Option Investor

Daily Newsletter, Saturday, 09/10/2005

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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

Energy Stocks Power S&P to Five Week High

In a continuation of the Labor Day rally the energy stocks bucked the trend and rallied strongly to push the S&P within three points of a new four-year high. I say bucked the trend because those gains were in the face of falling oil prices. Crude prices fell to close at just over $64 and well under the pre-Katrina levels. The gains came after the Dept of Energy released a report saying winter energy costs were going to be 24% higher than in 2004. The DOE said total energy costs would soar to $1.08 trillion for an increase to consumers of $209 billion. The report provided lift not only to oil stocks but coal, gas and even uranium issues. Also helping to push the indexes higher was a surge in homebuilders and materials stocks as the cost estimates for Katrina continue to grow.

Dow Chart - Daily

Nasdaq Chart - Daily

SPX Chart - Weekly

Friday was devoid of any material economic reports but there was plenty to move the market. The only economic report for the day showed Import Prices rose +1.3% in August and inline with expectations. Excluding energy prices remained flat. Export prices fell again for the third month out of the last four. The main driver for the headline import price increase was a jump of +7.1% in oil prices. This brought the rise for the year to 42.5% for oil prices and +7.6% for import prices overall. This data was all gathered before Katrina struck. Import prices should show another sharp jump over the next few months as the demand for building materials increases prices from around the globe.


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The main focus for the day was the cost of rebuilding in the aftermath of Katrina. New estimates are now saying the cleanup could take as long as two years and rebuilding as long as five years. FEMA is saying the sludge being left behind as water is pumped out contains a combination of toxic materials and dangerous bacteriological material. The bacteria comes from carcasses of dead animals onshore as well as fish washed ashore and dying in the stagnant water. There is also bacteria from flooded sewage systems and treatment plants. The toxic materials come from flooded chemical plants and waste storage companies. FEMA says homes flooded with this toxic cocktail are no longer fit for human habitation. They fear an outbreak of disease and are forcibly evacuating all remaining residents of the affected areas. Entire neighborhoods could be bulldozed including the top foot of topsoil to remove the toxic sludge.

Damage estimates have risen well over $100 billion and could reach $200 billion or more before it is over. Insured losses are now estimated at between $40 and $60 billion but much of the individual losses are uninsured. We will be hearing about Katrina cleanup for years to come with untold billions of dollars spent for rebuilding.

That spending is still not expected to add to the GDP in 2005. The official estimates are still for a reduction in Q3 GDP of -0.5% and Q4 GDP of -1.0%. Because the massive rebuilding effort is likely to gain traction by Q1-2006 the estimates are for an addition of +1.0% to GDP for all of 2006 and beyond. This will go down as the worst national disaster in U.S. history and that means the recovery effort will rival the Job Corp projects of the early 1900s. Companies in the building sector that have any presence in the south are soaring with regional companies seeing the biggest jump. Materials companies from around the globe are also seeing strong gains in stock prices from anticipated material demand. Waste companies, Waste Management (WMI) and Allied Waste (AW) stand to make windfall profits as the majority of demolished material makes its way to their landfills. Cleaning up the toxic problems will go to companies like Clean Harbors (CLHB) who clean up contamination problems. Actually the water being pumped back into the lake is very polluted and will cause serious problems for the lake. Groundwater has been contaminated and the more toxic water pumped into the lake the worse the future problems will be.

The gains in materials, construction and energy stocks sent the S&P soaring to a high of 1243 and only -3 points from a new four-year high. This is a major departure from historical norms but it was only the first week of September. It is entirely possible that the magnitude of expectations for the rebuilding process will overcome any historical Q3 decline. I am watching the process with a skeptical viewpoint while enjoying the gains in my energy stocks.

Compx Chart - Weekly

SOX Chart - Weekly

Some of the gains on Friday came from the chip sector after updates from three major companies. Intel affirmed their forecast for the quarter on the strength of notebook demand. Still INTC fell to $25.20 from $26.10 after the release. Their outlook was positive but the expectations had already been priced in over the prior three days. Those hopes were removed very quickly. Texas Instruments also released their Q3 update and TXN raised their earnings estimates from 31-31 cents to 36-38 cents. TXN also finished in the red but only by a penny. National Semi (NSM) announced earnings that fell -27% but beat the street. They also raised their outlook saying that their business was stronger than expected for the quarter. NSM also closed down for the day. The combination of the three chip updates and the positive outlook sent the SOX higher by +3.35 to 482 and very close to a new 52-week high at 486. This broke the SOX out of recent range from 465-475 and under normal circumstances would suggest a breakout ahead. Despite the chip gains the Nasdaq was only able to post a +9 point day. This is very anemic given the gains in the other indexes.

Not all companies are benefiting from the potential rebuilding effort. Yellow Roadway warned that Katrina would lower their earnings for the current quarter. An area the size of Great Britain has been taken out of their shipping universe for potentially an entire quarter. YELL fell -3.20 to a new 52-week low. Also near a new low is FDX at $79.80. Both of these companies should experience a dramatic jump in shipments into the hurricane area once the rebuilding effort begins.

