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Daily Newsletter, Wednesday, 02/16/2005

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Nothing Measured

Nothing Measured

Greenspan watchers poured over Greenspan's prepared testimony before the Senate Banking Committee Wednesday, expecting to see the "measured pace" language removed in preparation for its deletion from FOMC statements. They found it gone, as expected. When Chairman Shelby questioned Greenspan specifically about the likelihood of that phrase disappearing from the FOMC statements, Greenspan commented with a smile that no language was going to remain "in perpetuity."

No "measured" language appeared in that report, but markets certainly measured every word Greenspan wrote and spoke. Indices were parked at strong support before the prepared report was released and stayed there throughout the question-and-answer session. The afternoon response was less measured, with markets zooming up in a late-day stop-run that was soon to be reversed. That action was apparent on the Russell 2000.

Annotated 60-Minute Chart of the Russell 2000:


 

On a day when advancers finally outnumbered decliners but down volume remained ahead of up volume, other indices also failed to hold those late-day gains, but remained essentially unchanged for the day.

Annotated Daily Chart of the SPX:


 

Annotated Daily Chart of the Nasdaq:


 

As the two breakout attempts this week demonstrate, even such well-defined formations will sometimes see false breakouts, so market participants on a breakout either direction should be ready to jump out of a play if the move is soon reversed.

Annotated Daily Chart of the Dow:


 

On the Dow's chart, the TRAN's overbought status was mentioned. A monthly chart of the TRAN with a 30 percent envelope surrounding the 200-month ema illustrates that conclusion. The top envelope usually marks dramatic swing highs for the TRAN.

Annotated Monthly Chart for the TRAN:


 

Greenspan's testimony took precedence over other economic developments, but some homage should be paid to them, too. Other economic releases included the Mortgage Bankers Association's release of mortgage activity, with that report showing a slight 0.5 percent decrease in mortgage application activity, down considerably from the previous week's rise of 4.2 percent. Refinancing applications rose 4.1 percent, however, building on the previous week's gains, and was a higher percentage of all mortgage applications than in the previous week. The purchase index, a measure of loan requests for purchases, fell 4.8 percent, showing that home purchasing activity was not buoyed by continuing low rates for 30-year, fixed-rate mortgages. Those rates climbed 2 basis points from the previous week, but remained low by historical precedents. The decrease in mortgage application activity went counter to information to be released only a few minutes later.

Scheduled pre-market 8:30 releases included January's Building Permits, Housing Starts, Capacity Utilization and Industrial Production. Released at 9:15 rather than the expected 8:30, January's Industrial Production was unchanged from a revised-lower-to-0.7-percent December number. Expectations had been for a 0.3-0.4 percent rise from December's formerly calculated 0.8 percent rise, so that the number proved to be a disappointment. Capacity Utilization was 79.0 percent, slightly lower than December's 79.1 percent and the anticipated 79.3 percent. Capacity Utilization was the highest since 2000, according to some sources.

Against expectations of a decline, the Commerce Department noted that housing starts rose to a 21-year high, climbing 2.7 percent. The department revised December's rate higher, too. Building permits rose 1.7 percent. This evidence of activity among builders in the face of possibly dwindling new applications for loans questions what will happen to housing prices if the trend continues. Nevertheless, traders decided they liked that 21-year-high figure, sending the DJUSHB more than 2 percent higher despite a UBS downgrade of Ryland (RYL).

Mortgage rates and their impact on the housing industry were expected to be one focus on questions addressed to Fed Chairman Alan Greenspan. Some thinkers believe that the Fed's adoption of easy monetary policy created various bubbles, including one in the housing market, and now cannot let them all collapse at the same time due to deflationary risks. According to one source, an anonymous comment at the December FOMC meeting buoyed speculation about the existence of a bubble in the housing market. As discussed later in this article, Greenspan labeled the reactions of the bond markets--and by extrapolation, interest and mortgage rates--a conundrum.

