Option Investor

Daily Newsletter, Wednesday, 04/20/2005

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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

Intel Does It Again

I've lost count how many times Intel has pleased the market with its earnings/guidance which is then followed the next day by a market that tanks. You can almost take that play to the bank--after Intel gets the futures market excited the evening it makes its announcement, the following morning sees a bit of a rally and then the big guns step in to sell into the rally. Why they do this I do not know but it's happening too many times to ignore. Today was a classic post-Intel kind of day with a -175 point reversal in the DOW from its morning high.

The morning started with a market-spooking jump in the CPI numbers that were released at 8:30 am. The U.S. consumer prices jumped a seasonally adjusted +0.6% in March while core prices jumped +0.4% which was higher than the expected +0.5% and +0.3%, respectively. The reason this spooked the market (the pre-market futures) is because the higher inflation rate sparked concerns about the Fed's need to increase rates at a faster clip. It has been assumed they'll continue to slowly raise rates by only 0.25% and maybe not many more before they stop. Today's CPI numbers sparked fears about a 0.50% increase on May 3rd and the fear is the Fed will choke off economic growth. The Fed is stuck between a rock and a hard place on rates since they'll need to fight inflation (or worries about it anyway) but they know if they raise rates they'll hurt economic growth (credit will become more expensive for expanding companies and for consumers' insatiable appetite to consume). The housing market will be especially vulnerable to rising rates which will then further affect the economy in a negative way. Equity futures got slammed to the downside during pre-market, as did the bonds, but then as if by magic they v-bottomed and shot back up to their pre-CPI levels. At the same time bonds barely moved from their spike lower. It smelled of manipulation to me. After the cash market opened it got a little volatile while continuing to chug higher from yesterday's close, which lasted for about an hour. But then the selling started and it never really stopped for the rest of the day, closing very near its lows for the day.


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Inside the CPI numbers, increases were seen in energy (I'm shocked!), clothing and hotel prices which were offset somewhat by falling prices for new cars and prescription drugs. The gain in core CPI was the largest since August 2002 and the overall CPI increase was the largest since last October. March saw energy prices increase 4%, the highest since last October, and gasoline prices increased 7.9%. Food rose 0.2% lead by increases in beef, poultry and vegetables while pork and fruit prices declined. Housing prices rose 0.5% which was the biggest increase since January 2001. The largest component of this though was hotel fares which climbed a record 3.9%. Residential rents increased a more modest 0.2% and home ownership costs increased by 0.3%. Apparel costs increased a large 0.8% but this was attributed to seasonal factors and is expected to ease once a flood of imports from China makes it into the country. Unless of course Congress gets its way and slaps a 27.5% tariff on Chinese goods. Then watch what happens to our CPI! The Trannies should be doing better than they are (see chart later) considering the fact that transportation prices increased by 1.9% and airline fares rose 2.7% but obviously this hasn't been enough to offset higher fuel costs. This increase in airline fares was the most since June 2001. One look at the Transport Index (below) does not inspire bullishness.

Let's review some of today's charts, starting with the DOW:

DOW chart, Daily

After losing support at January's low, the DOW went into freefall and paused at the bottom of a parallel up-channel. But after only two days to allow the bears a drink of water, they renewed their selling today. The first potential support, from a Fibonacci standpoint, is where we would have two equal legs down from the March 7th high. That would be at 9920. The next price level support is not until the August/October lows in the 9700-9800 range. The rally from October was steep and fast and consequently doesn't offer much in the way of price level support between the January low and the October low.

SPX chart, Daily

SPX looks bearish here because it dropped below its 200-dma's, came back up for a test for two days and then dropped hard today. This makes it look like a kiss good-bye on this important moving average. A 62% retracement of the August 2004 to March 2005 rally is at 1126 and I would expect some support to be found there. If that doesn't hold, the bottom of the longer term up-channel sits near 1110 and then of course below that we have price level support at 1090 and 1060, the October and August 2004 lows, respectively.

Nasdaq chart, Daily

The NAZ actually looks like it has the best bullish potential, at least as measured by both Fib and price level support. It's been floundering around its 62% retracement level at 1920 and the previous price lows found in October. If it doesn't hold here, and it won't if the broader market sinks lower, next price level support is near 1850 and then the August low near 1750.

