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Daily Newsletter, Wednesday, 02/15/2006

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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

It Is Different This Time

At least it is according to the new Fed chief's testimony before the House Financial Services Committee. During Dr. Bernanke's much-anticipated testimony today, he assured questioners that the inversion of the yield curve might be different this time. Although such an inversion has historically signaled a potential economic slowdown, Dr. Bernanke reminded questioners that the relationship had been weakening over the last 15 years and that those other inversions had occurred at times when the yields were already high, causing a drag on the economy. This time is different, he said, in that yields are low. He doesn't believe that the recent inversions have been signaling a recession.

Perhaps it's a good thing that Bernanke offered those reassurances, as yields for the two-year treasury note closed the day at 4.70 percent, the 10-year note at 4.60, and the 30-year bonds at 4.57, all according to CNBC, showing an inversion of the two-year note over both of its longer-term counterparts.

Other reassurances included Bernanke's intention to direct the FOMC in continuity with practices under Alan Greenspan and Bernanke's belief that the economy had rebounded from its lull in the last quarter. He said that although further firming may be needed, much progress has been made in moving toward a neutral stance, and that the deficit should come down slowly over a matter of time. Committee members weren't always willing to accept Bernanke's reassurances, particularly when it came to the record deficit levels, but at the end of the day's testimony, most who had watched the hearing concluded that little new information had been relayed about Bernanke.

To varying degrees, indices wandered around before, during and after Bernanke's testimony, with a post-hearing afternoon bounce maintained by some and not by others. Ahead of AMAT's after-the-close earnings, the SOX was one index that did not hold onto the post-Bernanke bounce. Reaching another record new high, the TRAN did.

Annotated Daily Chart of the SPX:

The SPX might be caught in a narrowing triangle, but the Dow trades within a broadening formation. If anything, such formations are even more difficult to trade.

Annotated Daily Chart of the Dow:

In an old-style broadening formation that would ultimately break to the downside, the top red line would not be touched again, but there appears to be a drive to push the Dow up toward 11,117-11,156, so that won't-touch-the-top-again theory is not one that I trust yet. There is some suspicion appending to the Dow's pattern when neither the SPX nor the Wilshire 5000 are came close to challenging their January highs, much less exceeding them, but as long as the TRAN is driving higher, the Dow may make the attempt, too. As Jim noted last night, this looks like a rotation into big caps, more indicative of caution than of anything else. That caution was visible on the narrowing triangle on the SPX and in a similar one on the Nasdaq's chart.

Annotated Daily Chart of the Nasdaq:

Ahead of AMAT's earnings this afternoon, the SOX posted a gain, but its gain is not yet convincing proof of strength.

Annotated Daily Chart of the SOX:

Although few noticed, Bernanke's testimony was not the only economic event today. Jim Brown commented on the housing market in his Wrap last night, and the Mortgage Bankers Association released mortgage applications for the week ending February 10 at 7:00 EST. The report continued the recent downward trend, with the component measuring mortgage loan application volume falling a seasonally adjusted 7.3 percent. Other components fell, too, with the Purchase Index dropping 7.9 percent; the Refinance Index, 6.5 percent; the Conventional Index, 7.0 percent; and the Government Index, 11.2 percent. Four-week moving averages dropped 1.6 percent, 29.9 percent and 0.1 percent, respectively, for the Market Index, Purchase Index and Refinance Index. The average contract interest rate for 30-year fixed-rate mortgages remained the same at 6.25 percent, but points increased.

Although it closed well off its post-Bernanke high, the DJUSHB, the Dow Jones U.S. Home Construction Index, did manage a bounce today. That bounce had taken the index above the 10-sma, but it closed back at the average, not able to maintain values above it.

The NY Empire State Manufacturing Index, reported at 8:30, beat expectations of an 18.0-18.1 showing by turning in a 20.3 number for February, up from January's 20.1. Underneath the headline number, matters did not appear quite so cheery, as the employment index plunged to 4.7 from January's 11.7, the prices paid component rose to 52.8 from January's 46.6, new orders and shipments eased, and unfilled orders inched higher. Most responding to the survey felt that business conditions would improve over the next six months, but optimism did ease. As market participants awaited Bernanke's testimony and his take on economic growth as well as inflation, the higher prices-paid component and slight easing of optimism may have contributed to the wait-and-see attitude that seemed prevalent during early trading.

