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Daily Newsletter, Monday, 06/06/2005

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Options 101

Market Wrap

Lights On but Nobody Home

Lights On but Nobody Home

Bulls and bears returned to their screens on Monday full of anticipation. The first real decline in several weeks closed on Friday with the indices actually oversold on an intraday basis with prices just beginning to tick up. All were on the alert for an expected bounce. The Fed added $9 billion in overnight repurchase agreements, which yielded a net gain of $6.5 billion available to the market. With no economic reports, many were expecting a sizeable bounce.

The markets chopped sideways in the morning and eventually slid to new lows, but began to recover after 11AM. The bigger surprise, however, was a thorough lack of participation in either direction across the markets. QQQQ barely made it past half its average daily volume, and combined volume for the NYSE and Nasdaq struggled to surpass 2.6 billion shares. Throughout the day, volume breadth hovered around or just south of neutral, but the action was very slow overall, more appropriate to an afterhours session than the day after a big drop. What does it mean?

On a technical basis, a weak reaction to a strong move is generally thought to be corrective. That is, the true move on Friday was down, and the light volume, slow, hesitant bounce was merely a correction to it- a dead-cat bounce. If so, a break through today's lows tomorrow should be strong, sharper and on higher volume. "Forensically," it felt like the markets were waiting for something- possibly Greenspan's scheduled appearance in Beijing tonight (see below). In any event, it felt like a throwaway day, with short term traders getting stopped in both directions and the net change for the day insignificant to longer term traders.

Daily Dow Chart


The Dow traded as low as 10430 before bouncing to a high of 10481, at the lower end of Friday's broad range for a gain of 6 points. This gain was insufficient to impact the sell signal on the daily cycle stochastic, though we await a confirming cross from the Macd. 10440 is significant support, a break below which would trap all the buyers of the past 2 weeks and get the daily cycle downphase in gear. Bulls need a break above 10560 to reverse the bearish view. Note the potential for a reverse head and shoulders on a strong break above that level as a neckline. A move below 10380 would invalidate the pattern.

Daily S&P 500 Chart


The SPX added 1.49 to close at 1197.51, bouncing from a low of 1192.75 and failing at 1198.78. On the daily chart, the rise of the past two weeks has taken the shape of a rising expanding wedge or "bulloney bullhorn," a difficult pattern to read that generally breaks to the downside. That did not occur Friday or today as the lower support line was tested. While the oscillators are on the verge of their long awaited downphase, it's important to note that the pattern is still a rising pattern- that is, until it breaks, it's going up, not down. A break of today's low should be accompanied with stronger volume, and would set the stage for a daily cycle downphase. A bounce that clears today's high could run to the top of the wedge in the 1210 area, but again, these tend to be bearish patterns.

Daily Nasdaq Chart


The Nasdaq took out Friday's low and reached 2066 before its bounce to 2078, finishing at 2075 for a 4.33 point gain. Volume was impressively light, as it has been through much of the rally during the past few weeks. A failure below 2060 should have little support until the 2025-2035 area, which equates roughly to 10380 on the Dow. Above 2100, the bulls would reassert control. Again, it's worth noting that despite the bearish indicators, including the sky-high QQQQ:QQV ratio (see below), the low volume the toppy daily indicators and today's weak bounce, this is still a chart that has been rising for over a month. A close below 2060 would be the minimum price confirmation to suggest a rollover, with confirmation below 2040.

Chart of QQQQ and QQQQ:$QQV


Daily TNX Chart


The Treasury auctioned $34 billion of debt today via t-bills and cash management bills. The $12 billion in cash management bills generated 2.75 bids tendered for each accepted, at a high rate of 2.94%. The 13-week bill auction generated a bid to cover ratio of 2.06 at a high rate of 2.965%, while the $15 billion of 26-week bills fetched 2.5 bids for each accepted at a high rate of 3.06%. Foreign central banks took $9.4 billion of the total $32 billion in 13-week and 26-week t-bills.

Ten year treasury yields (TNX) held a relatively narrow range at the top of Friday's monstrous bullish doji hammer. That hammer launched from a morning low of 3.8% to nearly fill the gap left on the break below 4%. Today's range finished the job, touching 4% before falling back to Friday's highs. On the daily chart, an upphase is overdue with a bullish divergence on the 10-day stochastic. Ten year treasury bears/ TNX bulls will want to see a move above 4.05% to kick off that upphase. For the day, TNX finished lower by 1.7 bps at 3.962%.

