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Daily Newsletter, Monday, 09/19/2005

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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

Alan and Rita's Approach

Traders spent the session guessing at what tomorrow's FOMC announcement and Rita's arrival might hold, with last week's option expiration quickly forgotten. Equities fell straight from the open as gold, silver and energy futures rallied strongly. Gold hit 17-year highs and natural gas exceeded its Katrina highs, closing at a record high as the tropical storm headed toward the Gulf.

Volume breadth started out neutral to negative and worsened into the afternoon, improving slightly on a final-hour bounce but finishing the day in bear territory with 2.17 declining shares for each advancing on the NYSE, 2.51:1 on the Nasdaq. Overall volume was strong, with more than 3.1 billion combined DJIA and Nasdaq shares. QQQQ volume was less impressive, however, coming in just below its 74.7 million share average.

Daily Dow Chart

The Dow retraced all of Friday's gains and then some, exceeding the Friday low and testing Thursday's bottom before bouncing to close -84 at 10557. The loss of 10600 support erased roughly half of the post-Katrina gains, an auspicious start to the expected daily cycle downphase which should be imminent if the bears can hold it below 10600. Upside resistance is at 10630-10650, followed by the 10680 and 10700 lines. A close below 10540 should be enough to print the first daily cycle sell signals, below which 10440-50 comes into view.

Daily S&P 500 Chart

The SPX broke Friday's low but found support 2 points above Thursday's low, rising to close -6.89 at 1231.02. Nevertheless, the decline was enough to leave the daily cycle indicators on bearish kisses. Unless the bulls rally back to this morning's highs, new daily cycle sell signals should be imminent here, with 1218 and 1225 immediate key support below. Below 1218, 1205 is next meaningful support, by which point the daily cycle downphase should be in full swing. To the upside, bulls need to take out 1239 and 1245, but it would need to be a strong break to challenge the rollover in the longer weekly cycle (not shown).

Daily Nasdaq Chart

More bearish than its peers, the Nasdaq broke last week's lows with its 2139 low print, already well into its own daily cycle downphase. For the day, the Nasdaq lost 15 points to close at 2145. A close below 1240 is need to break 50 day EMA support and confirm that the daily downphase will not be corrective. With less than 40 points to the Katrina lows and the daily cycle downphase just kicking off, the bears will be in good shape provided that the 2160 high doesn't get violated from here..

Daily TNX Chart

Ten year note yields traded a narrow doji range today, finishing the session -1.5 bps at 4.247%. On the daily chart, the TNX held its September gains with the 10-day stochastic approaching overbought territory. 4.26%-4.3% is the confluence resistance level to beat, above which trendline resistance at 4.35% and 4.44% confluence will come into view.

The Fed's open market desk added some confusion this morning by announcing a relatively large $7.5 billion overnight repo to refund an even larger $9.5 billion weekend repo. This resulted in a net drain of $2 billion for the day, which was to be expected ahead of an anticipated rate hike tomorrow. The Oct. Fed Funds held the 96.265 level, and last week's open market operations had seen the stop out rate walking steadily higher, rising above 3.5 and indicating rising demand for overnight money toward an anticipated 3.75% overnight rate. The Fed's net $2 billion repo drain today actually saw the stop out rate decline slightly from Friday's level, however, losing 6 basis points on Treasury collateral to a reading of 3.53 for the day. Perhaps the Fed was trying to ease based on hurricane fears (see below). Or, perhaps it intends to "shock" the market if it raises tomorrow. In any event, the open market operations coincided with a sharp rally in commodities, with Dec. gold printing a new contract high and spot gold hitting 17 year highs while natural gas and crude oil both tacked on sharp spikes of more than 5% and 11% respectively.

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The action in the markets revealed the Fed's conundrum effectively enough. On the one hand, low rates and accommodative policy have encouraged rallies in commodities such as energy, metals, real estate, and other assets denominated in US Dollars. Greenspan himself raised the concern of stagflation in his Jackson Hole comments- economic stagnation exacerbated by prohibitively expensive energy- and said that the Fed would tighten in order to avoid it. But if the Fed tightens, then the massive exposure of US debtors, from consumers with negative savings rates and historically high levels of household debt to municipal, state and federal governments, will be threatened by an increase in borrowing costs. If the price of energy forces the Fed's hand, then those most directly exposed to interest rates would be the most at risk.