Airlines are moving lower every day as they struggle to work around the airline blackhole in Louisiana and the loss of huge numbers of business and tourist travelers into the area. Also impacting them is the high cost of jet fuel and the low availability. Jet fuel cost $1.00 a gallon in Q1 and a level that was already causing problems. It had risen to $1.73 in early Q3 and airlines expect to pay an average of more than $1.89 before the quarter is over. The rising price of fuel is squeezing the life out of the carriers. Continental said today that it will spend $2.6 billion for fuel in 2005 compared to only $1.6 B in 2004. How do you deal with a $1 billion increase in fuel costs in just one year? CAL said fuel would account for 24% to 26% of total costs in Q3 compared to only 14.7% in Q1. Delta said on Friday that every penny of fuel increase will cost them $25 million a year. When we see the price of oil up 50-75 cents a day we don't realize that this is hundreds of millions of dollars of impact to airlines and to transportation of all kinds. This is why the transports closed at a two month low on a day when the other major indexes are near 52-week highs.

Oil prices completed their fifth day of declines in anticipation of foreign supplies hitting our shores any day now. However, there have been some holdups in the 2 mbpd promised from the 20+ nations in the EIA. There is an extreme shortage of tankers to carry the product and organizing which tanker filled with what type of product goes to what port/refiner is also a challenge with four of our major refiners still offline. 5% of our daily refining capacity is still offline and will likely be offline for months to come. Four refineries, each individually owned by Exxon, Conoco, Murphy and Chevron accounting for 901,000 bbls per day have sustained severe damage and it is possible two of them may not be back online until December or even later. These refineries happen to be the "smart" refineries that can refine different types of crude including the sour Saudi crude. This means light sweet crude will be in higher demand than ever in an effort to refine gasoline and jet fuel. Jet fuel continues to be in short supply with numerous airports running at low levels. Airlines report having to top off tanks at airports with fuel and fly with more fuel than normal to those airports on short supply. This assures the planes will have enough fuel to return if a shortage occurs. Flying with full fuel loads burns more fuel because of the increased weight but it is better than having to wait for the next fuel delivery before being able to take off again. Continental said there was currently a daily shortfall of -100K to -150K gallons of fuel and that will grow as the fall flight schedule increases.

Some of the oil coming from overseas will come in the form of gasoline and jet fuel instead of crude oil. This is good considering the shortage of refining capacity but bad for users since this fuel will have a higher cost than that refined here in the U.S. Some refiners in Europe have higher costs resulting in higher sales prices plus there is the added shipping expense to the U.S. Most Americans don't realize that gasoline has been selling for over $6 a gallon in Europe for some time. Most people also don't realize that before the hurricane 10% of our gasoline was imported, mostly from Mexico and South America. Everybody in the U.S. is whining about $3 gas but the outlook is clear, prices are going higher. As the world's largest consumer we have been sheltered from the prices others have been paying but our time is running out.

The Minerals Management Services report for Friday showed that shut in oil from the Gulf had risen from 58% to 60% of capacity instead of falling as better data became available. This has been dropping much slower than expected and more damage is being discovered every day. It is not likely to completely recover in 2005. Shut in gas has recovered to only 38% but that is still amounts to over 4 billion cubic feet per day. This is putting a huge crimp in the electric generation sector. Coal demand is soaring with companies like Peabody Energy (BTU), Fording Coal (FDG) and Console Energy (CNX) hitting new all time highs.

The IEA also released a report on Friday saying that 90% of Gulf production would be back online within 3-6 months. They estimate a loss of 55 million bbls of production through December. They said there was substantial pipeline damage with 37 platforms in shallow water completely destroyed and four in deep water. Shell's deep water platform, Mars, had suffered extensive damage. Shell estimates six months to repair it. The Diamond Offshore rig, Ocean Warwick, is expected to take a year to repair after breaking free and running aground 66 miles away. The IEA said 20% of offshore platforms and 12% of rigs remain evacuated two weeks after the storm. Because of the hurricane and some slowdown in other areas of the globe the IEA lowered its demand growth by -240,000 bbls for 2005 to 1.35 mbpd. Demand growth for 2006 was still expected to be in excess of 1.77 mbpd. The committee will meet on Sept 15th to assess the hurricane impact and the result of their 60 million bbl release into the system.

On Friday oil prices fell in anticipation of foreign oil hitting our shores. However, energy stocks rose in anticipation of higher prices ahead as fall demand exceeds our current production capability. The pause we saw this week was simply profit taking from the Katrina bounce and uncertainty of how fast production would come back on line and how fast European oil would hit our shores. Now that the smoke is clearing the picture is still the same and buyers are coming back to energy.

The bounce in energy, materials and builders sent the indexes to four-week highs but not over strong resistance at those levels. There is also a quarterly S&P rebalancing in progress where funds increase their holdings of stocks, which have risen significantly and reduce positions on those who have dropped in price. Since energy already accounts for 9% of the S&P and nearly all energy stocks have risen strongly over the last year it stands to reason that funds have to increase positions in energy stocks. This would make me question the validity of Friday's energy bounce in the face of falling oil but I will take the profits it produced.