While oil prices have generally been heading higher, we've seen a significant pullback from the level reached about two weeks ago. Today's inventory report showed crude oil inventories fell 1.8M barrels, versus an expected 1.4M barrels, while gasoline inventories fell 1.5M barrels versus only a 275K expected decline. Do you suppose that will translate into cheaper gas prices at the pump? Me neither. But increasing inventories and decreasing demand (if the economy is slowing down) should continue to depress the price of oil.

Oil chart, May contract, Daily

From oil's high of $58.21 on April 4th, it dropped briefly below $50 on the 14th and 18th before rebounding slightly, closing at $52.50 today. But as shown on the chart, after oil fell out of its steeper up-channel it now appears to be headed to the bottom of its longer term up-channel which is currently near $46.50. At the same time its 200-dma's are rising and may arrive at its uptrend line about the same time it tests that level. I would expect we'll see strong support in the upper $40's should it pull back to that area.

Oil Index chart, Daily

The oil index shows a very similar picture to oil's chart. After breaking its steeper up-channel and then dancing at the top of its longer term up-channel, it looks like it should head lower. As with oil, it looks like the 200-dma's will coincide with its uptrend line, the bottom of the up-channel, and would likely provide strong support. If you're looking to buy any stocks in this index, you should be hoping to see a further pullback to provide a long term buying opportunity. Looking at this chart I'd say it's a little early to be doing your shopping.

Transportation Index chart, TRAN, Daily

As mentioned above, the Trannies don't look so good here. The index dropped straight through its 200-dma's, bounced slightly to give it a kiss and then fell away today. This is not bullish price action. If it can't hold near its 50% retracement of the rally from May 2004, the next potential Fib support is at 3181 which coincides closely with the July 2004 high near 3200.

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

The last chart shows what's happening in the home construction market. After falling out of its steeper up-channel it dropped back inside its longer term up-channel. It banged around at the top of this longer term up-channel and then fell sharply away. Are you beginning to see a pattern in all these charts? The sell-off we've witnessed over the past month or so has been broad based and this makes it that much more bearish. It may be too early to call it but this has the makings of the start of the 2nd leg down in the long term bear market that started in 2000. Watch the decline in this index to see if it finds support at its 200-dma's. If not then the bottom of the longer term up-channel may provide support. A break of that uptrend line would be very serious and would tell us unequivocally that we're likely into a bear market. Rising interest rates will not only choke off economic growth but it will also kill the housing market. This index may be telling us it's already happening. Yesterday's significant drop in new housing starts is also telling us that. Keep a close eye on this index.

Sector action today saw mostly red, no surprise considering the triple-digit loss in the DOW. The only green sector on my watch list was the internet index (thank you Yahoo). The leading losers were the broker index, the SOX, airlines, finance related, retail, and energy. The Fed Beige Book was released this afternoon and in summary showed choppy expansion in the U.S. economy with some of the districts reporting uneven growth. Some of the districts show poor retail sales (notice retail was a leader in the loss column today) but interestingly said that the retail sector is demonstrating increased ability to raise prices. So they can increase their prices but they must be selling less. Hmm, somebody needs to teach them the supply vs. demand marketing model. The factory sector continued to show solid growth. As part of what we saw in the CPI numbers, the Beige Book reported upward price pressure lead by energy prices.

We're in the middle of earnings season and generally speaking it's a mixed bag. But it seems not to matter. What matters is investor mood and it's currently bearish. Investor mood is what swings the market (and the economy) and the earnings of companies will then reflect that, not the other way around as most believe. Intel's good earnings numbers last night tanked the market. Huh? Don't ask why since it doesn't make any sense. Go with your charts and sell when you see sell signals and buy when you see buy signals. Simple, no? If only. The market is clearly oversold and we only got a small relief bounce this week. It seems like we should be close to some good support levels but don't fight the tape or sell signals on your charts. If you only like to be long the market, take a breather here and stay flat. Wait for some buy signals to emerge. If you like to short the market, we're in a downtrend so it's your game right now. But don't press your luck since a bottom could be the v-bottom variety. Follow your trades down with your stops and don't give a bunch back. It's better to reinitiate your short position instead of giving it all back. Look for more selling tomorrow, at least early, but start thinking about probing for a bottom if you're a short term trader. Longer term traders can follow their stops down or if you're looking to buy, wait for a better buy signal. Catching falling knives is cutting up a lot of bulls right now. Good luck tomorrow in your trading.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
None KBH

New Calls

None today.

