Oil Lubricates Gains
Oil rebounded on Friday from three-week lows and the rebound in oversold oil stocks powered the market higher. The S&P remained stubbornly in positive territory on Friday while the Dow and Nasdaq struggled to find buyers and languished in the red. Almost single handedly the rebound in the oil sector, led by the OSX, pushed the S&P steadily higher. A late day buy program provided the final spark that triggered yet another short covering spree. These factors combined to rescue the indexes from closing negative for the week.
We are choosing to wait on adding new plays this weekend. The major averages continue to look overbought and due for a pull back. The DJIA is up more than 450 points from its July low with out much of a correction. The NASDAQ Composite is up more than six percent from its July low without much rest and facing stiff resistance in the 2190-2200 range. The S&P 500 also looks a bit extended from its July low (up 4%). One could say follow the trend, which is up, but seasonal trends need to be considered. The markets tend to peak in the second half of July and head into the traditional Q3 slump to bottom in late September or early October. Right now we'd be more inclined to add bearish plays but the market's recent resilience makes that challenging. We will add new plays to the newsletter on Monday.
Las Vegas Sands - LVS - close: 40.30 chg: -0.01 stop: 36.99
LVS is a new bullish candidate from our Thursday night newsletter. There is no change from our original play description which we are reposting below.
Adding a new bullish play with the major market averages poised for more profit taking seems rather risky in our book. We find it appropriate that this stock is a casino. Overall the casino stocks have been showing decent relative strength. It is relative strength that draws our attention to LVS. The stock has managed to push to new three-month highs on a day most of the market was trading lower. More importantly LVS has broken through round-number, psychological resistance at the $40.00 mark and technical resistance at its 100-dma and its exponential 200-dma. The P&F chart shows a fresh double-top breakout buy signal that points to a $49.00 target. We are going to suggest calls with LVS above the $40.00 level. Our target will be the $44.50-45.00 range but keep in mind our time frame is pretty short. LVS is due to report earnings on August 3rd and that doesn't give us a lot of time. Any lack of follow through on today's breakout may be a good signal to abandon bullish positions.
BUY CALL AUG 40.00 LVS-HH OI=2725 current ask $1.80
Picked on July 21 at $ 40.31
Pediatrix Med Group - PDX - cls: 77.91 chg: +0.66 stop: 74.25*new*
This past week has been a decent one for shares of PDX. The stock managed to avoid the sell-off in the healthcare sector. This may have been due to the positive earnings guidance PDX shared with the market on July 19th. We remain bullish on the stock and we continue to target the $80-82 range (FYI: the P&F chart still points to a $92 target). The challenge now is our time frame. We do not want to hold over PDX's earnings report on August 3rd. That gives us about a week and a half. We hesitate to suggest new long positions here but aggressive traders might watch for another dip toward the $76 level as another entry point. We are raising our stop loss to $74.25 near the simple 50-dma.
Picked on July 11 at $ 76.10
Reynolds American - RAI - close: 83.92 chg: +0.93 stop: 79.99*new*
The rally continues for shares of RAI. The cigarette maker continues to climb and the stock came within one cent of our target on Friday. We will continue to target the $84.00-85.00 range but we strongly suggest that readers consider taking profits here. RAI is looking a little short-term overbought and due for a dip. We are raising our stop loss to $79.99 but more conservative traders may want to put theirs under the $81 level. We are not suggesting new plays at this time. Remember, we only have a couple of days before RAI is due to report earnings. If the stock does not hit our target by Tuesday we will close the play on Tuesday afternoon at the closing bell.
Picked on July 10 at $ 78.83
Infosys Tech. - INFY - cls: 72.20 chg: +1.77 stop: 75.01
Hmm... our bearish play in Indian software company INFY may not be working out exactly as planned but so far the stock has not strayed from our expectations. On Thursday we warned readers that INFY might bounce into the $72.00-72.50 region and that's exactly what it did on Friday. The gain on Friday is not so much relative strength versus the software sector here in the states. Instead we see it as a reaction to the strong day for the Indian markets on Friday. The Indian stock market surged with a 1.6 percent rally to close at new all-time highs. The rally in the Indian markets may prove to be our biggest risk here with put positions on INFY. Looking at the daily chart for INFY we see the next level of resistance near $74.00, which would be the bottom of its gap down from July 12th. July 12th was when INFY reported earnings. Investors reacted negative as they worried about future growth rates for INFY. The move down two weeks ago helped produce a big double-top pattern with resistance in the $79-80 region. It also produced a reversal on its P&F chart, which now points to a $59 target. Traders can watch for a failed rally under $74 or under $75 as a new bearish entry point. Our target is the $62-60 range.