For next week the markets are at a crossroads. We have rebounded to strong resistance at 10700, 2180, 1245 and we could not make it over those levels after several tries in July. I would be very surprised if we made it this time but then the strength of the Labor Day rally has already surprised me. With the S&P over 1225 we are in long territory but only with tight stops. A breakout here could develop some strong momentum very fast and quite a few bears will end up even more surprised then me. The anticipation of a September decline has many hedge funds in short positions and a sudden breakout would have them scrambling to cover.

SPX Chart - 5 min

If you look at an intraday chart of the SPX the high was set about 1:45 and we closed at the low of the afternoon. The Nasdaq high was in at 12:30 and it also weakened into the close. It looked to me like the beginning of a resistance fade on both indexes. However, given the lack of any material selling on a Friday afternoon after a strong rally I have to discount that possibility. That leaves me with only a slightly negative bias on a technical basis and bullish bias on an emotional basis. I would love to see a breakout and a rally for the rest of the year but there is no real justification for that desire. Late commentary suggests the Fed will continue raising rates and oil prices should stabilize either at the current level or higher. Both will continue to drag on the economy and eventually the market. Therefore, I plan on taking any profits we get on the long side but expect a failure at 1245 until the market proves me wrong. I did take another insurance short at the close on the Russell futures. If oil stocks move higher on Monday I will close the short and celebrate. If the reverse occurs I am protected against any drop. I am looking forward to my commentary on Tuesday night since odds are good it will be after strong directional move. Until then, remember to enter passively and exit aggressively and definitely don't get married to your positions or your bias.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
AIG None

New Calls

Amer. Intl Group - AIG - cls: 61.23 chg: +1.47 stop: 57.99

Company Description:
American International Group, Inc. (AIG), world leaders in insurance and financial services, is the leading international insurance organization with operations in more than 130 countries and jurisdictions. AIG companies serve commercial, institutional and individual customers through the most extensive worldwide property-casualty and life insurance networks of any insurer. In addition, AIG companies are leading providers of retirement services, financial services and asset management around the world. (source: company press release or website)

Why We Like It:
Property and casualty insurance stocks are already rebounding sharply from their recent Katrina-inspired lows. Now shares of AIG are breaking out over the $60.00 level and technical resistance at its simple 50-dma and simple 200-dma. AIG's Point & Figure chart points to a $90.00 target but we see some resistance in the $65 region. Given the volume and strength of Friday's breakout we think AIG can make a run to the $65.00 level as well. Our official target will be the $64.75-65.00 range.

Suggested Options:
We are suggesting the October calls.

BUY CALL OCT 60.00 AIG-JL OI=7950 current ask $2.45
BUY CALL OCT 65.00 AIG-JM OI=3712 current ask $0.40

Picked on September 11 at $ 61.23
Change since picked: + 0.00
Earnings Date 11/08/05 (unconfirmed)
Average Daily Volume = 7.2 million


Noble Energy - NBL - close: 89.80 chg: +2.00 stop: 84.99

Company Description:
Noble Energy is one of the nation's leading independent energy companies and operates throughout major basins in the United States including the Gulf of Mexico, as well as the recently added Patina Oil & Gas properties located primarily in Colorado's Wattenberg Field, the Mid-continent region of western Oklahoma and the Texas Panhandle, and the San Juan Basin in New Mexico. In addition, Noble Energy operates internationally in Argentina, China, Ecuador, Equatorial Guinea, the Mediterranean Sea and the North Sea. Noble Energy markets natural gas and crude oil through its subsidiary, Noble Energy Marketing, Inc. (source: company press release or website)

Why We Like It:
Shares of NBL have managed to hit new all-time highs despite news that a week ago only half of its operations in the gulf were operating following hurricane Katrina. Friday's intraday surge over the $90.00 mark produced a new triple-top breakout buy signal on its P&F chart, which now points to a $109 target. The rest of NBL's daily technicals are bullish and its MACD indicator recently produced a new buy signal. We are suggesting new bullish plays with the stock above the $88.00 level. More conservative traders may want to wait for a new high over $90.40. Our target is the $98-100 range before its November earnings report.

Suggested Options:
We are suggesting the November calls.

BUY CALL NOV 85.00 NBL-KQ OI= 932 current ask $7.70
BUY CALL NOV 90.00 NBL-KR OI= 535 current ask $4.50
BUY CALL NOV 95.00 NBL-KS OI= 457 current ask $2.60

Picked on September 11 at $ 89.80
Change since picked: + 0.00
Earnings Date 11/02/05 (unconfirmed)
Average Daily Volume = 796 thousand

New Puts

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Centex - CTX - close: 69.63 chg: +1.99 stop: 64.99*new*

Homebuilding stocks soared on Friday. A renewed speculation that the sector will benefit in the rebuilding process over hurricane Katrina and some positive analyst comments over the Las Vegas housing market seemed to do the trick. Shares of CTX added almost three percent on above average volume to breakout over resistance near $69.00. The stock does still have round-number resistance at $70.00 and technical resistance at the 50-dma overhead but the short-term trend looks strong following the late August bounce near its rising 200-dma. Our target is the $73.00-75 range. We are raising the stop loss to $64.99.