Chart of Crude oil


Oil was weaker today as OPEC President Sheikh Ahmad al-Fahd al-Sabah of Kuwait told the press that current prices are too high and may warrant another increase in the production limit. However, with OPEC currently pumping at rates above the current production ceiling, a quota hike would have little effect. Reuters quoted Alegerian Oil Minister Chakib Khelil as saying, "Why should we change our policy? OPEC is producing at full capacity. We cannot produce more." The current quota is 27.5 million barrels per day, with Reuters surveying May's production for the OPEC nations at 27.94 million bpd. The next policy meeting is scheduled for June 15 in Vienna.

On the daily chart, we see a sharp daily cycle upphase testing last Thursday's high, with today's session high 55.55. The low was reached in the early afternoon at 53.90, with an end of session bounce closing the July contract -.55 or 1.00% at 54.475. There's confluence support at 53.70-.90, below which 52.25 support comes into view.


It was a quiet news day, with no major economic reports released and a thin set of reports slated for the week. Tomorrow's Consumer Credit will be the first, scheduled for 3PM, followed by Wholesale Inventories on Wednesday morning, then Initial Claims on Thursday. Friday will be the heaviest day this week, with Import Prices and Export Prices, the Trade Balance and in the afternoon, the May Treasury Budget.

S&P reported that company stock buybacks rose 91% in Q1 of this year, from $43 billion to $82 billion. The report emphasized the benefit to shareholders in having all those extra bids for their shares, as well as the antidilutive effect of reduced floats and the corresponding boost to EPS. The subtext to this trend is that companies may see fewer users for their money, such as investment in their core businesses and operations, other than buying back their own shares. Nevertheless, in the short term stock buybacks are bullish for stock prices, and S&P anticipates that 2005 will easily surpass 2004's level of repurchases by public companies.

In corporate news, Washington Mutual (WM) announced that it will purchase Providian (PVN) for $6.45 billion. The purchase price will be paid 89% in stock and 11% in cash. Providian shareholders will receive .45 WM shares for each PVN. The deal values PVN at $18.71 per share, just over a 4% premium to Friday's closing price. WM said that intends to retain PVN's management and infrastructure, and that the company will remain in San Francisco. WM expects the deal to close in Q4 2005, and to add to profits by next year on a cash and GAAP basis. Following the announcement, S&P placed PVN on credit watch "positive," highlighting the transaction as well as PVN's decision to move from the "deep" subprime market to the middle-to-prime market. WM finished the day lower by 2.48% at 40.54, while PVN lost 1.84% to close at 17.63.

Homebuilder HOV announced that the net value of its new contracts, being new contracts minus cancellations, rose 34% in May. The number of net contracts rose 16.9%. Despite the increase, both the net value and number of new contracts in California declined, but the company attributed the slump to its "conscious effort" to restrict sales too far ahead of its expected delivery dates in certain communities, as well as regulatory delays. HOV gained 1.42% to close at 61.46.

There was more on the AAPL-INTC move today as Steve Jobs addressed the annual Apple software developers conference in San Francisco, announcing that AAPL will drop IBM and switch to INTC chips for its PCs. AAPL has just under a 2% share of the global PC market, and the shift would constitute a win for INTC and a snub for Big Blue. There seems to be a consensus that the move would result in AAPL machines running with smaller, cheaper, faster and more efficient chips, but that the transition would nevertheless involve a great deal of risk and re-engineering costs. Analysts also highlighted the expected exodus of AAPL users following another architectural transition and the redeployment of software that such would entail. AAPL closed lower by .92% at 37.89, INTC lost .59% to close at 27.17, and IBM lost 1.04% to close at 75.

Computer graphic processor maker ATI (ATYT) warned that Q3 and Q4's projected revenue would come in light at $530 million, roughly 5% below its previous minimum expectations, with consensus estimates $574.5 million. The company said that while volume overall is up, demand has shifted toward the lower end of the PC and notebook market. ATYT got smoked for a 10.35% loss, closing at 13.68 on nearly 9 times its average daily volume.

