The market weakness continued this week to bring pain to traders still in long positions and confusion to those trying to buy the dips. Friday provided a ray of hope as the reversal, which began on Thursday continued to move higher. A morning decline in oil and gas prices reversed late in the day and allowed a rebound in energy stocks to provide added support to the tech led rally. Is the rally real or simply a head fake from oversold conditions? Traders will have to hold their breath until Monday to know for sure.
Dow Chart - Weekly
Nasdaq Chart - Weekly
SPX Chart - Weekly
Friday was chock full of economic reports led by the Consumer Price Index. The CPI rose +1.2% and more than double last month's +0.5% reading. Energy prices rose +12% driven by a +17.9% jump in gasoline and +4.6% jump in electricity and natural gas. The 12-month rate rose to +4.7% and the fastest inflation rate since 1991. Core prices excluding food and energy rose only +0.1% for the fifth consecutive month. If you don't eat or use energy your inflation rate is nearly flat for the year. The rest of us are faced with paying ever-increasing prices for everything we buy due to higher energy costs. With inflation at 14-year highs it is practically impossible to expect the Fed to pause anytime soon. This report almost guarantees rate hikes at the next four meetings if not longer.
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Industrial Production fell -1.3% in September and much larger than the expected -0.2% drop. Much of the drop was related to a -9.1% decline in mining output which includes oil and natural gas. The production outage after Katrina was obviously the biggest factor in the drop including the drop in refinery output. Capacity Utilization fell -1.2% to only 78.6% overall. This indicator of industrial output was impacted strongly by the hurricanes and should not be seen as a true reading of industrial strength. The most troubling component was a -3.7% drop in business equipment, a component not directly related to the hurricanes. There was also a -15.1% decline in aerospace and transportation equipment. However, general consumer goods were largely unaffected and lends credibility to the tame core inflation numbers in the CPI. Overall this report contains nothing that should impact the Fed's decision process.
August Business Inventories rose +0.4% and more than consensus estimates of +0.35 and a complete reversal of last months -0.4% decline. Despite a large decline of -2.1% in auto sales retail inventories rose strongly in August. This data is pre hurricane and could fluctuate wildly next month as September data becomes available. Inventories destined for the Gulf would have been put on hold when those destination businesses were damaged or destroyed. Post hurricane orders to replenish damaged or destroyed inventory levels should also see a boost but it could be over several months and related to the pace of the recovery cycle. The inventory to sales ratio remained at 1.3 as it has since January. This is a cycle low and still points to a lack of confidence by manufacturers about future economic strength. Nobody wants to be caught holding lots of inventory when the next recession appears so they are keeping inventory risk very low.
Retail Sales rose only slightly at +0.2% in September and less than estimates of +0.5%. I would have thought sales would have a tough uphill climb with more than four million displaced by hurricanes during the month. Sales at gasoline stations rose +4.0% due to higher gasoline prices. Year over year sales growth fell to only +6.5% due to a drop in auto sales once the special deals ended. Growth ex-autos rose +9.6%. Considering the special circumstances and the negative impact of autos this was actually a very strong report.
Consumer Sentiment slipped again, falling to 75.4 in October from 76.9 in September and slightly below expectations. Present conditions fell to 95.7 from 98.1 and expectations fell to 62.4 from 63.6. Neither component saw an earthshaking drop but just another decline in a four-month trend. Considering the constant news chatter about a coming pandemic, constant warnings about a +50% jump in utility bills and a -450 point drop in the Dow I am amazed we did not see a -10 point drop in sentiment.
This weekend marks a generational change in bankruptcy laws and there is a rush on to file before the deadline. In Q1 there were 294,520 filings followed by 362,481 in Q2. The numbers for Q3 are said to be off the scale. Many areas are reporting hundreds of filings per day with one report claiming 9,000 per day. There were several reports of block long lines as Friday approached. Alaska, Minnesota and Colorado have reported a +25% increase in filings for September. The problem is the new restrictions on eliminating debts. If you have assets or income you may have to pay out debts over a five-year period rather than erase them. According to most analysts only 15% of filers would fall into the restriction group but that did not stop the uneducated from rushing to the court house. If bankruptcies are up +25% or more then how strong can we expect consumer sentiment to be? Warnings of a -40% drop in housing prices coupled with a +50% increase in utilities has got to be weighing on the outlook for consumers.