Suggested Options:
We are suggesting the October calls.

BUY CALL OCT 65.00 CTX-JM OI=2181 current ask $6.10
BUY CALL OCT 70.00 CTX-JN OI=8888 current ask $3.00
BUY CALL OCT 75.00 CTX-JO OI=2006 current ask $1.10

Picked on September 01 at $ 68.25
Change since picked: + 1.38
Earnings Date 10/25/05 (unconfirmed)
Average Daily Volume = 1.6 million


KB Home - KBH - close: 76.22 chg: +1.53 stop: 71.50

KBH also performed well on Friday following the gains in the homebuilding sector. Much like shares of CTX, KBH benefits from the belief that the builders will see big business from the Katrina rebuilding efforts. Plus, an analyst with JMP reaffirmed their "strong buy" rating on KBH while upgrading a couple of more stocks in the industry. We're encouraged to see KBH breakout over resistance at the $76.00 level and hit new five-week highs. The stock does still have some technical resistance at the 50-dma and more conservative traders may want to wait for KBH to push through that moving average first before initiating positions. Our target is the $80.00-82 range. FYI: the P&F chart target has risen to $89.

Suggested Options:
We are suggesting the October calls even through we plan to exit before its earnings report on September 22nd.

BUY CALL OCT 70.00 KBH-JN OI=1784 current ask $8.30
BUY CALL OCT 75.00 KBH-JO OI=2471 current ask $4.90
BUY CALL OCT 80.00 KBH-JP OI-4181 current ask $2.45

Picked on September 07 at $ 75.89
Change since picked: + 0.33
Earnings Date 09/22/05 (confirmed)
Average Daily Volume = 2.5 million


Lehman Brothers - LEH - cls: 110.97 chg: +0.37 stop: 104.99

We remain on the sidelines with LEH. Our plan was to catch a dip back toward support following the September 1st breakout over resistance and ride LEH toward the $112.00 region on any pre-earnings momentum. Unfortunately, LEH has not cooperated and there has been no hint at a dip over the last few days. Actually shares of LEH are now up about eight days in a row. Experienced traders know that stocks tend to move in cycles and LEH is definitely short-term overbought. We're not going to give up yet now that LEH is overdue for a pull back. Our strategy is to buy calls on a dip into the $107.75-106.75 range, which is an adjustment from our previous entry range. If triggered we'll target the $112.00-112.50 region. If triggered we'll use a stop loss at $104.99.

Suggested Options:
We are not suggesting new plays at this time. Look for a dip into our suggested entry range. We do plan on exiting before LEH's late September earnings report.

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 09/20/05 (unconfirmed)
Average Daily Volume = 1.9 million


MDC Holdings - MDC - close: 80.14 change: +3.54 stop: 74.45*new*

MDC really soared on Friday (+4.6%) out performing the market and its peers in the homebuilding sector. The group got a boost on positive expectations that the industry will benefit from the Katrina rebuilding efforts. Plus, an analyst at JMP reiterated their "strong buy" rating on shares of MDC. The stock vaulted higher on above average volume and broke through resistance at the $78.00 level and the $80.00 mark. We are raising our stop loss to $74.45. We're not suggesting new plays right here as Friday's gain will have inflated the option premiums. If you're looking for a new entry point consider waiting for a dip back toward $78.00. Our target is the $83-85 range.

Suggested Options:
We are not suggesting new plays at this time.

Picked on September 01 at $ 77.01
Change since picked: + 3.13
Earnings Date 10/13/05 (unconfirmed)
Average Daily Volume = 489 thousand


Noble Corp - NE - close: 71.65 change: +1.45 stop: 67.25

The oil sector including the OIX and OSX indices have managed to hit new highs despite a pull back in crude oil prices. Repair work following hurricane Katrina should keep the oil services companies pretty busy for months to come. Technically shares of NE are inching closer to the top of its recent trading range and Friday's push past the $71.00 level looks like a new bullish entry point. The MACD indicator has produced a new buy signal and NE's Point & Figure chart points to a $94 target. We are suggesting bullish positions here with a $78.00-80.00 target range but more conservative traders might want to wait for a new high above $72.50 before considering new plays.

Suggested Options:
We are suggesting the October calls.

BUY CALL OCT 70.00 NE-JN OI=762 current ask $4.20
BUY CALL OCT 75.00 NE-JO OI=449 current ask $1.80

Picked on August 31 at $ 71.30
Change since picked: + 0.35
Earnings Date 10/17/05 (unconfirmed)
Average Daily Volume = 1.8 million


Potlatch - PCH - close: 54.03 chg: +0.21 stop: 51.99

We are not seeing a lot of follow through on PCH's recent buy signal. That has a feeling cautious. If we do not see PCH push past the simple 50-dma in the next two or three days we're going to close the play early.