Greenspan's testimony included a set of central tendencies that detailed real GDP forecasts, core prices (PCE) and the jobless rate. Some expected Greenspan to trim the 2005 GDP forecast of six months ago of 3.5-4.00 percent, perhaps to as low as 3.25 percent. That did not occur. Instead, Greenspan targeted a 4-4.75 percent real GDP, up from last July's. Many economists believed that the Fed might trim its expected inflation rate, too, and keep estimates for unemployment somewhere near the middle of its prior range, with both of those occurring as expected. With PCE an inflation measure, the estimated range was trimmed from July's 1.5-2.5 percent to a current 1.5-2.00 range. The estimates for unemployment remained at July's levels.

Headlines quickly noted that Greenspan did not include the "measured pace" language, however, and the prepared speech delved into several areas of concern, including the need for Social Security reform by 2008, reasons why household or consumer spending might slow, the continued and unusual reluctance of businesses to hire or increase capital spending beyond the recent spending to finance a backup in inventories, the effect of lowered productivity on unit labor costs if continued, the rising of import prices as a reflection of dollar weakness and the impact of higher oil prices.

Greenspan's written address acknowledged concerns that long-term interest rates have not risen along with short-term rates, with some believing that this action reflects a belief that rising oil prices will lower economic growth in the future. He cautioned that this interest-rate reaction is not an effect seen only in the U.S., however, and that it would be a mistake to attribute it only to factors relating to the U.S. economy. He calls the action a conundrum, perhaps a "short-term aberration."

Expanding on those concerns, Greenspan noted that distant-horizon oil futures contracts hinted at a "sizable permanent component of oil price increases" but comforted readers by saying that energy prices are a lower percentage component of total business expenses than they once were. In further expansion on the concerns detailed above, Greenspan reminded that both rises and declines in productivity were notoriously difficult to anticipate.

When discussing the funding of private accounts as a part of Social Security Reform, Greenspan asserted that those accounts would by their nature be more likely to be fully funded and should be studied, but he also detailed concerns that a $1-2 trillion in new federal borrowing to fund them would be significant enough that any forced savings in private accounts would not be worth the effort. During the Q&A session, he noted that the "pay as you go" system had worked well for decades, but that it was not a general system, but one that had worked because of the demographics over the previous decades. Those demographics are changing. He further noted that he didn't know and didn't know how it might be possible to know the effect of a new system on bond markets. He believes, however, that the ability to own an account that can be bequeathed to one's offspring to be an enormous benefit, bestowing wealth on those who have not had it.

Despite the concerns detailed earlier, Greenspan's prepared comments noted that the U.S. economy entered 2005 in good shape, expanding at a "reasonably good pace." Participants in financial markets appeared more willing to take on risk than business executives. He reassures that despite sometimes enormous challenges, the U.S. has seen only five quarters of GDP declines in the last twenty years. He took away that reassurance almost at the same time it was offered, only a paragraph later commenting that "people experiencing long periods of relative stability are prone to excess" and stating the need to "remain vigilant against complacency."

He reiterated his insistence that fiscal discipline be restored, that the flexibility of economic and financial systems be maintained to weather the necessary adjustments as that discipline is restored, that the inexorable demographics prompt difficult choices relating to Social Security and Medicare, and that the population be educated or trained to compete effectively on a global scale. In the Q&A session, he noted that the only thing that maintained our standard of living was our creativity, the ideas we had, and the flexibility of our economic and political system to take advantage of those ideas. That must be maintained, he asserted.

His prepared comments ended with reassurance that the U.S. could deal with the challenges facing it, but his statement sounded eerily like that of a commander reassuring his troops before sending them into a tough battle. Still, after the testimony, commentators quickly summed up the good points: the "reasonably good pace" language when describing the economy in early 2005 and the low expectations for inflation. After the Q&A session concluded, markets consolidated a while longer, then shot up into a stop-run that was soon reversed.

Shortly after Greenspan began speaking, the Department of Energy released inventory numbers. During the overnight session, crude prices had been supported by a statement from the OPEC's acting secretary general that OPEC members lean toward a production cut at the March meeting. News of a blast in Iran, although soon denied, also supported prices, and crude for March delivery rose to its morning high at $48.00 as the inventories numbers were released.