A greater sign of investor sentiment for me was the marked decrease in the stock market internals last week. On Thursday we saw only 22 new 52-week highs and 598 new 52-week lows. This is a remarkable change in market sentiment and it came on a day when the Dow ended flat and the Nasdaq up +9. On the bright side this could be seen as something akin to a capitulation event. It came the day after a 4:1 imbalance with declining volume over advancing volume and more than five billion shares traded. The SPX traded as low as 1168, Dow 10156 and Nasdaq 2025 on that Thursday imbalance. Over the last week the Nasdaq had been the lead weight dragging the other markets lower and the Nasdaq was the first index to mount a rebound. The Russell also rebounded sharply from 615 to 632 from Thursday's bottom. This is very positive for sentiment as it indicates fund managers are again putting money into small caps. This suggests they are less fearful about a liquidity crunch or another major dip. October is now half over and we have seen a decent drop and five month lows on all the major indexes. Could this be the bottom we are looking for?
Refco Chart - 180 min
Refco was the main topic of conversation on Friday as it continues to unwind positions and close different businesses. The SEC got a court order that put restrictions on the various Refco companies to prevent last gasp attempts to trade their way out of a financial crisis or use customer funds to offset cash drains elsewhere. Refco closed its offshore securities and foreign exchange business, Refco Capital Markets, a hedge fund brokerage service after a surge in customers trying to take their money out. The entire Refco collapse was a major disaster for the markets but they appear to be handling it well. Refco is a major clearing broker on the futures exchanges as well as a major player in the introducing broker arena. There were billions of dollars in trades being unwound over the last week and many analysts believe the drop in gold and energy futures late in the week was due to dumping of those Refco positions. Customers with accounts at Refco were faced with the potential of a pending collapse and loss of their funds. While that may or may not be possible there is always the fear and closing positions and fleeing with cash to another firm was the number one priority this week. Refco stock fell from $28 to $8 before trading was halted and should trading resume it will likely go to near zero. The premeditated fraud prior to the IPO will likely unwind the entire IPO process but it will not be resolved until after the many class action suits wind their way through the courts. The main focus now is by regulators into what positions the company itself currently holds as well as the safety of customer funds. Once remaining customer funds are safe and released for disbursement we will see a mass exodus to other companies and those positions reinstated. Unless Refco itself or one of its subsidiaries has monster derivative positions still in force the impact to the market should be over. In fact, the market impact of the Refco news may have created the bottom we were looking for. If you remember the Refco news broke when the indexes were just above the critical support levels I had been watching, Dow 10250, Nasdaq 2100 and SPX 1190. The news sent shivers through the market and we broke that support with a new drop to the new lows. While a thank you is probably not in order for Refco I would be perfectly happy if those Refco lows were the lows for the rest of the year.
After the bell on Friday the Wall Street Journal said The Commodity Futures Trading Commission and the CME had asked Goldman Sachs to step into the gap left by Refco and take over at least some of the Refco liabilities and duties. Goldman would definitely have sufficient resources but the question remains if they would want to take on any of the liabilities of Refco without a guarantee by some agency that those liabilities would be limited. Goldman was hired by Refco this week as a financial advisor and rumor on the street late Friday was that GS was trying to sell the futures portion of the business not take it over.
The Refco problem started when trading losses of $335 million surfaced as a debt that had been shuffled from company to company to avoid being carried on Refco's books during the IPO. The debt, which has grown to $430 million over the years is said to be related to trading losses incurred when the hedge fund controlled by Victor Niederhoffer collapsed in 1997. Refco claimed at the time they suffered no losses but Niederhoffer claimed in a later suit that the broker, Refco, suffered substantial losses. Those losses appear to have been hidden to save face and reputation and Refco could never find a way to flush them through the books prior to the IPO. "Oh what a tangled web we weave when first we practice to deceive." (Sir Walter Scott)
Bennett, the CEO now on leave and indicted for fraud, still owns 34% of Refco post IPO. Thomas H. Lee Partners owned 49% of Refco pre-IPO but that was cut to 40% post IPO. Bennett also received a "special" $140 million dividend after the IPO. The money Bennett transferred to Refco reportedly to make Refco whole once the debt surfaced last week was in the form of 350,000 million in euros wired from an unnamed foreign bank to an account in the name of Bennett and Refco Group Holdings. It is said to be a loan against his remaining shares in the company. Considering the very good chance of a bankruptcy and shareholder suit that collateral may not be worth much.
AOL has suddenly become a hot property once again. I mentioned on Tuesday that MSN was in talks with Time Warner about some deal that included the possible merger of AOL and MSN. On Wednesday we heard a rumor that Google and Comcast were also in acquisition talks. The CEO of Time Warner refuted that as just a market rumor but on Friday Yahoo threw its hat into the ring as interested in acquiring all or at least part of AOL. When the Yahoo news hit the wires at 2:15 on Friday TWX stock shot up immediately. The company is trying to fight off an attack by Carl Icahn to produce higher investor returns by divesting non-core assets and buying back stock. Selling its AOL division could pacify Carl for at least the short term. We could actually see a strange deal emerge if the various non-Google parties decide to combine resources and take out the entire AOL division. It is not that they specifically have a burning desire to own AOL but mount a defensive play to keep Google from taking over a major Internet property.
