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Daily Newsletter, Wednesday, 06/22/2005

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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

A hunger for yield!

A hunger for yield!

Treasury bond prices surged on Wednesday, extending Tuesday's hefty price gains, which came on the heels of Sweden's central bank cutting rates by a half point to 1.5%. 

A hunger for yield was further fueled today after the latest minutes of the Bank of England's Monetary Policy Committee revealed that 2 of the 7 panel members voted to cut that benchmark rate 25 basis points from 4.75% on concern that euro-zone growth was slowing. Earlier this month, England's Monetary Policy Committee held rates at 4.75%.

The benchmark 10-year yield ($TNX.X) plunged 10.4 basis points to finish the session back below the 4.0% level at 3.945%. A strong round of buying was also found in the shorter-dated 5-year note with its yield ($FVX.X) down 11.9 basis points to 3.721%, while the longer-dated 30-year yield ($TYX.X) fell 8.2 basis points to 4.251%.


As market participants from around the world scrambled toward U.S. Treasuries, the U.S. Dollar Index (dx00y) 88.56 +0.43% had the greenback finding buyers.

Notwithstanding lower interest rates, which raise the current value of future earnings and thus should increase the current value of stocks, the major equity indices failed to retrace early-morning highs as investors contemplate euro-zone interest rates, which many feel have been too high given the regions more sluggish economic growth (compared to the U.S.), and the potential negative impact slowing may have on demand for U.S. exports.

All-told, market internals finished modestly positive at the a/d line, while bullish leadership persists among new high and new low ratios at both major exchanges.

Despite a weekly draw in U.S. crude oil inventories, pit traders cited "profit taking" for weakness in energy prices. August Crude Oil futures (cl05q) fell $0.95, or -1.61% to settle at $58.09. Meanwhile, August Unleaded Gas (hu05q) was down $0.167, or -1.02% to $1.6182, while August Heating Oil (ho05q) edged down less than a penny, or -0.46% to $1.6357. The EIA said crude oil stocks were down 1.6 million barrels, which was slightly less than updated consensus for a 2.0 million decline. Gasoline stockpiles rose by 200K barrels, which was a stronger build than the +50K consensus. While distillate inventories (i.e. heating oil, diesel fuel) rose by 1.3 million barrels, but shy of consensus for a 2.0 million barrel increase. 

Online broker Ameritrade (NASDAQ:AMTD) $17.87 +20.58% surged after being halted for trade mid-session, where gains gave a strong boost to the Securities Broker/Dealer Index (XBD.X) 154.85 +2.95%, which finished as today's bullish sector winner. Earlier this morning, CNBC reported that it had learned the company was set to make an offer for rival TD Waterhouse. At roughly 01:48 PM EDT, Ameritrade's stock was halted at $14.83, when the company then confirmed its intent to buy TD Waterhouse, with the overall value of the deal thought to be $2.85 billion in cash. At the same time, Ameritrade said it was not interested in a semi-hostile takeover attempt by E*Trade (NYSE:ET) $13.75 +6.50%. 

TD Waterhouse's parent, Toronto Dominion (NYSE:TD) $44.15 +1.23% will initially own 32% of the newly created company, which will be called TD Ameritrade. 

It would be my analysis that Wall Street liked the deal as Toronto Dominion (TD) will receive approximately 190 million newly issued shares of AMTD, where market participants see little effect of the all-stock deal actually hitting the market.

Ameritrade (AMTD) was today's most actively trade stock with just over 86.9 million shares changing hands. Average daily volume had been running at roughly 6 million shares per day the past three months.

Ford Motor (NYSE:F) $10.68 -4.38% was today's second-most actively traded stock on the big board, behind Lucent (NYSE:LU) $3.06 (unch), with 29 million shares traded. Late yesterday the automaker warned 2005 earnings would be lower than expected. 

Dow component General Motors (NYSE:GM) $34.82 -3.03% gave back $1.09 after a recent challenge of its 200-day SMA ($35.85). United Auto Workers President Ron Gettelfinger said the union is not yet persuaded by GM's argument that it must cut union members' health-care benefits to be competitive, and says the union wants time for a team of experts to study the automaker's costs.

U.S. Market Watch - 06/22/05


A spattering of green and red is found once again in the U.S. Market Watch. As hard as I stare at the QQQQ $37.81 -0.10% in recent weeks, this sometimes volatile index tracker has seen closes of $37.90, $37.87, $37.87, $37.85 and now $37.81 in the past 5 sessions.