At about 10:30, both the American Petroleum Institute and Department of Energy reported inventories numbers. The DOE reported a higher-than-expected jump of 2.1 million barrels in crude inventories, while API reported an even larger 5.1 million increase. However, the DOE also reported a larger-than-expected drop in distillates of 3.1 million barrels, with the API reporting an equal 3.1 million barrel drop. According to the DOE, gasoline inventories rose 4.1 million barrels with the API reporting an increase of 4.3 million barrels.

The immediate reaction was a drop in crude prices and then a coiling just above $47.00, with the 30-dma at $47.08 having provided support on a closing basis throughout the previous three trading sessions. Prices broke out of that coil to the upside, with crude for March delivery closing above $48.00, at $48.30. The OSX, the oil service sector, was a strong performer other than a brief blip after the release of the crude inventories, closing higher by 2.60 percent.

Other market influences included a meeting of two FDA advisory panels to discuss safety and effectiveness of anti-inflammatory drugs. Pfizer (PFE) and Merck (MRK) closed lower by 1.07 and 1.12 percent, with the DRG falling 0.61 percent. Earnings Wednesday included those from Coca-Cola (KO), Caremark Rx (CMX), Moody's Corp (MCO), Cooper Tire (CTB) and Jones Apparel (JNY). KO, MCO and CMX beat expectations while JNY disappointed. KO closed higher by 1.52 percent, but JP Morgan downgraded MCO, so that it had no opportunity to benefit from the better-than-expected earnings results. MCO dropped 2.94 percent. Also impacting trading was disappointing sales guidance from Network Appliance (NTAP), with NTAP plummeting 7.65 percent.

HPQ reported after the close, with the stock climbing in after-hours trading after reporting earnings of 37 cents per share, excluding items, against an expectation of 34 cents per share. Revenue was $21.45 billion against expectations of $20.96 billion. The reaction to HPQ's earnings may not yet be concluded, as many will want to know the company's plans post-Fiorina.

Tomorrow sees WMT report before the open. Thursday's economic releases include the January 12 Initial Jobless Claims, February 5 Continuing Claims and January's Export Prices ex-ag and Import Prices ex-oil, all at 8:30. January's Leading Indicators follows at 10:00, and February's Philadelphia Fed at noon. Not to be forgotten, the SEMI Book-to-Bill number will be released Thursday at 3:00 Pacific Time.

As Jim Brown has been cautioning, watch the SOX and the RUT for keys to market behavior. A sustained SOX breakout above the 200-week moving average at 442.51 would be good for market sentiment, but such a breakout Tuesday was soon reversed and the SOX may see choppy trading behavior ahead of that book-to-bill number. Market bulls would like to see a Nasdaq upside breakout above Tuesday's high, with bears wanting to see a downturn back through the big symmetrical triangle. Market bulls also want to see a Russell 2000 breakout above the neckline of that continuation-form inverse H&S, sustained on a 60-minute close, while bears want to see a downturn and a fall below the appropriate right-shoulder level.

With WMT's earnings release tomorrow morning before the bell, the RLX's behavior may be important, too, with the RLX stocks seeming to lead general market declines in January when the RLX gapped below a bear flag. Now the RLX has come up to retest the top of that gap as WMT is due to report.

Trade carefully. Aggressive bears may now want to nibble on positions, knowing that they'll now have excellent get-out points on indices. With the TRAN looking so overbought and the Nasdaq not leading the pack higher, long positions appear somewhat iffy until those conditions are changed. Remember opex tendencies to pin indices to certain levels beginning about noon on opex Thursday when deciding whether a play makes sense.