The US-China textile dispute was highlighted again today by a senior Chinese official, Vice Premier Wu Yi, who stated that the issue could "serious harm the process of economic cooperation" if not resolved. Wu, who had worked as Trade Minister on the negotiations that saw China enter the WTO, told US Commerce Secretary Carlos Gutierrez, "You believe that trade must be fair, but you impose restrictions on textile imports from China." Beijing has recently removed export tariffs on its booming textile trade and criticized the EU and US for its imposition of import controls.

Tonight, Chairman Greenspan), ECB President Jean-Claude Trichet, Bank of Japan Deputy Governor Toshiro Muto and People's Bank of China Governor Zhou Xiaochuan are slated to address the International Monetary Conference in Beijing.

For tomorrow, the question will be whether today's low volume, high-anxiety bounce was a mere correction to Friday's decline, or a stealth accumulation ahead of a retest of the rally highs. Bears need to break today's low to build their case for the former, while bulls need to match or top Friday's high to stall the decline building in the daily cycle. Today was a lower-low, lower-high session, and bulls will want to see today's high taken out as a first sign of potential trouble for the bears.
 

 
 




New Plays

New Option Plays

Call Options Plays
Put Options Plays
None None

New Calls

None today.
 

New Puts

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

Amer. Intl Group - AIG - close: 54.85 chg: -0.24 stop: 52.95

No change from our previous update on 06/05/05. We are still looking for AIG to dip toward the $54.00 level before continuing higher.

Picked on May 26 at $ 55.05
Change since picked: - 0.20
Earnings Date 02/09/05 (confirmed)
Average Daily Volume = 15.5 million

---

Caterpillar - CAT - close: 94.15 chg: +0.18 stop: 89.99

No change from our update on 06/05/05. We would watch for CAT to pull back toward the $92 level.

Picked on May 18 at $ 92.35
Change since picked: + 1.80
Earnings Date 04/20/05 (confirmed)
Average Daily Volume = 2.8 million

---

Career Education - CECO - close: 35.45 chg: +0.63 stop: 32.45

No change from our previous update on 06/05/05. CECO remains stuck in its trading range between $34.00 and $35.50.

Picked on May 23 at $ 35.24
Change since picked: + 0.21
Earnings Date 05/02/05 (confirmed)
Average Daily Volume = 2.5 million

---

Rockwell Collins - COL - close: 48.96 chg: -0.26 stop: 44.95

No change from our previous update on 06/05/05. COL's momentum is starting to stall and its MACD is very close to producing a new sell signal. We are suggesting a trigger to go long the stock on a pull back toward the 100-dma. Currently we're suggesting a bullish entry in the $46.25-45.50 range.

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/27/05 (confirmed)
Average Daily Volume = 800 thousand

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Reynolds American - RAI - cls: 82.97 chg: +0.30 stop: 78.75

No change from our previous update on 06/05/05. RAI continues to trade under resistance in the $83.40 region.

Picked on May 16 at $ 81.31
Change since picked: + 1.66
Earnings Date 04/27/05 (confirmed)
Average Daily Volume = 866 thousand

---

Teekay Shipping - TK - close: 44.40 chg: +0.19 stop: 42.45

Almost open. TK is still trading above its 200-dma but remains under what looks like resistance at the $45.00 mark and its 100-dma. We are suggesting that readers use a trigger at $45.05 to open the play.

Picked on June xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 07/20/05 (unconfirmed)
Average Daily Volume = 681 thousand

---

United Technologies - UTX - cls: 106.95 chg: +0.70 stop: 102.45

No change from our previous update on 06/05/05.

Picked on May 23 at $106.25
Change since picked: + 0.70
Earnings Date 04/20/05 (confirmed)
Average Daily Volume = 2.0 million

---

Wellpoint Inc - WLP - close: 67.80 chg: -0.60 stop: 64.90

No change from our previous update on 06/05/05.

Picked on June 05 at $ 68.40
Change since picked: - 0.60
Earnings Date 07/27/05 (unconfirmed)
Average Daily Volume = 3.5 million
 

Put Updates

MedcoHealth Sol. - MHS - close: 50.69 change: +0.35 stop: 52.21

Uh-oh! MHS did it again. The stock dipped intraday below our suggested entry point to buy puts and then rebounded again back above the $50.00 level. The fist time our suggested entry was a move under $49.90. The second time was a decline under $49.50. We remain bearish on the stock given its broken up trend but this oscillation between $49 and $51 is testing our patience. We would not consider new bearish positions with MHS trading above the $50 level.