I thought we would get some type of "resolution" break to the current sideways trade today, with some type of response after the weekly energy data. No go! And after yesterday's "doji" day, today's session saw an intra-day swing being equidistant and outside of yesterday's tight trade. 

The S&P Banks Index (BIX.X) 368.67 +0.01% looked as if it might be "the sector" to lead a meaningful break higher earlier this morning. But as the session wore on, and the hunger for bonds built, buyers faded in the banks. 

S&P Banks Index (BIX.X) - Daily Intervals


"Financials" comprise roughly 28% of the broader S&P 500 Index (SPX.X) 1,213.88 +0.02%, and just as the SPX has shown the ability to start to creep above the "right shoulder" of a head/shoulder top pattern, so have the more regional banks. Yes! Banks love a low interest rate environment (the FOMC sets interest rates), but with Treasury yields falling and the yield curve flattening, that will put some pressure on banks. I feel the banks really want to go higher, but buyers seem to lack the conviction for the push.

Now, I will stress the term BUYERS. I'm not just talking BULLS, but undoubtedly some BEARS that are short this group.

The above chart is shown with both MONTHLY (red) and WEEKLY (blue) pivot analysis retracement, where we would expect some formidable near-term institutional selling at the overlapping MONTHLY R1 and WEEKLY R1. Today's action wasn't a "test and smash of selling" either, as the BIX.X held above that correlative 370 area for about an hour. Usually, if sellers are just waiting for the chance to dump a sector on strength, the test of these institutional levels will find sellers rather quickly, when the computer programs that manage this basket of stocks gets turned on for selling. Note Monday morning's low found buyers immediately.

Here's a 30-minute interval chart of the BIX.X. Buggers have been strong, but just when it looks like buyers are really going to get aggressive....

S&P Banks Index (BIX.X) - 30-minute intervals


The WEEKLY Pivot analysis levels were derived from last week's high/low and close. I show a "bullish swing trade" in shares of Well Fargo (NYSE:WFC) $61.72 +0.35% as a like-stock, where after not seeing much follow through at a likely institutional level of resistance, I want to take a profit. True, its not a big profit, but it is what the market's gave me, or what I thought traders should take.

I also show some thoughts as to a range of emotions that market participants may be having. I have these emotions. I understand them. Sure looks like the banks are under accumulation, but buyers not overly aggressive. 

If we were to think that the lower YIELD in Treasuries is a signal of economic contractions, then banks will likely show weakness, even if the Fed does cut rates. Banks derive their income/earnings not only from the "spread" between rates and bond yields, which many loan originations will be tied, but they still need economic growth for loan DEMAND!

Today, the Mortgage Bankers Association released its Weekly Mortgage Applications Survey for the week ended June 17. The Market Composite Index, a measure of mortgage loan application volume was 786.8, a decrease of 11.3% from one week earlier (887.00). The Purchases Index fell by 9.4% to 479.4 from 529.3 the previous week, whereas the seasonally-adjusted Refinance Index decreased by 13.2% to 2575.0 from 2967.4 one week earlier.

Accordion to the association, the average contract rate for a 30-year fixed rate mortgage increased to 5.63% from 5.62% one week earlier, with points decreasing to 1.17 from 1.25.

So what's missing for another bullish leg higher in equities? How about cash? 

S&P 500 Index (SPX.X) - Daily Intervals


On a week-to-week basis, the SPX has seen gains, but they really came in two sessions. I won't chuckle out of bullish complacency, something "perma-bears" keep reminding bulls of.

What I do think trader/investors need to understand is this simplistic equation.

Treasury YIELD + Dollar + Oil = Equity prices/economy

What has taken place the past week to have the SPX looking "stalled out," but holding support of 1,211 despite a bears word of caution at his/her head and shoulder top they've so readily conceded?

Cash! The U.S. Dollar Index (dx00y) is relatively unchanged, but fractionally lower on a week-to-week basis. OK. In very simplistic supply/demand terms, some money has left the country.

However, it BONDS that have really seen the attraction of cash! 

If my simplistic equation is to show further bullishness for stocks, I think equity bulls NEED to see some money COME BACK OUT OF BONDS! It is NOT a negative sign than "junk bonds" as depicted by the Pacholder High Yield (PHF) $9.65 +0.52% is up 4.43% the past 5-days. Remember, this is the HIGHEST RISK asset class for fixed income. The trade in PHF tells us there is an APPETITE not only for YIELD, but RISK!!!!! 