New Puts

KB Home - KBH - close: 108.98 change: -4.48 stop: 115.01

Company Description:
Building homes for nearly half a century, KB Home is one of America's premier homebuilders with domestic operating divisions in some of the fastest-growing regions and states: West Coast -- California; Southwest -- Arizona, Nevada and New Mexico; Central -- Colorado, Illinois, Indiana and Texas; and Southeast -- Florida, Georgia, North Carolina and South Carolina. Kaufman & Broad S.A., the Company's publicly-traded French subsidiary, is one of the largest homebuilders in France. In fiscal 2004, the Company delivered homes to 31,646 families in the United States and France. It also operates a full-service mortgage company for the convenience of its buyers. (source: company press release)

Why We Like It:
If you can't beat them; then join them. Bears overpowered the bulls several days ago and KBH broke down below major technical support at the simple 50-dma. Now after consolidating above round-number support at the $110 level for a couple of days shares of KBH are breaking down again. The market was expected to produce an oversold bounce for a few days and its sudden reversal today suggests more weakness than expected. Odds are that some investors who withstood last week's decline may start to get a little spooked here and begin to do more profit taking. The recent housing starts number with a 17 percent drop doesn't build any confidence in homebuilders in spite of the fact that the summer selling (and building) season is almost upon us. The DJUSHB home construction index just produced a failed rally near old support at the 820 level and its 100-dma. Now KBH is breaking down under its simple 100-dma on very strong volume. The stock was already in a P&F sell signal but now the signal points to a $100 target. We agree. KBH could easily trade down to the $100 level just above its exponential 200-dma. Our only concern is the upcoming 2-for-1 stock split on April 29th. Normally a stock split can be seen as a positive influence on share price but considering the market atmosphere investors probably don't care. Our target is $100.

Suggested Options:
We are suggesting the June puts.

BUY PUT JUN 110.00 KBH-RU OI= 162 current ask $7.60
BUY PUT JUN 105.00 KBH-RA OI= 111 current ask $5.50
BUY PUT JUN 100.00 KBH-RT OI= 107 current ask $3.80

Picked on April 20 at $108.98
Change since picked: - 0.00
Earnings Date 06/16/05 (unconfirmed)
Average Daily Volume = 1.5 million


MGM Mirage - MGG - close: 67.10 change: -1.78 stop: 72.51

Company Description:
MGM MIRAGE, headquartered in Las Vegas, Nevada, is one of the world's leading and most respected hotel and gaming companies. The Company owns and operates 11 casino resorts located in Nevada, Mississippi and Michigan, and has investments in three other casino resorts in Nevada, New Jersey and the United Kingdom. (source: company press release)

Why We Like It:
MGG just reported earnings and managed to beat Wall Street estimates by 12 cents. Yet the stock has sold off sharply over the past two days with volume coming in more than double the norm. This looks like a classic case of "sell the news". We like MGG as a bearish candidate based on its technical breakdown. Shares just closed under support in the $69.00 region to hit new four-month lows. The overall pattern looks like MGG built a three-month top and could consolidate back toward its 200-dma near round-number support at the $60.00 level. MGG's bearish P&F chart shows a spread triple-bottom breakdown sell signal with a $57 target. We do see potential support near $63 at its exponential 200-dma and potential support near $62 with the gap up from last December. We're going to target a drop into the $62-60 level. Readers will note that we have a relatively wide stop loss. That's because MGG is short-term oversold and could bounce back toward the $70.00 level before turning lower again. A failed rally under $70 would make a good bearish entry point but we're not going to wait given the current bearish market environment.

Suggested Options:
We are suggesting the June puts.