Suggested Options:
We're not suggesting new plays at this time.

Picked on September 07 at $ 54.45
Change since picked: - 0.42
Earnings Date 10/17/05 (unconfirmed)
Average Daily Volume = 229 thousand

Put Updates

Carnival Corp - CCL - close: 49.70 chg: +0.28 stop: 50.26*new*

Traders need to be careful here and double-check their stop losses. Shares of CCL are trading just under resistance at the $50.00 mark and its 21-dma, which has been consistent resistance over the past several weeks marking the descending trendline of lower highs. CCL is oversold so a breakout over $50.00 could spark some short covering. We are not suggesting new plays. Instead we are tightening our stop loss to $50.26. Our target is the $47.75-47.00 range.

Suggested Options:
We are not suggesting new plays at this time.

Picked on August 10 at $ 51.79
Change since picked: - 2.09
Earnings Date 09/15/05 (unconfirmed)
Average Daily Volume = 2.5 million


Electronic Arts - ERTS - close: 56.12 change: -0.73 stop: 60.01

Video game titan ERTS continues to under perform the market. The stock lost 1.28% on Friday with volume coming in well above average and that suggests more weakness ahead. Not only is ERTS in a bearish pattern of lower highs and lower lows but rival Take Two Interactive (TTWO) just recently issued an earnings warning and that's weighing on the sector as well. Looking closer at shares of ERTS we do see a bounce from Friday's low so there could be another rebound on Monday but we'd expect that to fizzle in the $57.50-58.00 range. The P&F chart looks very bearish with $50 target. We are targeting a move into the $51.00-50.00 range.

Suggested Options:
We are suggesting the October puts.

BUY PUT OCT 60.00 EZQ-VL OI=1300 current ask $5.20
BUY PUT OCT 55.00 EZQ-VK OI=3068 current ask $2.05
BUY PUT OCT 50.00 EZQ-VJ OI=1349 current ask $0.65

Picked on August 30 at $ 56.41
Change since picked: - 0.29
Earnings Date 10/25/05 (unconfirmed)
Average Daily Volume = 3.7 million


Fedex Corp - FDX - close: 79.76 chg: -0.54 stop: 83.51 *new*

FDX under performed the broader market on Friday and joined its peers in the transportation sector with another decline. On a technical basis FDX has broken round-number support at the $80.00 mark on above average volume. Investors are cautious on FDX and UPS since both stand to lose a lot of transactions with so many businesses shut down along the gulf coast following hurricane Katrina. It's true. Jim mentioned in his wrap this weekend that the delivery companies should see a big up tick in business once the rebuilding has begun but the actual affect on earnings is yet to be determined. We see the decline under $80.00 as a new bearish entry point but FDX is oversold and a bounce back toward $81.00 and its 10-dma could occur before the stock hits new relative lows. We are lowering our stop loss to $83.51, just above the simple 50-dma. Our target is the $76-75 range.

Suggested Options:
We are suggesting October options but do plan to exit ahead of FDX's late September earnings report.

BUY PUT OCT 80.00 FDX-VP OI=7288 current ask $2.40
BUY PUT OCT 75.00 FDX-VO OI=1323 current ask $0.80

Picked on August 23 at $ 82.99
Change since picked: - 3.23
Earnings Date 09/22/05 (unconfirmed)
Average Daily Volume = 2.0 million


United Parcel Svc - UPS - cls: 68.50 chg: -0.33 stop: 72.01*new*

UPS is almost there! The stock tried to rally at the open on Friday but failed under the $69.00 level. Now shares of UPS look poised to hit our target in the $68.00-67.00 range on Monday. We are not suggesting new plays. More conservative traders may want to consider exiting early to lock in profits. We are lowering our stop loss to $72.01.

Suggested Options:
We are not suggesting new plays at this time.

Picked on August 17 at $ 71.99
Change since picked: - 3.49
Earnings Date 07/21/05 (confirmed)
Average Daily Volume = 2.6 million

Dropped Calls

Aetna - AET - close: 84.75 change: +1.00 stop: 78.95

Another strong day for healthcare-related stocks helped shares of AET add another 1.19%. More importantly AET traded to $84.96, which is inside our target range of $84.75-85.25. We are closing the play per our game plan. Readers can keep an eye on AET to watch and see if the stock pushes past overhead resistance in the $86.00-86.50 region.

Picked on September 06 at $ 80.25
Change since picked: + 4.50
Earnings Date 10/27/05 (unconfirmed)
Average Daily Volume = 2.0 million

Dropped Puts

KOS Pharma - KOSP - close: 69.45 chg: -0.06 stop: 70.51

While we have not been stopped out yet and KOSP still has overhead resistance at the $70.00 level and its simple 50-dma - we are choosing to exit early. The intraday action on Friday suggests that KOSP is poised to rally next week. We'd rather cut our losses early.