 
 




New Plays

New Option Plays

Call Options Plays
Put Options Plays
EXP None
SSI  

New Plays

Eagle Materials Inc - EXP - close: 82.90 chg: +2.41 stop: 78.50

Company Description:
Eagle Materials Inc. is a Dallas-based company that manufactures and distributes Cement, Gypsum Wallboard, Recycled Paperboard, Concrete and Aggregates. (source: company website)

Why We Like It:
As you know the construction business and homebuilding sector has been booming in this country. Just today the housing starts came out at a 21-year high. Of course the homebuilding stocks have been soaring and we hesitate to jump in again without a significant pull back. Fortunately, one of the raw materials companies that supply the sector is offering investors a pull back. EXP was actually spun off from homebuilder Centex (CTX) last year and the stock has been a winner ever since. Currently shares are beginning to bounce from a 38.2 percent Fibonacci retracement of its October to December rally. The MACD indicator has produced a new buy signal and its other technical oscillators look positive as well. We also like the bullish P&F chart with a new double-top breakout buy signal and a $92 price target. We plan to use today's breakout over the 40 and 50-dma's as an entry point. While there is some resistance in the $85-86 level our target is the $90.00 level.

Suggested Options:
We will suggest the April calls.

BUY CALL APR 80 EXP-DP OI= 30 current ask $5.20
BUY CALL APR 85 EXP-DQ OI=516 current ask $2.60
BUY CALL APR 90 EXP-DR OI=250 current ask $1.10 *higher risk*


 

Picked on February 16 at $ 82.90
Change since picked: + 0.00
Earnings Date 01/26/05 (confirmed)
Average Daily Volume = 107 thousand

---

Spectrasite Inc - SSI - close: 61.80 chg: +1.95 stop: 58.00

Company Description:
SpectraSite, Inc. (www.spectrasite.com), based in Cary, North Carolina, is one of the largest wireless tower operators in the United States. At September 30, 2004, SpectraSite owned or operated approximately 10,000 revenue producing sites, including 7,802 towers and in-building systems primarily in the top 100 markets in the United States. SpectraSite's customers are leading wireless communications providers, including Cingular, Nextel, Sprint PCS, T-Mobile and Verizon Wireless. (source: company website)

Why We Like It:
We like SSI for its relative strength and bullish technical breakout today. The stock has been a consistent winner the past several months but the rate of climb slowed in December through February. That allowed SSI to pull back toward its long-term rising trendline of support (see chart). Shares rallied strongly off that trendline today with a little help from Bear Stearns. The firm reiterated their "out perform" rating on the stock and raised their price target to $73. Volume on today's rally was almost three times the norm, which typically a bullish signal too. We want to go long here (or anywhere above $60) and target a run towards $66-67.

Suggested Options:
We are going to suggest the April calls.

BUY CALL APR 55 SSI-DK OI=105 current ask $8.10
BUY CALL APR 60 SSI-DL OI= 36 current ask $4.30
BUY CALL APR 65 SSI-DM OI= 20 current ask $1.60


 

Picked on February 16 at $ 61.80
Change since picked: + 0.00
Earnings Date 03/14/05 (confirmed)
Average Daily Volume = 391 thousand

New Puts

None Today


Play Updates

In Play Updates and Reviews

Call Updates

eBay Inc - EBAY - close: 86.09 chg: +0.69 stop: 81.50*new*

The bounce continues in shares of EBAY and shares are starting to look overbought but they are also nearing our target at $87.50. Readers can prepare to exit anywhere over the $87 level or even now with EBAY up almost five points from our entry. We plan to exit at $87.50 but in the mean time we're raising our stop loss to $81.50. Don't forget that EBAY splits 2-for-1 tomorrow and your option contracts will be altered because of it. Double check with your broker how the symbols may change. For those of you who don't want to do the math it also means that our target will become $43.75 not $87.50 post-split.


 

Picked on February 10 at $ 81.22
Change since picked: + 4.87
Earnings Date 01/19/05 (confirmed)
Average Daily Volume = 13.8 million

---

Loews Corp - LTR - close: 72.44 chg: -1.71 stop: 69.95

Here it is. We suggested yesterday that readers look for a pull back toward the $72.00 level and consider buying a bounce. LTR has pulled back just as expected now we just need to see a bounce.


 

Picked on February 15 at $ 74.15
Change since picked: - 1.71
Earnings Date 02/10/05 (confirmed)
Average Daily Volume = 452 thousand

Put Updates

None today.