The problem seems to stem from the fact that all assets cannot rally indefinitely together- expensive oil and natural gas are incompatible with expensive houses (the NAHB-Wells Fargo housing market index fell to a 2 year low today) and stocks. Complicating the problem further is the incompatibility of expensive energy with low interest rates. Back in 1979-80, I was able to buy a GIC that yielded 20% for a year- which it had to in order to compete with expensive oil that year. Without foreign central bank purchase of debt, there can be little doubt that interest rates would be closer to 20% than to their current 4%.

For tomorrow, there is a great deal of dispute amongst experts as to what the Fed will do. Former Vice-Chairman of the Fed, Alan Blinder (who wrote my college economics text) told Marketwatch that in his opinion, Greenspan himself is still undecided. However, even when the stop out rate was above 3.5 last week and when it appeared that a rate hike was a certainty, metals and energies were holding strong, energies perhaps less so. With supply disruptions and steady strong demand (see below), however, energies continue to look strong whatever the Fed does. As a friend noted this weekend, bull markets are strong and scary, stressing bulls and bears alike by affording few opportunities to buy. Crude oil, natural gas and gold have been like that. Equities, however, have been far more accommodating to buyers, more rangebound than actually bullish or bearish. My own feeling is that the Fed will raise tomorrow, and continue to try to talk down the housing and energy rallies while leaving in the "measured-pace" language.

In the early afternoon, the Treasury auctioned $32 billion in 3-month and 6-month bills. Foreign central banks bought a solid $8.7 billion of the total, with the 3-month bills selling for 3.495% and fetching 2.25 bids for each accepted. The 6-month bills set a high-rate of 3.715%, with a bid-to-cover ratio of just 2.11.

Daily Chart of Crude oil

OPEC kicked off its 2-day meeting with an announcement that there will be no increase to its 28 million bpd production ceiling, but added that it would release up to 2 million bpd from spare capacity as and when needed. Libyan Energy Minister Fathi Omar Bin Shatwan said that there is no shortage of crude supply, but rather a paucity of refining capacity. A Saudi Arabian producer added that there are too few buyers of crude currently, implying an actual oversupply of crude product.

I would add that with price having declined from its 70.85 high to the 63 area, it may be the case that there was a drop in demand, but prices remain well over the 40-50 area where Saudi Arabia began talking down the price and Greenspan was calling it a spike. While it's true that refining capacity has been reduced and remains an important problem, producer cartels such as OPEC represent the interests not of buyers but of the sellers who comprise them. If OPEC is going to cancel expected production increases because "there are no buyers" at 63, then we can expect that the cartel will be resisting every decline in price for some time to come. The only way I see for energy costs to decline meaningfully is for demand to decline meaningfully- which, as I watch the ad for the new Dodge Charger, shows little risk of occurring.

These problems were exacerbated over the weekend as Tropical Storm Rita continued its approach toward the Florida Keys with the NHC issuing a hurricane watch. Its current path could threaten the Golf Coast, still recovering from Katrina. Natural gas was up over 6% this morning, back above the 11.50 level, as traders returned to their screens. The supply disruptions and inelastic demand of energies makes it a formidable opponent for a Fed only now beginning to acknowledge inflation risks. While there was a brief exuberant speculation that the Fed would be forced to abandon its round of rate hikes in the wake of Katrina, the market thought different and the consensus has returned to a 25 bp increase at tomorrow's 2:15 announcement.

On the daily chart, crude oil gapped and ran above what appears to have been a daily cycle bottom printed last week, adding 4.35 or 6.9% to close at 67.35, a nickel off the high of 67.40. Natural gas closed +1.495 or +13.41% at 12.64, a record close, 4.5 cents off the intraday high. Crude oil bulls will need to see a break above 68 on the way to an eventual break of the 70.85 top in order to avoid a potential head and shoulders within the broader weekly cycle (not shown). A lower high at this year's high could result in a right shoulder above a probable 63 neckline if the bulls are unable to take out that 67.50-68.00 resistance area.

The euro got smashed and German equities fell overnight as Angela Merkel and Chancellor Schroeder both claimed victory in a deadlocked general election. Merkel's conservative coalition took 35.2% of the votes in preliminary results, less than 1% ahead of Schroeder. Merkel's party, which had vowed to improve relations with Washington, came in well below poll projections- as much as 14% lower. The next results will come with Dresden's October 2nd vote, but in the meantime, uncertainty appears to be the only clear outcome of the preliminary vote. December euro futures finished -.74% at 1.2204, off a low of 1.2155.

