this stock appears to have been weakened, and 
we are closing this play.  As a Dow stock, Wal-Mart could 
continue downward on a market pullback after Friday's 
unemployment and payroll data is released.  Use a market rebound 
as an opportunity to close positions.


PUTS:
*****

None


***********************************************************
DAILY RESULTS
***********************************************************

Please view this in COURIER 10 font for alignment
*************************************************

CALLS              Mon    Tue    Wed    Thu

EFX      21.02    1.60  -0.57  -0.46  -0.18  Drop, No movement
BAX      38.18    2.32  -0.66   1.67  -1.73  Support there
ADP      36.31    1.40   0.22  –0.04  -0.98  On track
LTR      46.81    2.14   0.45  –0.23  -0.63  Holding up
MMM     122.13    5.81  -1.17   0.34  -3.70  Good fundamentals
LLY      55.00    3.45   1.10   0.17  -3.42  Drop,Stopped out
MSFT     45.70    2.90  -0.15  –0.15  -2.28  Still a leader
WMT      47.40    1.35  -0.41   0.06  -1.78  Drop,Weakening
CHKP     15.87    0.32   0.68  –0.69  -0.91  Drop, New resistance


PUTS               

BBOX     34.20   -0.02  -2.19  –1.02   0.39  Taking a breath
JPM      25.02    1.77  -0.21   0.07   0.06  Still Trouble
DD       41.53    1.85  -1.85  –0.14  -0.38  Slow down
CCMP     39.86   -2.45  -1.34  –0.60  -2.48  New,Rolling over
DHR      60.12    3.07  -0.06  -0.45  -1.93  New,Falling
KLAC     37.28    1.06   1.93   0.06  -2.11  New,No Floor


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********************
PLAY UPDATES - CALLS
********************

ADP $36.31 -0.98 (+0.60) Following the action in the broad market
over the past 2 days, shares of ADP ran up to the $38 level at
the close on Wednesday, before reversing course this morning on
the heels of the disappointing economic news.  While the selling
was pretty much kept in check throughout the day, the late-day
drop pulled ADP back down to test the $36 support level.  While
this level may make for decent entries into the play, we need to
be cognizant of the possibility of a steeper profit-taking drop
to major support near $35.  Use a drop and volume-backed rebound
above that level to initiate new positions, provided the broad
market cooperates.  We do need to be cautious here though, as
the stock's reversal lower came right at the declining 20-dma
($37.55) and with daily Stochastics now rolling down out of
overbought territory, ADP may see a more pronounced downward leg
before the bulls move back in to propel the stock up towards
major resistance at $40.  We're keeping our stop in place at
$35 to protect against just that sort of development.  For those
looking to enter on strength, wait for a move above $38 before
taking the plunge.

---

BAX $38.18 -1.73 (+1.60) Riding along with the rebound in the
Pharmaceutical sector (DRG.X), shares of BAX have had quite a
ride over the past week, rebounding from the $30 level to just
kiss the $40 level at the close yesterday.  Not only is that a
huge gain in a very short period of time, but the $40 level is
formidable overhead resistance.  That made the run up to that
level an ideal time to harvest some gains and get ready for
another dip and bounce to re-enter the play.  Sure enough, BAX
fell back today, finding support at the $38 support level, which
just happens to be the site of the 20-dma.  Note that yesterday,
we raised our stop to $38, so we're at a critical juncture here.
A rebound from this level could make for another attractive
entry.  On the other hand, if BAX falls below this level on a
closing basis, then it will time to let it go.  Watch for
renewed strength in the DRG index to confirm strength in BAX
before playing.

---

LTR $46.81 0.63 (+1.73) With the buyers running out of steam in
the broader market, over the past 2 days, shares of LTR have
naturally pulled back after their strong rally off the $41
support level.  But given the sharp decline in the market on
Thursday, the stock has held its ground rather well.  Intraday
support seems to be building above the $46.50 level and a bounce
from that level could make for a solid entry, provided the broad
market doesn't break down.  On a deeper dip, we can look to
initiate new positions near the $45 level, as that is the bottom
of the stock's range on Monday.  Correspondingly, our stop is
set at $45, as a close below that level would likely indicate a
more substantial retracement.  Traders that are looking to enter
on strength will want to wait for LTR to clear the $48 level
accompanied by renewed strength in the broad market.  Note that
LTR is set to announce earnings on August 8th, so there is one
more week left to play.

