Option Investor

Daily Newsletter, Wednesday, 03/02/2005

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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

Shake, Rattle and Roll

Shake, Rattle and Roll

The market is doing a fine job of shaking the trees, rattling traders, and rolling over their stops. There has been little follow through in the market day to day and even intraday. Today was no exception. After gapping lower this morning, the market immediately rallied from the open, lifting the DOW almost 100 points off its low, making a new annual high in the process. Much of the rally was attributed to Greenspan's testimony in front of Congress and his statements about the economy growing at a reasonably good pace, that capital spending was also showing signs of growth, and that there was little evidence of foreigners baling out of our Treasury market. The strange thing about this was that the rally was in the face of rising oil prices and falling bond prices and seemed more like money managers simply took advantage of a dip and continued to put to work the money that's been flowing into the mutual funds. But they must have finished before lunch because the market then proceeded to stall and sell off for most of the rest of the day. This may have been aggravated as oil prices continued to climb which topped out just above $53 (+$1.37), quickly approaching its previous high just above $55. Gasoline futures hit a record high above $1.47/gallon. It looks like they're getting us ready for a very expensive summer travel season.

SPX chart, Daily


The SPX chart shows that the up-channel containing price since last August continues to hold. This is our uptrend and all the chopping around that price is doing doesn't really matter in the slightly longer term. This uptrend isn't violated until price drops below 1180, which granted is giving up a lot of profit in any current long positions, but the choppiness of current price action makes it difficult to determine a better support level. Stay long above 1180, short below it.

DOW chart, Daily


The DOW is in the same pattern as the previous SPX chart. As shown on the SPX chart, there is a possibility that the upside from here will be limited. If SPX manages to reach its initial fib target of about 1233, the DOW should get a little over 11,000, though I suspect that round number will offer quite a bit of resistance. Stay long above 10,600, short below it.

Nasdaq chart, Daily


The Nasdaq continues to languish as compared to the other indices. It looks more like it's consolidating and waiting for the others to finish doing their thing to the upside. This looks negative for the overall market--without the participation of the techs, the upside appears limited. If the Naz breaks below 2000, this would be a signal to get short.

There were no major economic reports today but some information on mortgage applications may have depressed the housing market a bit. Mortgage applications fell for the 3rd week in a row with the Mortgage Index dropping 2.4% to 710.1. The Refi Index dropped even more--down 9.9% to 2281.1.

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


The Home Construction index shows how price has risen in a steeper and steeper angle, in other words it's gone parabolic. Think of past parabolic rises and almost every one of them has not ended well. They usually come crashing down. That's not a prediction that the housing market will come crashing down, but this chart says be careful.

One of the things that was blamed for this afternoon's sell off was the large increase in oil prices, especially gasoline prices. The worry of course is the "hidden tax" on consumers. With less money to spend on things other than energy costs, there could be less growth in other businesses. In fact today's winners were led by gold indices and oil/energy indices. Pulling up the rear were airlines (higher fuel costs), the SOX, high tech industries, banks and retail. These are the industries that will feel the impact of slower economic growth from higher energy costs.

Oil Index chart, OIX.X, Daily


Like the housing chart above, this oil index shows price has been rising in a parabolic fashion. Price has risen above its up-channel and now we'll watch to see if price remains supported by the top of its channel or if it comes crashing back down inside the channel, heading for the bottom of it. Lower energy costs could improve the picture for the rest of the market so the linkage between the two is worth watching. One of the key sectors to watch is the banking sector--as go the banks, so goes the economy.

Bank Index chart, BKX.X, Daily


The bank index chart shows price broke its steeper uptrend line from October 2004 but found support at its longer term uptrend from May 2004. It's now bouncing around between these two uptrend lines, having found the steeper one acting as resistance now. Any break back below the longer term uptrend line would also be another break of its 200-dma's and would be bearish for the market. The other index to watch is the TRAN. The correlation of this index with the DOW is what the DOW Theory is all about. New highs or lows in one without confirmation of the other is divergence and gives a heads up (long term) that we could be near a reversal in the market. So far the Trannies have made a new high (in December) which was not confirmed by the DOW.

