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Daily Newsletter, Monday, 07/18/2005

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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

Post Op-Ex Whimper

Post Op-Ex Whimper

Those who shorted today's dull market were sentenced not to losses but to boredom, as an extremely light volume session held a narrow, actionless range almost for the duration. Prices drifted lower into the close, with the Dow leading its peers to the downside. Volatility ticked up from the fresh multiyear lows on Friday, but fell back as the quiet session wore on, the VXO finishing at 10.07 after touching 10.01 at the low.

It wasn't just a quiet session for equities, as bonds and oil futures traded narrow ranges for most of the session as well, both finishing lower. In the case of treasuries, bonds finished at their session lows in an afternoon selloff. Other than that, the summer doldrums weighed heavily on price action and traders' eyelids.


Volume was extremely light, with combined Nasdaq and NYSE volume barely surpassing 2.5 billion shares and QQQQ falling 10 million shares shy of Friday's light volume. Volume breadth was negative all day long, but only mildly so, but it finished at its worst levels, with declining volume leading 1.98:1 on the NYSE and 1.85:1 on the Nasdaq.

Daily Dow Chart


The Dow lost 65.84 points to close at its low of 10574.99. This was the first down day since last Tuesday, which was itself only fractionally negative. Bears would have liked to have seen more significant range and volume to market the biggest down day since the daily cycle upphase began, but it was not to be. Still, the move broke the (very) steeply rising support line off the July low and took out Friday's low. I'm very dubious of my interpretation of this sharp upphase as a bear wedge, mostly because of the poor trendline fit and the shortage of data points. A failure to break today's high would add some confidence to the pattern, as well as taking some of the spring out of the current daily cycle upphase. Today marked the first session in 7 that did not print a higher high and higher low.

Support is at 10560, resistance today's 10640 high print.

Daily S&P 500 Chart


The SPX lost 6.79 to close at its session low of 1221.13 after failing at a high of 1227.92. The move broke likewise out of a steeply rising but dubious bear wedge, and took out Thursday and Friday's lows. If so, that 1228 level should not be exceeded, and the implied target is in the 1188-1190 area. 1219 is immediate downside support. While the daily cycle upphase continues, it has failed to keep pace with the sharp rise in price, setting up the SPX for a possible bearish divergent downphase if the price fails to rise from here. However, until the oscillators print sell signals, it will remain only a potential divergence.

Daily Nasdaq Chart


The Nasdaq fared better than its peers, losing 11.91 to close fractionally above its low of the day at 2144.78. The move failed at a lower high, but unlike the Dow and SPX, the Nasdaq did not significantly break either Friday's or Thursday's low. The same potential bearish divergence is present, however, as is the tentative bear wedge breakout. Below 2140, 2100-2110 is key support. However, a bearish divergent downphase from current levels would have an excellent chance of breaking back below it, with a bear wedge target in the 2045 area.

Daily TNX Chart


The Treasury reported that inflows of foreign capital to the US rose in May to $60 billion, the strongest since February's $79.6 billion. Foreign central banks reduced their purchases of US Treasury bonds and notes from $13.9 billion in April to $6.8 billion in May, while increasing their purchases of long term assets from $11.5 billion in April to $13.2 billion in May. The $60 billion total covered the $55.3 balance of trades deficit for the month.

Ten year notes didn't react notably, holding their light opening losses. There was light buzz about Chairman Greenspan's testimony before Congress, scheduled to commence on Wednesday, but the bond market was quiet overall. Greenspan released a series of comments in the afternoon ahead of the Congressional testimony, in answer to written questions submitted by the Joint Economic Committee of Congress. Among other things, he believes that the economy is coping "quite well" with the rally in oil prices and expects that the oil rally will reduce 2005's GDP by 0.75%, but that the GDP should display slow, steady growth ahead.

The Treasury auctioned $34 billion of 13-week and 26-week bills, with both auctions setting high-rates in the neighborhood of 5 year highs, and bid-to-cover ratios near 5 year lows. The 13-week bills set a high-rate of 3.22%, with 1.95 bids tendered for each accepted. The 26-week bills set a high-rate of 3.42%, with a bid-to-cover ratio of 1.93. Foreign central banks purchased $9.15 billion of the $34 billion total.