---

MMM $122.13 -3.70 (+1.28 for the week) 3M is the Dow's most 
heavily weighted component.  As such it has taken a fall with the 
broader market today.  However, the long-term, and most important 
for this play, short-term, prospects for this stock are still 
strong.  The stock traded up to $127.55 on Tuesday, and a $5 drop 
from that level is not as much of a concern with a stock priced 
over $100 as it would be for a lower priced issue.  Prudential 
has raised their price target on 3M to $145 from $122, reflecting 
their belief that conversion to a digital business model should 
contribute to a sales growth rate of 5%-6% by the end of 2002, 
and 8%-10% by 2003, from just over 2% in the 2nd quarter of this 
year. They also believe the company benefits from its ability to 
take market share, its solid financial condition and diversified 
product lines. The stock managed to hold above its Monday lows of 
$121.61.  We have raised our stop-loss to $118.50, just below 
last Friday's low, as we feel this would represent the point 
beyond which a bounce is unlikely. This level coincides with 
MMM's 200-dma, which should provide support. While the stock 
certainly has exposure to a sliding Dow, it is also a candidate 
for a significant rebound if tomorrow's economic data is 
positive, based on its strong fundamentals. 

---

MSFT $45.70 -2.28 (+0.35 for the week) Microsoft has receded with 
the rest of the Dow this afternoon, however has maintained itself 
above our $45 stop loss.  With MSFT's 50-dma, 100-dma and 200-dma 
all above $50, this stock still appears to have room to the 
upside.  Their strong financial condition and coming foray into 
the CRM arena later this year provide forward stability to which 
investors can cling.  On Wednesday, Microsoft announced an 
alliance with AT&T Wireless too provide wireless data services to 
business customers.  The two companies have developed and will 
distribute end-to-end systems laptops, pocket PCs and 
Smartphones.  They plan to launch their first set of devices 
commercially in the 4th quarter.  Today the company also 
announced the release of the 2003 Money 2003 Deluxe collection of 
personal finance software, which includes free services such as a 
credit report and credit monitoring, tax filing, options 
investment tracking, and a consultation with a financial advisor.  
In addition, Microsoft's new licensing arrangement goes into 
effect today, which will provide yearly usage fees for products 
that previously collected only a one-time fee.  We are lowering 
our stop loss on this play to $44.00, in order to give Microsoft 
more room to bounce.  If there is a rebound in the market, this 
stock will surely participate.


**************
NEW CALL PLAYS
**************

None


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*******************
PLAY UPDATES - PUTS
*******************

BBOX $34.20 +0.39 (-2.72) In another interesting episode of
divergence, shares of BBOX bucked the broader market trend on
Thursday, registering just over a 1% gain.  That is pretty
impressive, given that even the Networking index (NWX.X) lost
almost 4% on the day.  Despite that positive action, we're
sticking with our guns on BBOX, as today's gain looks like
nothing more than a bit of short covering after the breakdown
under major support at $36.  Thursday's early rebound were just
what was needed to fill yesterday's gap lower, and a rollover
(already begun) below the $35 level may be a decent entry
opportunity.  We'd feel a bit better about a rebound near the
$36 level before opening new positions, but we'll have to take
what we can get.  Recall that the stock still looks vulnerable
to the $30 level, so momentum traders may want to consider
entering on a drop under yesterday's low at $33.  Keep stops
set at $36.50, the site of the bottom of Tuesday's gap.

---

DD $41.53 -0.38 (-0.35 for the week) DuPont has rolled over from 
its high of $44, having been turned away from its 200-dma of 
$44.25.  The stock experienced a run-up with the Dow and a look 
at its steep graph shows a level that appears unsustainable 
without continuing support of the overall market.  The negative 
economic data of the last 2 days, including lower than expected 
GDP, ISM, and Chicago PMI, combined with higher than expected 
initial unemployment claims, have combined to drive the bulls 
into hiding.  Worse than expected nonfarm payroll and 
unemployment numbers on Friday, which seem likely based on 
today's initial claims data, could overwhelm support for the 
broader markets and spell doom for this Dow component. There is 
continuing weakness in the semiconductors, which look headed for 
another 52-week low, as measured by the Semiconductor Sector 
Index (SOX.X), after attempting a rebound the last two days. This 
does not reflect well on DuPont's recent purchase of Chemfirst, a 
company that specializes in chemicals for use in the 
semiconductor industry.  With overhead resistance in place at 
$42.50 after the last two days of trading, the short-term trend 
has turned decidedly down in this stock.  Stochastics have 
confirmed this trend with a sell signal as the oscillator turns 
down from overbought territory. Apparently the company itself is 
unsure of its near-term possibilities, as Ann Gualtieri, DuPont's 
Vice President of Investor Relations, used the word "quandary" 
when asked to describe the company's outlook for the rest of 
2002.

