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Daily Newsletter, Wednesday, 02/23/2005

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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

Oversold Bounce

Oversold Bounce

After yesterday's massacre of the bulls, it was no surprise to see an oversold bounce today (although CNBC's Ludlow would like us to believe that today's small bounce wipes out any negative connotations about yesterday's sell off). This morning's CPI numbers were favorable in that the inflation rate was less than had been expected (+0.1% versus +0.2% expected) and therefore allayed fears that a higher inflation rate would prompt the Fed to act more aggressively in raising interest rates and thereby choke off economic growth (repeating past mistakes in this regard). And without growth, the stock market doesn't do well. So if it sniffs out lack of growth, we'll see that first "reported" in the prices of stocks. After the FOMC minutes were released at 2:00 today, and the inference that they were removing the "measured pace" of rate increases, the market spiked up and down and was probably a result of many traders fearing this rate increase scenario. But then the market rallied a little more after that as if to say "we ain't afraid of no Green Wolf". So back to this morning, with the CPI numbers out of the way, and a deeply oversold market on a short term basis, we were set up for a bounce today and that's what we got. But whether or not it was just an oversold bounce or something that will lead to a more significant rally is the real question. By the title of today's Wrap, you can guess my opinion on that question.

SPX chart, Daily


 

The short term pattern looks like it needs another low but it looks close to forming at least some kind of short term bottom. It could surprise to the downside and it's certainly poised for that possibility but until it does, one should never bank on a crash scenario. The SPX daily chart, and the DOW chart below, shows a bullish possibility that could be playing out. Price has pulled back to the bottom of the up-channel that price has been in since last fall. Even if we get a minor new low this week, this uptrend could remain intact as long as the uptrend line isn't violated too much and for no more than 3 days. So this pattern bears watching to see if we get a stronger bounce soon.

DOW chart, Daily


 

Like the SPX chart above, price has pulled back to the uptrend line from last October's low, currently 10600, making this number doubly important as support. As long as this uptrend line holds, the trend is still up. If price breaks below the line, and sticks, watch for a beeline down to January's low which is also where the 200-ema is (10363).

Nasdaq chart, Daily


 

The NAZ has been relatively weaker since the bounce started from January's low. It's the one index that should be giving the bulls the willies. This pattern is looking like it will drop hard from here, potentially as low as 1900 before it even thinks of bouncing. The 200-dma's and last October's high, gives us a potential support zone of 1971-2007 and could provide support. Certainly it should provide bounces, but if the bounces continue to look weak and choppy, as it's been since January's low, keep looking for lower prices.

The primary reason I am calling today's rally an oversold bounce is due to the price pattern of the bounce. It was also a rally on lower volume, a classic signal of a countertrend move. After the strong decline yesterday on heavy volume, which was an impulsive move (no overlapping highs and lows in the move down), today's rally was choppy and overlapping, i.e., it was a corrective move. Corrective moves are found between impulsive moves and therefore I am expecting another impulsive move lower once this bounce is finished, which it looks to be very close to doing, if it didn't finish just before the close. It may not have much further to go to the downside, and in fact one more push lower should do it, so bears should be getting ready to tighten up their stops. Bulls should be getting ready for an opportunity for at least a larger bounce if not something much stronger to the upside.

Looking a little deeper at some of today's reports, one of the factors that helped the lower than expected CPI increase was energy costs. Energy prices declined 1.1% for the same period. Gasoline prices declined 2.1% and heating oil declined 5.2%. Guess what's happened to the price of oil since these numbers. Yep, and guess where CPI will probably be next month. Yep, and guess how the market will react. The market of course knows this and is part of the reason for the choppy price action as the competing forces argue their cases. The following chart of the Oil Index, OIX.X, gives some perspective on its rally.

Oil Index chart, OIX.X, Weekly


 

As noted on the chart, the price rise on this index has gone parabolic and just recently broke to the upside of its up-channel that price has been in for the past 2 years. If price drops back down inside the channel (a drop below 458) it will leave a "throw-over" above the upper trendline, a classic finish to a parabolic move. This will likely correct very fast back down if the correction starts soon. Also, the Oil Service Index, OSX.X, looks like it too is topping right here.