Ten year treasury notes were drifting sideways-lower for most of the day until shortly after Greenspan's comments, following which they began to sell more aggressively. Ten year note yields (TNX) rose to close at session highs, +4.8 bps at 4.223%, a new high for the move. While the TNX has become overbought on the daily cycle, there is no sign yet of a turn, and 4.2% was important resistance. The TNX is bullish above that level, with next resistance at the 4.25% fib line.

Daily Chart of Crude oil


Crude oil was weak this morning following Friday's pullback as Hurricane Emily was downgraded from a category 4 hurricane to category 1 in the early afternoon. Experts were expecting the storm to regain strength as it left Mexico to return to the Gulf, but as of this morning, crude oil was holding a better than 1% loss. The US Minerals Management Service reported that Emily has reduced daily oil production in the region by 12,851 barrels per day or 0.9% of daily output. Daily natural gas output has been cut by 0.6%.

Also contributing to the weakness was a downward revision from OPEC to its world demand growth forecast. OPEC now expects world deman to rise by 1.62 million barrels to 83.66 million barrels a day, lower than last month's estimate by 150,000 bpd. OPEC cited a slowdown in economic activity in some regions for the lowered target. OPEC expects that the world will require 85.2 million bpd during the beginning of 2006.

August crude oil has been declining from upper rising channel resistance in a bearish-divergent daily cycle downphase. Next support is at 56, 90 cents below today's session low, while 58.25 is upside resistance. For the day, August crude oil lost .775 to close at 57.325, a two week low. While the bearish oscillator divergence is ominous, this is a chart that had nearly tripled since late 2003, and the fundamentals remain no less bullish than usual. The real test should come at the bottom of the rising daily channel, if the current downphase makes it that far.

There were no economic reports scheduled for release today, but earnings season kicked in to take up the slack. 3M (MMM) reported before the bell, announcing Q2 earnings that rose from $773 million or 97 cents per share in Q2 2004 to $776 million or $1 per share in the current quarter. Revenue rose from $5.01 billion to $5.29 billion for a 5.6% gain, but missing estimates of $5.3 billion. Net of non-recurring items, MMM earned $1.09, inline with consensus estimates. The company revised its adjusted earnings view for the full year from its previous $4.15-$4.25 range to $4.20-$4.25. MMM lost 1.22% to close at 74.53.

Citigroup (C) reported Q2 earnings of $5.07 or 97 cents per share, up from 22 cents or $1.14 billion in Q2 2004, on revenue that declined from $20.89 billion to $20.17 billion. EPS missed estimates by a nickel, and revenue expectations had been for $21.41 billion. CEO Charles Prince stated that "The capital markets environment was one of the worst we have seen in years." Analysts have noted that other banks, such as GS and MWD have reported weakness in bond trading due to the flattening of the yield curve and squeezing of the carry trade. Following the C release, Prudential cut its 2005 EPS estimate from $4.15 to $4.00, and 2006's view from $4.55 to $4.30. Last Thursday, COO Robert Willumstad announced his resignation, and CNBC reported in the afternoon that Chairman Sandy Weill joined him today, but the company later denied the latter report in a terse press release. C gapped lower in the morning and sunk throughout the session to close -3.06% at 45.

Bank of America (BAC) reported Q2 earnings of $1.06 per share or $4.3 billion, up 12% from 2004's Q2 EPS of 93 cents and beating consensus estimates by 5 cents. Revenue rose from $13.22 billion to $14.21 billion, as the company cited strength in card income and service changes to offset weaker trading, investment banking and mortgage banking income. BAC closed lower by 1.96% at 45.80.

MBNA (KRB) reported a Q2 decline in earnings from 51 cents to 50 cents on volume that rose 9.6% to $57 billion. The credit card lender cautioned that its heavy reliance on low introductory rates boosted this quarter's volume and is likely to cut into net interest margin in the second half of the year. KRB lost 1.41% to close at 25.85.