The drop in oil prices back to a three-month low was all Occidental Petroleum needed to add to its proven reserves by purchasing Vintage Petroleum for $3.52 billion. OXY wanted to expand its reserves in Latin America and California. It will sell Vintage assets in East Texas, the Gulf and the Midwest. Those assets consist of 19,000 mbpd of oil production. Vintage produced 76,000 boe per day in Q2 and has 437 mb of proven reserves. OXY said it would double Vintage's production in Argentina within 5 years and output in California by 20%. The Vintage (VPI) deal is expected to add to OXY earnings and cash flow immediately once closed in Q1-2006. With oil companies accumulating cash as oil prices continue to rise we can expect to see many more acquisitions as companies find it is cheaper to buy reserves than find them.
Refiners are coming back online with all the Houston refineries running with the exception of the 437,000 mbpd owned by BP. In Lake Charles only the XOM 348,000 mbpd and Motiva 285,000 are still offline. Three refineries in New Orleans representing 534,00 mbpd are also still offline. That means only 10% of our total capacity is still offline. Oil production in the Gulf is slowly coming back online with the offline number falling to 67% for oil and 56% for natural gas. While the numbers are improving we need to remember that much of the remaining production will NOT be back online until March or even later. 3 bcf of natural gas will not be back online until March and after the winter heating season.
The oil and gas inventories on Thursday showed a decline in gasoline, heating oil and jet fuel for the fourth consecutive week. Oil imports rose +500,000 bbls to 8.619 mbpd but this was still the lowest weekly number since March 2003 and -7.9% below last years levels. U.S. production rose to 3.9 mbpd but that is -18.5% below last years levels. Bottom line we are far from back to normal levels and there are still shortages ahead. It does appear that we are going to dodge a serious bullet if we can get back to 50% production in the Gulf before Nov-1st when the traditional cold weather begins. It will still result in higher prices for utilities simply due to the demand/supply equation.
Several analysts were speculating that the Wed/Thr drop in oil/gas futures was related to the Refco positions being unwound to raise cash. We had a nice rebound underway from Monday's lows when lightning struck and knocked us back to $61. Late in the afternoon on Friday we saw a sharp spike in natural gas, which took it back into positive territory for the day at 13.21. We saw the same rebound in oil from the $61.15 low for the day to close at $62.75. There was definitely a sudden end to the selling and buyers returned. If in fact the selling was due to Refco position clearing and that clearing is complete then we could see a continued bounce next week. However, there is resistance at $65. I have been recommending buying the dips in oil stocks and this would be the last week before I would change that practice. Earnings for most oil stocks will be announced the week of Oct-24th and I expect lots of damage claims and lower earnings from lost production. I do not want to be in energy stocks over the week of the 24th. Once that week passes I would again favor buying the dip as we move into the winter heating season.
Natural Gas Futures Chart - 5 min
November Crude Futures Chart - Daily
Natural Gas Futures Chart - Daily
I have noticed a lot of TV advertisements for Conoco Phillips (COP) over the last two weeks. While they are my favorite oil stock for a long-term investment it does make me wonder if they are trying to increase investor comfort ahead of a nasty earnings surprise. Why else would they spend millions to run hundreds of costly high profile ads when the stock is only $9 from an all time high? That was the thought that occurred to me as I watched the charts this week. Conoco's 247,000 bpd Alliance refinery is not expected to restart until December or even January. The Lake Charles refinery just restarted this week. Several platforms were damaged and suffered production losses. 20,000 boe of daily production was lost for the entire quarter. The Ursa field remains shut in pending restoration of infrastructure in that area. These are just a few of the problems for COP that could help generate a negative surprise. I would not hold COP over earnings but I would buy any surprise dip. This also illustrates why I would not want to hold any oil stock with Gulf exposure over earnings.
Friday's rally was also seen in yields on the Ten-year treasury, which rose to 4.528% intraday and closed at 4.49%. This is eventually going to cause trouble in the equity market as it closes in on 5%. This is typically where institutions decide a safe 5% is better than a risky stock market. However, if last weeks low really starts looking like the low for Q4 then stocks could remain in favor until January. If the Fed does continue raising rates as expected and analysts are now talking about an end rate beginning with a 5, then ten year rates will definitely be in nose bleed territory by January. That means any equity weakness in January will immediately see an equity flush and asset allocations into bonds and away from stocks until the Fed is done raising rates. But, that is months away and we have a lot of fun ahead of us between now and January.