BUY PUT SEP 75.00 IUN-UO OI= 0 current ask $5.30
Picked on July 20 at $ 69.92
Lehman Brothers - LEH - cls: 107.00 chg: +1.87 stop: 108.01
LEH is a new bearish candidate from the Thursday night newsletter. Friday's rebound is certainly a surprise considering the Tuesday-Thursday pattern looked like a bearish reversal. This is a very speculative play and our strategy remains the same so we're reprinting the original play description from Thursday here:
If the new call play in LVS isn't risky enough for you take a look at this put play in LEH. The stock has been a pillar of strength in the market and in its own industry group. Shares of LEH have produced a string of new all-time highs and helped lead the XBD broker-dealer index to its own series of new highs. So why buy puts on a stock that is looking so strong? We believe that LEH is way overdue for some profit taking. The rally in LEH is about nine-weeks old and nothing goes up in a straight line. We want to reiterate that this is a speculative play and carries a higher degree of risk. Our strategy is to try and catch the next bout of profit taking. With the major indices still overbought and looking poised for more weakness we feel odds are leaning toward a consolidation in LEH too. Plus, the action over the last three days looks like a potential bearish reversal pattern. We're basically betting that LEH will pull back toward the $100.00 region before the August $100 puts expire on August 19th. Our official target will be the $100.50-100.00 range. Any dip toward the $100 level should significantly raise the value of the AUG 100 puts currently trading in the $0.50-0.60 range. Our stop loss at $108.01 (above yesterday's high) is superficial. If LEH trades to a new high our puts will probably be close to worthless. More conservative traders may want to pass on this play or wait for LEH to trade under the $105 level first. The biggest challenge we see is the $102.50 level where we expect bulls to try and defend the stock and buy the dip.
BUY PUT AUG 100.00 LES-TT OI=2220 current ask $0.40
Picked on July 21 at $105.13
3M Co. - MMM - close: 74.71 change: +0.16 stop: 77.51
MMM continues to under perform the market and its peers in the DJIA. There appears to be no catalyst to buy the stock as investors worry over MMM's profit growth. Technically MMM has filled the gap from its late June drop. Plus, MMM continues to trade under the bottom edge of its April-June trading range. The Point & Figure chart is also bearish with a $63 price target. We will suggest put positions at current levels or under the $76 level. More conservative traders may want to wait for a decline under the $74 mark before buying puts. Our initial target is the $70.00-68.00 range.
BUY PUT SEP 80.00 MMM-UP OI= 45 current ask $5.90
Picked on July 19 at $ 74.29
Children's Place - PLCE - cls: 46.34 chg: +1.32 stop: 47.51
We cannot know whether Friday's rally in PLCE was short-covering ahead of the weekend of bulls trying to buy a bounce from round-number support at the $45.00 level. PLCE continues to suffer under a five-week trendline of lower highs and we believe it still has new relative lows to set. Our plan is to wait for a breakdown under support at the $45.00 level. A decline under the $45.00 level would produce a new triple-bottom breakdown sell signal on its P&F chart. Our entry point to buy puts is at $44.90. Our target is the $40.50-40.00 range. Traders need to be aware that we plan to exit ahead of PLCE's August 11th (unconfirmed) earnings report.
Picked on July xx at $ xx.xx <-- see TRIGGER
Chubb Corp - CB - close: 86.99 change: +0.13 stop: 84.99
We have almost run out of time on this bullish play in CB. The company is due to report earnings on July 26th and we do not want to hold over the event. Per our previous guidelines we are closing the play as of Friday afternoon.
Picked on June 10 at $ 85.05
Ishares Global Energy - IXC - cls: 90.31 chg: +1.81 stop: 91.61
It was a volatile day for the IXC but the trend on Friday was pretty clear. Crude oil prices are bouncing and that helped produce a bullish engulfing candlestick pattern on the IXC. The breakout back above the $90.00 level is our cue to exit. Yes, the IXC still has additional resistance in the $91.50-91.60 range but we're not going to sit here and watch the oil sector hit new highs, especially when the oil services sector is surging sharply to new all-time highs. We're choosing to close the play early to minimize any losses.