Schwab (SCH) also reported, announcing Q2 earnings that rose to $186 million or 14 cents on revenue of $1.09 billion, up 65% from $113 million or 8 cents on revenue of $1.03 billion in Q2 2004. Estimates were for EPS of 13 cents. SCH stated that the company is seeking to reduce its reliance on trading commissions and increase its revenue from fees and assets under management. Associated Press quoted Chief Financial Officer Christopher Dodds as saying "It's a foggy day in San Francisco, but the sun is shining on Schwab. It's pretty clear to us that we have finally turned the corner." SCH gained 4.95% to close at 13.37.

Toymakers HAS and MAT reported as well, with HAS beating estimates by a nickel on strong sales of Star Wars products. MAT reported a loss this quarter on rising revenue, missing EPS estimates by 2 cents. HAS gained .37% to close at 21.56, while MAT lost 4.42% to close at 18.59.

After the bell, the much-anticipated Q2 10Q from IBM was released. Operating income, excluding charges and gains, rose for the quarter, from $1.74 billion or $1.01 per share in Q2 2004 to $1.85 billion or $1.12 per share. The 2004 Q2 result was restated to reflect the expensing of stock options. These results beat consensus EPS estimates by 9 cents, with the stock jumping from its $81.81 close to $84.50 as of this writing.

In other news, Standard & Poor's reported that the 369 companies in the S&P 500 which offer defined-benefit pensions remain underfunded by $164 billion in 2004, which was only $1 billion better than in 2003. The Chairman of S&P's index committee said that they expect slightly higher interest rates to improve the picture slightly, reducing the gap between pension commitments and assets to the $140-$150 billion range.

This is scheduled to be a very light weak for economic data, with Housing Starts and Building Permits tomorrow, then Initial Claims, Leading Economic Indicators, the FOMC Minutes and the Philly Fed on Thursday. Chairman Greenspan will testify before Congress on Wednesday and Thursday as well.

For tomorrow, traders will be watching for more earnings, including reports from F, JNJ, INTC, LU, MER, MOT and YHOO, to name a few. Today's price action was bearish for the indices and treasury markets, but volume and range were slim. This is especially notable in light of the strong, steep rises that preceded today's dip. With option expiration distortions mostly behind us, we can hope that the markets will return to normal. For the moment, the daily charts suggest a continued bullish bias, but with caution in light of today's violation of the prior lows on the Dow and SPX. The intraday bias remains bearish, but also cautiously so because of the utter lack of volume and strength to the downside. Today's range can be used a benchmark in tomorrow's trading, but with the daily trend being preliminarily challenged and the intraday action so far only corrective, Jim's maxim to "Enter Passively, Exit Aggressively" is particularly apt.
 

 
 




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

Chubb Corp - CB - close: 86.76 change: -0.21 stop: 84.40

Profit taking finally hit the markets today and we would expect it to continue short-term. That means CB is likely to retest the $85.00 level and technical support at its simple 50-dma. We are not suggesting new longs. More conservative traders may want to exit now as there is no guarantee CB will bounce before we exit ahead of its July 26th earnings report.

Picked on June 10 at $ 85.05
Change since picked: + 1.71
Earnings Date 07/26/05 (confirmed)
Average Daily Volume = 1.2 million

---

Coventry Hlth Care - CVH - cls: 72.11 chg: +0.70 stop: 69.49

Healthcare stocks were one of the few sectors to close in the green today. CVH continued its rebound that began on Friday. This may be a potential new bullish entry point but we hesitate to suggest new longs if the broader market is going to pull back.

Picked on July 05 at $ 72.75
Change since picked: - 0.64
Earnings Date 08/02/05 (unconfirmed)
Average Daily Volume = 1.0 million

---

Fortune Brands - FO - close: 94.63 chg: +1.30 stop: 90.51

Good news! FO displayed great relative strength today. The stock added 1.39 percent to breakout through the top of its five-day trading range. Shares are very close to our $95.00-96.00 price target. More conservative traders may want to seriously consider taking profits right here.

Picked on July 03 at $ 90.51
Change since picked: + 4.12
Earnings Date 07/22/05 (confirmed)
Average Daily Volume = 648 thousand

---

Quanex - NX - close: 55.94 change: -0.51 stop: 52.99

The early rally failed today. Watch for NX to pull back toward the $55.00 level or worse the $54.50 region to find support.