Next week there are quite a few economic reports but none are particularly exciting and none should be market movers. The highlights next week will be earnings as the calendar is weighted heavily with the major names through Thursday. Leading the list are these companies of note with those most watched in bold.
Monday: GM, IBM, NVLS, RMBS, PHG
The tech giant missing from the list is Microsoft, which reports on the 27th. There are nearly 500 companies reporting in the week of the 24th but after this coming Thursday closes we will already know what the future holds. If guidance is good then investors will probably rush in for the historical Q4 rally.
The bears will be screaming foul if a real rally breaks out but the stage is definitely set. The bullish sentiment in the market has declined substantially from levels seen just last month. The bears have ratcheted up their whining about the various reasons they see a new bear market just ahead. Short interest is high and the dip over the last three weeks has struck fear into the hearts of many investors. The stage is set for a surprise rebound on any run of good guidance.
Those following my suggestion to maintain a short bias under SPX 1185 had a nice run to 1168 before the rebound began. The rebound took us back to 1186 at Friday's close and based on Friday's action I am cautiously long again over that 1185 level. Friday's internals swapped sides with the negative divergence on Wednesday with a 3:1 edge of advancing volume to declining and advancers beat decliners 2:1. New 52-week lows were cut nearly in half at 345 from the 606 average of Wed/Thr. Clearly buyers were slipping back into the market BUT the market was also very oversold. Friday's rebound could have been just short covering before the weekend. Given the -450 Dow points lost in the prior drop a +70 point bounce was lackluster at best. Every rally has to start somewhere but I would have wished for about +125 points and 4:1 advancers to decliners for confirmation it was broad based. As traders we don't always get what we wish for and I will be content to see the SPX move back over 1200 and out of the congestive resistance formed over the last two weeks. If you are ultra cautious that move over 1200 would be real confirmation for me that the October lows are in.
Should the rally not continue then we have a clear line in the sand at 1168 and the five-month low. A successful retest of that level would be the desired result of any new dip. It also establishes clearly the level at which market sentiment would change 180 degrees almost instantly if broken. With a five month low already in place a failure of that low in October would be a disaster and a sign of serious market problems. Overhead resistance on the Nasdaq is just under 2100. Resistance on the Dow is much closer at 10300-10325 and just over Friday's close. With nearly a third of the Dow components reporting next week it faces an uphill challenge. While I would like to assume the bottom is in we all know what ass-u-me really means. I am going to maintain a bullish bias as long as the SPX is over 1180 but be ready to dump everything if it appears that level will fail. That gives me a five-point cushion for my longs I established at the 1185 level on Friday. Energy prices are right in the middle between their lows and overhead resistance so we could see some support from the energy sector. If energy loses traction ahead of earnings then it will fall to the tech stocks to save the day. Techs managed to post a +17 point gain on Friday without the help of the SOX, which lost -3.64 for the day. With IBM, RMBS, NVLS and PHG earnings on Monday and INTC, MOT and several lesser chip stocks on Tuesday there could be considerable uneasiness in chips and therefore techs. For the rally to continue it may have to overcome a chip deficit and it remains to be seen if we have that kind of tech traction at this stage of the rebound. We are also facing option expiration and traders will have to make an early week decision about holding expiring October positions. All of this makes next week very difficult to forecast and makes it even more important to enter passively, exit aggressively and definitely don't get married to your positions or your bias.
Burlington North/Santa Fe - BNI - cls: 57.43 chg: +0.59 stop: 55.99
Why We Like It:
BUY CALL NOV 55.00 BNI-KK OI=251 current ask $3.70
Picked on October 00 at $ 00.00
Target Corp - TGT - close: 53.49 change: +1.14 stop: 51.49
Why We Like It:
BUY CALL NOV 50.00 TGT-KJ OI=1767 current ask $4.40
Picked on October xx at $ xx.xx <-- see TRIGGER
AmerisourceBergen - ABC - cls: 74.81 chg: -0.07 stop: n/a
Why We Like It:
BUY CALL NOV 80.00 ABC-KP OI=544 current ask $0.95
This would put our total cost around $2.10. Try not to pay more than $2.50. We plan to exit if either option trades at $4.00.
