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Daily Newsletter, Monday, 06/27/2005

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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

The Day After

The Day After

$60+ oil and negative equities dominated the headlines this morning. While crude oil closed positive at a record high and the equity indices finished negative, there was surprisingly little drama in the markets. Volume was light and the range no wider than usual as the markets attempted to consolidate in the wake of last week's decline.

Volume breadth was negative 1.33:1 on the NYSE and 2.01:1 on the Nasdaq as of the cash close. Volatility rose for all indices except the OEX, with the VXO (the old VIX) finishing lower by .27 at 11.5. 

Daily Dow Chart


The Dow declined 7.06 to finish at 10290.78, bouncing from a low of 10253. The close came within the middle of the daily range, resulting in a doji star at the bottom of last week's sharp drop. If the break was indeed a bear wedge failure, then the implied target would be in the 10100 area. The break confirmed a bearish stochastic divergence, with the 10-day stochastic rolling over from a lower high against the higher price high. That signal reversed the daily cycle upphase that had launched the previous week, closing the door on a bull trap. The daily cycle should remain in a downphase below 10430. 1st resistance is at 10360, a break above which would be the first sign of trouble for bears. 

Note that today's candle printed almost entirely below the lower 20-day Bollinger support at 10328. A Bollinger violation is usually reversed quickly in all but the strongest trending moves, and so we can expect a corrective bounce or sideways drift from here. A failure to hold today's range tomorrow would be the less likely outcome, and would be a very bearish development.

Daily S&P 500 Chart


The SPX lost less than one point, also printing a doji at the bottom of Friday's drop. The oscillator signals are similar to those on the Dow, but the drop less dramatic, with the lower Bollinger band not even touched. Below 1196, this remains a bearish chart in the heels of last week's bull trap closure, and the implied bear wedge target is in the 1150 area. Bears will be looking for a break of 1184 support, below today's 1188 low, for acceleration of the new daily downphase.

Daily Nasdaq Chart


The Nasdaq lost 8.07 to close at 2045, just above confluence support at the 50 day EMA. The bearish divergence noted above is steepest here, and a drop below 2040 support should see a quick trip to stronger support at 2020-2025. 2055-2060 is confluence immediately overhead, below which the bears control the daily cycle.

Chart of QQQQ with $QQV overlay


Last Monday's high wasn't "the" QQQQ high for the week, but it came close, as did the low in the NDX volatility index (QQV), which got down to near 12.25, a record low for the young index. On this chart, the QQQQ price candles are overlaid with the QQV in blue. As discussed in last week's Market Wrap, it appears as if the indicator was giving us a heads-up for the QQQQ decline that kicked off on Thursday.

Daily TNX Chart


The Treasury auctioned $30 billion in debt today, comprised of $16 billion in 13-week Bills and $14 billion in 26-week Bills. The 13 week auction had a high-rate of 2.965%, in line with this month's 3 previous auctions, and bid-to-cover ratio of 2.27, the highest since the April 25th auction. The 26-week bills set a high-rate of 3.175, the highest this year, and a bid-to-cover ratio of 2.1, the lowest since the May 31 auction. Indirect bidders (foreign central banks) took $8.5 billion of the $30 billion total.

Ten year treasuries traded in light positive territory all day, the ten year note yield (TNX) finishing lower by 1.2 bps at 3.902%. On the daily chart, we see support at 3.88% in play at current levels, below which next support is down at 3.80%.

Daily Chart of Crude oil


Crude oil made the top headlines today as traders awoke to find the front-month August crude contract bidding above 60.50, trading a high of 60.64 in the early morning. This represented only a minor rise from last week's levels, but the round-number attracted mainstream attention. OPEC's comments in recent weeks about high prices being the result of a lack of refining capacity remain as puzzling as the day they were uttered, as crude prices continue their climb. Reuters referred to the 500,000 bpd output increases as "symbolic," and the market clearly agreed as prices rose despite Sheikh Ahmad al-Fahd al-Sabah's weekend statement to the effect that OPEC is considering another such increase.

While the 6-month daily chart shows backing and filling to higher highs, the 3-year weekly chart is less ambiguous, with prices nearly tripling during that time. While demand continues to increase, it has not tripled. Nor has "refining capacity" been reduced threefold. Incidentally, I continue to be unable to understand how a lack of refining capacity would cause the price of crude oil to rise. If anything, one would expct a lack of refining capacity to cause demand for crude to fall, as the barrels sit idle awaiting processing.