Picked on August 22 at $ 68.25
Change since picked: + 1.20
Earnings Date 08/04/05 (confirmed)
Average Daily Volume = 642 thousand

Trader's Corner

A Primer on Elliott Wave Theory

Mention EW Theory to most traders and their eyes immediately glaze over. It's a difficult trading method to master but once you get a feel for the movement of the market through EW analysis you start to understand what the next move is likely to be. And if your interpretation of the wave pattern says the market is going to zig but instead it zags, that too can be very useful information. EW Theory is a measure of social mood which can be measured by many different methods. We of course use measurements such as Consumer Sentiment to gauge public mood so as to get an idea how that will affect investor mood. The stock market happens to be one of the best gauges of social mood through history.

EW Theory is probably the most accurate and consistent stock market forecasting strategy ever. It is subject to interpretation and therefore is not foolproof but it provides some of the best forecasting out there. It can be used wherever human beings show their emotions--the stock, bond, commodity and currency markets, in fashion trends, political trends, and any other arena that is subject to a herd mentality and a prevailing social mood. There is some suggested reading material at the end of this article for anyone interested in learning more about this fascinating topic.

Before the stock markets we can see swings in social mood through the history of art, music and writings. Human beings have natural rhythms and together we have up and down cycles. Even in business we see these cycles as business expands and contracts, as does our economy. Left to operate on its own, we see these cycles play out in the stock market and these cycles have names--bull and bear markets. There are larger degree cycles such as Kondratieff cycles which average 54 years from high to low back to high. We've had some significant government interference in the past 20 years that has distorted these cycles but eventually the market forces (social mood swings) will prevail.

Some of the government interference in the market (e.g., injecting massive amounts of money into the banking system through the stock, bond and currency markets) will skew the daily and weekly swings in the market and generally speaking it will aggravate the swings and make them larger or last longer than they would normally. The swings can still be measured with EW analysis. And this analysis is basically done by counting waves. So when asked what they do all day, Elliotticians will say they count from 1 to 5 and say their ABC's.

I'll start this tutorial by stating the study of Elliott Wave is not a quick and short endeavor. What started as a theory by R.N. Elliott in the 1930's has evolved into a trading technique as well as a method to predict large social mood changes and what that will mean to the world. He studied the cycles in the stock market and noted repeating patterns in these cycles. He also noted fractals of these patterns, which basically are the same patterns in different time frames. This is where the real power of EW analysis comes in. Like so many other technical studies of the market, EW analysis can be used intraday, daily, weekly, monthly, you name it. Each wave in a larger wave pattern consists of similar smaller waves and this can be taken right down to tick charts. I will say that this analysis is subject to more error once you get below 60-min charts and this may have to do with program trading and market manipulation but longer time frames tend to smooth out these anomalies.

The Basics
Elliott isolated thirteen patterns of movement, or "waves," that recur in market price data and are repetitive in form, but are not necessarily repetitive in time or amplitude. He named, defined and illustrated the patterns and then described how these structures link together to form larger versions of those same patterns (fractals), how they in turn link to form identical patterns of the next larger size, and so on. The primary patterns are either motive which we'll call impulsive, or corrective. Impulsive moves consist of 5 waves whereas corrective moves are generally speaking 3-wave moves but can be more complex variations. The impulsive wave structure is the easiest one to grasp:

Figure 1

These impulsive 5-wave moves identify the primary trend in the time frame of interest. After a 5-wave move it will then be corrected. The simplest correction is an A-B-C wave count and this is what a correction would look like after the 5-wave move:

Figure 2

Notice in the above chart that after the 5-wave move is completed it is then labeled as a larger degree wave-(1). After the 3-wave A-B-C correction it is labeled wave-(2). Wave-(1) is the motive wave which is the impulsive move and is the one that identifies the trend. Each wave in the direction of the motive is also an impulsive wave and will consist of 5 waves (so it's a smaller fractal of the larger wave). Each wave that is counter to the motive is a correction and will consist of a smaller 3-wave move (or some variation of it). So in the pattern above, waves 1, 3 and 5 will be impulsive and consist of 5 smaller waves whereas waves 2 and 4 will be corrective and will be 3-wave moves. Looking at wave-(2) above, the primary direction is down and waves A and C are in the direction of this primary direction and therefore will be impulsive 5-wave moves (the exception is that wave-A can be more complex and have a corrective count) whereas wave-B is against the move and therefore will itself be corrective.

Putting this together we get a structure that looks like this:

Figure 3

Notice the fractals of the waves within the larger degree waves. Also note the Fibonacci number of waves within the groupings of waves. The Fibonacci sequence is 1, 2, 3, 5, 8, 13, 21, 34, 55 ... (keep adding the previous 2 numbers to get the next number). There are two large degree waves [1] and [2], which consists of 8 smaller waves (5 waves up, 3 waves down), and the number of waves comprising those 8 waves is 34 waves. Not only is the EW pattern comprised of a Fibonacci number of waves but as I'll show later it is typically guided by Fibonacci retracements and projections. This is the natural order of the universe and it's found right here in the stock market.