In corporate news, Nike (NKE) reported Q1 earnings which rose from last year's Q1 earnings of $326.8 million or $1.21 per share on revenue of $3.56 billion to $423.3 million or $1.61 on revenue of $3.86 billion. Analysts were expecting EPS of $1.42 on revenue of $3.82 billion. This was a significant improvement for NKE, with its previous quarter marking the slowest revenue rise in 9 quarters. Reuters noted that the company's acquisition of "Starter" brand sold in Walmart stores had helped it extend its reach to a broader market segment than that reached by its premium shoes alone. NKE closed the day +6.36% at 83.45.

Just before the closing bell, it was announced that the finance ministers and central bank governors of the G7 nations have scheduled a meeting in Washington for this Friday, and will lunch with leaders from China, India, Brazil, South Africa and Russia. A statement will be issued following the meeting at roughly 6:30PM EST.

There were no major economic reports today, and tomorrow is light with Housing Starts and Building Permits at 8:30, followed by the FOMC at 2:15. It will be the heaviest day of this quiet week, however, with only Initial Claims and Leading Economic Indicators on Thursday. We can expect light volume and range going into the FOMC announcement tomorrow, followed by the usual stop running gyrations on high volume. After that, the real trend should emerge. If today's action was the reversal of positions put on in anticipation of a Fed pause, then the question will be whether we see its continuation in the event of a Fed hike. My guess is for 25 bps and tighter policy, in which case the gold/silver rallies should pause or reverse, while the weakness in homebuilders and the broader markets today should continue. Energies would presumably correct as well, but the fundamentals seem much more bullish to me there, particular as the latest hurricane bears down on the Gulf.

On the other hand, if the Fed does pause, we can expect the party in commodities to continue. My guess, however, is that the energy and raw materials rallies, even if they're somehow not fully reflected in the PPI and CPI, will nevertheless prove to be fatal to continued strength in US equities. Timing is the issue there, but I don't see how the broader markets can continue to avoid the ongoing multiplication in prices of natural gas and petroleum products, the lifeblood of our economy. Equities might initially rise on a reversal from the Fed, but ultimately I'd expect the energy rally to be the last one standing.

Regardless of what the Fed does tomorrow, caution is the rule. With equities close to their daily and weekly cycle highs, the technical picture favors bearish positions over bullish ones. But with the markets mulling the Fed, and the endless inflation-deflation debate, judicious entries and meaningful stops are essential to avoid getting caught on the wrong side of a sudden move. We'll be covering it tick-by-tick in the Market and Futures Monitors- see you there!
 


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

Amer. Intl Group - AIG - cls: 60.35 chg: -0.95 stop: 58.99

As a Dow component shares of AIG definitely struggled as the DJIA index reversed Friday's rally. AIG appears to have broken its short-term two-week trend of higher lows. Currently the stock is testing support near $60.00 and its simple 200-dma. Now that crude oil is spiking higher again the DJIA looks vulnerable so we would not suggest new bullish plays in AIG at the moment. A move over $62.00 might inspire new confidence. More conservative traders may want to adjust their stops closer to the $60 level.

Picked on September 11 at $ 61.23
Change since picked: - 0.88
Earnings Date 11/08/05 (unconfirmed)
Average Daily Volume = 7.2 million

---

Apache - APA - close: 76.60 change: +3.18 stop: 69.49

Potential hurricane Rita has sparked new concerns over supplies shortages and shutdowns for the oil and natural gas industries. This fueled a huge move in crude oil and natural gas prices today, which in turned helped power some pretty strong gains in the oil and energy stocks. APA, with exposure to both oil and natural gas, gapped higher to open at $75.10 and then spiked to $77.30 before paring its gains. Traders looking for new bullish entries might want to wait for a pull back toward $74.00 (or 73.50) in an attempt to fill the gap but there is no guarantee that APA will do so. Our short-term target is the $79-80 range.

Picked on September 18 at $ 73.42
Change since picked: + 3.18
Earnings Date 10/27/05 (unconfirmed)
Average Daily Volume = 2.6 million

---

Cameco Corp - CCJ - close: 54.70 chg: +1.40 stop: 49.49

CCJ turned in a strong session by adding 2.6% on above average volume. The higher oil rises the more interest there will be in alternative sources like nuclear power. Our target is the $58-60 range.