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Warm weather contributed to an easing of January's industrial production, reported this morning. Production at utilities dropped 10.1 percent, a record number, sending the headline number down 0.2 percent. Analysts had expected a rise of 0.2 percent, but it's unlikely that many were concerned about the weaker-than-expected showing due to its cause. Manufacturing output actually rose 0.7 percent. Capacity utilization was reported at the same time, up 80.9 percent against an expected 80.8-percent rise.

That unexpectedly warm weather contributed to a decline in crude prices, and conversely, to a climb in the Dow Jones Transportation Index, the TRAN. Tuesday, the TRAN reached a new record high of 4418.09, but at Monday's open, the index plunged below 4400 again, to a 4369.78 day's low reached during the first 15 minutes of trading, prior to the release of the inventories number. The TRAN eventually climbed to a new record high of 4444.32, with a new closing high of 4442.64. The TRAN verges on breaking out of resistance that it has not broken on a weekly closing basis since mid-1997, but the converse of that is that it could be verging on falling back through the envelope again.

Annotated Weekly Chart of the TRAN:

Crude inventories had been expected to build, and they did, but much more than expected. Crude inventories rose 4.9 million barrels; distillates, 900,000 barrels; and gasoline inventories, 2.2 million barrels. All remain above their average ranges for this time of year, and crude inventories are now pegged at their highest since the week that ended June 24, 2005. The TRAN promptly bounced to a new record high, abetted not only by the encouraging inventories numbers but also by Bernanke's expectation that the Fed's economic predictions were realistic and that the last quarter's lull was temporary. The TRAN was to show some volatility, dropping again before it soared to that new record high.

At the Nymex close, crude futures for March delivery closed at $57.60 per barrel. That close on the crude contract was to leave the maximum number of market watchers guessing, with the November low, hit twice on the daily chart, at $57.50. Is crude going to find support and bounce, even if perhaps into another lower high, or will it plunge through support that has held twice? As this report was prepared, it was bouncing, at $57.97.

Once Bernanke began to speak and until he finished, however, all attention focused on his comments. Widely anticipated by many to be hawkish on inflation, Bernanke seemed to confirm that impression when he commented that unless the FOMC was proactive, the economy could "overshoot" targets. Inflationary pressures could build. However, while he was still speaking, one online article was already terming him a "gentle hawk."

Committee member Paul Kajorski [(D)Pennsylvania] questioned Bernanke about the deficit, commenting that it was growing faster than productivity was growing. Under his questioning, Dr. Bernanke confessed to his own concerns about what the deficit does to personal savings and how demographics might factor into the deficit's impact on the economy.

Representative Ron Paul [(R) Texas] was to grill Bernanke on inflation, too, commenting that price increases were only a result of inflation, not the cause, which was an increase in money supply, among other factors. He asked Bernanke about the Fed's decision not to publish M3 money supply figures any longer. Bernanke answered that their research committee had concluded that M3 was not being used by either the academic community or the FOMC itself, and that it was a burden on the financial community to produce those figures. Representative Ron Paul commented that many considered the information important and that the appearance was that the information was being hidden.

All during his testimony, Bernanke tried to deflect any questions that would require him to intrude on territory that he thought properly belonged to Congress. When asked by Representative Christopher Shays [(R) Connecticut] whether the Federal budget had "a revenue problem or a spending problem," he asserted that Congress needed to make a decision on the proper size of the government, for example. When asked by two representatives to advise President Bush against the inadvisability of retaining all tax cuts, he commented that he did not want to inject himself into decisions that were the domain of others.

During the course of the testimony and the day's releases, the Fed raised the outlook for the economy from its previous 3.25-3.75 percent increase to a 3.25-4.00 percent increase, but at the conclusion of Bernanke's testimony, most felt that little new ground had been covered. The economy was still on track, the housing market was softening, the Fed had now begun a period of watching economic indicators, and an anticipated March rate hike might not be the last one.