Picked on October 16 at $ 74.81
E*trade Financial - ET - close: 16.28 chg: +0.34 stop: n/a
Why We Like It:
BUY CALL NOV 17.00 ET-KR OI=1037 current ask $0.50
Our total investment should be around 0.85. Try not to pay more than $1.00. We'll exit if either option trades into the $1.60-1.75 range.
Some of our readers might want to consider a straddle. You can probably buy a straddle, where you buy both a call and a put at the same strike, at the $16.00 strike for around $1.60.
Picked on October 16 at $ 16.28
Google Inc. - GOOG - close: 296.14 chg: -1.30 stop: n/a
Why We Like It:
BUY CALL NOV 320.00 GGD-KD OI=8242 current ask $5.70
This puts our cost around $12.20. We want to exit if either option trades in the $18.00-20.00 range (sell both options).
If you want to play the Decembers:
BUY CALL DEC 330.00 GGD-LF OI=4121 current ask $6.60
This puts our cost around $12.80. We want to exit if either option trades in the $18.00-20.00 range (sell both options).
Picked on October 16 at $296.14
Biosite Inc. - BSTE - close: 64.92 chg: +1.53 stop: 59.99
The market rebound helped BSTE confirm its Thursday breakout from its two-week trading range. We do not see any change from our original play description on Thursday so we're reprinting it here:
We are going to hedge our bets a little bit and add BSTE to the list as a bullish candidate. The company isn't quite a pure biotech play but the stock seemed to rally strongly with the BTK index. We also like how BSTE has been very resistance to the market's weakness over the past two weeks. While the rest of the market was falling shares of BSTE were consolidating sideways above the $60.00 level. Today's rebound from the $60.00 mark pushed through short-term resistance at the $62 level on volume about twice its daily average, which should suggest more strength ahead. We have two targets. Our first target is the $67.50 mark, where BSTE failed back in May. Our second target is the $69.50-70.00 range. The Point & Figure chart currently points to a bullish $87 target. The biggest risk here is the time frame. We want to exit ahead of the October 25th earnings report. Thus if we do not see some significant follow through on today's breakout over the next couple of sessions we're going to exit early!
BUY CALL NOV 60.00 BQS-KL OI= 70 current ask $6.70
Picked on October 13 at $ 63.39
Cardinal Health - CAH - close: 63.48 chg: +0.56 stop: 59.85
CAH's rally on Friday looks like a new bullish entry point although more conservative traders may want to wait for more confirmation with a move above the $64.00 level. Short-term technical oscillators are turning positive again and its P&F chart continues to point to a bullish $75 target. We are targeting a move into the $66-67 range before the company's earnings report on October 26th.
BUY CALL NOV 60.00 CAH-KL OI= 307 current ask $4.50
Picked on September 25 at $ 61.95
Pre Paid Legal - PPD - close: 40.53 chg: +0.88 stop: 37.85
PPD enjoyed a strong rally on Friday. The stock added 2.2% to breakout over the $40.00 level and technical resistance at its simple 50-dma. If you didn't buy the bounce from the $39.00 level then this is our entry point! PPD has broken its three-month trendline of resistance and almost all of its technical indicators are pointing higher. It is true that the P&F chart is still bearish but that won't stop the stock from bouncing back toward our target in the $44.00-45.00 range. We do plan to exit ahead of the October 24th earnings report but at this time that date is unconfirmed.
BUY CALL NOV 37.50 PPD-KU OI= 81 current ask $4.20
Picked on October 10 at $ 40.10
Teleflex Inc. - TFX - close: 66.36 chg: +0.42 stop: 69.01
TFX couldn't escape the market's bullishness on Friday but fortunately the stock continues to have a bearish posture. Shares appeared to top out in September-October and the recent sell-off has broken multiple levels of support. We would not be surprised to see TFX rebound higher again but traders can watch for a failed rally as a new entry point. Currently the $67.00 level is short-term overhead resistance but a move to $68 isn't out of the question. The Point & Figure chart has a relatively new sell signal that points to a $60.00 target. We do plan to exit ahead of the October 26th earnings report. Our target is the $62.50-62.00 range.
BUY PUT NOV 70.00 TFX-WN OI= 15 current ask $4.60
Picked on October 13 at $ 66.49
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
General Dynamics - GD - cls: 120.08 chg: +0.94 stop: n/a
This may be our last chance to initiate new positions in this strangle play. Shares of GD trended higher on Friday with the rest of the market but remains inside its short-term trading range between $121 and $119. Stunting GD's rally on Friday was news that Prudential initiated coverage on the stock with an under weight rating. We have a bullish bias on the stock but with this strangle play we don't care what direction the stock moves as long as the move is big enough to make our investment profitable. We do plan to hold over the company's earnings report on October 19th (this coming Wednesday).