Drops

Invitrogen - IVGN - close: 70.93 chg: -0.71 stop: 69.95

IVGN got close to our target on the gap up early last week but we've run out of time to wait for another rally. The company is expected to report earnings on February 17th after the market's close. Wall Street is looking for $0.77 a share. It may be a good thing that we're exiting now. Lehman Brothers started coverage on IVGN with an "over weight" and a $83 price target today and shares slid lower instead of responding positively.


 

Picked on January 27 at $ 70.05
Change since picked: + 0.88
Earnings Date 02/17/05 (confirmed)
Average Daily Volume = 800 thousand


Trader's Corner

A Trade and Trend Checklist, Part 3

I've written quite a bit on Pattern, the P word of my "POVS" checklist. For going into, staying in and deciding whether to exit an index option trade, I need a mental checklist to not forget to look at the (chart) Pattern, Overbought/Oversold indicators (Oscillators), Volume and Sentiment.

My last Trader's Corner article can be viewed here

This article covers the concepts of overbought and oversold by using Oscillators like RSI (Relative Strength Index) or (slow) Stochastics - what I think is an effective use of them in making trading decisions. Next time I will describe a Volume indicator that gives an idea, ahead of time, that a significant S&P or Nasdaq bottom is being made. (Not about individual trading volume on an Index or a stock.) Also, an explanation of the Call/Put indicator you see every week in my Index Wrap, such as my last one, the 2/13 Index Trader wrap viewed here.

BUT FIRST A WORD FROM OUR SP0NSOR
That is, a question from one of our Option Investor Subscribers, whom we toil for -

QUESTION:
I'm never quite comfortable deciding which strike price, expiration and so forth is best to use. Even though I usually only hold them for a few days to a few weeks, I tend to go with an expiration that's 2 or 3 months away (comfort zone) and I try to stay 1st in the money, or 1st out of the money.
1. Would you please tell me what you usually do?
2. Will using QQQ's with NDX parameters work okay?
3. Do you have a minimum that you use for "Open Interest"?
4. Do you have a minimum that you use for "Volume"?

RESPONSE:
Let me start with the easiest to answer - your questions 3 and 4. I don't have a "minimum" average daily volume and open contracts number. However, I do have the criteria that the contract be actively traded, so am looking for a month and strike price that will allow me to say, buy 5-10 puts or calls and not have the price jump substantially on such a trade - which is relatively small.

I don't however, go out beyond about 4-6 weeks. You may be paying a greater time premium than is necessary assuming your TIMING is good - timing is, as they say, everything!

Probably like you from the way it sounds, is that I tend to buy markets at what I think is a significant high or low point, at their infrequent extremes - when the index or market is either quite oversold or overbought.

I want to go out beyond the lead month options if there is only a 2-3 weeks left to expiration. I prefer to have 4-6 weeks left to expiration and be able to stay with a trend, if one develops in the direction I anticipated.

If I think we're at a bottom, I tend to buy At The Money (ATM) or slightly Out of The Money (OTM) calls. If I think the market is at a top, it becomes a bit trickier.

Bottoms are "easier" in a sense. Selling tends to be more of a once or twice decision among the sellers. Whereas there is multiple and piecemeal buying of stocks on the way up, selling tends to be more emotional and investors/traders exit frequently all at once - sell everything, get me out of the market kind of thing. This dynamic creates a bottom that is often a one-time spike low - of course, sometimes you get a retest of the low and get a double bottom or a slightly lower low, then it rallies.

Tops can take longer to form and in an advancing trend a rally can keep going for some time - this is where you see rolling tops. The indexes tend to "hang" up there and it makes timing of put purchases a bit different. I am more inclined to buy half the number of puts I want to end up with and have room to buy more, perhaps to price average. I am more inclined to buy ATM or In The Money (ITM) puts. Again, I will tend to go out a month or so.

Now, what I am writing about in each and every Trader's Corner (currently on Wednesday) is HOW the heck you can find those significant rally highs or downswing lows. This is a longer story - you could get my book for example - there was enough of a story in market timing to motivate me to write "Essential Technical Analysis".