Due to the focus on Bernanke's testimony, little attention was paid to an announcement by Merrill Lynch (MER) and BlackRock (BLK) confirming their anticipated merger into an asset management firm that will be one of the largest in the world, with that merger expected to be accomplished by the third quarter. MER closed higher by 0.18 percent, and BLK by a heftier 3.62 percent.

At first, retailers reacted negatively to Abercrombie & Fitch's toned-down outlook for the year, reported late Tuesday in a conference call with analysts. Some interpreted the remark as an attempt to force analysts to temper expectations that might have been unrealistic, that ANF could continue to deliver indefinitely same-store sales in the 20-30 percent range, as it had been doing over the last year. Many retailers were to see a strong bounce post-Bernanke, pushing the RLX, the retail index, into a 1.07 percent gain. ANF bounced off its low, too, but still closed lower by 2.10 percent. TGT, reporting tomorrow, gained 0.84 percent.

In other news, Delta Air Lines Inc. reported a fourth-quarter loss that narrowed from the previous quarter's loss. Fuel costs flamed 26 percent higher than they had in same quarter the previous year. The company also narrowed its loss for the year. The company operates under bankruptcy protection. The airlines were to gain 1.65 percent today.

After-hours developments included earnings reports from AMAT, HPQ, NTAP, SNPS and EXPE, and most gained in after-hours trading. AMAT reported that profit declined 51 percent, but sales and orders climbed. Excluding charges of 10 cents a share, the company's earnings were $0.17, beating expectations for $0.16. As this report was prepared, AMAT last traded at $20.79, up from its $20.46 close. HPQ reported earnings, excluding one-time items, of $0.42 a share, beating expectations of $0.44. The company's stock last traded at $32.88, up from its $31.67 close. NTAP last traded at $34.00, up from its $31.16 close, with one source noting earnings per share lower than expected, but revenue higher. SNPS traded at $22.90, above its $22.22 close. EXPE, however, traded at $21.39, down from its $24.25 close.

Traders will be busy fielding economic reports at 8:30 tomorrow morning, too, when January's building permits, export and import prices and housing starts will be released. Initial claims for the week of February 11 will be released at the same time. Natural gas inventories will be released at 10:30. Fed Chairman Bernanke will continue his testimony tomorrow. At noon, the February Philly Fed number will be released. Tomorrow evening, the important semi book-to-bill number will be released.

Companies reporting earnings include Administaff (ASF), Baker Hughes Incorporated (GHI), Bio-Rad Laboratories (BIO), Brocade Communications (BRCD), Cabot Oil & Gas Corporation (COG), DaimlerChrysler (DCX), Dell (DELL), Goodyear Tire & Rubber (GT), Guess (GES), ING Group (ING), JCPenney (JCP), NETGEAR (NTGR), NVIDIA Corporation (NVDA), Priceline.com (PCLN), Reliance Steel (RS), Sapient (SAPE), Target Corporation (TGT), Watson Pharmaceuticals (WPI), among others.

Almost every chart examined in tonight's Wrap indicates indecision and reveals chart formations that are known to be difficult to trade and less amenable than usual to technical analysis. A strong bias about the market might produce a winning trade--there's at least a 50 percent chance of that happening--and with these kinds of formations, a 50 percent chance of being right is about the tops that can be expected. These charts show us that ultimate direction is not yet decided, that even those who govern where markets can go are still battling the accumulation versus distribution decisions. Complicating these patterns will be another day of Bernanke testimony and option expiration. Beginning tomorrow at midday, the normal attempt to lock prices into certain levels will begin, whether or not that process is ultimately successful.

Watch the TRAN. It's unlikely that the DOW, OEX or SPX are going to fall too far as long as the TRAN charges higher. By many measures propounded by different types of technical analysts, the TRAN should be topping, but it tends to lead those three indices, and as long as it's charging higher, they might go higher, too. Watch the SOX, reacting to AMAT's earnings tomorrow and the book-to-bill Friday. The SOX also has exhibited many behaviors indicative of a topping out process, but it has not yet fallen out of the rising regression channel in place since October.