Where there's an APPETITE for RISK, what comes next, when the appetite for YIELD is exhausted, is the APPETITE for GROWTH!

I make note that the Federal Open Market Committee will meet next week. Bond bulls are eating up Treasuries like there is no tomorrow. They may continue to do so into the FOMC meeting. 

Dow Transports (TRAN) - Daily Intervals


The TRAN and the SPX don't look "identical", but we can see where two-days of gains did find some participation from the TRAN. As an economically sensitive group, SPX bulls do like to see some "strength come from weakness." Bears hate it.

Let's look quickly at the NASDAQ Composite Index (COMPX) 2,092.03 +0.04% and a chart I put together in TUESDAY evening's Market Monitor. This chart doesn't have today's trade (h= 2,103 / l= 2083) but may well speak to the markets willingness to get aggressive at this point. 

NASDAQ Composite Index (COMPX) - Daily Intervals


Is the bullish move in the COMPX "way overdone" as some bear bloggers are saying? Not if we're looking at the NASDAQ Composite Bullish % ($BPCOMPQ) from www.stockcharts.com, which just started to show some meaningful addition of new point and figure buy signals.

I'll give the 2,100 level of horizontal resistance to the bear bloggers, just as they have conceded that level from 2,000. And while there's more banks/financial listed on the big board, as well as energy stocks, I find it very hard to believe that bears are resting comfortably at this point.

There may be some "freed up cash" from the bond market come Wednesday afternoon, Thursday morning of next week. I view a close above 2,100 as BULLISH!

For those traders that do follow moving averages, it is thought by many market technicians that when both the 21-day and 50-day SMA are ABOVE the longer-term 200-day SMA, it is a sign that near-term, intermediate-term and longer-term price action is in unison.

NASDAQ Composite Bullish % ($BPCOMPQ) - 2% box scale


The very broad NASDAQ Composite Bullish % ($BPCOMPQ) continues to show strengthening internals as more and more 4 and 5-lettered stocks generate reversing higher point and figure buy signals. I've benchmarked some inflection price levels. 

If bears (sellers) flinch above 2,100 and bulls (buyers) start showing some conviction, we should really start to witness a quick and rapid building of buy signals.

 
 




New Plays

New Option Plays

Call Options Plays
Put Options Plays
IBM None

New Calls

Intl Bus. Mach. - IBM - cls: 77.23 chg: +0.82 stop: 74.99

Company Description:
IBM is the world's largest information technology company, with 80 years of leadership in helping businesses innovate. Drawing on resources from across IBM and key IBM Business Partners, IBM offers a wide range of services, solutions and technologies that enable customers, large and small, to take full advantage of the new era of e-business. (source: company press release)

Why We Like It:
The market appears to be stuck in a new trading range. Yet even though the major averages aren't moving much the bias still appears to be bullish. If the DJIA and S&P 500 can breakout to new relative highs we believe they will drag shares of IBM with them. IBM has been consolidating under resistance at the $78.00 level for two months and appears to be coiling for a breakout. If IBM can breakout over the $78.00 level it will produce a new buy signal on its Point & Figure chart. We are suggesting that readers use a trigger over resistance at $78.00. Our suggested entry point will be $78.25. Once triggered the next obstacle will be round-number and bottom-of-the-gap resistance near $80.00. Our target is the top of the gap near $83.50. One of the biggest risks we see with this play is the time frame. We do not want to hold over IBM's earnings report and that only gives us about three weeks. 

Suggested Options:
While we plan to exit ahead of IBM's July earnings we still feel more comfortable suggesting the August calls.

BUY CALL AUG 75.00 IBM-HO OI= 345 current ask $3.70
BUY CALL AUG 80.00 IBM-HP OI=1491 current ask $1.10

Picked on June xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 07/14/05 (unconfirmed)
Average Daily Volume = 7.4 million 

New Puts

None today.


Play Updates

In Play Updates and Reviews

Call Updates

AmerisourceBergen - ABC - close: 67.35 change: -0.52 stop: 63.85

ABC is still pulling back as we expected. We are watching for a bounce now near $66.50 or at its 10-dma near 66.80.

Picked on June 13 at $ 65.57
Change since picked: + 1.78
Earnings Date 07/21/05 (unconfirmed)
Average Daily Volume = 1.3 million 

---

Ashland Inc - ASH - close: 70.49 chg: +1.15 stop: 66.99

ASH is showing some relative strength today with a 1.65 percent rebound from its dip yesterday to the $69.00 level. Volume was above average on today's gain. If you missed the entry point yesterday this still looks like a good spot today. Our target is the $74.75-75.25 range but we do not plan on holding over ASH's July earnings report.