Lastly, you need to look at QQQQ to some extent as a SEPARATE market or chart. However much it tracks the Nasdaq 100 (NDX) - it is the NDX tracking stock. But the chart pattern may be clearer on NDX; or, on the Q's. For example, the $38 level appears to me so clearly to be key overhead resistance, whereas 1550 in NDX doesn't leap out at me so much.

Also, QQQQ given the sizable volume of the stock may not move proportionately as much as the underlying index. NDX will tend to overshoot technical targets more. Lastly, QQQQ has a very KEY element that you can chart - daily volume. For example, there was this amazingly clear price/volume DIVERGENCE a while back that was such a good advance signal for a short -


 

AND, ON WITH OVERBOUGHT/OVERSOLD CONCEPTS -

RSI (the Relative Strength Index) and Stochastics are considered to be both indicators of momentum AND indicators suggesting levels that an index or stock is at an extreme or "overbought" or "oversold" - what these terms mean varies a good deal. OVER-bought and OVER-sold always have to be qualified some: what is meant usually is that a stock or index is thought to be at an EXTREME on the downside or upside. We need keep in mind that an Index (or stock) is that way only in terms of TIME and CONDITION.

TIME -
Here we are looking at whether we are talking on an intraday chart (e.g., hourly), a daily chart or weekly; whether we are talking short or longer-term and is that on a 5-day, 2-week or 2-month time frame?

A so-called extreme is based on some period of time. OEX might be thought to be quite oversold because it went down sharply down for 5 straight days. However, this might be in the context that the index went up strongly for 5 straight weeks.

Shown below is a chart from the fall (10/14/04) of the Nasdaq Composite (COMP) that I marked up using the Relative Strength Index (RSI) indicator, one of the two main types of overbought-oversold technical indicator (also, a technical "study"). The fluctuation that the RSI can make is between 0 and 100, although an index rarely registers much over 75 or below 25 on a daily chart, especially if the common 14-day setting is used as below -


 

I've highlighted each time the RSI reached a peak or the first time it did so. You'll notice that I have created an overbought and oversold RANGE or bands that are between 30-35 on the downside and approximately 63-70 on the upside.

When I observed that tops in the Composite during those prior months were being reached at 63 and above, I set the lower number there, but this will vary depending on market conditions. An important thing to note is that most charting programs will have a SINGLE line that is set for the two extremes - usually, 30 and 70 in the case of the RSI indicator.

By use of a "level-line" marking tool (i.e., the dashed lines) and hopefully your charting options include this, I created a range of values for overbought and a range of values for what I am defining as oversold in the chart above - this is not a wide range, but a few points can make quite a difference in the RSI. Again, overbought and oversold are relative concepts, not absolute. So, there is no one (absolute) number that says a given index or stock is at an extreme. It's when it gets in a certain range.

HERE'S THE CHART AGAIN -


 

You'll notice that there are several instances when the RSI got into the overbought or oversold range two or more times. So, how is the RSI useful in trading?

#1 - use of the RSI or another like indicator gives you an idea that the market is VULNERABLE to a reversal - the index or stock may reverse within a few days or it might be within a couple of weeks; e.g., 8-10 trading sessions. Now, of course, this is an eternity to a shorter-term trading, especially in
options.

#2 - by the time a second extreme reading is made, almost always by 3 times, this is usually a top, especially in a trading range market like the above period.

A trading range market is one that may have wide-swinging trading swings, but is not going up or down mostly, month after month or quarter after quarter. In the above chart, COMP has traded between 2150 and 1750. While the overall trend is down during this period since each top has peaked at a lower level than the prior high, this market is trading in a wide range on the way down. Each bottom and top is not that far below the prior one.

The best use of an overbought-oversold indicator like the RSI (another is the stochastic indicator) is in a market like the one above - a trading range where, once the market gets to an upper or lower extreme, it will before too long start in the opposite direction, until it reaches an extreme in this opposite
direction.

#3 - when the RSI is at an extreme, it puts you on high ALERT to watch for OTHER signs of a reversal; e.g., a double top or bottom; a new high followed by an immediate sharp decline the same day or over 2-days (bull trap reversal); or, a new low followed by an immediate sharp rebound the same day or over 2-days (bear trap reversal).