The boundaries on those chart formations are clear. Conservative traders should wait until there's a breakout and then a successful retest, and stay away from the chop inside those formations. Aggressive traders can either buy support and sell resistance (with most indices closer to resistance than to support) or buy or sell breakouts, but watch position size and be ready to reverse, if you're attempting either type of trade.

I wouldn't be surprised to see an attempt to push higher tomorrow. I wouldn't be surprised to see a runaway gain powered by a short-covering and I'm-late-to-the-party type environment, and I wouldn't be any more surprised to see an attempted push higher followed by a sharp reversal. These types of consolidation patterns just don't give any clues, and anything can happen. Trade with care. Watch the Futures and Market Monitors for minute-by-minute updates on what's going on, as these experienced commentators watch the action. I'll be reading their commentary right along with the rest of you.
 


New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None None None

New Calls

None today.
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

Beazer Homes - BZH - close: 64.43 change: -0.15 stop: 62.29

BZH did continue to bounce this morning but the bad news is that the rally failed at its descending 10-dma. Our trigger to buy calls was at $65.05 so the play is now open. Remember, this is a high-risk, speculative play as BZH tries to bounce from its simple 200-dma. We would not open new positions with BZH under $65. More conservative traders can wait for a move over the 10-dma (above today's high).

Picked on February 15 at $ 65.05
Change since picked: - 0.62
Earnings Date 01/19/06 (confirmed)
Average Daily Volume = 1.2 million

---

Chico's FAS - CHS - close: 48.78 change: +1.17 stop: 44.49

CHS continues to rally higher. Today's 2.4% gain put it at a new all-time high. Volume came in above average, which is positive for the stock. Readers can choose to chase it here or wait for a possible pull back toward the $46 region. Our target is the $52.00-52.50 range.

Picked on February 14 at $ 47.61
Change since picked: + 1.17
Earnings Date 03/01/06 (confirmed)
Average Daily Volume = 1.8 million


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Cigna - CI - close: 122.52 change: +0.83 stop: 117.85

CI is trying to inch higher but the stock has still not closed the gap down from Monday morning. More aggressive traders may want to consider new positions here. Our target is the $129.50-130.00 range.

Picked on February 12 at $123.63
Change since picked: - 1.11
Earnings Date 02/08/06 (confirmed)
Average Daily Volume = 979 thousand

---

Express Scripts - ESRX - close: 92.85 chg: +1.02 stop: 88.45

ESRX has finally turned positive for us and the stock hit a new all-time high on an intraday basis today. The stock probably benefited from a generally positive earnings report from rival Caremark (CMX) today. Our target is the $99.50-100.00 range. We do not want to hold over the late February earnings report and that only gives us about a week but so far the 22nd earnings date is unconfirmed.

Picked on January 29 at $ 92.42
Change since picked: + 0.43
Earnings Date 02/22/06 (unconfirmed)
Average Daily Volume = 2.1 million

---

Hartford Fin. Srv. - HIG - cls: 83.00 chg: +0.88 stop: 79.49

The bullish rebound in shares of HIG continued on Wednesday. Technical traders will note that the MACD indicator has also produced a new buy signal. We don't see any change from our new play description from Tuesday night. More conservative traders may want to exit near resistance at $85.00. We're going to target the $87.50-90.00 range.

Picked on February 14 at $ 82.12
Change since picked: + 0.88
Earnings Date 01/26/06 (confirmed)
Average Daily Volume = 1.1 million

---

Universal Health - UHS - close: 50.94 chg: +1.53 stop: 48.90 *new*

Our bullish play on UHS has been opened. Our trigger to buy calls was at $50.51. The stock added over 3% today and broke out over significant resistance in the $50.00-50.50 region. We have less than two weeks before UHS is expected to report earnings. Investors should keep that time frame in mind. We don't want to hold over the report. Our target is the $54.50-55.00 range. We are going to raise our stop loss to $48.90.

Picked on February 15 at $ 50.51
Change since picked: + 0.43
Earnings Date 02/27/06 (confirmed)
Average Daily Volume = 613 thousand
 

Put Updates

Cameco Corp. - CCJ - close: 70.26 change: +2.14 stop: 72.56

The strength in CCJ's bounce today and its close back over the $70.00 level makes us a bit uncomfortable. If you recall we are long-term fundamentally bullish on CCJ. This play is an attempt to capture some short-term profit taking since the stock was so overbought and its chart was flashing a sell signal. We are not suggesting new plays. More conservative traders may want to tighten their stops. Really conservative traders may just want to exit early right here to minimize their losses! Our target is the $61.50-60.00 range.