---

JPM $25.02 +0.06 (+2.77 for the week)  J.P. Morgan has been in a 
holding pattern since its rebound after its executives finished 
Senate testimony in the Enron investigation.  This company still 
has a great deal of exposure to this investigation, and even a 
hint of additional bad news can land the stock back below $20.  
While the bank responded to Senate inquiries last Monday, as 
requested by the Sen. Levin, the government has yet to exonerate 
JPM.  This company is not out of the woods yet.  The stock closed 
over $25, which has provided resistance, but not by much.  A look 
at the CBOE open interest shows large open interest in JPM puts, 
which is a good indication that there are still plenty of bears 
in the aforementioned woods. The stock has reached previous 
resistance on the PnF chart at $25.  A new buy signal would not 
be achieved until there is a trade of $26, which is our stop loss 
on this play.  If the Dow continues south after tomorrow 
morning's unemployment and payroll data, this stock may follow it 
down.  The real story here is news related, however, including 
JPM's exposure to Enron dealings, and any other accounting 
problems that may present before the August 14 deadline for CEO 
and CFO certification.  There are still many companies out there 
that have yet to certify, and one of the nation's largest banks 
may be behind more than one curtain.


*************
NEW PUT PLAYS
*************

DHR – Danaher Corp. $60.12 -1.93 (+1.17 this week)

Company Summary:
Danaher Corporation operates in two business areas: Process/
Environmental Controls and Tools and Components.
The company's Tools and Components segment produces and
distributes general purpose mechanics' hand tools and automotive
specialty tools.  Among the household names they are responsible
for are Sears' Craftsman line, Allen wrenches, and NAPA hand
tools.  The Process Controls division, led by Veeder-Root, makes
leak detection systems for underground storage tanks, as well as
sensors, switches, measurement devices, and communications and
power protection products.

Why We Like It:
With evidence mounting that the economy is headed for a double
dip, positive guidance from economically sensitive companies is
likely to provide attractive some put opportunities.  Shares of
DHR have gotten an impressive bounce off the lows of last
Wednesday, but it looks like they are running into some
formidable resistance near the $62-63 level.  The stock was
turned back at resistance in the middle of the day on Tuesday,
and since then has now fallen back under the 20-dma ($60.74).
This most recent bout of weakness has pushed the daily
Stochastics over and they are now in bearish decline.  After
drifting down over the past two days, DHR is likely to get a
boost in the morning following the company's affirmation of its
earnings expectations after the close.  We want to take advantage
of that boost by entering new put positions when the upward
momentum runs out of steam.  An ideal place to fade that expected
rally is in the area of the $62-63 resistance level listed above.
Note that the picture on the PnF chart is still very bearish,
with the current price target of $51 looking very achievable.
Our near-term target will be a re-test of last week's lows near
$55.  Place stops initially at $64, just above Tuesday's intraday
high.

BUY PUT AUG-60*DHR-TL OI=1958 at $2.15 SL=1.00
BUY PUT SEP-55 DHR-TK OI= 346 at $0.75 SL=0.25

Average Daily Volume = 1.07 mln


---

CCMP – Cabot Microelectronics $39.86 -2.48 (+1.10 this week)

Company Summary:
Cabot Microelectronics is a supplier of high performance
polishing slurries used in the manufacture of advanced
integrated circuit (IC) devices, within a process called
chemical mechanical planarization (CMP).  CMP is a polishing
process used by IC device manufacturers to flatten many of the
multiple layers of material that are built upon silicon wafers
and necessary in the production of advanced ICs.  CMP enables
IC device manufacturers to produce smaller, faster and more
complex IC devices with fewer defects.

Why We Like It:
In a glaring contrast from its behavior in other market bottoms,
the Semiconductor index (SOX.X) just can't seem to get out of
its own way.  With reductions in cap-ex spending and earnings
disappointments occurring on a seemingly daily basis, it's no
wonder that the gains from last Wednesday's lows have all but
disappeared.  In fact, today's close at a fresh 3-year low
certainly doesn't bode well for any hopeful bulls.  Many chip
stocks are lurking near major support, making for less attractive
risk reward ratios.  But shares of CCMP are looking much more
attractive to the short side, as the stock is more than $8 above
last week's intraday lows.  Helping to keep the stock off its
lows is the strength of its earnings report last Thursday.  If
the SOX falls apart though, it is likely to drag all the stocks
in the sector lower in its wake, and CCMP just has further to
fall.  The PnF chart is showing the most recent rise as
generating a "bull trap" formation, just below the formidable
bearish resistance line (currently $45).  It is interesting to
note that CCMP is now back below the 50-dma ($42.19) and is
currently resting just above the 20-dma ($38.88).  The best
entries will come from a rollover near the 50-dma or a breakdown
under the $38.50 level.  Keep a sharp eye on the action of the
SOX to make sure it is confirming the trading of CCMP.  Stops
are initially set at $44, just above the recent highs.