Weekly Chart of Crude oil


In any event, aside from purely technical factors, I believe it noteworthy that the media aren't correlating recent comments from Chairman Greenspan and Secretary Snow concerning the effects of China's currency peg. As Snow put it last week, "China's rigid currency regime has become highly distortionary. We know that it poses risks to the health of the Chinese economy, such as sowing the seeds for excess liquidity creation, asset price inflation, large speculative capital flows, and over-investment." 

Greenspan stated that, "Rapid accumulation of foreign, largely dollar, reserve holdings by the People's Bank of China, China's central bank, as a consequence of support for the RMB could boost the growth of the money stock, with the accompanying risk of triggering upward pressure on inflation and a general overheating of the Chinese economy. The Chinese central bank's issuance of liquidity management bonds to lessen potential increases in the money supply created by foreign asset accumulation has accelerated since regular issuance began in April 2003. Nonetheless, only about one-half of the increase in reserves over the past two years has been offset, with the remainder showing through as money growth." It's worth considering that if the Fed wasn't printing new dollars, the Bank of China wouldn't be printing new RMB to absorb them.

My point here is that while demand for oil is probably not even capable of tripling in a three year period absent some kind of worldwide catastrophe, the supply of dollars or other foreign currencies is. If you were the owner of 30 million barrels of crude oil (per day, in the case of OPEC), and your largest customers were paying you with printed paper (or account credits) that could be and were being created by them at will, perhaps you too might demand more of that paper or those credits in return.


On the weekly chart, there are potential bearish divergences shaping up in the Macd and stochastic oscillators. While price remains in a strong uptrend, traders who are long will want to keep stops close to protect profits in the event of a weekly downturn. The daily cycle indicators are also looking toppy, but until price turns, both charts remain clearly bullish and the daily cycle appears to be trending. The first sign of trouble for bulls will be a break below rising support at 59, with next confluence at 57.70-58.00. For the day, August crude oil closed at a record high, +.775 at 60.575, off a high of 60.95 and a low of 59.875.

In corporate news, Nike (NKE) announced fiscal Q4 earnings that rose 15% from $305 million or $1.13 per share to $349 million or $1.30 per share on revenue of $3.72 billion, up 7% from last year's Q4. Estimates were for EPS of $1.27 per share and revenue of $3.69 billion. The company attributed the gains to strong demand across all regions and cited the weak dollar for a boost in overseas sales. NKE lost 4.01% to close at 85.77.

Walgreen (WAG) reported fiscal Q3 earnings that rose from $342.3 million or 33 cents per share to $411 million or 40 cents on sales that rose 13.1% to $10.83 billion. Estimates were for 38 cents EPS on sales of $10.88 billion. Same-store sales grew 8.7%, and the company cited a longer flu season for an increase of 8.8% in prescriptions filled. WAG finished higher by 3.31% at 45.85.

Creative Technologies (CREAF) reduced its expected Q4 sales forecast to $300 million from earlier projections of $330-$360 million. The company, which makes audio cards, speakers and portable mp3 players, expects gross margins to come in below 20%, down from earlier forecasts of 24%. The company blamed softer than expected demand for mp3 players. AAPL got pulled down in the undertoe from this announcement, recovering later in the morning but fading back to a lower low in the afternoon. CREAF got smoked for 10.51% loss, while AAPL lost 1.65% to close at 37.10.

After the bell, Paychex (PAYX) announced fiscal Q4 earnings that rose 65% from $61.4 million or 16 cents in last year's Q4 to 27 cents or $101.5 million on revenue that rose from $330.4 million to $379 million. PAYX was up 2.93% in afterhours trading to 30.90 after closing at 30.02.

Although there were no economic reports released today, it's scheduled to be a heavy week. Tomorrow we get Consumer Confidence at 10AM, then on Wednesday the GDP report. On Thursday, it's Initial Claims, Personal Income and Personal Spending, Chicago PMI and the Help-Wanted Index, as well as the FOMC policy announcement. On Friday we'll get Michigan Sentiment, Construction Spending and the ISM Index. Note that the FOMC policy meetings usually commence on Tuesday and finish on Wednesday, but the current meeting only commences on Wednesday, no doubt due to scheduling conflicts.