Picked on September 18 at $ 53.30
Change since picked: + 1.40
Earnings Date 11/01/05 (unconfirmed)
Average Daily Volume = 862 thousand

---

Altria Group - MO - close: 72.98 change: -0.16 stop: 69.90

Shares of MO actually managed to hit new all-time highs before sliding backwards under the weight of a negative DJIA. A minor 16-cent gain might be interpreted as a show of relative strength considering that MO could have seen a lot more profit taking. If the broader markets continue to slide we would watch MO for a pull back toward the $71.50 region and buy a bounce there. Our target is the $78.00-79.00 range.

Picked on September 18 at $ 73.14
Change since picked: - 0.16
Earnings Date 10/19/05 (unconfirmed)
Average Daily Volume = 6.7 million

---

Noble Energy - NBL - close: 45.65 chg: +0.91 stop: 42.49

The rally in energy stocks helped push NBL to a new all-time high above the $45.00 level ($90 pre-split). Volume was pretty strong. Our target is the $49.00-50.00 range.

Picked on September 11 at $ 44.90 *post-split price
Change since picked: + 0.75
Earnings Date 11/02/05 (unconfirmed)
Average Daily Volume = 796 thousand

---

Noble Corp - NE - close: 72.38 change: +2.23 stop: 67.85

Same story, different stock. Fears that tropical storm, soon to be hurricane, Rita will damage and shut down oil and refining operations along the gulf coast has sent crude oil and natural gas prices soaring. This lifted energy stocks and shares of NE have broken out to a new all-time high. We see today's move over $72 as a new bullish entry point. Our target is the $78-80 range.

Picked on August 31 at $ 71.30
Change since picked: + 1.08
Earnings Date 10/17/05 (unconfirmed)
Average Daily Volume = 1.8 million
 

Put Updates

Adobe Sys. - ADBE - close: 28.72 chg: -0.71 stop: n/a

Monday's weakness in tech stocks, driven by rising oil prices, proved to be an excuse to take profits in ADBE. We continue to target the $30.00 level and its simple 200-dma. (Remember, this is a strangle play. We are not suggesting new entries.)

Picked on September 13 at $ 26.82
Change since picked: + 1.98
Earnings Date 09/15/05 (confirmed)
Average Daily Volume = 6.2 million

---

Black & Decker - BDK - close: 82.31 chg: -0.89 stop: 87.75

Given the broad market sell-off we honestly would have expected BDK to display more weakness. We see no change from our weekend update. Our target is the $78-77 range.

Picked on September 14 at $ 83.31
Change since picked: - 1.00
Earnings Date 10/25/05 (unconfirmed)
Average Daily Volume = 636 thousand

---

Fedex Corp - FDX - close: 77.93 chg: -2.26 stop: 82.01

My, my... amazing what changes in a day's time. As of Friday the transport sector, and shares of FDX, looked poised to bounce higher. The spike in energy prices has sent the transportation sector lower and FDX lost 2.8% to breakdown under support to hit new yearly lows. The stock is nearing our target in the $76-75 range but traders may want to strongly consider taking some profits now and exiting early.

Picked on August 23 at $ 82.99
Change since picked: - 5.06
Earnings Date 09/22/05 (unconfirmed)
Average Daily Volume = 2.0 million

---

Hovnanian - HOV - close: 52.87 chg: -1.70 stp: 57.81

Monday's decline of more than three percent certainly looks like a strong follow through on Friday's technical breakdown under support. The stock actually dipped to $51.55 before bouncing. Volume was very heavy. If there is any oversold bounce we would watch for a failed rally under the $55.00 level as a new bearish entry point. Our target is the $50.25-50.00 range.

Picked on September 18 at $ 54.75
Change since picked: - 1.70
Earnings Date 09/07/05 (confirmed)
Average Daily Volume = 1.2 million

---

Hershey Co. - HSY - close: 57.65 change: -0.31 stop: 59.51

HSY is still struggling to breakdown under its three-week trading range. More conservative traders may want to wait for a decline under 57.35 before considering new bearish positions. Our target is the $54.00-53.50 range.

Picked on September 14 at $ 57.90
Change since picked: - 0.25
Earnings Date 10/20/05 (unconfirmed)
Average Daily Volume = 760 thousand

---

MBIA Inc. - MBI - close: 58.28 chg: +0.08 stop: 59.01

MBI's lack of participation in the market's (and financial sector's) weakness today is certainly an unusual show of strength. The stock remains under resistance at the simple 200-dma (58.50) and the top of its descending channel. Yet we are feeling rather cautious here and more conservative traders may want to exit early just to protect themselves. We are not suggesting new plays at this time.