The US dollar got a bounce today, which also might just be an oversold bounce. One rumor I heard today was that South Korea, who reported yesterday that they were going to "diversify" their currency holdings (smart, don't you think?), reportedly said "never mind" today. They were apparently misunderstood yesterday and didn't really say what everyone heard them say and if they said it they didn't really mean it. Hmm, do you suppose someone from our government might have called them and asked if they'd like to see anymore of those dollars from us that they're no longer interested in holding? Nah, I'm sure we play nice with all our allies. The daily chart of the USD shows it to be oversold and threatening to turn back up. By getting down to 82.40 yesterday, the decline from the recent high of 85.44 came within pennies of the 62% retracement (82.32) of the rally off the December low of 80.39 and therefore if the dollar has more upside work to do, this is a likely spot for it to find support. And if the dollar is going to bounce, the metals will probably sell off. Silver in particular looks vulnerable to a new round of selling that could take it back below its January low of 6.35 (March contract). Today's close was 7.445. An alternative view is that the dollar, gold and silver will consolidate between the lows and highs that prices have seen in the past month.

For those who follow, or trade, the home builders, you may have heard Robert Toll (President, Toll Brothers) on CNBC this morning talk about their robust growth, limited supply, immunity to interest rate hikes (they sell to a lot of wealthier buyers who "aren't affected by higher interest rates"), and green pastures (that they own) as far as the eye can see. Excuse me but that sounds a little bit like "it's different this time". He laid down his gauntlet by stating emphatically that "short sellers are going to get crushed". He's certainly been correct over the past two years--anyone shorting the home builders has been as successful as those trying to short GOOG. And they had a good day today. But the weekly chart of the home builders doesn't get my bullish juices flowing. In fact I might just have to take Mr. Toll up on his challenge and short his company. Actually his stock does look like it has a little more work to do to the upside so I'd go pick on a weaker candidate within the index.

U.S. Home Construction Index chart, DJUSHB, Weekly


 

Like the Oil Index chart above, price has gone parabolic ("but it's different this time") and price broke above the upper trendline before falling back underneath, leaving a throw-over. This is bearish and this is an index I'd want to short (again, search out the weakling trailing the pack and start nipping at its heels).

The Trannies (TRAN) had a big up day today. After declining hard all day yesterday, along with the rest of the market, it reversed all of that in one big green candle on the 60-min chart. The merger news between USF Corp (USFC) and Yellow Roadway (YELL) was considered good news and gave generally good cheer to the industry. Perhaps it was just shorts caught by surprise because once the initial spurt in the first hour was finished, there were no more buyers to be found. The sellers were also too nervous to sell and therefore price went virtually nowhere for the rest of the day.

DJ Transportation Index chart, TRAN, 60-min


 

Note on the chart that price stopped at the broken uptrend line from January 24th's low. Previous support turned resistance--it's looking like it's going to give it a kiss and then get slapped so this chart does not look bullish even after today's strong rally, or I should say in spite of today's rally.

Not surprisingly, the market is leaving us with many mixed signals at the moment. If I look at the daily and weekly oscillators I get a bearish picture. We recently had a major double-top (DOW and SPX) with bearish divergences and have since sold off. Is it reasonable to expect that we'll only get a small pullback after that? Probably not. But it is after all a game of probabilities, not certainties. As I mentioned earlier, the short term pattern looks like we should get another leg down tomorrow after today's corrective bounce and it could happen out of the gate tomorrow. But it looks like we could be close to support levels and therefore it's probably not wise to bet on a significant decline. It could happen since there are several bearish indicators lining up, but again, the game of probabilities says we should be close to good support levels from which we should see a stronger bounce if not the next rally leg. The daily SPX and DOW charts above argue the possibility for a continuation of the rally. However, any break of the uptrend lines on those charts and I'll be looking to get short in a major way since March could be very ugly for the bulls. Even Mr. Toll might have to eat his words.

 
 




New Plays

New Option Plays

Call Options Plays
Put Options Plays
NoneNone

Play Updates

In Play Updates and Reviews

Call Updates

None today.

Put Updates

Research In Motion - RIMM - cls: 69.33 chg: -1.57 stop: 73.01

The NASDAQ may have closed in the green (just barely) but there was no strength to be seen for RIMM. Actually that's not entirely true. RIMM started the session this morning with a brief spout higher but it faded. Today's 2.2 percent decline on above average volume looks like bad news. RIMM has now broken its trendline higher lows (support) dating back to May and it has broken technical support at the 200-dma and it has broken round-number, psychological support at the $70.00 level. Our entry point or trigger to buy puts was at $69.75. This play is now open. Our initial target is the $64 region.