For tomorrow, the question is whether the indices will continue lower or bounce. The very light volume today was all the more dramatic in the wake of Friday's big numbers. Some speculated that the markets are waiting for the FOMC's policy announcement- an unpleasant prospect, given that it comes on Thursday afternoon. Despite the higher highs in oil, equities did not decline dramatically. This is less surprising in light of the fact that the intraday cycles were bottomy and due for a corrective bounce. The greater surprise was that the bounce was so weak, and in fact non-existent on the Nasdaq. It appeared as if traders were watching so closely for bounces to sell that none could even get started.

While the put to call ratios indicate plenty of put volume and, presumably, bearish index speculation, price remains the primary indicator. The daily cycle upphases whipsawed, confirming the bearish price action, and volatility rose again today. Friday's decline had huge volume, well above the thin days we endured week after week in the upper range. To sum up a confusing picture, the markets are primed for a corrective bounce within a broader (daily cycle) downphase, with the possibility of choppy, narrow action ahead of the FOMC announcement. Below the resistance levels discussed above, the benefit of the doubt goes to the bears except in the shorter and intraday timeframes. 

 
 




New Plays

New Option Plays

Call Options Plays
Put Options Plays
RTP None

New Calls

Rio Tinto - RTP - close: 123.33 chg: +1.33 stop: 119.99

Company Description:
Rio Tinto is a world leader in finding, mining and processing the earth's mineral resources. The Group's worldwide operations supply essential minerals and metals that help to meet global needs and contribute to improvements in living standards. (source: company website)

Why We Like It:
Now that crude oil is soaring to $60.00 a barrel there is going to be increased interest in alternative forms of energy. One alternative could be nuclear energy. RTP is a mining company that seems to come up rather quickly when discussing who would benefit from any sort of build out of nuclear energy plants in the U.S. It is true that even if the government were to green light a new nuclear plant today it would take years to build so we're not talking about any short-term boost for RTP's revenues. What we are talking about is the bounce in today's share price. RTP broke out from a bearish trend of lower highs a couple of weeks ago. Since then the rally has failed at the $130.00 level but now it appears that traders are buying the dip near its six-week trendline of support (see chart). We would consider this a more aggressive, higher-risk play but we're willing to speculate that RTP could rally back towards the $130.00 level. We'll suggest positions at current levels. More conservative traders may want to wait for confirmation of today's bounce with a move over $124.00 or $124.50. 

Suggested Options:
We are suggesting the August calls. Option volume and open interest is very low. Place your trade carefully.

BUY CALL AUG 120.00 RTP-HD OI= 0 current ask $7.20
BUY CALL AUG 125.00 RTP-HE OI= 0 current ask $4.20
BUY CALL AUG 130.00 RTP-HF OI=10 current ask $2.25

Picked on June 27 at $123.33
Change since picked: + 0.00
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 160 thousand 

New Puts

None today.


Play Updates

In Play Updates and Reviews

Call Updates

AmerisourceBergen - ABC - close: 66.81 change: -0.24 stop: 63.85

As we expected ABC dipped toward the $66.00 level and managed a bounce from there. Volume came in above average today. This might be a new bullish entry point but ABC needs to break the short-term four-day trend of lower highs. Our target is the $69.50-70.00 range. 

Picked on June 13 at $ 65.57
Change since picked: + 1.24
Earnings Date 07/21/05 (unconfirmed)
Average Daily Volume = 1.3 million 

---

Ashland Inc - ASH - close: 70.20 chg: -0.25 stop: 66.99

No change from our weekend update.

Picked on June 16 at $ 70.05
Change since picked: + 0.15
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 1.1 million 

---

Chubb Corp - CB - close: 86.18 change: +1.48 stop: 82.49

Relative strength continues for shares of CB today. The stock added 1.74 percent to close near its recent highs. We see no changes from our previous update.

Picked on June 10 at $ 85.05 
Change since picked: + 1.13
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 1.2 million 

---

Rockwell Collins - COL - close: 47.38 chg: +0.10 stop: 44.95

Ding! COL dipped to exactly $46.75 today and hit the top edge of our suggested entry point to buy calls so the play is now open. While we are bullish on the stock and believe that this dip to its simple 100-dma is a new entry point we suggest that more conservative traders may want to wait for signs of a bounce first. A move over $48.00 or $48.50 might be sufficient. Our initial target was resistance at the $50.00 level but now we're adjusting our target to the $52.50 region (52.25-52.50). The P&F chart points to a $69 target. Remember, we do not plan on holding over COL's earnings report in late July. 