Picked on June 01 at $ 49.90
Change since picked: + 0.79
Earnings Date 07/26/05 (unconfirmed)
Average Daily Volume = 2.0 million
 

Dropped Calls

None
 

Dropped Puts

United Thera. - UTHR - close: 47.95 chg: -1.18 stop: 51.26

Target achieved. UTHR lost another 2.4 percent on above average volume to break down below the recent lows and trade into our target range of $48.25-47.50. The move was partially fueled by a press release from Pfizer today. PFE announced that the FDA has approved a new pill for PAH or pulmonary arterial hypertension. This new pill from PFE will compete with several other available therapies on the market and one of them is an injected treatment made by UTHR. We are closing the play at $48.25. We would not hold on to bearish positions as UTHR is nearing what looks like heavy support near $47.50, which is also bolstered by its simple 100-dma.

Picked on May 24 at $ 53.38
Change since picked: - 5.43
Earnings Date 05/03/05 (confirmed)
Average Daily Volume = 452 thousand
 


Options 101

The Combination Double Credit Spread

Playing the middle against both ends, with insurance of knowing what you maximum risk will be.

The Theory behind the Practice

Sometimes it is better to play the middle against the ends, especially when you have a stock that you feel is really not going anywhere or is stuck in a trading range. The combination double spread works similar to the straight naked combination. However, you can tell by its namesake that this is going to be a lot safer transaction than selling naked calls or puts. Basically, we are establishing risk and rewards with the anticipation that our stock will trade in a range and have both our call and credit spread expire worthless and keep the premiums. The strategy for this trade came about when in 1987 and again in the great Tech Wreck, individual traders would love to sell naked combinations and have a stock trade between a given trading range with both the written call and put expiring worthless and the seller collecting both sides of the premium. However, if one feels that naked call and put combination writing is the way to go, let me remind you of what can happen if you are NAKED the call or the put side. Unlimited losses on the call side and devastating losses on the put side. I only need to mention several high tech issues that fell by the wayside and told many a trader's account values along with them
The combination double spread alleviates the fear of the catastrophic crash or untimely buy out or merger. The strategy is very simple instead of trading anything naked you put on two credit spreads, one on each side of the market using puts and calls. Examine this hypothetical situation for a moment.

Let's say you think company MANX is going to lay flat in a trading range or slightly move up or down very little in the next 30-45 days. Well here is a little strategy that you might want to try with several issues, especially if you have a strong feeling that their performance is going to take them no where fast. Let's say MANX is trading at 65 and has been in a trading range between 60 and 70 for the last 6 months. In fact, the whole market has seemed to be just going nowhere, but you want to profit from this stagnation.

Well here's your opportunity. What we are going to do is to sell a MANX call spread
by doing the following:

Sell 10 MANX Jun 70 Calls to Open @ 3 and
Buy 10 MANX Jun 75 Calls to Open @ 1.

This we can do for a net credit of 2 times 10 contracts or a total net credit of $2,000
In addition, we will simultaneously execute the following:

Sell 10 MANX Jun 60 Calls for 2.75 and
Buy 10 MANX Jun 55 Call for 1

This we should be able to do for a net credit of 1.75 times 10 credits or a net credit of $1,750.

This should give us for the two spreads or 4 transactions a Total net credit of $3,750.

Now our goal here is to have MANX, which was trading at 65 when we made our trade, to close at the end of the June expiration between 60 and 70. If this happens all the options expire worthless and we keep the premiums.

MARGIN ISSUE: Although MANX cannot close at both above 70 and below 60 at the same time. The margin requirement for this trade is the difference between the strike prices and the premium received. Unfortunately, unlike a naked combination, where you are only marked against the mark on one side, you must put up the margin requirement for both the call and the put side. (Just a house requirement, doesn't make much sense, as they can at best only go against you on one side.). Anyway, the house requirement would be $300 per contract times 10 on the call side and $325 per contract times 10 on the Put side for a total margin requirement of $6,250. However, the most you would ever be at risk is $5000, which is the difference between the two strike prices on either side. Remember MANX can't close BOTH above $70 and below $60 on expiration. MANX can only close at one price. So one of the sides has to expire worthless. So your net loss would be $5000 less then $3,750 premium you received on an out of pocket maximum loss of $1,250.