Picked on July 07 at $ 55.10
Change since picked: + 0.84
Earnings Date 08/25/05 (unconfirmed)
Average Daily Volume = 337 thousand

---

Pediatrix Med Group - PDX - cls: 76.06 chg: -0.44 stop: 72.34

The market weakness today weighed on PDX. We would expect shares to retest the $75.00 level soon. We do not suggest new bullish plays at this time.

Picked on July 11 at $ 76.10
Change since picked: - 0.04
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 158 thousand

---

Reynolds American - RAI - close: 81.90 chg: +0.12 stop: 76.49

RAI held up pretty well considering the news today. U.S. prosecutors asked the Supreme court to reinstate the potential penalty of $280 billion in the government's racketeering case against the industry. We would probably expect any further market weakness to pull RAI back toward the $80.00 region.

Picked on July 10 at $ 78.83
Change since picked: + 3.07
Earnings Date 08/01/05 (unconfirmed)
Average Daily Volume = 664 thousand

---

Rio Tinto - RTP - close: 124.38 chg: -0.80 stop: 123.33

The initial gap down today brought RTP dangerously close to our stop loss but the play is alive but it looks like it's in intensive care. The stock does have price support in the $122 level and technical support at its 50-dma near $122.70. We really didn't want to see this play move from a winner to a loser so last week we raised the stop loss to break even at $123.33. There is still a chance that RTP could rebound as the stock is hovering near its two-month trendline of rising support but we are not suggesting new bullish plays at this time.


Picked on June 27 at $123.33
Change since picked: + 1.05
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 160 thousand

---

Toll Brothers - TOL - close: 56.30 chg: +0.33 stop: 51.98 *new*

Homebuilder TOL continued to rally today and hit an intraday high of $57.15. That's pretty close to our target range of $57.50-60.00. We would suggest that more conservative traders seriously consider taking some profits here. The market indices are overbought and beginning to pull back. This could easily weigh on TOL, which itself is overbought. We are going to raise our stop loss to break even at $51.98.

Picked on July 10 at $ 51.98
Change since picked: + 4.31
Earnings Date 08/22/05 (unconfirmed)
Average Daily Volume = 2.4 million
 

Put Updates

Ishares Global Energy - IXC - cls: 88.35 chg: -0.22 stop: 91.61

Crude oil continued to pull back after OPEC trimmed their forecast for demand by 150,000 barrels a day. We are targeting a move into the $85.25-85.00 range for IXC.

Picked on July 14 at $ 89.15
Change since picked: - 0.80
Earnings Date 00/00/00
Average Daily Volume = 33 thousand

---

Martin Marietta - MLM - cls: 68.58 chg: +0.42 stop: 70.51

So far we remain on the sidelines. We're suggesting that traders wait for a drop under the $68.00 level before buying puts on MLM. Our trigger is at $67.85. Our target is the $63-62 range.

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 313 thousand

---

Children's Place - PLCE - cls: 46.81 chg: -0.44 stop: 47.51

No change. We are still waiting for PLCE to breakdown under technical support at its 100-dma and price support at the $45.00 mark. Our trigger to buy puts is at $44.90. Our target is the $40.50-40.00 range.

Picked on July xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 08/11/05 (unconfirmed)
Average Daily Volume = 775 thousand

---

Wellchoice - WC - close: 70.13 chg: +1.63 stop: 72.51

The healthcare stocks were one of the few sectors that closed in the green today. This may have inspired some bulls to buy the dip in shares of WC. The stock rallied back above the $70.00 level, which is a big warning flag for us. Now this is high-risk, aggressive play for us and the lack of follow through lower on last week's breakdown may be a signal for more conservative traders to exit this play early.

Picked on July 14 at $ 69.46
Change since picked: + 0.67
Earnings Date 08/03/05 (confirmed)
Average Daily Volume = 268 thousand
 

Dropped Calls

Lowes Corp. - LOW - close: 64.56 chg: +0.91 stop: 59.90

Target achieved. Retail stocks turned in a decent session in spite of the market weakness. Shares of LOW have not slowed down and powered right past the $64.00 level. Our target was the $64.50-65.00 range so we're closing the play.