Picked on June 16 at $ 70.05
Change since picked: + 0.44
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 1.1 million 

---

Chubb Corp - CB - close: 85.25 change: -0.80 stop: 82.49

CB isn't moving very fast. The churning up and down does have an upward bias. Our target remains the $89.50-90.00 range. 

Picked on June 10 at $ 85.05 
Change since picked: + 0.20
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 1.2 million 

---

Rockwell Collins - COL - close: 48.36 chg: +0.44 stop: 44.95

Hmm... we're starting to wonder if COL is building support near $47.50 and its 50-dma. We're still waiting for a dip toward the 100-dma before opening the play but more aggressive traders might want to consider positions on a move over $48.75. 

Picked on May xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 07/26/05 (unconfirmed)
Average Daily Volume = 800 thousand 

---

Cummins Inc - CMI - close: 74.88 change: -0.13 stop: 70.95

No change from our previous update. Our target is the $77.50-80.00 range.

Picked on June 19 at $ 74.03
Change since picked: + 0.85
Earnings Date 07/21/05 (unconfirmed)
Average Daily Volume = 970 thousand 

---

Eagle Materials - EXP - close: 93.40 chg: +0.17 stop: 89.49 

It was a relatively volatile day for EXP with the stock hitting a high of $94.35 and a low of 92.62. It looks like EXP had begun to bounce higher from its 10-dma late Wednesday afternoon. 

Picked on June 09 at $ 90.45
Change since picked: + 3.25
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 134 thousand 

---

Fording Candn Coal - FDG - cls: 93.27 chg: +2.27 stop: 87.49 *new*

Trading on FDG was temporarily halted this afternoon for news pending. The company announced that it was declaring a cash dividend or in FDG's language a second quarter cash distribution of $2.80 per "unit". When trading resumed the stock continued to climb and by the end of the day it had added 2.49 percent on volume well above the average. Our target is the $97-100 range. We are raising the stop loss to $87.49. 

Picked on June 19 at $ 90.30
Change since picked: + 2.97
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 384 thousand 

---

St Joe Co - JOE - close: 81.40 change: -0.64 stop: 79.45

JOE did produce a dip toward the $80.50 level near its 10-dma and we would use it as a new bullish entry point. It is true that technical indicators are overbought and look vulnerable but that's why we're using a relatively tight stop loss. 

Picked on June 20 at $ 82.56
Change since picked: - 1.16
Earnings Date 07/20/05 (unconfirmed)
Average Daily Volume = 507 thousand 

---

Netease.com - NTES - close: 61.05 chg: +1.35 stop: 55.95 *new*

Wednesday proved to be another bullish session for NTES. The stock added 2.2 percent on above average volume and broke through the $61.00 level. More conservative traders may want to seriously consider exiting here for a profit. Our target is the $62.00-63.00 range. We are raising the stop loss to $55.95. 

Picked on June 13 at $ 57.29
Change since picked: + 3.76
Earnings Date 07/26/05 (unconfirmed)
Average Daily Volume = 752 thousand 

---

SLM Corp - SLM - close: 50.95 change: -0.11 stop: 48.95

No change from our previous update.

Picked on June 20 at $ 50.92
Change since picked: + 0.03
Earnings Date 07/14/05 (unconfirmed)
Average Daily Volume = 1.8 million 

---

United Technologies - UTX - cls: 52.96 chg: +0.06 stop: 51.80 

No change from our weekend update. If we don't see a move past $53.50 in the next couple of sessions we may close this play early.

Picked on May 23 at $ 53.12
Change since picked: - 0.16
Earnings Date 07/20/05 (unconfirmed)
Average Daily Volume = 4.0 million 

---

Wellpoint Inc - WLP - close: 69.98 chg: +0.25 stop: 65.90 

No change from our weekend update. WLP just keeps on creeping higher and hit a new high today at $70.69. Our target is the $74.00-75.00 range.

Picked on June 05 at $ 68.40
Change since picked: + 1.58 
Earnings Date 07/27/05 (unconfirmed)
Average Daily Volume = 3.5 million 

Put Updates

Quality Systems - QSII - cls: 46.37 chg: +0.43 stop: 50.01 

No change from our previous update on 06/21/05.