Picked on June 27 at $ 46.75
Change since picked: + 0.63
Earnings Date 07/26/05 (unconfirmed)
Average Daily Volume = 800 thousand 

---

Cummins Inc - CMI - close: 73.21 change: +0.91 stop: 70.95

CMI produced a decent bounce today from the $72.00 level and shares are challenging the 200-dma again. Our weekend update suggested waiting for a move over the 200-dma or the $74.00 level before considering new bullish positions. More aggressive traders may want to buy today's gain over the $73.00 level. 

Picked on June 19 at $ 74.03
Change since picked: - 0.82
Earnings Date 07/21/05 (unconfirmed)
Average Daily Volume = 970 thousand 

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Fording Candn Coal - FDG - cls: 94.40 chg: +0.57 stop: 87.49 

No change from our weekend update. More conservative traders may want to consider taking some profits here. 

Picked on June 19 at $ 90.30
Change since picked: + 4.10
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 384 thousand 

---

Goldman Sachs - GS - close: 103.20 chg: -0.47 stop: 101.89

No change from our weekend update. We are waiting for a breakout over the $104.00 level. Our suggested entry point to buy calls is $104.35. 

Picked on June xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 06/16/05 (confirmed)
Average Daily Volume = 4.8 million 

---

Netease.com - NTES - close: 56.67 chg: -1.78 stop: 55.95 

Uh-oh! Today's three percent decline in NTES could spell trouble. The stock's drop below the $58 level and its simple 10-dma suggests the short-term rising channel has been broken. A pull back to the $55.00 level or even $54.00 may be in order here. We're not suggesting new bullish positions and more conservative traders may want to exit early here to avoid further losses. 

Picked on June 13 at $ 57.29
Change since picked: - 0.62
Earnings Date 07/26/05 (unconfirmed)
Average Daily Volume = 752 thousand 

---

SLM Corp - SLM - close: 49.65 change: -1.23 stop: 48.95

Hmm...we can't see any specific event to account for SLM's relative weakness today and its 2.4 percent decline. It's possible that investors reacted negatively to news that Federal student loans rates are going to rise this coming Friday. It is noteworthy that the selling stalled at previous resistance near $49.50. Readers can use a bounce back over the $50.00 level as a new bullish entry point. 

Picked on June 20 at $ 50.92
Change since picked: - 1.27
Earnings Date 07/14/05 (unconfirmed)
Average Daily Volume = 1.8 million 

---

Wellpoint Inc - WLP - close: 67.57 chg: -0.62 stop: 65.90 

Negative earnings news from the likes of Cardinal health (CAH) may have weighed on WLP today. The stock broke down under the $68.00 level and could be headed toward support near $66.00. We would not suggest new bullish positions at this time.

Picked on June 05 at $ 68.40
Change since picked: - 0.83 
Earnings Date 07/27/05 (unconfirmed)
Average Daily Volume = 3.5 million 

Put Updates

Ambac Fincl. - ABK - close: 69.32 chg: -0.30 stop: 71.51

No change from our weekend update.

Picked on June 26 at $ 69.62
Change since picked: - 0.30
Earnings Date 07/20/05 (unconfirmed)
Average Daily Volume = 992 thousand 

---

ESCO Tech. - ESE - close: 99.97 chg: +2.17 stop: 102.51

Our new aggressive bearish play in ESE is showing why we labeled it higher-risk. The stock produced an oversold bounce back toward the $100 level today. If ESE breaks out over the 100 level (or 100.50 or 101.00 depending on your risk profile) then traders may want to exit early. 

Picked on June 26 at $ 97.80
Change since picked: + 2.17
Earnings Date 08/10/05 (unconfirmed)
Average Daily Volume = 102 thousand 

Dropped Calls

None

Dropped Puts

Quality Systems - QSII - cls: 48.43 chg: +3.54 stop: 48.01 

Looks like the bears panicked today after an analyst upgraded shares of QSII to an "above average". Volume was pretty heavy on the spike and the stock pushed back above the 10-dma and its 100-dma. We were stopped out at $48.01. 

Picked on June 15 at $ 47.75
Change since picked: + 0.68
Earnings Date 06/13/05 (confirmed)
Average Daily Volume = 330 thousand 


Options 101

Shorting Against the Box and the Put Write

If you have ever short sold, or better yet, shorted-against-the-box. Lets examine how interesting it gets when you write puts in conjunction with this unique short position.