BUY PUT JUN 70.00 MGG-RN OI= 5930 current ask $5.10
BUY PUT JUN 65.00 MGG-RM OI=11369 current ask $2.55

Picked on April 20 at $ 67.10
Change since picked: - 0.00
Earnings Date 04/19/05 (confirmed)
Average Daily Volume = 1.1 million

Play Updates

In Play Updates and Reviews

Call Updates

Eaton Corp - ETN - close: 59.09 chg: -0.01 stop: 56.99

ETN is holding up pretty well considering the triple-digit loss in the Dow Jones Industrials. Shares encountered some resistance at the $60.00 mark today. Don't be surprised to see a pull back toward the $58 level. No other change from previous update on 04/18/05.

Picked on April 18 at $ 58.51
Change since picked: + 0.58
Earnings Date 04/14/05 (confirmed)
Average Daily Volume = 1.1 million


Ishares Dow Jones Energy - IYE - cls: 70.77 chg: -1.52 stop: 68.84

We are a little surprised by today's decline. Crude oil prices were higher today and the inventory numbers showed a surprise decline in oil and gasoline supplies. This should have sent the IYE higher. Look for a retest of support near $70.00. We would wait for signs of a bounce before considering new positions.

Picked on April 18 at $ 70.78
Change since picked: - 0.01
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 170 thousand


Patterson Cos. - PDCO - close: 50.06 chg: -0.31 stop: 49.45

We remain cautious. PDCO held up pretty well compared to the broader markets. Shares of PDCO are still trading above support at $50.00 and its 50-dma - BUT there has been a significant lack of buying near this support and conservative traders may want to step to the sidelines here. We are not suggesting new positions until PDCO trades over $51.00 or $51.50.

Picked on April 18 at $ 50.75
Change since picked: - 0.69
Earnings Date 05/19/05 (unconfirmed)
Average Daily Volume = 789 million

Put Updates

Expeditors Intl Was. - EXPD - cls: 48.42 chg: -0.70 stop: 52.51

No change from previous update on 04/17/05. Our target is the $46-45 range. Watch the Dow Transports. The TRAN index just rolled over under the simple 200-dma.

Picked on April 14 at $ 49.31
Change since picked: - 0.89
Earnings Date 05/04/05 (unconfirmed)
Average Daily Volume = 748 thousand


Ishares Russ 2000 Val - IWN - cls: 176.00 chg: -2.80 stop: 183.51

The IWN has produced a bearish reversal today. The ishares traded to its exponential 200-dma and then reversed course. The move also produced a bearish engulfing candlestick pattern. We would use today's move as a new bearish entry point. Our target is the $170.00 level.

Picked on April 14 at $178.04
Change since picked: - 2.04
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 324 thousand

Dropped Calls

Red Robin Burger - RRGB - cls: 51.15 chg: -0.87 stop: 49.49

Over the last several days we've been suggesting that more conservative traders consider exiting with RRGB up four or more points from our entry point. Now that the market's oversold bounce is already failing we're choosing to exit RRGB early. Shares of RRGB managed to bounce from round-number support at the $50.00 level today but we don't want to see the stock erase any more gains.

Picked on March 10 at $ 48.00
Change since picked: + 3.15
Earnings Date 02/14/05 (confirmed)
Average Daily Volume = 199 thousand

Dropped Puts

Starbucks - SBUX - close: 45.67 chg: -0.55 stop: 51.75

Target achieved. Another tough day for the markets was just one of many for SBUX. Shares of the coffee purveyor declined sharply at the opening bell and traded to $44.58. This was inside our profit/target range of $45.00-44.00. We are closing the play at the $45.00 mark. More aggressive traders may want to consider merely tightening their stop and letting SBUX continue to sink. Yes, the stock is oversold but with the market showing more weakness there's no telling how low SBUX can sink. However, it's worth noting that we'll be watching for more support in the 42.50 region and worse case the $40.00 level, which should be very strong support. We may suggest SBUX as a bullish candidate if shares dip that low.

Picked on April 10 at $ 48.62
Change since picked: - 2.95
Earnings Date 04/27/05 (confirmed)
Average Daily Volume = 4.3 million

Trader's Corner

Using Trendlines To Find High-Potential Trades

These are responses to two OI Subscribers' questions, both relating to determining market trend.