BUY PUT AUG-40*UKR-TH OI= 742 at $3.20 SL=1.50
BUY PUT SEP-35 UKR-TG OI=1859 at $1.30 SL=0.75

Average Daily Volume = 1.44 mln


---

KLAC – KLA-Tencor $37.28 –2.11 (-0.01 for the week)

Company Summary:
KLA-Tencor is the world leader in yield management and process 
control solutions for semiconductor manufacturing and related 
industries. Headquartered in San Jose, Calif., with operations 
around the world, KLA-Tencor ranked #6 on S&P's 2002 index of the 
top 500 companies in the U.S. KLA-Tencor is traded on the Nasdaq 
National Market under the symbol KLAC. (Source: company release)

Why We Like It:
KLAC has been languishing on OI's watch list for a couple of 
weeks now.  We have recommended put spreads on this stock on the 
Market Monitor, however have left it off our official play list 
for a couple of reasons.  KLAC had a drop of over $6 in four 
days, and we didn't want to get caught chasing a rebound.  Once 
it showed continued weakness, its earnings were around the 
corner, and OI's policy against playing earnings got in our way. 
The stock made back a little ground leading up to earnings, on 
speculation that they may surprise the troubled semiconductor 
sector with decent earnings.  Alas, the good news wasn't so good 
after all.  While the company surpassed analysts' expectations, 
they were unable to "put some lipstick on this pig."  Net income 
was cut to just over a third of last year's number, while revenue 
fell 38%.  

The stock's original fall through $40 support signaled weakness, 
as that level had provided a floor going back to the beginning of 
July.  Its upcoming earnings seemed to halt the slide and gave it 
a temporary boost.  Now that the news is out, however, the bulls 
have gone back into hiding, and the bears are piling on.  The 
stock has not yet seen its September lows in the $32 range, but 
this would be a good initial target for this play, as it is the 
first level of visible support.  The stock has been in a long- 
term descending channel since the beginning of April, and has 
rolled over just above its centerline, as it seeks out new lows.  
The bearish vertical count on the point and figure chart is $26, 
and its earlier break below $40 signaled a triple bottom 
breakdown.  A trade of $36 will constitute a bearish catapult, 
which is a triple bottom breakdown, followed by a double.  

As if the news and technical analysis were not enough bad news 
for this stock, the semiconductor sector is in bad shape.  The 
Semiconductor Index (SOX.X) finished today at a new 52-week 
closing low, and its long-term downtrend looks even worse than 
KLAC's.  Continued warnings, such as Taiwan Semiconductor (TSM) 
slashing its budget by more than $500 million for the rest of 
2002, continue to flood the sector, as the current spending 
environment remains poor for these companies.  We will place our 
initial stop-loss at $40, above this stocks previous level of 
support.


BUY PUT AUG-40 KCQ-TH OI=5209 at $4.00 SL=2.00
BUY PUT SEP-40*KCQ-UH OI=3790 at $5.40 SL=3.00

Average Daily Volume = 15.1 mil



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The Option Investor Newsletter                 Thursday 08-01-2002
Copyright 2002, All rights reserved.                        3 of 3
Redistribution in any form strictly prohibited.

In Section Three: 

Play of the Day: KLAC - PUT
Traders Corner: Oscillators - Part 2: The Relative Strength Index (RSI)
Options 101: Bullish or Bearish - Stay hedged, Make Money, Part II


*********************
PLAY OF THE DAY - PUT
*********************

KLAC – KLA-Tencor $37.28 –2.11 (-0.01 for the week)

Company Summary:
KLA-Tencor is the world leader in yield management and process 
control solutions for semiconductor manufacturing and related 
industries. Headquartered in San Jose, Calif., with operations 
around the world, KLA-Tencor ranked #6 on S&P's 2002 index of the 
top 500 companies in the U.S. KLA-Tencor is traded on the Nasdaq 
National Market under the symbol KLAC. (Source: company release)

Why We Like It:
KLAC has been languishing on OI's watch list for a couple of 
weeks now.  We have recommended put spreads on this stock on the 
Market Monitor, however have left it off our official play list 
for a couple of reasons.  KLAC had a drop of over $6 in four 
days, and we didn't want to get caught chasing a rebound.  Once 
it showed continued weakness, its earnings were around the 
corner, and OI's policy against playing earnings got in our way. 
The stock made back a little ground leading up to earnings, on 
speculation that they may surprise the troubled semiconductor 
sector with decent earnings.  Alas, the good news wasn't so good 
after all.  While the company surpassed analysts' expectations, 
they were unable to "put some lipstick on this pig."  Net income 
was cut to just over a third of last year's number, while revenue 
fell 38%.  

The stock's original fall through $40 support signaled weakness, 
as that level had provided a floor going back to the beginning of 
July.  Its upcoming earnings seemed to halt the slide and gave it 
a temporary boost.  Now that the news is out, however, the bulls 
have gone back into hiding, and the bears are piling on.  The 
stock has not yet seen its September lows in the $32 range, but 
this would be a good initial target for this play, as it is the 
first level of visible support.  The stock has been in a long- 
term descending channel since the beginning of April, and has 
rolled over just above its centerline, as it seeks out new lows.  
The bearish vertical count on the point and figure chart is $26, 
and its earlier break below $40 signaled a triple bottom 
breakdown.  A trade of $36 will constitute a bearish catapult, 
which is a triple bottom breakdown, followed by a double.  