Picked on February 07 at $ 68.57
Change since picked: + 1.69
Earnings Date 01/31/06 (confirmed)
Average Daily Volume = 1.1 million

---

Intl Bus. Mach. - IBM - close: 80.85 change: -0.24 stop: 82.05

IBM continues to under perform its peers in the technology sector but we remain wary. The stock is butting up against resistance from its two-month trendline of lower highs. Yet bulls might point out the short-term trend of higher lows. If the market continues to rally we would expect IBM to follow so we're not suggesting new plays at this time. Our target is the $75.25-75.00 range.

Picked on February 06 at $ 79.49
Change since picked: + 1.36
Earnings Date 01/17/06 (confirmed)
Average Daily Volume = 6.0 million

---

MGIG Invest. - MTG - close: 63.86 change: +0.88 stop: 66.05

Today's rally in MTG may prove to be another entry point. Shares rallied to $64.42, near its exponential 200-dma, before turning lower again. While this might look like the sort of failed rally we could short we would wait for a move back under $63.40 before considering new positions. More conservative traders may want to tighten their stop losses. Our target is the $58.00-57.50 range.

Picked on February 06 at $ 63.70
Change since picked: + 0.16
Earnings Date 01/12/06 (confirmed)
Average Daily Volume = 833 thousand

---

Meritage Homes - MTH - close: 58.17 chg: -0.32 stop: 61.11

If you have not noticed yet we are hedging our bets in the homebuilders. MTH remains a bearish candidate in the group but we've recently added BZH as call candidate since shares look poised to bounce. Focusing on MTH the stock continues to trade under a short-term trendline of lower highs. We are not suggesting new positions at this time. Our target is the $52.00 level and this coincides with the P&F chart's target at $52.

Picked on February 02 at $ 58.76
Change since picked: - 0.59
Earnings Date 01/26/06 (confirmed)
Average Daily Volume = 560 thousand
 

Strangle Updates

(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.)

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Building Materials - BMHC - cls: 70.39 chg: +1.71 stop: n/a

We are not suggesting new strangle positions at this time. The options in our strangle play are the March $90 calls (BGU-CR) and the March $70 puts (BGU-ON). Our estimated cost is $8.20. Our target is $12.50 by March expiration.

Picked on December 18 at $ 80.95
Change since picked: -10.57
Earnings Date 02/07/06 (confirmed)
Average Daily Volume = 527 thousand

---

Encana Corp. - ECA - close: 40.97 chg: -0.35 stop: n/a

Crude oil futures sank again today dragging the sector along with it. ECA might be on the verge of a breakdown below the $40 level. We are not suggesting new strangle positions. Our strangle strategy involves the April $50 calls (ECA-DJ) and the April $40 puts (ECA-PH). Our estimated cost is $3.45. We are aiming for a rise to $5.95.

Picked on January 10 at $ 45.56
Change since picked: - 4.59
Earnings Date 02/15/06 (confirmed)
Average Daily Volume = 4.4 million

---

Loews Corp. - LTR - close: 95.05 change: -1.07 stop: n/a

LTR provided traders one last attractive entry point to consider launching strangle positions with the dip back toward the $95.00 mark today. The company is expected to report earnings tomorrow morning. Wall Street is looking for profits of $2.03 a share. We are not longer suggesting strangle positions in the stock. This is a high-risk speculative play. Buying this strangle is a bet that LTR will be trading at more than $102 (above resistance) or less than $88 (under support) by March expiration. The options in our strangle are the March $100 calls (LTR-CT) and the March $90 puts (LTR-OR). Our estimated cost is $1.75.

Picked on February 13 at $ 95.72
Change since picked: - 0.67
Earnings Date 02/16/06 (confirmed)
Average Daily Volume = 513 thousand

---

Ryland Group - RYL - close: 68.26 change: +0.54 stop: n/a

We do not see any change from our weekend update on RYL. We're not suggesting new strangle positions. Our play involves the April $80 calls (RYL-DP) and the April $70 puts (RYL-PN). Our estimated cost is $7.00. Our target is $12.00.