 

Picked on February 23 at $ 69.75
Change since picked: - 0.42
Earnings Date 03/22/05 (unconfirmed)
Average Daily Volume = 7.9 million

Drops

None today.


Trader's Corner

Trade and trend checklist - Sentiment and Volume (Part 4)

After studying the chart PATTERN (#1) of what I'm trading, usually Indexes in my case, then, anything noteworthy regarding an OVER-bought/oversold (#2)situation, the last parts of my "POVS" trend and trade checklist are VOLUME (#3) and SENTIMENT (#4), explanations and examples about which I'm going to complete in today's column.

#1 - PATTERN
A look at the chart pattern implies studying things like prices being in a proximity to prior lows or highs, an apparent second bottom or top made near the same price (a double top or double bottom), closeness to a trendline; deflection from or piercing/trading through an important trendline, etc.

In my (2/20) Index Trader column I recently discussed the patterns highlighted in the S&P 100 (OEX) chart below which has been updated to reflect the first trading day of this week -

The pattern of key significance to me was the fact of the rally stopping right in the area of the prior top from late-December/early January. It was assumed then, and borne out with subsequent market action, that this pattern looked like a double top in the making. This implied a significant decline to follow.

Another aspect of pattern, besides the possible double top, was the return to the previously broken up trendline and the potential that this would now mark a deflection point or stopper to the rally. It sure enough did!


 

#2 - OSCILLATOR (Overbought/Oversold)
I also noted in my Index Trader column the tendency for the Dow 30 Industrials (INDU) to make bottoms or tops when a 21-day (i.e., "length" setting = 21) slow stochastic, a type of indicator called an "Oscillator", reached the kind of extremes shown in the chart below -

The only "false" signal so to speak, given by the stochastic model for the period shown, was at the point of the highlighted red down arrow - it was only beginning a sideways consolidation.

The overall record of the 21-day stochastic as highlighting very good entry points for Dow Index (DJX) calls or puts was very good. To pin down even more precise entry points I employ analysis of Pattern, Sentiment and, for bottoms only, a special indication of Volume.


 

The explanation of Overbought/Oversold concepts in my last Trader's Corner article can be found by clicking here.

#3 - VOLUME
My "Volume" indicator is almost solely an attempt to alert to a upcoming market LOW, typically ahead of when there is a market bottom being made. It's not an indicator that can pinpoint tops as well at all, but its helpful in finding bottoms - but hey, this is at least half the trading opportunities that come along! More so in bull market.

Volume is an important ancillary indicator that is second only to price in being important for technical analysis. Of course in fact, all technical works with is price AND volume information - well, in stock index futures, there is some analysis that can be done with "open interest", but this doesn't enter in here.

Stock market volume will often "precede" price. For example, before a market gets to or near a price area that will be perceived as offering value, especially a market that is in transition, there will usually tend to be a contraction of trading activity (volume) to a similar and reoccurring level and this occurrence will tend to precede the most substantial and sustained market rallies.

The most significant volume figure for stocks, for its use as one type of indication for significant or major bottoms, is UP or ADVANCING volume. Total NYSE daily advancing volume is a count of all shares bought on UPTICKS, or at a price higher than the
preceding transaction.

The study of Up Volume trends is an excellent way of uncovering actual buying interest, or the lack of it, as the UpVol activity reflects a willingness to "pay up" for stocks so to speak. To refine the daily figure, I use a 10-day moving average of advancing volume for both the New York Stock Exchange (NYSE) and Nasdaq.

There is a tendency in any given period, of months or years, for there to be a "base" line for how far (what contraction level) a 10-day moving average of Nasdaq or NYSE Up volume will fall to BEFORE there is a market bottom.

I use for the S&P and Dow indices an a 10-day average of NYSE total daily Up Volume ($UVOL) and a 10-day average of Nasdaq Up Volume ($UVOLQ) for the Nasdaq. I then check for when the average pulls back to a "baseline" and then turns UP - the baseline is a 10-day average value associated with key bottoms.