IMPORTANT: It is important to put both sides of the trade on at the same time. This can get a little sticky if you try to be too cute with your entry points. If at all possible enter all 4 trades with a total net credit. This way if all 4 transactions do not get executed you will not be left owning one side of the spread, while failing to execute the other side, which may now have gotten away from you. Secondly, do not try to guess which way the market is going to go and try to leg on these positions one at a time or by buying the long positions and then selling the shorts. You may guess right, but if you don't the whole rationale for the trade is gone and you might end up not getting enough premium as you thought or enough to make it a viable play.

Anyway, if MANX closes between 60 and 70 you keep the premiums. If it closes above 70 or less then 60 your loss is $1275 (plus transaction fees, but no more, even if the stock goes to zero or up to infinity.)

The perfect strategy for the stagnate market.

Now that you understand the theory, lets look at an actual scenario that you can follow

The Real World Example: Actual Date April 20, 2005

CHART 1: YAHOO

Yahoo trading at 34.75

Let's take a look at this strategy using the issue Yahoo. For this transaction, we will be looking at the June series. We will put on the following credit spreads:

Buy (Long) Yahoo Jun 40 call @ 0.30 = $30 Debit
Sell (Short) Yahoo Jun 37.50 call @ 0.90 = $90 Credit

This gives a net credit of $0.60 = $60
We will be selling 20 contracts so our Net Credit = $1,200

Sell (Short) Yahoo Jun 32.50 put @ $0.60 = $60 Credit
Buy (Long) Yahoo Jun 30 put @ $0.20 = $20 Debit

This gives us a net credit of $0.40 = $40
We will be selling 20 contracts on the put side as well for a Net Credit = $800

Our total credit from both spreads is $2,000
Our net positions should look like the following:

10 Buy (Long) Yahoo Jun 40 call @ 0.30 = $30 Debit
10 Sell (Short) Yahoo Jun 37.50 call @ 0.90 = $90 Credit
10 Sell (Short) Yahoo Jun 32.50 put @ $0.60 = $60 Credit
10 Buy (Long) Yahoo Jun 30 put @ $0.20 = $20 Debit

TOTAL NET CREDIT = $2,000

In addition lets see what are maximum gain, maximum loss, breakeven and margin requirements look like after we have successfully put on this trade.

FIGURE 1: Combination Double Credit Spread

As you can see, here is the position laid out when successfully executed. I have included the Margin requirement, the maximum gain, maximum loss and the two (2) breakeven prices. (Remember, you have a range where the trade will be totally profitable and you will keep the $2,000 premiums.

In figure 2 below you will see a complete breakdown as to how this options will act at expiration time the third Friday in June. To get a better idea I have indicated the maximum gain and loss at each possible price that the stock could close on the June expiration.

FIGURE 2: A CLOSER LOOK AT THE DOUBLE COMBINATION IN ACTION

From the chart above we can see that if Yahoo closes on the June expiration anywhere between 32.50 and 37.50 we will keep the entire $2000 premium.
If is only when Yahoo goes outside of that trade range will the trade become unprofitable.

NOTE: The yellow in the chart above clearly shows the profit and loss at each price the stock could close at on the June expiration.

Also note that the maximum losses do not get any larger no matter how high or low the stock should go below or above the breakeven points

Please understand that no matter how high Yahoo may climb or how low Yahoo is able to sink. Your maximum exposure is only $3,000. Even though your margin requirement is $8,000.

The Bottom Line:

In recap, this strategy offers an option individual the opportunity to take advantage of a stagnate market, while carefully avoiding any type of unforeseeable major move or surprise on either the upside or the downside. This is the type of trade that let's you stay in the market and hopefully adds to your gains when the market goes through one of its many lulls.

Until Next Time
 

Today's Newsletter Notes: Market Wrap by Jonathan Levinson, Options 101 by Steve Gail, and all other plays and content by the Option Investor staff.

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Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

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