I recently read your article on trendlines in The Option Investor Daily Trader's Corner article. I found it very informative and essential which leads me to two questions I would like to ask. The first would be where can I obtain a copy of your book Essential Technical Analysis.

The second would be as to how I can use the trendlines to place buy and sell orders. I have noticed that the price can sometimes sit near a top or a bottom or even break through a channel only to quickly reverse and enter the channel again.

Then of course, there are the times it just simply bounces off the line and goes right to the next like we expect it to do, those are easy. How to we build a trading plan to allow for the two?

Buying my book is no different than you would any other; e.g., ordering via amazon.com

The trading plan to use when trendlines do what we "expect it to to do" is the same as when they don't. If I'm buying calls when prices penetrate a resistance trendline, I want to risk to just under the trendline, as it should not be pierced again. If the trend works out, that is a winning trade. If it does not that is one of my losses. The trick is to keep losses SMALL! You've heard that a million times!! What is small to one is not so small to others.

Let's define what "small" or reasonable and expected losses are. They are small in relation to the potential profit. If an Index has been in a steep downtrend for some weeks and then rallies strongly up through a trendline, the rubber band effect (and past market behavior) is going to tell us that prices could bounce back some distance. Why? The sellers are all cleaned out. Pretty much everyone who was going to sell stock did so already.

So, lets say the trade ends up with us buying OEX calls, after the S&P 100 Index has fallen 30 points and AFTER the index has broken out ABOVE a resistance trendline; I assess upside potential to be for a rally of half of the decline, or 15 points. That's a reasonable expectation based on looking at the market through diverse cycles and types of markets.

If I am buying or selling near a trendline, I can risk a small amount as I have a reference point for my stop that makes sense in terms of common market action.

The basic bottom line answer to your question is to use stops, use stops and use stops. There may be 50 percent or half FALSE "breakouts" above or below valid trendlines. By "false", I mean that prices reverted, as you say, to being BACK in the trend channel.

In the chart below, the hourly S&P 100 (OEX), buying OEX calls was suggested by the price breakout at the circle. Buying calls here runs the risk that OEX will fall back INTO its price channel. How to protect against this?

The answer is simplicity itself. Exit the trade if there is a close under the top of the downtrend channel later on. If the trend has in fact reversed to up, the index will not close back down IN the channel and support (noted at green arrow) should contain sell offs

What was resistance is assumed to be a new support area. Let's see what happened next

The OEX during the late-January to early-March time frame rose from the 563 area to 585. The lower trendline was the obvious low end of the hourly uptrend channel and when it was broken at the second yellow circle it suggested exiting calls and taking out OEX puts.

But how to protect yourself in case the index popped back up back INTO its uptrend channel, which as you point out it has a disturbing tendency to do? Buying puts in the 580 area, your initial exit point on those puts is just over the red down arrow at 584. Since I estimated that OEX could fall to 565 or 15 points, a 5-point "risk" was a one to three ratio risk-to-reward ratio; 1 in 3 or better, is what I prefer. Risking one dollar for every 2-2.5 dollars (you hope to gain) is ok, but 1:3 as a threshold is better.

Once a downtrend is "confirmed" by the rally failure at point "a" on the charts, your protective exiting stop point is lowered to just above rally peak 'a'. As the OEX trend cascaded down, it was then a question of what your trade objective was.

Further "confirmation" of the downtrend came as rally point 'b' stalled shy of the prior price peak 'a'. Now I could start to drawn a downtrend channel

The parallel lines to form a downtrend price channel came after there was a low AFTER rally peak 'b'. Since I had 3 points to define a down trendline, I could draw a preliminary downtrend CHANNEL intersecting the first downswing low. Later lows fell to the trendline also. Imagine that.

Until, that is, the period shown in the circled period noted 'a' in the chart below when prices seem to slip under the lower line. Which is unimportant as the lower channel line is only an approximate area where sells off could find buying interest.