As if the news and technical analysis were not enough bad news 
for this stock, the semiconductor sector is in bad shape.  The 
Semiconductor Index (SOX.X) finished today at a new 52-week 
closing low, and its long-term downtrend looks even worse than 
KLAC's.  Continued warnings, such as Taiwan Semiconductor (TSM) 
slashing its budget by more than $500 million for the rest of 
2002, continue to flood the sector, as the current spending 
environment remains poor for these companies.  We will place our 
initial stop-loss at $40, above this stocks previous level of 
support.


BUY PUT AUG-40 KCQ-TH OI=5209 at $4.00 SL=2.00
BUY PUT SEP-40*KCQ-UH OI=3790 at $5.40 SL=3.00

Average Daily Volume = 15.1 mil



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Oscillators - Part 2: The Relative Strength Index (RSI)  
By Leigh Stevens
lstevens@OptionInvestor.com

The RSI (as is stochastics) is an "oscillator" that is 
constructed in a way that its numerical scale goes from a fixed 
point on the low end (0) to a fixed point on the upper (100) end. 
This is not the case in the Moving Average Convergence Divergence 
or MACD ("mack-dee"), which will be the subject of the final 
article in this series on Oscillators.   

The Relative Strength Index, usually referred to as the “RSI” was 
developed by a trader and market analyst named Welles Wilder back 
in the 1970's. A simple way to understand the RSI is that it is a 
ratio (one number divided by another) that compares an average of 
up closes to down closes.  There is only ONE variable, which is 
the length or the number of periods (hours, days, weeks, etc.) 
that the RSI formula works with.    

The common RSI default (the preset value) for length is usually 
either 9 or 14.  The relative strength index calculations will be 
based only on the number of closes specified as the length 
setting.  The reason for the widespread use of either 9 or 14 is 
mostly a matter of convention.  Obviously, a setting of 9 or 14-
days does not represent an even number of 5-day trading weeks.  

However, both 9 and 14 are the most common default settings and 
there is a repository of experience among users of the RSI with 
these levels and instances of overbought or oversold conditions 
associated with them. The commonly used default settings are 30 
to represent an oversold reading and 70 and above to suggest an 
overbought condition.

The optimum length settings are a function of your time horizons 
relative to trading or investing.  5 to 9 (or 10) for the RSI 
length on a daily or hourly chart is appropriate for the minor 
trend and short-term trading.  A length setting of 14 up to 21 
for daily charts is good for looking at the longer trend, such as 
over 2-3 weeks or more. On weekly charts, my preference is an 8-
week period for the RSI – 8 represents a 2-month period or 1/6th 
of a year, which can provide a relevant picture of the secondary 
trend.  

RSI is derived by calculating the average number of points gained 
on up days, during the period selected (e.g., 14), then dividing 
this result by the average point decline for the same number of 
bars – this ratio is “RS” in a 14-period formula for RSI or 100 – 
100/1+RS.  RS = the average of 14-days’ up closes divided by an 
average of 14-days’ down closes.  9 or 21, or any other number, 
would be used instead of 14 in this example.  

Every up close during this period is added and this sum is 
divided by the number of bars that had up closes to arrive at a 
simple average.  Every down close during the period selected is 
added, then this sum is divided by the number of bars that had 
down closes.  If 10 of 14 days had up closes, the result of this 
division is a ratio that rises rapidly.  Subtraction from 100 of 
the result of the division is what makes for a “normalized” scale 
of 1 – 100.   

In a period of a rapid and steady advance the RSI will reach 
levels over 70 rather quickly and RSI can then remain above 70 
for some period of time.  The reverse is true in a decline, as 
readings under 30 are seen.  



 

Once the RSI retreats from high levels, it can offer an alert 
that the trend may be reversing. It is also true that relatively 
brief sideways consolidations or even a minor counter-trend 
movements will cause the RSI reading to back off from the preset 
70/30 “extremes” and get back below 70.  

The reverse situation would be where a steep decline causes the 
RSI to fall well under 30 – a brief sideways move or counter-
trend rally can put the RSI back above 30.  Once a strong trend 
continues, the RSI can quickly get back into oversold or 
overbought territory again. 



   

In a strong up trend, it is often advisable to both use longer 
length settings of the RSI – for example, 14 – 21 on daily charts 
and to define “overbought” as a level above 70; e.g., in the 80-
85 zone.  In a strong down trend, changing to a longer RSI length 
setting is also appropriate – in addition, define oversold only 
as an RSI level that is at or below 20.  

You can change your conception of constitutes the overbought and 
oversold extremes to an area closer to what has been reached 
already as the highest, and lowest, RSI readings – 



 

The above chart is also an excellent example of a bearish RSI 
"divergence" that set up on the second rally to the highest peak.  
You'll notice that the RSI did not then ALSO move to a new 
relative high - a great "sell signal" resulted. 