DJ Transportation Index chart, TRAN, 60-min


The chart of the Trannies shows that the up-channel is still holding, although it broke below it twice this year. There is an upside Fib target of about 3882 before it could top out.

The DOW hit a new intraday high for the year today while SPX came within 2 points of doing the same. It seems hard to believe we'd do that without making another attempt to close above Jan 3rd's highs. Obviously that would make for good press, especially since January was such an ugly month. The charts shown above are showing the up trends are still intact and therefore trade with your friend--buy the dips until we have a trend change. We may not be far from a high for the run up from January's lows, but we'll worry about that when the time comes. Trying to call a top is always risky business. But in case we're getting close to at least a more significant pullback, if not the start of a run to new lows, don't get married to your long positions--keep trailing those stops below the uptrend lines and protect those profits!


New Plays

New Option Plays

Call Options Plays
Put Options Plays
None None

Play Updates

In Play Updates and Reviews

Call Updates

Alliance Resource - ARLP - cls: 78.25 chg: +2.03 stop: 71.95*new*

Coal stocks are on the run again, well at least ARLP and FDG. Shares of ARLP added another 2.66 percent to out perform the market again. The stock is nearing our initial target at $80.00. Our secondary longer-term target is still $85. Short-term players can prepare to exit. We are raising our stop loss to $71.95.


Picked on February 27 at $ 75.01
Change since picked: + 3.24
Earnings Date 01/27/05 (confirmed)
Average Daily Volume = 95 thousand


Fording Candn Coal - FDG - cls: 96.05 chg: +4.35 stop: 89.99*new*

Target achieved! FDG soared for a 4.7 percent gain today with volume coming in above average as traders bought this morning's dip toward the $90.00 level. Our initial target was a move into the $96.00-98.00 range. Normally we would close the play here and readers should strongly consider doing so as the option values have soared. The April 85s have climbed from $7.20 to $12.30. The April 90s from $3.80 to $8.00. The April 95s from $2.15 to $4.20. We are going to keep the play open another day or two to see if FDG can trade near the $98.00 level. Actually, we will close the play if FDG trades at $97.90. The rally is being fueled by yesterday's news that FDG is going to pay a $1.30 cash dividend on April 15th and today's news that the company is going to ask shareholders to approve a 3-for-1 stock split in May. We are going to raise our stop to $89.99.


Picked on February 27 at $ 90.43
Change since picked: + 5.62
Earnings Date 02/05/05 (confirmed)
Average Daily Volume = 326 thousand

Put Updates

None today.

Dropped Calls

Chicago Merc. Exchg - CME - cls: 199.00 chg: -21.00 stop: 206.00

Wow! Talk about your reversal of fortunes. One analyst firm cut its rating on CME from a "buy" to a "hold" on valuation concerns and the stock plummeted. Shares gapped lower to open at $212.75 and they crashed through technical support at the 100-dma and round-number, psychological support at the $200.00 mark. This is a very bad reversal and the MACD already reflects a new sell signal. Volume was huge at close to five times the average. Our trigger to buy calls was at $221.01 and thankfully it was not hit. Thus we are closing this play unopened. Aggressive traders may want to follow CME as shares may retrace back toward the $185-180 region.


Picked on March xx at $xxx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 02/01/05 (confirmed)
Average Daily Volume = 817 thousand

Trader's Corner

Moving Average Envelopes

FIRST, a note to Option Investor Subscribers - 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.

A major challenge in trading options, especially Index when buying calls or puts, is to know when the particular index or the Market is at an extreme relative to its back and forth price swings. If you are buying when the market is still in a strong move, premiums are inflated or pumped up to attract sellers. If you pay a substantial risk or time premium, you risk being right on the direction of the market but making nothing as the premium erodes more than the point distance covered by a further market move.