Picked on June 15 at $ 47.75
Change since picked: - 1.40
Earnings Date 06/13/05 (confirmed)
Average Daily Volume = 330 thousand 

---

Semiconductor Holders - SMH - cls: 34.74 chg: +0.24 stop: 35.05

No change from our weekend update. We are not suggesting bearish positions until the SMH trades back under the $34.00 level. 

Picked on June 15 at $ 33.95
Change since picked: + 0.79
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 26.3 million

Dropped Calls

None

Dropped Puts

None


Trader's Corner

Moving Average Envelopes 

This Trader's Corner article is a continuation of what I wrote a week ago in this space, when I discussed Bollinger Bands, and how they differed from Moving Average Percent Envelopes (MAPE), which are commonly called simply Moving Average Envelopes; sometimes, just 'envelopes' or moving average 'bands'. 

I'll recap just a bit on Bollinger Bands. My prior article, in its entirety, can be seen on 6/15 OI Newsletter by clicking here

BOLLINGER BANDS  
Bollinger Bands consist of a set of three 'bands' drawn in relation to an index, stock or any financial instrument. The middle band is a 20-day simple moving average, that is not usually shown, but serves as the base for the upper and lower Bollinger Bands (BB). 

The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data used for the average. The default parameter is 20 periods and 2 standard deviations.

"Standard deviation" describes how prices are arrayed around an "average" value. One standard deviation is a set of values that contains close to 70% of the price fluctuations that occur above and below the moving average used in the Bollinger band 
calculation. 95% of the fluctuations will occur within two standard deviations of the moving average in question. 

The purpose of the BB Indicator is not that different from the "moving average envelope" indicator: are prices 'high' or 'low' on a relative basis? 

With the BB indicator, the two bands (calling these lines "bands" helps distinguish them from the fixed percentage "envelope" technique) are placed above and below the centered, unseen moving average. The average is usually, but not always, set to a 'default' setting of 20 by the charting software. If not, you can change to a length setting of 20. 

John Bollinger indicates that he considers it a key factor to be what can be derived from "BandWidth"; from BandWidth, can be derived something he calls "The Squeeze": a volatility-based trading opportunity. 

When the distance between the bands substantially narrows in from a usual pattern with a stock or index, it may be time to look next closely for signs of a break out move, above or below any recent narrow trading range. 

Good examples of such "squeeze" opportunities or narrowing in of the bands are seen in the S&P 100 (OEX) chart below. The squeeze in the Bolli Bands outlined by the two instances below, where the narrowness shown by parallel horizontal (cyan) lines, highlight a reduced volatility and are followed by a sharp expansion of the bands, may be characteristic of some major tops:

At the two significant bottoms shown in the OEX daily chart above, as outlined by the two blue circles, volatility was high and the Bolli Bands had expanded to a greater than usual degree. 

Maybe this is something to look for at major bottoms; however, it can't be said to be always true, as can be seen in the next chart (lower, far left), which takes us back to the 2003 bottom in OEX:

Of course, this is all relative, as the narrowing squeeze in the BB in early '03 was nothing like witnessed in the more reduced volatility seen at the two tops seen in 2004. However, relative to what had come before, they were significantly narrow. 

Which brings me to the point I always make about INDICATORS: they are not usually best used, or cannot usually be used, as 'mechanical' signals. 

As part of trading systems, yes; such systems may have indicator-based entry defined in certain ways, with entry rules refined by back-testing, etc. However, in trading decisions based on experience and study of various technical and fundamental aspects of the trend, indicators provide helpful clues sometimes; but not always and not always in the same way. 

MOVING AVERAGE PERCENT ENVELOPES (MAPE)  

I'll refer initially to Moving Average Envelopes as Moving Average PERCENT Envelopes, to reinforce the idea that these bands or envelope lines are set to equal a fixed percentage above and below the changing (each day's) moving average; e.g., lines that are set to equal 3 percent above and below the moving average. 

There is not a set "default" for the Moving Average. Usually, but not always, the percentage above AND below is the SAME. In some software applications, the upper and lower line MUST be the same since the application allows only ONE input. 

The moving average (percent) envelope indicator has 3 component lines, as does Bollinger Bands (BB); however, the moving average above and below which the BB lines are traced, is not shown. It is shown in the MAPE. 