Confirming signs of a reversal in the chart pattern, is usually a good basis on which to take a trade, and even to go in more heavily on the trade. Not all trade "set-ups" are equal - some warrant more employment of trading money, others less, within risk management prudence of course such as never trading with all your trading account.

#4 - to look for an RSI extreme is to find those occasional instances where a bullish or bearish Price/RSI DIVERGENCE sets up and this brings me back to the time period that was circled in the chart above and is reproduced in close-up below -


 

In the period shown in the chart above (late-May to late-June), a bearish Price/RSI divergence occurred where PRICES went to a new high, but where the RSI did not ALSO go to a new high reading. Therefore, this bearish divergence seen at the second high was an excellent indication to buy Nasdaq puts, even if using the Nasdaq 100 options.

I'll provide a very recent example of a price/RSI divergence -


 

One thing to be aware of with the HOURLY chart divergence shown above in the S&P 100 (OEX), is that this is an hourly chart. This is a shorter term divergence and may signal only a short-term correction, if that. Sometimes of course price/RSI divergences lead to significant trend reversals (e.g., 15-20 points or more), but the significance of such technical divergences is far greater when the divergence appears on a DAILY chart. However, this one above bear watching, as there is a possible double top setting up - stay tuned! And time will tell.

What we expect is that an indicator like RSI, will tend to "confirm" what price action is doing. If it doesn't, it's not confirmation, but "divergence". The reverse situation - a BULLISH Price/RSI divergence is seen below in the Dow 30 (INDU) WEEKLY chart -


 

Divergences are considered valid when they occur within the same time frame as the indicator is measuring. "Length" on the RSI indicator above is set to 8, meaning it measures 8 trading intervals, in this case 8 weeks. We usually then are looking for divergences that occur within this same 8 week period, but the one above occurred within 12 weeks - for a weekly chart, I like using the 8-week length setting and because the same divergence showed up on the 13-week RSI, I allow the use of the shorter length setting above as the divergence is so clear cut.

Getting back to TIME considerations - when you hear someone say the market is overbought or oversold, you should next think about what time frame they are they talking about, assuming they KNOW what they are talking about and not just repeating something that they have heard.

If you own puts, trading for a short-term decline, knowing the market is in a long-term oversold condition only suggests that you not end up turning a trade into a "position" by owning puts for more than the short-term downswing you're looking for.

CONDITION -
I started out talking about "condition" as also being a consideration about what it means when a stock or index is overbought or oversold - these terms mean different things in different market conditions or different types of markets.

Overbought and oversold as concepts are best used when a market is in a fairly defined TRADING RANGE as seen above (so far) in the OEX hourly chart.

In a runaway bull or bear market, the concept of "relative" really comes out. In a strong bull market bull or bear market, the market is going to get overbought or oversold and STAY that way for long periods of time - making the indicators that measure overbought/oversold, less useful for trading purposes. The below chart uses the 14-day RSI (i.e., 14 is the "length" setting) -


 

In the conditions prevailing in a strong bull or bear, the
overbought/oversold concepts, especially in the indices, are less meaningful. You can see that after the 2003 advance shown in the above chart, the Dow (INDU) was NEVER really "oversold" according to this convention way of measuring it with the RSI.

The same is true in a bear market, where the RSI never gets to an overbought reading - too many sellers waiting to pounce on it! The conventional technical indicators that attempt to define the relative concepts overbought and oversold are going to say that the market is oversold, and oversold and again, oversold!

SOME BASICS -
An index, or an individual stock, is commonly thought to be overbought or oversold when prices have an advance or decline of a degree that is greater than what is normal or usual relative to its past price behavior for a certain time frame and condition.

Take the case of a stock that for five months, or 5 years even, has never traded at a price that was greater than 10% of its closing average for the prior 200 days. Then comes a period when there is such a steep advance that the stock reaches a price that puts it 20-25% above this same average - this stock may be considered to be "overbought". Overbought here implies simply that any surge in buying well in excess of what is usual on an historical basis, also creates a likelihood that the stock price will correct.