Market timing is of course more crucial in options trading than in buying or selling stock - time is not on your side if your trade entry was too soon or too late. You can't hold on to the option like you can a stock, in the hopes that the option will reach a more favorable price at some point.

Moving average envelopes (also known as trading "bands") are a useful technical tool to help us spot the occasional extremes which may be the high and low points for a given period. I use moving average envelopes mostly on DAILY charts.

There are 3 types of the Indicators known generally as envelope "bands": Moving average envelopes, Bollinger Bands, and Kelter channels. Bolinger Bands and Kelter channels build volatility into their equations and are not the subject of this article. "Moving average envelopes" are my topic here.

Moving Average envelopes have THREE component lines. ONE is a line in the center that is a moving average of the daily closing price. [A moving average of the close is simply a price that is the average of some number of days' closes; e.g., 21 days. This number is said to "move" because, at the end of each day, we recalculate the average for the LAST X number of days; "X" is whatever we have set as a "length" for the moving average.]

LINE # TWO is a line that is set to be X percent ABOVE the average (e.g., 3%) - the upper Envelope line.

LINE # THREE is a line that is set at some percentage BELOW the moving average - the lower Envelope line. Usually, but not always, the percent setting is the same for the upper and lower lines or bands -


In the moving average envelopes Indicator you can, at most, set
the following different inputs or vary the following:

  1. Type of moving average; e.g., simple, exponential, etc.
  2. Length of the moving average; e.g., the number of trading periods - this will be some number of days' closes on a daily chart, some number of hourly closes on an hourly chart, etc.
  3. A line that is equal to the moving average PLUS some added percent of the moving average; e.g., 3%
  4. A line that is equal to that day's moving average figure MINUS some percent of the average price that day.

In some or many application programs, you will not be allowed to make the upper envelope percentage any greater or lesser than the lower envelope line - in other words, the lower moving average envelope line AND the upper moving average envelope can only be the SAME percentage - there is only one "envelope" percent setting possible.

You can see in the daily chart ABOVE of the S&P 500 (SPX) that I have set the envelopes values slightly differently - the lower line is 2% and the upper line is 2.5%. When using a different percentage for the upper envelope percent versus the lower envelope line percentage, it is not typically a huge variation, perhaps 1/2 or 1% only.

HOWEVER, a half percent difference in an Index can make a significant difference in trading - in the above chart of SPX there were two last "touches" to an lower envelope line when it was set at 98% (envelope line = 2%) of the center moving average, versus NO touches to a line equal to 97.5% of the moving average (envelope line = 2.5%).

The limitation of some charting programs to be able to only set one figure for both the upper and lower envelope lines is a bit of an unfortunate limitation for trading the indices. In the indexes, in an uptrend, the moving average percentage will increase some or slightly on the upper side - that is, the percentage at and under which MOST trading occurs is a bit higher than the lower envelope line; e.g., 3% versus 2%, or 4 versus 5%.

And, for the type of moving average, I use a simple moving average (SMA), so it a matter of adding the closing price of some number of trading periods (e.g., days, hours, etc.) and dividing by this same number, for example the sum of the past 10 closes divided by 10.

My favorite moving average length to use for Stock Indexes is 21, which as I said I use only on Daily charts. The blue chip market as represented by the S&P 500 Index, in an average market cycle or trend duration, will tend to see prices fluctuate in a range that is typically 2-3 percent above or below its 21-day average. As we are interested in also seeing the high and low extremes relative to the envelope lines, bar (or candlestick) charts are used.

In a volatile market, the S&P envelope line can expand to 4% or more, but it won't typically be more than this. With the Nasdaq, this percentage might be 5-6%. The percentage line we are looking for is the one that will then contain within it most of the daily highs and lows that have occurred in the past few months to a year.

In an uptrend I may end up setting the UPPER band at a greater percentage ABOVE the center moving average. In a declining trend that goes on for a long period (a bear market), the declines may bottom at a greater distance BELOW the center moving average.

You'll notice that I am demonstrating the use of moving average envelopes for the Indexes only. Due to the bouts of volatility associated with earnings, business developments, etc., individual stocks tend to work less consistently than for the indexes, which "smooth" out the individual stock "hiccups" and reversals.