In the chart below, this baseline figure in recent months was when a 10-day moving average of daily NYSE Up Volume dipped to around 530 million shares. This baseline level varies from time - the number itself is not a constant, only the tendency for a contraction to a similar reoccurring area that tends to occur around the time of, ahead of or just ahead of a major or significant low. To be useful as a trading signal this drop to a baseline figure, than an upturn, should happen along with other aspects of technical analysis pointing to the same thing.


 

The same indicator will help identify Nasdaq final lows by using a 10-day average of daily Nasdaq Up Volume in relation to its "baseline" - i.e., where this index has tended to bottom in recent months. In recent months the Nasdaq Up Volume indicator has not been getting down to many low extremes before rallying, so the indicator has lately been useful in timing major market turning points.

SENTIMENT -
"Sentiment" is generally considered to be any statistical way that attempts to measure how bullish or bearish traders and investors are regarding the future prospects of the market.

A measure of market "sentiment" I use to see if the market is getting overheated or just the reverse is by examining the daily volume of option call volume relative to daily put volume.

However, the "standard" measure is the put/call number. This is a ratio of total put volume to call volume, such as on the CBOE (Chicago Board Options Exchange) alone or all options exchanges together.

Put volume any given day for both (individual) equities AND index options is compared and is (usually) a fractional number - for example, .75, indicating that put volume was 75% of call volume. If the put/call reading was 1.00, put volume equaled call volume that day, which doesn't happen all that often.

Total daily index AND equities options put volume is divided by total daily call volume. You can check this number all over the place, such as on the CBOE web site or in charting programs like Q-Charts; e.g., under symbol "QC:PUTCALL" I believe.

It has been noticed that when put volume gets quite high, such as being equal to call volume, traders are getting pretty bearish - and, trader sentiment may reflect an "oversold" situation, where the market may finally be near a tradable bottom.

In the case of call volume being very high relative to puts, the market may be at or approaching an "overbought" extreme in terms of how traders feel about the market - bullish or bearish, which way are they trading.

The concept of "contrary opinion" was sort of started with Charles Dow in that he held that extremes in bullishness start being the contrary - bearish. As well, extremes in a bearish point of view an early indication that the market may be near a bottom.

PUT/CALL RATIO - THE CONVENTIONAL WAY
Something that can make the put/call standard way of measuring market extremes tricky is the effect of INDEX calls and index puts in the total option volume figures. There is a lot of hedging by money managers and hedge funds that goes on and this can be related more to that (hedging) than simply how individual traders see the market.

I have found it useful to keep up my own way of measuring option volume numbers. I only look at daily EQUITIES option volume numbers. Its been my experience that a more pure measure of bullish or bearish trader sentiment is gotten this way.

This method also makes an indicator that is more like the other overbought/oversold indicators like stochastics and RSI. A LOW number is suggesting a possible "oversold" market and a high reading is indicating an "overbought" market.

So, with this indicator be aware of the ORDER of the words - the indicator I use is a CALL divided by put volume indicator and it takes OUT Index option volume, using only equities volume totals. (This is different than the PUT/call ratio that divides put volume by call volume and INCLUDES the Index options.)

You see this radio plotted below on an OEX chart. I'm able to put a "custom" data item into my TradeStation software - there are other ways of doing it too such as by keeping this ratio on a spreadsheet. I used to plot it my hand even.

My Call Put indicator as of the 2/23 close today is seen below with the S&P 100 (OEX) chart. The Indicator is pretty self-explanatory. Extremes are seen by how I have the level lines constructed - areas where this daily ratio is suggesting an extreme. This is similar to saying a market may be overbought or oversold -

Sometimes this indicator never produces an extreme on the on the downside, especially in a rising trend - the same situation of a rising price trend, it may produce multiple extremes. The most recent market top was however preceded by a sharp spike up in my sentiment indictor. Indicator extremes, when they are working as an advance "signal", will register such extremes within 1 to 5 trading days of the market turning point - in this case, at least an interim top.


 

One reason that I thought the recent sell off was suggesting the start of what may be more than a shallow correction, is that the sharp down days barely produced a decline in my Call/Put sentiment indication. That is, traders to not appear to get very bearish in the face of it. I think they must, or will, BEFORE there is a final bottom to this correction.

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 Keene H. Little, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.

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