A common situation is where there is a strong initial price 
swing, then a period of consolidation such that the RSI stays 
within the 30 to 70 levels.  While these readings are in this 
zone, the RSI is of little practical use.  More value is gained 
in using the RSI in a market that develops a well-defined trading 
range such as in the FIRST chart above.

If prices falter in an area of prior highs, accompanied by even 
1-day when the 14-day RSI is over 70, this indicator gives an 
added indication to sell in a prior resistance area.  In the area 
of prior relative lows, accompanied by even 1-day with an 
oversold reading of the 14-day RSI at or under 30, the RSI 
provides some technical reinforcement for buying while prices are 
in a likely support zone. 

The use of indicators to “confirm” other technical developments 
relating to prior highs and lows or such things as price 
reversals at trendlines, is one of their most useful aspects.  A 
rounding or rectangle bottom coupled with an oversold RSI reading 
would be a good technical validation for purchasing, especially 
if prices also broke out above a trendline.  

Trendlines may also be applied to a series of lower RSI highs or 
higher RSI lows, with the same implications for a breakout above 
or below the line – this may lead or “confirm” similar price 
action.  

OSCILLATOR DIVERGENCES AS BUY OR SELL “SIGNALS” 
Indicators, besides their usefulness in providing some idea of 
whether a market is overbought or oversold, will also generate 
occasional divergent buy or sell “signals”, on either an 
intraday, daily or weekly chart basis. 

RSI will normally move to a new low or new high when prices do 
the same - this is "confirmation" by an indicator.  When 
confirmation does not occur, the resulting divergence is an 
important alert for the possibility that it’s signaling an 
upcoming reversal to the current trend.  

In a sense, divergences are more "important" than indicator 
confirmations as they can provide either an excellent buy or sell 
signal.  If the signal is one that indicates a possible reversal 
to a trend that you are participating in, this is a valuable 
advance warning – one of the chef risks to potential gains being 
caught in a trend reversal that you did not see coming and were 
not prepared for.   



 


A classic example of a bearish divergence is a higher price peak, 
accompanied by a lower low in the oscillator reading, compared to 
its last extreme – this development suggests some likelihood of a 
downside reversal developing in the near future.  

A classic example of a bullish divergence would be a higher high 
in an oscillator relative to what came before, in the same 
trading period when prices made a lower low – this situation 
suggests the possibility of an upside reversal. 



  

There is a third situation that comes up, which is not considered 
a “classic” divergence, where the indicator bottoms or tops in 
the same area – marking a double top or bottom or a line 
formation – whereas prices go on to make a new high or low.  This 
type of divergence is also valid in terms of suggesting that the 
market may have topped or bottomed.  Such measurements of 
momentum based on an oscillator formula, suggest that the trend 
strength could be waning and that the item or financial 
instrument in question, vulnerable to a reversal.  

The RSI has a maximum reading of 100 and it has the same tendency 
to “flatten” in very strong trends which is even more pronounced 
in the stochastic model – however, the RSI will fall relatively 
quickly from its most extreme point as soon as a correction 
develops – when a rally resumes, the RSI will rise again with the 
advance, but will also give a more clear cut divergent reading by 
not rising as far as previously if the momentum is not as strong 
on the next advance.   

There are often multiple divergences and some will be early and 
well before the actual occurrence of a trend shift.  Instances of 
multiple divergences create a risk of premature trade entry one 
or more times if trade entry was based primarily on an oscillator 
divergence.  There are some ways to avoid this situation, as 
follows:

1. Give more weight to divergences that occur during or after 
overbought or oversold oscillator extremes that have been 
adjusted to reflect the strength of the dominant trend – e.g., if 
in a very strong up or down trend, the appropriate RSI 
overbought-oversold levels may be 80 and above or 20 and below, 
rather than 70/30. 

2. Look for  “confirming” price (chart) patterns that are 
associated with trend reversals – especially trendline breaks or 
breakouts.

RSI tends to be my oscillator of choice in looking for 
divergences, although a good strategy is to also look at the 
other common oscillators like Stochastics and MACD -- sometimes 
it is a different oscillator, such as the stochastics model, that 
highlights a particular bullish or bearish divergence.  


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OPTIONS 101
***********

Bullish or Bearish - Stay hedged, Make Money, Part II
Buzz Lynn
buzz@OptionInvestor.com

The last time we had a chat in this column was on July 18th where 
I promised I'd get to the "adjustment" phase of the hedged 
strangle or straddle trade "next week".  Woops!  I missed a week!  
And what a great week it was for me personally, as I got to take 
my eight-year-old daughter to Disneyland for her first visit.  She 
had a blast - liked it better than Disney's Big Red Boat and 
Disneyworld.  