Picked on January 22 at $ 75.19
Change since picked: - 6.93
Earnings Date 01/24/06 (confirmed)
Average Daily Volume = 1.1 million
 

Dropped Calls

Lehman Brothers - LEH - cls: 145.40 chg: +3.47 stop: 134.49

Target achieved. News that MER and Blackrock had agreed to merge helped push the broker-dealer index to a new all-time high. Helping lead the way was LEH, which added 2.44% on big volume. Our target was the $144.95-145.00 range. More aggressive traders may want to keep the play open and aim for the $149 level.

Picked on February 12 at $137.50
Change since picked: + 7.90
Earnings Date 03/14/06 (unconfirmed)
Average Daily Volume = 2.0 million
 

Dropped Puts

None
 

Dropped Strangles

None
 


Trader's Corner

Technical Indicators: 'Oscillators' (Part 2)

Indicators are derived from, or are the results of, the computations of various formulas computed from either price or volume. That's all technical analysis works with in stocks; two inputs, price and volume.

The price used could be the High, Low, Open or Close. Most indicators, and the ones I will be describing briefly here, work with the closing price. A moving average formula is a simple example of a technical indicator. Take the last 10 closes of the Dow, add them, divide by 10 and you have a 10-day moving average; it 'moves' because with each day's close the close 11 days ago is dropped and today's close is added in; so, the average changes or 'moves' to a new result each day.

'OSCILLATOR' DEFINITION:
Oscillators are indicators that move with the (price) trend up or down and measures price 'momentum' in various ways. Oscillators are best known for their use in measuring potential extremes in a trend, especially in a strong up or down trend. These extremes are defined as 'overbought' or 'oversold'. A common use of this information is to look for shorting or put buying opportunities in a rising trend and buying opportunities in a falling trend.

Another important use of these type technical indicators is when there is a failure of an oscillator to also move, along with prices, to a new high or new low relative to the recent past.

Two very common oscillators are 'normalized' so that they only can have numbers ranging from 0 to 100. The Relative Strength Index (RSI) and Stochastic indicators move ('oscillate') between 0 and 100 only. This is unlike other technical indicators that measure momentum, such as the Moving Average Convergence Divergence model or 'MACD' (pronounced 'macdee') where the daily results can range from a positive to negative number.

Very frequently you will see below charts displayed by the various commentators on Option Investor.com and elsewhere, one or more of the 3 most common oscillators shown in the chart below. The Stochastics model in widest use is the 'Slow' variation, which employs a 'smoothing' factor that slows down the rate of fluctuation (oscillations) between the highs and lows.

By the way, you'll also note on the S&P 500 (SPX) daily chart below how recent lows held in the area of the dominant up trendline. The price pattern here was of most significance than the Indicators shown in suggesting a possible low and resumption of the up trendline (next key is if SPX pierces 1280).

The upper and lower (red or green) level lines on the 'normalized' (0 100) scale of the RSI and Slow Stochastics are the common 'default' settings for 'overbought' and 'oversold' settings typically seen on charting applications; 70,30 on the RSI and 80,20 on the Stochastic model. It's different on the MACD, where its use is more in seeing where the indicator stops falling and reverses to the upside and vice versa.

It matters a great deal which setting you select for 'length' on RSI and Stochastics. '5' is very short-term, 10 a bit less so, as well as 13 or 14 (a common setting). 10 would calculate its formula based on 10 daily closes on a daily chart, 10 hours on an hourly chart, 10 weeks on a weekly chart. On the RSI, I favor the use of 13 for daily charts, 21 for hourly and 8 for weekly charts (sometimes 13 for comparison on weekly charts).

I have gotten into the habit of using 21 as the 'length' setting for the daily Stochastics study, especially on the Dow 30 (INDU). There is no 'right' or 'wrong', 'good' or 'bad' setting on any of these. It depends a lot on how short, or longer, term you want to measure momentum for and whether you trade for small (price) swings or try to capture the longer intermediate trends (me).