There are some typical relationships between the size of the waves which is a subject for another article (this will become too long if I go into all the details). But one EW rule is that wave-3 can't be the shortest wave. This is a hard and fast rule, no exceptions, unlike some of the other EW rules. If wave-3 becomes the shortest wave in your count then you have the wrong count. The 5th wave and 1st wave are often the same size. There is usually a Fibonacci relationship (38%, 50% or 62%) between the waves. Along with the count itself this can often help identify price targets where the move might find support/resistance.

Another EW rule is that wave-4 can not overlap with wave-1. So the low of wave-4 must stay above the top of wave-1 in the example above. This rule does have an exception and that's when the 5-wave move is inside an ascending or descending wedge (called diagonal triangles in EW terminology) which might look something like this:

Figure 4

Inside the wave-(5) in the above examples, which is where these wedges are often found, you can see that the 1st and 4th waves overlap. Also note that these wedges consist of all 3-wave moves for each of the 5 smaller waves. These wedges (and triangles discussed later) are the only place you find a lack of impulsive waves for 1, 3 and 5. This is what you look for when you see these wedges forming.

This brings us to some of the corrective wave structures. While there is only one motive wave--a 5-wave move--there are several types of corrective waves and these are by far the most difficult to interpret. It's often times not obvious what the EW count is until after it finishes. This is still helpful in identifying where you might be in the larger pattern and is therefore helpful in identifying the probable direction of the next move. But real time trading corrective moves can be a lot more challenging than trading an impulsive move.

There are two major styles of corrections--sharp and sideways. The sharp correction is a steep pullback against a rally or rally against a decline. A sideways correction tends to chew up time instead of getting a deeper price correction. Corrections will often be identified by the number of waves that make up each leg of the correction. For example, in an A-B-C correction that has waves A and C consisting of 5 waves each and wave-B consisting of 3 waves then it'll be referred to as a 5-3-5 correction and denotes a sharp correction (like the A-B-C corrections in Figure 3 above) and is referred to as a zigzag. The two primary styles of corrections can be broken into four main categories:

Zigzags (5-3-5 structure, includes 3 types: single, double and triple)
Flats (3-3-5 structure, includes 3 types: regular, expanded and running
Triangles (3-3-3-3-3 structure, includes 4 types: 3 contracting types--ascending, descending and symmetrical, and 1 expanding type (reverse symmetrical)
Double threes and triple threes (a combination of the above types)

I'll save a more detailed description of the various corrective types of waves for a follow-up article. Keeping it simple (?) for now, this shows an example of some of the above corrections:

Figure 5

This is a zigzag and shows the 5-3-5 structure of the A-B-C count. This would be a pullback correction to a rally.

Figure 6

This is a flat correction with a 3-3-5 structure. Note that in these 3-wave corrections wave-C is always a 5-wave move. When we're in a correction this is the wave to look for to indicate that the correction is ending. When you see this pattern ending with a 5-wave move you can prepare for a reversal back up in this case. An expanded flat is a little different in that wave-C will extend beyond wave-A. Also, wave-B can be higher than the start of wave-A which can throw off the correct interpretation since the new high is often thought of as the end of the previous move (up in this case) but in fact it may have ended at the previous high. That would look like this:

Figure 7

The common Fibonacci relationship between waves A and C in these expanded flat corrections is wave-C = 162% of wave-A. So again, using that Fib relationship and the final 5-wave move for wave-C will often give you a downside target to watch for a reversal back up.

The next category is triangles and this shows the 4 types:

Figure 8

Notice the internal structure of each of these patterns is a 3-3-3-3-3. In other words there are 5 internal waves (labeled a-b-c-d-e) and each consists of 3 waves. Once again, if you see one of these patterns developing, count the number of internal waves and when you think wave-e is tracing out, get ready for a reversal.

The last category is the double or triple threes. This is simply a combination of the above waves separated by a 3-wave move that is labeled wave-X. It could be a zigzag and a flat separated by a wave-x and would look like this:

Figure 9

You can see how the corrections are much more difficult to deal with than a single type of impulsive 5-wave move. Trading 5-wave moves is much simpler but unfortunately the market spends most of its time correcting and therefore it pays to study and practice these corrective waves. Because our stock market is in a very long term uptrend any pullback is by definition corrective. In other words bear markets are corrections to the longer term impulsive uptrend. That means bear markets are full of corrective moves and it makes EW analysis challenging. But even inside a correction you will see impulsive waves at the smaller degrees and therefore it's a very useful tool in all market conditions.

Practice is the key. There are charting programs out there that make an effort to label the waves for you. I have found all of them deficient and it's mostly due to these corrective waves. Labeling waves by hand on your own chart is the single best way to learn the nuances of them and helps you get a feel for how the market is moving. An example of getting a feel for a wave count is what I call the sniff test. If it doesn't look right it probably isn't. Computer programs have a hard time with the sniff test whereas the human brain is very good (with a little practice). Since the corrective wave count is often not clear until after it finishes, or just before it's about to finish, the human brain is better than a computer at projecting (visualizing) possibilities.