The Theory behind the Practice

This strategy actually works best when you have a stock where you would like to lock in the gains because you feel its going to go lower in the short term, but you don't want to sell the stock outright. Traditionally, when a trader or investor had a stock that he had a nice profit in, but doesn't want sell it at the current price, because he believes it was going to go possibly higher, but in the mean time is anticipating the stock either going nowhere or going down. An individual in this position, usually would short the same amount of shares that he held in his Long or Margin account. This process is called shorting-against the-box. The position ultimately would look like this. Let's pretend it is now around late November and we own the hypothetical stock HGF at a price of 85, which we purchased a while back at 72. We believe that this stock could see higher prices down the road, but we see a potential market correction regarding this stock. We really would like to lock in the 13 point profit that we have in the stock presently, however we do not want to take the gain right now. We want to defer this gain until 2006. So as I mentioned , we would short against the box. To illustrate the position, this is what our hypothetical account would look like shorting 500 shares of HGF against the box.

Figure 1: Long/Margin Account with 500 shares of HGF and Short Account, short 500 shares of HGF against the box.

This transaction of shorting against the box locks in your price of $85 a share until you close out the short against the box by buying back the shares.

What makes the short against the box so interesting is if the stock goes up to let's say 90, then the long stock gains $5 a share, while the Short that we have against the box loses the same $5 a share. (See figure 2 below). So whether the stock goes up or down the account value stays the same. This is the intent of the short against the box, to lock up gains until a future date and in this case until after January the 1st.
Figure 2: Stock goes up to 90. No impact on the total account value since the short account goes $5 against you to offset the $5 gain in the Long or Margin account.

Figure 3: If the stock drops to $80, we lose $5 in our long account, but that loss is offset by the $5 gain in the short account. Once again a wash.

Now let's see what happens if we where to Sell 5 Jan 75 Puts at $200 each.
The reason we are selling the January 75 puts are two fold. First, we receive a premium of $1000 (5 X $200), which goes immediately into our account. Secondly, we sold a Jan 75 Put because that is about the low price we would like to cover our short against the box. (See figure 4 below)

Figure 4: 500 Long HGF, 500 Short against the Box HGF and 5 short HGF Jan 75 puts for a credit of $1000.

Now when we sell the puts something interesting happens. First and obvious we receive the $1000 premium, but also if the stock drops anywhere below 75 after the January expiration, 500 shares of HGF will get put to us at 75, which will COVER our short position and net us out at $85. (Remember we lost $10 a share from our $85 price in the long account, but we offset that loss with the $10 gain from our short account, however because we sold the put options we also keep an addition $1000 premium. On the other hand, no matter what the stock does we net the $1000 premium advantage. (E.g. if the stock goes to 90 or 100, every dollar that the short account goes against us is offset by the long account plus we still get the $1000 in put premiums.

Now I don't want to hear anyone say," But we lost the upside potential of the stock. Remember an earlier article where I mentioned the INTENT of the trade. Always remember what you set out to do and if that is what you were able to achieve. Don't change the analogy of the trade with hindsight. So in adhering to our intent for this trade, we make an additional $1000 by selling the puts, where as we would have made nothing extra except locking in our price of $85 by just shorting against the box. 

NOTE: The naked puts are actually covered since the stock if it is ever put to us; covers our stock position that we would eventually have to buy back anyway.

The Real World Example: Actual Date May 12, 2005 MSTR 50.67

Figure 1: MSTR CHART - PRICE 50.67

Figure A: 500 Long MSTR and 500 MSTR short against the box. Just like in our hypothetical we lock in $50.67.

Figure B: It trade as above, except we sell the addition 5 MSTR September puts

Just like in our hypothetical example, The Microstrategy Inc stock still nets us the extra $1100 in put premiums and no matter where it ends up at the September expiration, we get the extra cash and lock in the $50.67 price.

The Bottom Line: 

The key concept to remember here is, when just adding a slight variation can augment the rewards of doing a strategy where the risks are almost identical. The investor has to take an edge like that every time. Can you imagine how much money could have been made additionally had a put write been utilize on every stock in a portfolio that had a short-against-the-box position. No reason to even wonder. It would just drive you crazy.

Until Next Time

Today's Newsletter Notes: Market Wrap by Jonathan Levinson, Trader's Corner by Steven Gail, and all other plays and content by the Option Investor staff.

DISCLAIMER

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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