Picked on July 11 at $ 60.73
Change since picked: + 3.83
Earnings Date 08/15/05 (unconfirmed)
Average Daily Volume = 3.4 million
 

Dropped Puts

None


Options 101

The Long Combination or Strangle

You anticipate something big is going to happen, but you dont know which way. The long combination or strangle might be the way to go.

The Theory behind the Practice

It could be a take over announcement, a buy-out, a horrid or fantastic earnings report, a unanticipated rise or drop in the prime or a gambit of other possibilities that could mean a major move one way if they do happen or a major move in the opposite direction if dont.
This simple strategy anticipates a major move by a stock or an index one way or the other, with the problem being the uncertainty to a major event that will effect the underlying trading vehicle, either stock or index. This strategy is called the combination (by the old school traders) or the strangle by others. This basis of this strategy involves the simultaneous purchase of a call option at higher strike price and a put option at a lower strike price.

Example:

The hypothetical stock DET is selling at 72.34. We believe that some big news is coming out regarding the stocks earnings in the next 45 days. The anticipated news of these earnings could impact the companys bottom line 20 fold. However, this announcement is being overshadowed by the fact that the FDA might not approve this earth shattering, revolutionary drug and DETs anticipated windfall could be just a flash in the pan. Any way, you decide that no matter what happens there is going to be a huge move in one direction or another with this stock. So in anticipation of this even, you purchase 10 DET July 75 calls for a price of $2.50 and simultaneously you purchase 10 DET July 70 puts at $2.25. This would cost you a total net debit of $4,750 and your position would look as follows. (See Figure 1-1 below)

Your total risk on this investment if $4,750 which is the amount that you would lose if DET closed between 70 and 75 at the end of the July expiration period. If that should happen both your July 75 calls and your July 70 puts would expire worthless. The price at which your trade becomes a breakeven is 79.75 on the high side and 65.25 on the low side. (This breakeven is calculated by adding the two debit transactions together and then adding that amount $4.75 to the call strike price of 75 (75 + 4.75 = 79.75) and also subtracting the $4.75 from the put strike price (70 4.75 = 65.25

So you begin to make money as DET goes above $79.75 or drops below $65.25. Your Profit over $79.75 is wherever on the upside. Every point above $79.75 earns you $100 per contract. Since in this scenario you have 10, you make $1000 every point over $79.75. On the flip side, your profit would be the same $100 per contract for every one-point drop of the stock under $65.25.

The Real World Example: Actual Date May 23, 2005
Johnson and Johnson Price 67.35

CHART I: CHART OF JOHNSON AND JOHNSON (SYMBOL: JNJ)

Here that strategy is the same as our hypothetical example:
We are going to Purchase 10 JNJ Oct 70 call @ $1.55 and 10 JNJ Oct 65 Put for @1.55. This will cost a Net Debit of $3.10 or $310 per each contract spread.

The breakeven for this JNJ combination spread is 73.10 on the high side and 61.90 on the low side. If JNJ closes anywhere in between 73.10 and 61.90 you lose the $3,100.
However you have unlimited profit potential if the stock goes over $73.10. You receive $1000 a point ( since you have 10 calls) and you could get a $1,000 move for each point JNJ drops under$61.9 for your 10 put contracts

CHART II: Spread analysis. The higher or lower the stock moves the greater the profit as long as they stock trades outside of the $73.100 - $61.90

The Bottom Line:

The scenario is pretty cut and dry once you establish your net out of pocket and your breakeven prices (high side and low side). Remember this strategy is for a situation where you feel there is going to be a major movement in the stock or Index in either direction, but you really are not sure which direction because of an unknown event. This strategy can be rewarding at time. The key with this strategy is being able to buy both positions for reasonable premiums and be sure that there is enough volatility in the underlying stock issue you ultimately decide upon. The Premiums usually correlate with the rumors and uncertainty behind the stock. The more likely a major move, the higher the premium you will have to pay. The key to any Long combination is being able to put on the positions before the rumor causes activity in the stock. Unfortunately, that is much easier said then done.


Until Next Time
 

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

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