Assuming long OEX puts in the 580 area, there is no market action warranted until either a downside target is reached OR there is breakout ABOVE the down trendline, suggesting an upside reversal. If I did not take profits on my puts during the sideways slide at 555, exiting at 561 or just above the violated down trendline, is a protective given in the way I trade.

Assume a buy of OEX calls on the upside trend reversal at 561. The exit or "risk" point is to just under the broken trendline; as long as that amount is not more than 1/3 of what I hope to make on my calls. On this basis, an exit point of 558 is warranted, not lower. With the eventual dip to the 556 area, I would be out of calls if I was faithful to my trading plan.

There might have been factors that then suggested I re-enter my call position but that's another story.


Your commentary remains a valuable part of my learning about identifying tradeable trends. My question is "How can I judge if I've waited too long to act on a trend?"
The current situation is a good example (as of 4/18/05). The direction of the indices appears to certainly be down now. Is it too late to short? My sense is that in order to make any money and minimize risk a trader now has to wait for some kind of bounce to develop in order to have acceptable risk/reward potential.
You guess at it correctly you have waited too long to act on a trend IF potential trades don't meet a favorable risk to reward assessment.

In a sense you've never waited too long to trade WITH the trend, as long as its intact. I also agree with what you say about it being necessary or advisable to wait until "some kind of bounce" developed so that risk-to-reward would be acceptable.

It's hard to quantify what "some" is; i.e., how much of a rally must develop to play the short side (e.g., long puts) and not take too high of a risk given how far the market has already come down in this recent instance. Sometimes you need to pass on potential trades.

There is a tendency when we "miss" a sizable market move, to be too over-eager to get in on this new trend; to have another trading opportunity. We get blinded by greed rather than "fear", which we would do so to speak if we took as much notice of the risk in bad timing in getting in too late, such as when the market could be due for a rebound.

Pictures are worth a thousand dollars... er, words

Was it worth it for example to buy index puts around 552, after the rebound in the S&P 100 (OEX) went from 546 to the 552 area. Not for me! The only "logical" exit point would be above 560, or above its down trendline.

By some ways of measuring it, a downside price objective I had for 543 was already near at hand. 540 was also where I pegged some significant support. Downside potential was from around 552 to perhaps 542, for a 10-point "reward" potential, assuming I got puts bought at the recent rally peak.

Against this I ought to give my puts the benefit of the doubt UNLESS there was a close fully 8 points higher than my entry or above 560. With this assessment, my risk is 8 points, reward is 10 for a risk to reward of 1 to 1.25; quite far from my 1 to 3 screening. Screening trades for their risk-to-reward potential is as important as any other considerations.

Consideration examples: yes there is still "potential" profit in puts. Yes, the market is weak; yes, further events could happen to take us lower; but ... do I have a risk point that makes sense and not just some random point? ... Is profit potential 3 times or more than that?

Contrast these two possible trades, involving shorting QQQQ

Trade #1 you short the stock on a return to the down trendline or when the Q's reach the 36.5 36.7 area; risk can be held to a very small amount, as even a relatively minor breakout above the down trendline would cause me to want to exit a short play here.

I would have assessed downside or profit potential as to the lower trend channel boundary (at the first green up arrow) or around 34. If I was short above 36.2, my exiting buy stop would be 36.9 for a risk of 70 cents, versus profit potential of 2.2; an OK risk to reward.

Contrast with Trade #2 -

I short the stock around 35.2, assuming I rightly see that upside momentum is running out of steam. QQQQ then breaks its minor up trendline at 35. I get short the stock on a bounce and am lucky enough (I think) to be short at 35.2.

Is risk to reward ok? I can risk to a new high above 35.30, but that is just a guess. Is 35.3 significant technically in the next 2-3 days after I'm short? Not based on the chart.

Only a move above 36.5, to above the down trendline is significant for possible trend reversals based on chart considerations. If I am to follow the logical stop point, I should have a buy stop (liquidating) order at 36.7; for a risk of $1.50. For downside ideas, how far to the lower channel line?: to around 33.75. If so, this makes reward potential equal to $1.45.

You get the picture! Reward potential here could be LESS than what you got to risk with an exiting stop; at least one that makes sense on technical points and that is the way that I trade. Others trader differently and may make it work for them and have profitable years in options.

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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