As mentioned above, Fibonacci retracements of a move give us targets for a correction. The most reliable Fib retracements to use are 21.4%, 38.2%, 50%, 61.8% and 78.6%. The combination of these retracements and the Fibonacci projections based on Fib relationships between the waves can be very helpful in identifying price targets. Another useful technique, and quite simple to employ, is the use of trend lines and parallel channels.

The wave patterns very often stick to trend lines and parallel channels. In an uptrend take a parallel to the uptrend line and attach it to the first high between the two lows. Referring to Figure 10 below, draw a line from the start of a rally through the first pullback which is wave-2. The parallel is attached to the top of wave-1 and the extension of it is often times a good guide for where wave-3 will stop.

Figure 10

After drawing in the trend lines as described above, once it appears wave-3 may have ended, draw a line from wave-2 to wave-3 and attach a parallel to wave-2. This lower line will often mark where wave-4 will find support. If wave-4 stops at a different place than the parallel, draw a line from wave-2 to wave-4 and then attach a parallel to wave-3. This parallel line will then often mark where wave-5 will end.

Drawing these kinds of parallel channels also works for corrections. Once you have two highs in a pullback, snap a parallel to the low that is between those two highs and that often marks where the next leg down (wave-C) will stop. This will be especially true if the market gives two equal legs up or down in its correction (wave-A = wave-C).

This is a lot of information to absorb so I'll save more details for future articles. Let's look at a couple of real life examples. Actual wave patterns are never as cut and dried, or as easy to identify, as the above patterns and this is where the subjective interpretation comes into play. A combination of EW analysis, Fibonacci retracements/projections and trend lines/channels makes for a powerful combination to determine price moves. Add in your other favorite technical tools for confirmation and you've got a trading system that is hard to beat. Let's take a look at the May-July rally in the RUT to see how the count progressed:

Chart 1

After the rally got underway, you can take a guess at waves (1) and (2) and then once we got a deeper pullback underway from the high on June 17th we could label that as wave-(3). As an alternative it would have been labeled A-B-C in case it was going to be just a 3-wave upward correction against the decline from earlier in the year. So a red trend line was drawn from wave-(1) to wave-(3) and a purple parallel line was attached to wave-(2). This provided a guide as to where wave-(4) might pull back to. Some times it drops down to it and other times it runs sideways over to it.

And sure enough wave-(4) stopped near that lower trend line. Now it became a question where wave-(5) would end.

Chart 2

As the rally progressed and came up near the upper trend line on July 12th, it looks like it ended and wave-(5) should be at that high. But looking a little closer at the inside of wave-(5) shows why it wasn't to be trusted as the end of the run up--as the rally progressed we got a quick succession of two highs and pullbacks, labeled waves 1 and 2 and then (i) and (ii) in the above chart. It can't be waves 1-2-3-4 because 4 would overlap wave-1 so it has to be another smaller degree 1st and 2nd wave as labeled above. This meant we needed to look for waves (iii), (iv) and (v) to finish wave-3.

Chart 3

Remember, each impulsive wave, as wave-3 is, consists of its own 5 waves so once wave-(v) was finished, that finished one larger degree wave which was wave-3. Then we got a sideways triangle wave-4 and note how this predicted the last move up to wave-5. Sideways triangles in this position of a rally are highly accurate in predicting the last move is coming. Once wave-5 was completed that finished the next larger degree wave-(5), thereby completing the 5-wave count up from the April low. One other thing to note on this chart is the mid-line of the up-channel. I've often found that the final 5th wave ends at this mid-line rather than making it all the way up to the top of the up-channel.

One last technique to help identify where the final 5th wave will end is to look for the relationship between the 1st and 5th waves. The common relationship between these two waves is that wave-5 will equal 62%, 100% or 162% of wave-1.

Chart 4

This chart shows a Fib projection for wave-5 based on the size of wave-1. QCharts has a tool to do this but you can obviously calculate it by hand. Wave-1, of wave-(5), ran from 625.84 to 646.04 so 20.20 points. From where wave-4 ended at 668.82, adding 20.20 points gives us an upside target of 689.02 which is what the Fib projection on the above chart shows. Had the rally not stopped there, I would have been looking for the upside Fib target of 701.50 up near the upper trend line.

Also note the negative divergence as shown by the stochastics on this chart at the top of the rally, which is very typically found at the 5th wave. I didn't get into the "personalities" of the waves but one of the hallmarks of 5th waves is that they lack the breadth of the stronger 3rd waves. This helps you identify whether you've got the correct EW count.

As I said at the start, this is not an easy tool to master. If you're serious about adding this technique to your toolbox, here is a recommended reading list. I would read them in the order listed so as to get a better understanding of the subject without getting overwhelmed with detail that's hard to understand. You may email me any questions you have on the subject. Good luck and have fun with it.

1) The Elliott Wave Principle Robert Prechter and A.J. Frost
2) Mastering Elliott Wave - Glenn Neely and Eric Hall
3) Conquer the Crash Robert Prechter
4) The Wave Principle of Human Social Behavior Robert Prechter

Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Keene H. Little, and all other plays and content by the Option Investor staff.


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