Another example of an overbought condition might make an assumption about an Index that has closed higher for 10 days straight - if this price behavior is "over" or beyond what is usual for this item, the assumption is that prices are vulnerable to snapping back - a rubber band analogy is a good one, as market valuations get stretched, so to speak, but then tend to also come back to a mean or an average.

The concept of overbought and oversold refer to rallies or clines that are steeper than usual, but the degree of this can vary a good deal in terms - there is no precise, objective or
agreed upon measurement.

RSI and STOCHASTIC Indicators -

Both are also called "oscillator" type indicators in tha both are constructed in a way that the numerical scale goes from a low of zero (0) to a maximum high of 100. (This is not the case in the Moving Average Convergence Divergence or MACD; "mack-dee".) They oscillate in a fixed range. Both RSI and Stochastic measure price momentum.

The Relative Strength Index, usually referred to as the "RSI" was developed by Welles Wilder back in the '70'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 in charting applications 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 even represent an even number of 5-day trading weeks.

However, both 9 and 14 are 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 1/6 of a year, providing a relevant picture of the secondary or major 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 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.

SLOW STOCHASTIC -
The stochastic indicator is calculated in a different way than RSI and is LESS useful in finding a divergence like the one above that was based on using the RSI.

Technical indicators can be generally grouped into trend following type indicators like moving averages, or into indicators of this type called "oscillators" that are formulas when graphed, move back in forth in a range from 1-100.

The central idea or concept of stochastics - what it is attempting to show - is that in an up or down market trend for any number of trading periods (e.g., 10 hours or 14 days), prices will at times move away from the lowest low made during that 10 hours or 14-days, or the highest high, at an increasing rate - this "rate" or speed of price changes is what the (slow) stochastic oscillator is showing visually.

The stochastics "default" oversold and overbought levels are typically pegged at readings at or below 20 and at or above 80. The stochastics tend to have wide-ranging fluctuations between 0 and 100; e.g., a low at 5 or 10, a high at 90.

The stochastics indicator is composed of two lines - a slower line called the percent D (%D) line is a simple moving average of the faster %K line. The two lines of varying speeds lead to crossovers that generate buy and sell "signals" -

Lets look at the SAME 2003 period as shown in the Dow chart above only adding the 14-day Stochastic model for comparison -


 

CONDITION -
It's a bull market! Therefore I want to skew the overbought and oversold readings UPWARD and consider above 90 in the Stochastic to be (relatively)"overbought" and at or between 40 and 30 to be "oversold". And, with these parameters in mind, there are a few useful indications of buy points, at the maximum extensions of the pullbacks, in which to help me with a few instances of buy side or bullish trades in calls.

The Stochastic study looks at the current price in relation to the highest high or lowest low in the period being measured. Stochastics plots the current close in relation to the price range over the length set for this indicator and gives this a percentage value.

The initial calculations for a stochastic of 14-days are twofold, establishing a "fast" and "slow" line. The fast line or "%K" formula is 100 - (the close minus the 14-day low) divided by (the 14-day high - the 14-day low; i.e., the price range). The slow line or "%D" (here called "FastD") is equal to a 3-day average of "%K". This first formula is referred to as the "fast stochastic" model.

The "slow stochastics" variation of the basic stochastics formula is simply to take the "FastD" figure and apply a "smoothing" calculation yet again, which results in another line which we can call "SlowD", to differentiate the two versions of "%D". The important thing to remember is not this "alphabet soup", but the fact that the slow version of the stochastics oscillator (slow stochastics) is the version that is in most common use and is most likely what you will be using if you choose the stochastics indicator to apply to a price chart.

SUMMING UP -
Best use or most effective use of oscillators is in a market with two sided trading swings, rather than one in a strong bull or bear trend. Best single oscillator to use??

RSI, in a normal trading range market, as its use will also best highlight bullish or bearish divergences. In a strong trending market on the other hand, use stochastics for the few useful signals that suggest that brief counter-trend price swings are likely to have run there course.

NOTE -
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

Good Trading Success!!

Today's Newsletter Notes: Market Wrap by Linda Piazza, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.

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