NOTE: The Slow Stochastics indicator is often referred to simply as 'Stochastic(s)', since this variation of Stochastics is so common; the plural stochasticS is also common since there are two Stochastic lines that cross above and below each other.

For the MACD indicator when I use it, I use the common 12, 26 and 9 'default' settings suggested by Gerald Arpel, who invented MACD and use it like him, mostly on weekly charts.

A key reason why I use the Relative Strength Index (RSI) much more than the Stochastic and MACD indicators, which are in the same CLASS of Oscillator indicators, is for the instances when bullish or bearish PRICE/RSI DIVERGENCES show up by using the RSI specifically, which can signal trend reversals ahead.

I might as well diverge (no pun intended!) here and talk about my current market view, which includes one recent minor bullish price/RSI bullish divergences seen in the Nasdaq 100 hourly chart when using the 21-period RSI.

MY MIDWEEK TECHNICAL OUTLOOK:
I noted last week how the Dow 30 (INDU) had reversed right at a well defined up daily chart trendline. A 'well-defined' trendline is my way of describing a trendline where the lows or highs establish AT LEAST 3 points for the straight trendline but usually I am seeing many more than 3 in this reference.

Looking now at the HOURLY chart below for INDU, we see the breakout above a well-defined down trendline with the move above 10900 (this down trendline is an 'internal' or 'best-fit' line drawn through the MOST number of highs).

Piercing the down trendline was followed by a further sharp INDU advance and a new high for the move. I've often seen that rallies led by the Dow (a 'solitary walk of the Dow'), to be defensive rallies that may imply only limited upside potential in the broader market. The rebound WAS splendid for a play in Dow Index (DJX) calls. The tip off buy occurred on the formation of the trendline lows around 10750.

Regarding my topic of the use of oscillators, the hourly RSI shown above never got 'fully' oversold at recent lows, so was of less use than trendline considerations. This relates to an aziom about PRICE patterns being the dominant or 'lead' consideration in technical analysis.

Indicators tend to 'confirm' or amplify what we're seeing in the price chart. Or, indicator extremes can put us on ALERT or HIGH ALERT for the potential for an upside or downside reversal. It is like saying: 'pay attention' here!

Looking at the hourly chart of the broader S&P 500 (SPX) shown below, SPX does look poised for a bullish trendline breakout above 1280 (although it still has some way to go to achieve a decisive upside penetration of its prior high). Tomorrow (Thurs) should tell the story on that. With SPX, the formation of the recent 1258 low and point 3 of a lower trend channel line, was the telling trendline consideration.

The RSI did not provide as much of an 'aid' as the price pattern in taking a bullish trading stance at recent lows in SPX, as seen above. '21' as my length setting (calculates 21 hourly closes) on the hourly chart is a 'fibonacci' number (e.g., 5, 8, 13, 21, etc.); and, which I have found highlights the short-term extremes quite well when using the hourly RSI indicator.

We don't always see the upper or lower extremes of 70/30 with the longer 21-hour setting, as noted at the up/down blue arrows above. When the extremes DO occur with this (length) setting, it often occurs at or near a trend reversal. I would also note ('as above, so below') that the prior high (and a good put trade) was not accompanied by an 'overbought' RSI reading; nor was an oversold extreme then seen on the recent low. Patterns repeat!

In the widely traded S&P 100 (OEX) index, an earlier, also well-defined, hourly down trendline was pierced on the move above 577 as shown on my next chart. A prior rally high around 583 is the next resistance point.

As the OEX is getting near 'overbought' territory it would put me on alert to not overstay in OEX calls if the prior high is not exceeded; or only briefly, after which the Index then falls back.

DIVERGENT PRICE/RSI TRENDS:
The tech heavy Nasdaq is of course lagging the NYSE market. Per my topic of oscillators, the Nasdaq 100 or NDX had a bullish price/RSI DIVERGENCE seen in the hourly chart and the (21-hour) RSI indicator. As hourly prices were falling to two successively lower lows, the RSI was trending higher. An opposite directional tilt in the price and RSI trendlines is highlighted below.