Picked on July 14 at $ 89.15
Each morning, CNBC commentators note whether futures weigh in above or below fair value. What is fair value as it applies to the indices, anyway, and why does it appear to be such a confusing topic? According to H.L. Camp and Company, more callers to CNBC's Squawk Box ask about fair value than any other topic. The term doesn't hold the same meaning for all, it turns out, and some would argue that the CNBC-type accounting of fair value proves to be a sloppy and useless measure. An article written by Mark Hanes and contributed first to CNBC.com and then reprinted on another source argues against that conclusion.
Most CNBC watchers want to know each morning whether S&P 500, Nasdaq and Dow futures are trading above or below fair value. They want an idea of how sentiment lies as the open approaches. If futures trade above fair value, they feel that early trading might have an upward bias. If futures trade below fair value, they prepare for early trading with a negative bias. Wise traders don't expect that bias to always appear or to carry much beyond the opening moments, however, with other factors then kicking in to contribute to the behavior of the markets.
The CNBC version of fair value differs from the strictest interpretation of that term, according to some sources. According to Investopedia, the CNBC-type meaning references the difference between the actual cash value of an index and the futures contract on that index. More specifically, Herb Greenberg, Senior Columnist for TheStreet.com defined the CNBC-type term as the difference between the closing cost of the component stocks of an index the day before and the closing cost of the futures contract.
That definition of fair value will garner complaints from purists, however, as it did for Herb Greenberg back in 1998 when he briefly answered a reader's question about fair value. One correspondent wanted to redefine that "CNBC-type" fair value, as many sources tagged it, as the "the closing spread," a different value entirely from the more respected "fair value" meaning. Greenberg's next column was comprised of a number of excerpts from readers who wanted to expound upon or argue against Greenberg's brief answer, but none contested Greenberg's characterization of CNBC's use of fair value. Hanes' definition, however, comports with the more traditional definition of fair value, as it turns out.
Investopedia, brief as its definitions tend to be, offers a more analytical computation for this equilibrium price or fair value for a futures contract, different from its "CNBC type" definition. This site notes that fair value is calculated by figuring in spot price, compounded interest paid and dividends lost until the expiration of a futures contract. Futures owners do not collect dividends, as do owners of the actual stocks.
Index arbitrage traders may be more interested in that traditional computation than in a closing spread. Here's how it works. If futures are priced at fair value, then they're theoretically at the same value that cash indices are in the absence of transaction costs. To calculate fair value, financing charges, a function of interest rates, would be added to the spot prices, and dividends would be subtracted to account for those transactions costs. The Chicago Mercantile Exchange's Rule 813.D sets forth the calculation and rules for fair value. HL Camp & Company uses the following formula:
FV = S[1 + (I - D)], where "FV" is fair value, "I" is the interest a trader would pay to borrow enough money to buy all the SPX stocks, and "D" is the dividend that would have been collected if the stocks had been owned instead of futures.
There's a time factor applied to the calculation of the interest, as the interest must be calculated from the date of the FV calculation until the expiration of March, June, September or December expiration of a futures contract. Carrying costs will drop as a futures contract draws nearer to its settlement day, so the fair value will more closely approach the actual spot price of the index in question. Those interested in following an exact computation of fair value, an exercise that might be useful for all to follow at least once, can find such a sample computation at www.cme.com/trading/prd/equity/fairvalue2543.html on the Chicago Mercantile site. Following such a computation provides a greater grasp of how fair value might change as interest rates or dividends change.
Hanes' article makes note of the same computations in the CNBC's version of fair value. At the time his article was written, CNBC was receiving fair values from Prudential Securities, and Hanes noted that the formula used was as follows:
F = S[1 + (I-D)t/365], where F is the fair value for futures; S, the spot index price; I, the interest rate, expressed as a money market yield; D, the dividend rate, expressed as a money market yield; and t, the number of days from the spot value date until the settlement of the futures contract. That formula argues against detractors who claim that the "CNBC type" fair value is a less useful measure of closing spread.
Useful or less useful to index arbitragers, that is, although many everyday traders might be interested in the times when futures and index values get so out of synch that program buying or selling programs are likely to be triggered. For that reason, the discussion of fair value probably wouldn't be complete without a discussion of premium. One of Greenberg's correspondents described premium as a threshold amount above or below fair value, at which buy or sell programs might be triggered.