BUY CALL NOV $125.00 GD-KE OI=1059 current ask $1.10
Picked on October 09 at $119.59
Legg Mason - LM - cls: 104.78 chg: +2.23 stop: n/a
LM out performed its peers and the market on Friday with a 2% bounce from its 100-dma and a continuation of the rebound off the $100 level, which is also the bottom of its three-month trading range. We suggested that more aggressive traders could buy calls to speculate on a bounce from the $100 level or buy puts if LM broke down under the $100 mark. We chose to launch a strangle play because of LM's conflicting signals. The stock was near support at $100 and its 100-dma and look poised to bounce but its P&F chart has recently produced a new sell signal that points to a $92 target. On Wednesday night we suggested a strangle with the November $110 call and the November $90 put. Thursday gave us a great entry point with the stock churning sideways in a narrow range. Given today's rebound we probably would not suggest new plays at this time. If LM returns back toward the $100 level before its earnings report on October 20th we might consider new strangle plays. Our goal is to exit if either option trades in the $7.00-8.00 range before November expiration.
CALL NOV $110 LM-KB OI=4709
Picked on October 12 at $102.59
3M Co. - MMM - close: 70.72 chg: +0.65 stop: n/a
It's probably not too late to consider new strangle positions on MMM. The stock did bounce higher with the rest of the market on Friday and the three-day trend looks like a bullish reversal but the longer-term trends still look bearish, especially the Point & Figure chart with its new triple-bottom breakdown sell signal. Of course with a strangle play we don't care what direction the stock moves as long as it moves big. We're counting on MMM's earnings report on Tuesday, October 18th to provide the catalyst for a big move between now and November option expiration. We would not suggest new plays after Monday's closing bell. We are planning to exit if either option trades in the $1.60-2.00 range. More aggressive traders may want to hold out for more.
BUY CALL NOV 75.00 MMM-KO OI=11766 current ask $0.50
Picked on October 12 at $ 70.38
O'Reilly Auto. - ORLY - close: 26.38 chg: +0.08 stop: n/a
We have nothing new to report on for ORLY. At this point we're in a "wait-and-see" mode. We're not suggesting new strangle positions since the stock has fallen out of its neutral consolidation pattern. We're expecting to see more movement following the October 25th earnings report.
Picked on October 09 at $ 28.23
Verifone Holdings - PAY - cls: 19.76 chg: +0.06 stop: n/a
PAY traded in a relatively narrow 33-cent range on Friday. The stock remains near the $20.00 mark so we would still consider launching new strangle positions on the stock. A quick glance at the chart shows the big three-month rally from its May lows and then a ten-week sideways consolidation that has narrowed significantly around the $20 level. We are suggesting a strangle to capture any future breakout and as long as PAY trades in the $19.25-20.75 range we would consider new positions. We do plan on holding over the November 18 earnings report.
BUY CALL JAN 22.50 PAY-AX OI= 50 current bid 0.80 ask $1.30
We would look for a $4.25-5.00 move in the stock.
If you choose to play Novembers:
BUY CALL NOV 22.50 PAY-KX OI=132 current bid 0.30 ask $0.60
We would look for a $3.00 or better move in the stock.
Picked on October 12 at $ 19.98
Biotech HOLDRs - BBH - close: 186.37 chg: +2.09 stop: 185.25
It looks like the tide has turned in the biotech stocks. Wednesday the BTK biotech index broke down under support and its 100-dma. Thursday saw the sector reverse course and Friday's big gain in the BTK helped confirm the rebound. We were never triggered so we're dropping this play unopened. Technical traders will note that the BBH still has a trend of lower highs at the moment.
Picked on October xx at $xxx.xx <-- see TRIGGER
Ryland Group - RYL - close: 64.65 chg: +1.20 stop: 66.75
We are still somewhat bearish on the homebuilders given all the technical damage done to their long-term trends over the past couple of months. However, the core-rate of inflation (ex-food and energy) came in low again for the fifth month in a row on Friday and that might spark a larger bounce in the homebuilders. Shares of RYL are already oversold so we'd rather exit early and watch the stock for another entry point. More aggressive traders may want to keep this bearish position open since RYL failed to rally through its exponential 200-dma on Friday. Right now we feel it's better to jump out than see this turn into a loss.
Picked on October 05 at $ 65.70
You didn't know that Ozzy Osbourne offered advice on trading options? Perhaps he doesn't. However, the lyrics of one of his songs, "I Don't Know," offers advice that day traders might consider when choosing an option. "You can choose," Osbourne sings, "don't confuse, win or lose, it's up to you." Sometimes the correct choice of an in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM) option for a day trade or any short-term trade determines whether that trade will profit or lose.