The price/RSI bullish divergence shown above was a good indication that an upside reversal was coming in NDX, but says nothing about how high this current rally can or will carry.

NDX is approaching resistance defined by the down trendline highlighted (red down arrow) above; and, resistance implied by the top end of the downside price gap at 1685. The 1680-1685 area will be the key test for how much further upside and buying interest, exists in the Nas 100 index.

MORE ON OSCILLATOR TYPE INDICATORS:
I always try to emphasize that 'overbought' and 'oversold' relate a POTENTIAL vulnerability (to a reversal) only. A stock or an Index can stay oversold or overbought for a relatively long period in a strongly trending market. It is also true that rapid and steep advances or declines are not sustainable for an unlimited period. A market WILL correct at some point after a steep rise or fall, but WHEN is an open question.

This point is important because there is a tendency to think that the first time or two that an oscillator reaches an extreme reading, whether using an hourly, daily or a longer-term weekly chart, it might be time to EXIT that stock or Index.

However, we see many instances where the trend takes prices significantly higher or lower before there is a correction. Moreover, a 'correction' may turn out to be a SIDEWAYS move ONLY or a lateral consolidation. And, which has been going on for weeks, broadly speaking, in the current market.

Oscillators 'work' well in terms of timing and buying dips in a downswing and selling rallies in an upswing in a market that is experiencing two-sided price swings, rather than trending strongly in one direction.

CALCULATING THE STOCHASTICS INDICATOR:
The "stochastics process" (its first name) study was popularized by George Lane and someone who was involved in futures markets.

If I select Stochastics as a 'Study', in some applications such as Q-charts, I can edit length 'smoothing' of %K and 'smoothing' of something called '%D'. When these kind of choices are presented, I suggest setting the smoothing factor of %K to '1' so there is NO smoothing of this number. And I leave the default setting for smoothing of '%D' at 3; this is the number that 'smoothes out %K and that is the way this Indicator was designed to be used.

The most common 'length' used or the period (number of hours, days or weeks) that the stochastics formula will 'reference' tends to be either 9 or 14. At least these are common 'default' setting for 'length'; i.e., the number of closes that are calculated.

The stochastics 'default' oversold and overbought levels are typically pegged at 20 and at 80 and I find these a generally good setting, at least for the stock indexes. The stochastics can have very wide-ranging fluctuations between 0 and 100; e.g., a low at 5 or 10, a high at 90, especially in individual stocks and especially in ones more volatile in their price swings.

The Slow Stochastics indicator is composed of two lines a slower line called the percent D (%D) line which is simply a simple moving average of the faster %K line. As with the MACD, the two lines of varying speeds lead to 'crossovers' that generate buy and sell 'signals', at least that's how they're often perceived.

THE STOCHASTICS FORMULA -
The Stochastic study looks at the current price in relation to the HIGHEST HIGH and LOWEST LOW in the period being measured. Stochastics plots the current close in relation to the price range over the length set for this indicator and gives this a percentage value.

Buy and sell crossover signals are considered to be optimal if they occur in or near the overbought and oversold zones, respectively. There will be instances of crossovers that occur in the middle of these ranges and these shouldn't be utilized unless there is compelling other technical considerations that are guiding you; for example, a break out above or below an important trendline.

I won't say more than this on Stochastics; too boring! There are some reasons why I tend to favor the use of similar Relative Strength Indicator or RSI indicator, which is a single ratio between an average of up closes versus the average of down closes for a given ('length') period. I'll get into this next Wednesday.

MY INDEX TRADER COLUMN:
This Wed. Trader's Corner article serves as an adjunct to my weekend 'Index Trader' column. In my Trader's Corner article I update a midweek technical picture of the major indexes and use recent chart/technical indicator patterns to more fully explain their possible relevance to trading decisions in general.

More on my specific predictions, support and resistance, etc. is found in my weekend Index Trader column, available on the Option Investor.com WEB site (and not part of the e-mailed weekend OI Daily). You will see a web LINK to the Index Trader at the top of your weekend Option Investor Daily e-mail. My most recent (Sat, 2/11) Index Trader can also be viewed online by clicking here.


** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **
 

Today's Newsletter Notes: Market Wrap by Linda Piazza, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.

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