Little did we know what lay in store for us at the newest park in 
the Disney chain, Disney's California Adventure.  It was awesome!  
For those that haven't been to Disneyland for at least two years, 
or not at all, the California Adventure was built right where the 
old parking lot used to be.  I couldn't recognize the place.  
Anyway, California Adventure, my daughter and I agreed, was even 
better than the regular Disneyland, though we still liked the 
Magic Kingdom a whole bunch too.  

Why do I bring up this Disneyland stuff (other than to artfully 
fess up as to why I didn't write last week)?  The answer is 
because I was planning to do a Fundamentals Guy piece upon 
returning from my vacation as to why Disney (DIS) might or might 
not make a nice investment in a tumultuous market.  Because the 
service at the parks was first rate, and the parks were populated 
like I'd never seen before with happy faces freely spending money 
(What recession?  One $8 hamburger please.), I figured Disney must 
be making a huge amount of cash worthy of my investigation if not 
my investment. 

Further research proved me wrong thanks to a bunch of debt and the 
possibility of drastic travel and entertainment budgets cuts at 
the family level in coming months if not years.  Dividend yield 
wasn't too hot; neither was the earnings multiple.  That would 
make a boring story.  Then I remembered (and was reminded by a few 
e-mails) that I promised a follow-up to the last column.  And 
that, Dear Reader, just like explaining how to build a clock when 
asked for the time, is how we arrive at today's topic of adjusting 
our hedged straddle or strangle.  For those that missed the last 
article, you can get up to speed at the following link:

http://members.OptionInvestor.com/options101/071802_1.asp

On with the story.  Remember that we want to be market agnostics 
by not thinking "bull or bear".  We go where the market tells us, 
and we let volatility premium decay on the other guy from our 
short positions.  We profit no matter what as long as we remain 
hedged in the direction of the trade.  With that in mind, let's 
get to the fine points using the QQQ trade we referenced earlier.  
Recall that we were short the AUG-25 straddle (a put and a call).  
The following daily chart shows support and resistance as of July 
18th.  

QQQ daily chart:


 


A breakout over $26.50 resistance would be enough to get my 
attention to go long QQQ shares, which hedges our $25 call 
position and locks in a $1.50 profit for us as long as QQQ remains 
above $26.50 by expiration.  Similarly, a breakdown under $23.50 
is going to get me going short to hedge the $25 put, which also 
locks in a $1.50 profit as long as QQQ closes under $23.50 at 
expiration.

Here's my logic behind picking $26.50 and $23.50 as pivot points.  
That's where we find support and resistance.  We could just as 
easily pick $25.25 and $24.75 as pivot or hedge points, but 
clearly, that will have us in and out, short and long, possibly 
many time during our hold period to expiration.  The other side of 
the coin is that by picking $27 and $23, we run the risk of wiping 
out a big part of our collected premium from the short 
straddle/strangle.  By waiting that long to hedge, we let $2 of 
the $3 collected premium get away before protecting ourselves - 
not much of a return there, and reversals of the underlying stock 
back under $27 or over $23 would whittle away at our remaining $1 
profit.  We must pick a strategy here and stick to it.

This may seem trivial like a background explanation, not the main 
point.  But it is the essence of the real dangers of this trade.  
If you get nothing else from tonight's article, understand this.  
Profits will be eaten alive and can turn into a loss if the 
underlying gets stuck trading around a pivot point and we do not 
ultimately exit the trade while there is till money in our pocket.  
Note the updated QQQ chart below.

Current QQQ chart (daily):


 


Eeeeew. . .that doesn't look so good, does it?  Nope, but if we're 
smart we still come out ahead by evaporating vega and theta 
(volatility collapse and time decay).  But let's follow the course 
of action here.  First we went short when, at the end of the day, 
we saw a close under $23.50.  Three days later (long green 
candle), QQQ closed at $23.63.  So we follow the discipline and 
buy our short shares back.  Bummer - because the next day, we 
short again when the QQQ falls under $23.50 (next red candle).  
Two day's later, BAM!  Gap up and close over $23.50.  So we cover 
our short shares by purchasing them back.  Today (last red 
candle), back under $23.50 so we are short again.  Ideally, every 
time we stick around a pivot point, commissions will be the most 
expensive part of the transaction since bid/ask spread on the 
underlying should be minimal.  Spreads will be almost neutralized 
if we are going short and getting filled, then covering the shorts 
with stop orders.  Simply set a limit order such that when QQQ 
trades below $23.50, we get short the shares.  Hopefully it 
continues down.  NO?  Ok, once filled, we then set a stop limit at 
$23.50 to cover our short shares if the price moves back up.  
Lather, rinse, repeat.

Now all this can get pretty expensive commission-wise even with a 
small spread on the underlying.  If we get tired of the in and out 
action, we can simply cover the short while simultaneously buying 
back the short straddle.  The bid/ask spread on the options will 
be much more noticeable here and can slurp off what little profit 
remains.  We might get out with a small profit or loss.  But the 
point is to plan to close the whole trade if it isn't going our 
way.  Don't let a profit turn into a loss from overtrading.  Get 
out of the whole thing and re-evaluate or do a different trade.