A little review might be in order for newbies, but experienced traders can skip this paragraph. A call is in the money when the underlying's price is above the strike price of the call, and a put is in the money when the underlying's price is beneath the strike. For example, if the OEX is at 550, a 545 call is five points in the money and a 555 put is also five points in the money. That five points is intrinsic value. That's part of the option's computed price, but only part. Other factors influencing an option's value include time to expiration and volatility of the underlying, among others. One formula often used for calculating an option's value is the Black-Scholes model. For those who would like to delve deeper into the particulars of options pricing, the www.cboe.com website offers a 25-minute Options Pricing self-paced tutorial on the Online Learning Center portion of the site.
Comparing apples and oranges never works well, so this article on choosing the correct option for a short-term trade focuses on the OEX. In that way, the article doesn't attempt to compare what might happen on an options trade with a volatile GOOG or CME and a complacent-by-comparison index such as the OEX. Generally, the shorter the time period you expect an OEX play to last, the more in-the-money you want your option to be. In other words, if you enter an OEX play in the early afternoon and expect to be out by the close, and anticipate that the OEX will move only two or three points during that time period, you want an ITM option.
Consider a recent OEX move, with a long entry at the close of trading Monday, October 10, when the OEX was at 550.01, and an exit near 9:40 am EST on Tuesday, October 11, when the OEX was between 552.15-552.21. Two call options are detailed, an ITM 545 and an OTM 555 strike. Because the 555's bid/ask spread is tight and the price is above $3.00, a buy at the ask and a sell at the bid are assumed. (Note to newbies: If an option's price is under $3.00, the minimum increments are $0.05, and it's conceivable that you could have split a $0.20 bid/ask spread with the market maker, but since the 555's price was above $3.00, the minimum increment was $0.10, and a market maker wasn't going to split the spread evenly with someone attempting to buy or sell the option, shaving off ten cents of the bid/ask spread. In such a tight spread, you would have had to have paid the ask and sold at the bid.) Because the 545's bid/ask spread is wider, the assumption is made that the buyer paid 70 percent of the spread at the purchase of the option, and collected 30 percent of the spread when the option was sold. That 70/30 spread seems reasonable for many OEX trades, at least in my experience. With those assumptions, the following table depicts the results.
Profit for an ITM and OTM Call:
Why did the ITM option profit more than the OTM one? That has to do with delta, also noted on the chart, both at the time the option was purchased (BTO) and when it was sold (STC). Technical texts define delta as the amount that the option moves for every one-point move in the underlying, the OEX in this case. The deeper ITM the option is, the higher the absolute value of the delta, and the more closely the option's price moves in lockstep with a move in the OEX's.
Call options possess positive deltas, and put options, negative deltas. This reflects the fact that put options' prices move in opposition to the underlying's moves. If the OEX moves up, for example, the price of a put option will move down. For calls, delta ranges between 0.0 and 1.0, and for puts, between 0.0 and -1.0. A call with a delta of 1 would theoretically move up one point for every point the OEX increased, while a put with a delta of -1 would theoretically decrease one point in value for every point the OEX climbed.
In non-technical terms, if you purchase an OTM option with a low delta, the OEX is going to have to move a whole bunch to change the value of that option by a little bit. Sometimes that big move happens, even in the often-range-bound OEX. Big moves were happening then week, for example, when the OEX was cascading lower. More often over the last year, the OEX has tended to move big for a few days and then consolidate in four-to-six-point ranges, sometimes for weeks. Sometimes a four-to-six-point move isn't completed in a single day, so a day trader who never or seldom holds overnight isn't going to capture even that entire four-to-six-point move.
If that's the case, imagine that you're pretty good but not perfect at market-timing and got in rather near the top of a three-point decline and exited fairly near the bottom, all during the same day. If you caught a two-and-a-half-point chunk out of the middle of that range, you'd probably feel pretty good about your timing skills, with a right to that pride. However, capturing that chunk out of the middle might not even capture enough profit in an OTM option with a delta near 0.30 to pay for your portion of the bid/ask spread and commissions. A 2.5-point move in the OEX would theoretically have brought you a 0.75-point move in the put. You might have picked the right time, the right entry and the right exit, and still not have profited, or have barely done so if you were good at splitting the bid/ask spread on both entry and exit and your brokerage charged low commission fees. As of the close on Friday, October 7, with the OEX at 552.93, an October 560 call had a delta of 0.3154, and an October 545 put had a delta of -0.2805. The call was about seven points OTM, and the put, almost eight.