In the moving average envelopes Indicator you can at most, set 
the following different inputs or vary the: 
1. The type of moving average; e.g., simple, exponential, etc.
2. Length of the moving average; e.g., the number of trading 
periods - averaging 10, 20 or 30 days; or, hours, etc. 
3. Percentage figure above the moving average in question. 
4. Percent figure below the moving average.

Not being able to set different moving averages (above and below) is a minor limitation for trading the indices. In an index uptrend, the moving average percentage will tend to increase 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., 3.5% versus 3%, or 2.5 versus 2 percent. 

Most of the time, a simple moving average (SMA) is used, 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 I mostly use on Daily charts only. The regular 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 90-95 percent of the time in a range that is 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, as in today's S&P 100 (OEX) chart below on which is applied the moving average envelope indicator using upper and lower envelopes lines of 1.5% and 2%, respectively.

A number of down (red) arrows, indicating precise or approximate areas of resistance, are applied at different points by way of illustration of where the upper envelope line OR the moving average acted as resistance, even if this was temporary. 

Conversely, the up (green) arrows, indicating precise or approximate areas of support, are applied at different points by way of illustration of where the lower envelope line OR the moving average acted as support, even if that was temporary. 

There are some instances where the upper or lower envelope line also intersected an existing, or the start of, a trendline; e.g., such as those defining a price 'channel'. There are also instances where a touch to the upper or lower envelope line also coincided with, or were in vicinity of, extremes in OTHER key indicators. The convergence of indicator extremes can be a definitive sign of a possible intermediate top or bottom. 

Often it is the second touch to the upper or lower envelope line that marks a 'final' top or bottom for that move. So, for example in the chart above, another push in the OEX up the 580, or higher (e.g., 585) area, might mark a 'final' top for this current uptrend. 

In a volatile market, the S&P envelope line can expand to 4% 
or more, but it won't typically be more than this; in a less volatile market trend, the envelope range might be 1.5 2.5 percent, as it is currently. 

With the Nasdaq, this percentage range will be 4 to as 5-6 percent or more; I typically start with a 4 percent envelope in the Nasdaq indices and see if MOST of the trading is occurring within an envelope line of that percentage. The percent line we are looking for is the one that will contain within it most of the daily highs and lows that occur WITHIN the past 6-12 months. 

You note, as in the daily chart of the Nasdaq 100 (NDX) chart below, a tendency for prices to go up "hugging" the upper envelope line. There is less of tendency with tops, for the first 'touch' to the upper envelope line to mark a 'final' top. 

The final NDX bottom was also the second touch, but prices did not 'hug' the line. There was an attempt to rally, followed by a sideways trend, then a couple of drops, one sharp, then a final 'touch' to the lower envelope line. This was 'the' bottom were looking for to cover puts and buy NDX calls. 

I usually use 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.

In an uptrend I often 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 will typically bottom at a greater distance BELOW the center moving average. There is not typically a huge gap between the upper envelope percent and the lower envelope line percentage; e.g., a half percent, more rarely, especially in Nasdaq, a full percent such as from a prior period in NDX below:

In an uptrend, a high probability trade is to buy dips (e.g., buy Index 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, at least one that has been "containing" the rallies that have occurred in the past 6-9-12 months. 

After about 6 weeks of an uptrend or downtrend that has been closely hugging the upper/lower envelope lines, the odds increasingly favor a correction and can be favorable to a bet on at least a sideways trend ahead which suggesting selling option premium; e.g., shorting calls or puts. 

As I mentioned already, often in recent years in the Nasdaq 100 (NDX) Index one of the most volatile of the major indices, my current settings for the two envelope lines may be as much as a percent difference; e.g., 4% for the upper band, especially in an uptrend and 3% for the lower envelope line. However, currently, as can be seen in the current NDX chart (one chart back from the above one), both envelope lines are at 4%. 

In a prolonged or dominant uptrend, 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. In a prolonged downtrend, there will 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 envelope
line. 

SEVEN TRADING RULES OF MOVING AVERAGE ENVELOPES: 

1. Determination of what moving average to use somewhat arbitrary but is found by what 'works' for the past 6-9-12 months to contain within the lines most of the highs and lows. The 
variation is with the percentages above and below this line. I don't vary the 21-day moving average length for the stock indices. You can experiment yourself with different lengths.

2. A common starting point for the Index envelope size is 3% with the Dow and S&P and 4-5% in 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 for the past 6-12 months. 

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 opportunity. 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. 

7. 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, it often marks a very good trading opportunity. And, we don't need more than a few of these to make for a profitable year trading options. 

Good Trading Success! 

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. 

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

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