Another bar chart with a moving average envelope, that of the Nasdaq 100 (NDX), with moving average envelope lines set at the same values -


In an uptrend, a high probability trade is to buy dips (e.g., buy NDX calls) when prices fall to the lower envelope line. The reverse is true in a sustained downtrend - buy puts on moves up to the upper envelope.


There are situations, as can be seen from looking at these charts, that there may be a period of several to many WEEKS where the highs/lows keep bumping against one envelope line or the other. However, after several (e.g., 5-6) weeks of an uptrend or downtrend that has been closely hugging the upper/lower envelope lines, the odds increasingly favor a correction - either a sideways move or a move in the opposite direction - and it can then be favorable to sell option premiums; e.g., short calls or puts.

In a prolonged downtrend/bear market, there will tend to be MORE instances of the index topping out in the area of the "centered" moving average and there will be more "touches" to the LOWER line. The reverse is true in a dominant uptrend or bull market, where there will tend to be a number of lows that are "contained" or held at the centered moving average and more "touches" to and along the UPPER envelope line.

The following characteristics list is one I have used to sum up and categorize the tendencies of market action relative to moving averages and their upper and lower envelopes:

  1. Determination of what moving average to use somewhat arbitrary but is found by what "works" in the most number of markets. The biggest variation is with the percentages above and below this line. I suggest using a 21-day moving average length for the Stock Indices. You can experiment yourself too with different lengths.
  2. A common starting point for the Index envelope size is 3% with the Dow and S&P or 4-5% in the case of the Nasdaq. The envelope size varies from trend to trend and market to market. For an envelope size that "works" - the percent figure that contains within it 90-95% of the price moves above and below the moving average -- start with 3% and expand or contract the envelope size as is appropriate for the dominant trend.
  3. If the last high was 4% above the moving average, the next high will often reflect the same extreme. Conversely, if the last significant downswing low was 3% below the moving average, keep this figure as the lower envelope setting until market action otherwise dictates.
  4. If prices cross above the moving average, assume that this line will act as support on pullbacks and the next rally will have the potential to advance to the upper envelope line. If in an uptrend, the envelope line can act as a rising line of resistance for multiple rallies - the rally tops will "hug" and move up along the upper envelope line. The key thing is that rate of increase will SLOW - the index will not always reverse on move to or above the line.
  5. If prices cross below the center moving average, assume that this line will act as resistance on any rebounds and that downside potential now becomes for a move to the lower envelope line. If the trend is down, the envelope line may act as a falling support line and there may be multiple downswings that touch or "hug" and move down along the lower envelope line.
  6. In an uptrend, the optimum Index Call purchases are the declines to the lower envelope line - this area will both define where the stock or other item is both "oversold" AND the SPECIFIC price area that offers a opportune buying. If in a downtrend, sell advances to the upper envelope line - this area will help define where the market is both "overbought" and the specific price area most opportune as a selling point.

ANOTHER CHART - back when it was QQQ, not QQQQ!


In an uptrend, when the index goes through and STAYS ABOVE the 21-day average it usually does it quickly and maintains a pattern of higher highs such as is seen in the QQQQ chart above for several months in 2003, until around year-end anyway.

When a rally after a prolonged uptrend fails very quickly and fairly soon again has a pattern of falling relative highs and lows and, within a few trading periods again falls under the center moving average, it is a pattern that suggests adopting a bearish trading bias.

  1. Even if there is an extension of a price swing to above or below the envelope lines, the probability for a significant further move in that direction is limited, especially if the price swing is a counter-trend move. At a minimum, there should be a reaction (countertrend move) once prices are above or below the envelope line in question.

There is not much more to say about how to use envelopes except to say that the use of this technical indicator gives another kind of an idea about where a market might be at an extreme. While extremes don't happen all that often, when they do there is often a good trading opportunity at hand. And, we don't need more than a few of these to make for a profitable year trading options.

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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