If futures contracts are trading at fair value, big funds or institutions don't care whether they own stocks or futures. Arbitrageurs aren't going to find an opportunity to exploit the difference. If futures are trading at a threshold amount above fair value--if it would cost a threshold amount more to buy and hold futures until their settlement than to buy the equities and pay the transactions costs until that settlement day--then futures contracts might be sold and equities bought. If equities are trading at a threshold amount above futures, arbitrageurs might take the opposite action. HL Camp and Company claims that index arbitrage actions currently account for only about 10 percent of all program trading activity, however.
For those interested in watching for program trading activity, premium value should also be understood. Premium values are spreads that measure the arithmetic difference between futures and spot index values. So there's that plain old spread showing up again, rather than the more complicated formulas for fair value. Hanes says that CNBC defines "premium" just as it's defined here. Premium value can be monitored on many charting or quote services. Traders should check the symbol help section on their services to find the appropriate levels.
So how is that spread or premium used on CNBC or elsewhere? HL Camp & Company provides program selling levels each day for those traders interested in setting alerts for potential program selling or buying signals. On our site, Jeff Bailey usually provides those numbers for the benefit of readers who want to watch or set alerts. For example, on Friday, July 15, the company's fair value for the S&P 500 was set for +$3.57, with their computers set for program buying at +$4.71. The same day, another service listed fair value at +$3.52 and suggested that traders buy the SPY if the premium rose above +$4.85, so obviously the various companies issuing these program trading signals might offer slightly different results.
While these sources include premium, as defined as that spread, in their decisions as to where program buying or selling might occur, they do not use premium alone. Rather, they include proprietary studies on where program selling is most likely to occur with respect to the fair value and the premium of the futures to the cash index. They're making proprietary guesses, if computer-assisted and sophisticated ones, as to the probability that a buy or sell program would be triggered at a certain premium level. Hanes' article indicates one reason that some buy or sell programs might not be triggered when expected and why those proprietary studies might be needed. Because arbitrageurs use borrowed money and since each might have a slightly different interest rate, not all arbitrageurs might act at the same premium level.
HL Camp and Company describes premium as the spread between the most active of the available S&P 500 futures contract, usually the front-month contract, and the actual cash index value, with the cash index value subtracted from the futures contract. Most times, the spread varies between +/-$5.00, the site notes. This company's numbers are projections for the amounts at which they believe program trading will kick in and index stocks might be bought or sold as a result. The company corroborates that premium values cannot be used as a pure indicator of when a buy or sell program might kick in, as the company's extensive research has shown some occasions when PREM signaled that a buy or sell program should occur but didn't.
Some traders find it helpful to monitor premium values and match that to a preferred source's projections of when buy or sell programs might be hit, to gauge their own buy or sell decisions on these best guesses. However, as Hanes himself cautioned, the action of buying stocks when futures are a certain threshold above fair value helps to narrow that spread. That action brings futures closer to fair value. The narrowing can happen quickly, as it can when futures might have been at a discount to the indices, and equity selling occurs. Those who have seen pre-cash-market futures values far above or below fair value are often surprised to see action at the open. That upward or downward bias sometimes doesn't last long, sometimes not even until the cash open. Use those comparisons as one tool only.
If Hanes' characterization is correct, it turns out that those who disparage "CNBC type" fair value might need to be a little fairer in their criticisms, but let's look at actual numbers. On the morning of July 21, CNBC noted that fair value for the SPX was +$2.05. The SPX close the day before had been 1235.03 while futures saw a 4:00 closing value of 1236.75, a 3:15 value of 1237.50 and a 5:15 closing value of 1236.25, none of which translated into a closing spread of +2.05. However, HL Camp & Company noted more traditional calculation of fair value at +2.08 for the day, roughly analogous to the CBNC-announced version. It appears Hanes was right. Early in the morning, futures had been positive, but below fair value, indicating that expectations were for a flat or slightly lower open, but the Chinese announcement about the unpegging of yuan and the news of new bombing attempts in London changed the outlook, with equity futures shooting all directions. Fair value comparisons probably proved less useful than other factors.
This article was intended to provide an overview of these often-confused terms rather than to promote a trading style based on potential program selling or buying points. Some find such tactics useful; others, less so. Traders should monitor premium and expected buy or sell programs for a time to determine applicability to their trading styles before basing decisions on those signals.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.
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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