Just for grins and giggles, suppose we are type A traders that 
won't leave an ounce of wiggle room on the $25 straddle.  With 
that mentality, a large enough short straddle position, which 
won't be drastically affected by commissions, and the ability to 
watch our charts minute by minute, we might have decided to stick 
to $25 even, as our pivot point.  Long above $25; short below $25; 
no emotion; no second guesses; a pure trading machine; long or 
short as we hit the $25 number.  In that case, we would have been 
short two weeks ago and never looked back - that $3 premium still 
in our pocket.  

Now, are the dangers and rewards apparent?  Can we now understand 
why trading style has everything to do with the profitability of 
this play and why discipline to sticking with the strategy is so 
important?  That's one of the reasons I was careful two weeks ago 
to suggest readers NOT make this trade unless we had full 
understanding of the strategy.  Again, short the straddle or 
strangle to take advantage of expensive volatility premium and 
time decay.  Then let it evaporate on the other guy while we hedge 
in the direction of the underlying security - short under the 
strike price, long over the strike price.  It's really simple.

But as we get more comfortable with this strategy, we can make it 
even more sophisticated.  Here's a great example of one our sharp-
brained readers getting it absolutely correct with an edgy twist, 
edited for brevity.  Beginners, don't try this at home without a 
thorough understanding of what you about to read. . .and for gosh 
sakes, paper trade it first with pretend money!  

Reader T.D. (probably stand for touchdown!) writes:

Hi Buzz,

Waiting with bated breath for the follow up to your 18th July 
article.  Because of the high premiums available I have several 
short straddles, short strangles and naked puts/calls open on 
individual stocks.

So far the hedges have been simple but there is bound to be a time 
when I get a dreaded oscillation about a strike. :-(  [author's 
note: see above]  Gap openings are another danger of course but I 
do each of these positions in relatively small size so any single 
problem should not be too much of a disaster.  Perhaps I will 
already be hedged (in the right direction) when if it happens - I 
can hope.

I view these trades as number of points credit available to cover 
me against adverse events and I have adjusted them as time goes by 
in order to add more "points" to the position.

e.g.

Sold 460/500 strangle for 54.

Price fell below 460 - sold underlying @ 459 for the hedge.

Price fell a little further.

Closed 500 call, sold 460 call for a credit of 7.  I now have a 
460 straddle with 61 points credit and a short hedge already in 
place.

Price fell further still.

Closed 460 call, sold 420 call for a credit of 9.  I don't know 
the technical term for this but I now have a strangle again but 
with the call price below the put.  I also have 70 points credit 
and a short position in the underlying.

Underlying bounces back above 420

Close hedge @ 420 losing 1 point since I did not protect the 460 
put until 459. (in fact there was an obvious intraday "bounce" 
taking place so I closed earlier.  This created an extra profit 
but is not included here since as you pointed out, we do not trade 
the underlying in these positions.  I did; took a risk and it 
worked.  This was an EXTRA decision and nothing to do with the 
other principles discussed here).

The price now is between the 420 and 460 strikes so no underlying 
position is in place; but sell and buy stops are.

I am new to options but not new to trading.  It seems to me that 
the more premium I can take in on any position, the more 
protection I have and downside protection is always my FIRST 
consideration.  Profit is OK but not losing is even more 
important.  [T.D nails the philosophy exactly right.]

The position above is now 69 points up so I can now stand more 
things going wrong.  Also I am now back in a strangle which 
appears less risky than a straddle since the adjustments may be 
less frequent with a "free" area to work in.

I would be very keen to know when you will be publishing the 
follow up.  I can only hold my breath for so long :-) 

Thanks a lot. Love the site.

T.D.

Thanks T.D.!  It's great e-mails like this that make our day and 
convey to us that OIN readers have learned how to fish, not just 
accept the gift of fish!

In an ideal world, this is exactly how a trade is supposed to work 
out.  For the article, in order to keep it simple, I had planned 
merely to talk about shorting the underlying at [in T.D.'s 
example] 459 or going long at 501 and let the short options 
expire.  But he already knew to do that and some better by 
covering and shorting the option on the way down, thus getting 
vega to work even more in his favor.  He swerved into an effective 
strategy - Nice Job!

I know this is a hard strategy to get at first for the 
uninitiated, but it will sink in, and once understood is very 
simple.  Again, short expensive options so that volatility and 
time decay works in our favor, and hedge in the direction of the 
underlying security.  It's kind of like a jet getting off the 
runway.  It requires 103% power just to get off the runway, but 
once airborne, we can climb and fly faster with less power.

Questions always welcome.  Trade smart and make a great weekend 
for yourselves!


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