Usually, you don't want to choose an option that much OTM, with a delta that low, if you intend a short-term play. On Friday, October 14, the OEX 565 call had a volume of 3,453, according to one broker. That call had a delta of 0.0494 at the end of the day. In other words, the call was moving up in price about a nickel for every point the OEX climbed. Although the OEX ranged from a low of 545.97 to a high of 550.63, the 565 call ranged only from a low of 0.15 to a high of 0.25. Perhaps these weren't purchased for day trading purposes, but the example demonstrates how difficult if not impossible it would have been to have profited on a short-term trade with an option that much OTM.
Lawrence G. McMillan, more widely quoted than Ozzy Osbourne when considering the choice of a correct option, says in OPTIONS AS A STRATEGIC INVESTMENT, "The shorter-term the strategy, the higher the delta should be of the instrument being used to trade the strategy." He advises that day traders buy near-term options with deltas of 0.90 or above, as those are going to be the options that move most in tandem with moves in the underlying. In fact, McMillan would advise that those day trading equities trade the equity and not the option, since the equity has the biggest delta, a delta of 1.0 or -1.0, depending on whether the stock is bought or shorted. For those day trading indices, however, options provide the needed leverage to be able to participate in movements. In my own day trading of the OEX, I'm more likely to choose an option with a delta of about +/- 0.70-0.80, as that seems to offer the best tradeoff between high deltas and liquidity of the option. At the close on Tuesday, October 4, for example, a trader would have had to choose a put more than 35 points in the money to approach a delta of -0.90, while a put 15 points in the money had a delta of -0.71.
For physics and math types, delta can be found by taking the partial derivative of the Black-Scholes equation for the option price with respect to the stock price. As an option moves more deeply into the money, the pricing curve turns up more sharply, and that tangent line you derived from the partial derivative slopes more strongly. Delta's absolute value increases up to a limit of one.
For the non-math or physics types whose brows are sweating at the thought of trying to take a partial derivative in order to calculate the delta of a particular option, you certainly aren't required to calculate those values or to visualize how that tangent might change as the option pricing curve changes. Many charting or quote services offer information on deltas for specific options. What most traders need to know is that ITM options have deltas with higher absolute values than ATM or OTM options, and the deeper ITM an option is, the higher its delta's absolute value.
Referring back to the chart above, at the time of the purchase of the two options, delta for the call about five points ITM was 0.65. For the call almost five points OTM, it was 0.37. The OEX move was about 2.20 points, so the ITM option should have moved approximately 1.43 points higher (2.20 x 0.65) and the OTM option should have moved about 0.81 points (2.20 x 0.37), a greater difference than that actually seen between the two options. Unfortunately, in this real-life example, it's not possible to isolate changes due to delta alone. The difference between the theoretical movements and the actual movements could be attributed to amateur-hour effects on the exit of the position as well as to other factors.
You math and physics types will have already have glimpsed another truth about delta. Since it's the tangent of a curving line, it will change as the curve does. What that means to the rest of you is that the delta of your option will change as the underlying moves up or down. If you purchase a call and the underlying moves up, the delta of the option will increase, too. That's apparent when studying the chart above. Deltas of both call options rose as the OEX did. In fact, the delta of the OTM option had risen more rapidly, probably also contributing to the narrowing of the differences between the profit on the two options. A more OTM option would not have risen so rapidly.
Generally, most day traders are not going to be calculating subtle changes in delta after an entry and basing exit decisions on those changes. They will be paying more attention to likely support and resistance levels or oscillator evidence. For the everyday trader, most decisions about delta are made at the time of entry. Options pricing changes during a play can be complicated by the peculiarities of puts and calls, the time remaining until expiration, and volatility contraction or expansion. This article was intended to focus on the narrow topic of choosing the correct option for a short-term trade, capturing as near a dollar-for-dollar move in the option and the underlying as is possible. That's not the same thing as getting a bigger return on investment, but the choice is often one that determines whether there's any return on your investment at all.
When making the decision to buy higher delta options, traders must recognize that a move against the position will also result in the price of the option moving down more quickly, so stops must be set and honored. A trader who is swing trading for a number of days and thinks the entry might be a little early and there's a chance of a movement against the position before it becomes profitable might want to choose an option with a slightly lower delta. That's a topic for another article, but I wanted to point out this difference in short-term trades and longer-term trades and reinforce the need to honor stops.
The whole subject might appear complicated, but it boils down to choosing an option that has a delta with an absolute value of 0.70 or above for short-term trades. That's not too complicated for options traders. After all, as Bonnie Raitt might counsel, "We can choose, you know, we ain't no amoeba."
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.
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