Picked on September 13 at $ 57.75
Change since picked: + 0.53
Earnings Date 11/01/05 (unconfirmed)
Average Daily Volume = 1.2 million
 

Dropped Calls

None
 

Dropped Puts

None
 


Options 101

Writing Covered Calls Using Leap Options

Why buy when you can lease?

The Theory Behind the Practice

The concept is actually very simple. We all know how a covered call write works, when an individual writes a covered call he sells an option (call option) against the appropriate number of underlying shares of his common stock.

HYPOTHETICAL EXAMPLE

1. You own 400 shares of XYZ Corporation currently trading at 80 that you purchased for a price of 76 back in March.

2. You sell 4 calls options of the XYZ Corporation October 85 calls @ $1.00 or $100 each, for a total premium of $400 dollars.

This is an example of a covered call write.

But did you know you could also sell covered options against any LEAP option that you own?

How does that work?

Simple, You purchase a LEAP (1-3 years out in time) of a stock you ultimately would like to own, or at least like to own at a later date. The reason you are buying the leap is the same reason you are hopefully buying a stock; you anticipate the price of the stock to eventually go higher. However with the LEAP you have a smaller cash outlay then you would if you outright purchased the stock and paid for it in cash, or even if you purchased the stock on margin
(Remember you are being charged interest for everyday you have a debit balance with the brokerage firm)

However with the LEAP you can select how long you want to hold the right to purchase the stock down the road. That LEAP can be purchased anytime from 1-3 years out in time.
Hence, if you feel that the stock will not take off for at least 2-3 years. A three (3) year LEAP would be most appropriate. If on the other hand you think that the stock will be making a move in less then 2 years you might consider a 1-2 year LEAP option. No matter the choice, you can help reduce the cost of that LEAP option over the course of its life by selling call options against your LEAP position. The difference is instead of owning the shares of the underlying stock; you own the right to purchase the shares of the underlying from 1-3 years out, depending on your personal outlook for that particular stock issue. It is similar to you taking our a 2 3 year lease with an option of turning the car at the end of the lease or paying the residual and keeping the car. The LEAP gives you basically the same option; you can exercise the option and take the stock or sell the option for whatever it is worth, or walk away, spending only what you paid on the LEAP option. However, like I mentioned above, you can drastically reduce the ultimate price that you are paying for that LEAP by selling call options against the LEAP position. Here's an example.

Here is an example of how a covered LEAP would look.

1. You Buy 4 XYZ January 2007 LEAP OPTIONS @ 20 or $8,000 total
2. You Sell 4 XYZ OCT 85 Calls @ $1.00 or $400 against your LONG LEAP position.

Now let's look at a side-by-side comparison between the two positions

FIGURE 1-1 HYPOTHETICAL COVERED CALL WRITE VERSUS A COVERED LEAP WRITE

In addition you can sell covered calls every month, or quarter against your LEAP position, just like your covered write position against your stock. At the end of the 3 years you should have drastically reduced the net out of pocket cost of your LEAP options and are in a position to sell the LEAP for whatever value it has or exercise the LEAP and take the stock. It you ever get exercised, you exercise your LEAP and delivery the shares, just like a covered write.

The Real World Example GOOGLE $288

Here is a real world example using Google comparing the covered write of 400 shares of Google using the Google OCT 300 call @ $10.20 vs. the Google January 270 Call January 2007 LEAP @ $63.00. Notice in Figure 2-2 (below) how much leverage the LEAP covered call writer has versus the stock covered call writer.

FIGURE 2-2: GOOGLE EXAMPLE COVERED CALL WRITER VS. COVERED LEAP WRITER

The Bottom Line

Here was an example of how you could achieve a goal for a lot less capital outlay, buy using the LEAP option in place of the actual stock itself ( or even a purchase on margin). You gain the advantage of premium, as the LEAP option premium is less as a percentage then the short term call option premiums, so if the covered call writer who uses LEAPS does the same strategy as the call writer who uses stock. The bottom line is the call writer that utilizes the LEAPS will have a much lower capital outlay doing the same strategy, writing options at the same strike price and will be able to reduce his net capital outlay to a lot less out of pocket.


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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