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Daily Newsletter, Wednesday, 04/12/2006

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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

A New Season

The new earnings cycle has begun. However, the rumble of Harley Davidson's (HDI) mufflers Wednesday morning wasn't enough to deflect attention away from global worries early in the pre-market session. Deflecting those worries, even if only temporarily, required the release of the narrowed trade deficit. That release pushed the dollar higher, raised ten-year yields, and buoyed futures. The Nasdaq futures dallied a little longer than the Dow and SPX futures, but did eventually move higher into the cash open. If bulls felt encouraged, boredom and worry were soon to set in, however.

Worries included this week's rise in crude and metals, decline in global bourses, and increase in rhetoric from Iran. Secretary of State Rice commented Wednesday on Iran's announcement about uranium enrichment by saying that the UN Security Council must take strong steps. The Nikkei had continued a slide that dropped the index 400 points off Friday's high, echoing our Dow Jones Transportation Index, also dropping steeply off Friday's high.

In addition, the International Energy Agency cut its estimate for global demand for crude, but only slightly, and the agency also stated that crude's rise in price was beginning to be felt across the globe. The action of two airlines emphasized that impact, with those airlines raising fares this week. Those concerns focused attention on the crude inventories to be released mid-morning.

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The spring earnings cycle might have begun, but futures weren't springing anywhere during the pre-market session until the release of the trade deficit. Economists had expected a narrowing, but a narrowing to $67.50 billion, not the reported $65.47 billion.

Bulls couldn't follow through on the boost provided by that number, however. Beginning about 10:00, many indices trended sideways to sideways down, with the TRAN, RLX and RUT modest exceptions. The TRAN had been diving since Friday's early morning new record intraday high, but after the crude inventories, the TRAN began rising. The RUT and RLX rose, too, but then chopped around in a tight range. Bulls staring at their monitors, hoping for a V-shaped recovery, might have done better to have gone out and enjoyed the beautiful spring weather in many parts of the country. Bears might as well have done the same, however.

The SPX formed a potential inverse H&S on its 15-minute chart Tuesday and Wednesday, but about midday, it became apparent that the right shoulder was beginning to stretch too far out in time. That signals dangers for bulls. Despite the short-term bullishness indicated by the formation, they don't have enough strength to drive prices higher and confirm it. Bulls who heeded the sign and exited with whatever profits they had were rewarded by an afternoon when they at least did not have to share their cohorts' boredom.

Annotated Daily Chart of the SPX

The Dow also formed a potential inverse H&S, but the right shoulder also stretched out too far. Still, the Dow's gain on the daily chart looks more impressive than the SPX's. There's a reason for that. The narrower Dow is often the recipient of buying when the intention is to make mom-and-pop investor believe that the markets are doing well.

Annotated Daily Chart of the Dow

Like the SPX, the short-term charts show that the Dow is trapped between near-term support and near-term resistance. That resistance appears be a little tougher than the support on the DOW, but all afternoon, resistance currently at 11,139.53 held on 15-minute closes while support currently at 11,129,42 held on 15-minute closes, so saying that resistance is tougher may be a judgment call. As the day ended, the Dow appeared ready to challenge that resistance again, so look to see whether that 11,139.53 resistance holds again on 15-minute closes.

The Dow obviously needs to break out of that tight consolidation pattern established most of the day before bulls or bears can profit, but if it breaks to the upside, watch that 10-sma and 11,160 for possible next upside resistance. If the Dow rolls over, strong support exists at 11,081 and then again at 11,028.

Like the Dow and the SPX, the Nasdaq formed a potential inverse H&S over Tuesday and Wednesday's trading, and, like the others, it also failed to push high enough to confirm that inverse H&S. The Nasdaq, however, perhaps has not yet invalidated its formation. The daily chart left some questions to be answered, too.

AAnnotated Daily Chart of the Nasdaq

The Nasdaq's chart is not bullish, as the former resistance should have held as support on the pullback. The pullback should have been choppier and not that straight-down fall. Denser support did hold, at least temporarily, and the 30-minute Keltner chart looks more hopeful than it does on some other indices. The 2323-2326 resistance should be watched closely for rollover potential if the Nasdaq should bounce above the 2318 level that kept showing up as resistance today. I'm not yet convinced that a test of the 50-sma and possibly the 72-ema is not still needed.br>
Positive developments in SOX components KLA-Tencor (KLAC) and Micron Technology (MU) helped that index during the early part of the session, before it, too, succumbed to that sideways/sideways-down pattern ahead of this afternoon's AMD report. RBC Capital Markets' Stuart Muter upgraded KLAC to a sector-perform rating from its previous under-perform one. An analyst reportedly had good things to say about MU's prospects, although that could not be verified by an independent source and the report found on Muter's comments did not include MU. Muter's comments about KLAC included his notation that some of the big-cap equipment names might be beginning to look attractive for long-term investors, but he rated Novellus Systems (NVLS) and Applied Materials (AMAT) below KLAC. He noted the low expectations that investors have for companies such as Taiwan Semiconductor Manufacturing Company (TSM), and said that if orders turned out to have been back-ended, that company's stock could rebound.

AAnnotated Daily Chart of the SOX

As of Wednesday's close, an intraday chart gave no more guidance than the daily one as to short-term direction. The SOX looked about equally likely to rise toward 509.25-510.99 as it was to drop toward 503.30, with lighter support and resistance between those levels. Fifteen-minute RSI squiggled near the neutral level. The formation had at one time looked like a possible inverse H&S, like the ones forming on other indices. Like the ones on those other indices, bulls couldn't manage a confirmation.br>
Advanced Micro Devices (AMD) reported in-line sales and earnings that appeared to beat expectations, at least as first reported. Earnings were $185 million or $0.38 a share, up from the year-ago level of $17 million or a loss of $0.04 a share. The company predicted that the second-quarter's sales would be slightly below the first quarter's. As this report was prepared, AMD was still halted.

The DJUSHB, the Dow Jones U.S. Home Construction Index. dropped heavily, with this rate-sensitive sector likely hit by a persistent climb in yields throughout the day. The Mortgage Bankers Association released mortgage applications for the week ending April 7 at 7:00 EST. The component measuring mortgage loan application volume dropped 5.5 percent on a seasonally adjusted basis from the previous week's number, and decreased 14.7 percent on an unadjusted basis from the year-ago level. All components fell, including conventional, government, refinance and purchase components. Four-week moving averages were mixed. The rate for thirty-year fixed-rate mortgages inched higher, to 6.50 percent from the previous week's 6.49 percent, but points increased, too.

As already noted, February's trade deficit narrowed more than expected, providing an early, if fleeting, boost to markets. That narrowing produced a 4.1 percent decline from January's record deficit, but it should be noted that January's number was revised slightly higher, to $68.6 from the previous $68.5 billion. The petroleum deficit increased. Exports declined 1.2 percent, but imports fell more, by 2.3 percent, with all major components of the imports number declining. The trade deficit with China was its lowest in eleven months.

While the surprise in this number could produce a slight upward revision in the GDP, economists do not expect the downtick to last. One footnote to the trade deficit--a statement by China that its March trade surplus with the U.S. widened--emphasizes the possible fleeting nature of this narrowing of the trade deficit. In addition, today three think tanks in Europe--the IFO, INSEE and ISAE--expressed concern about domestic demand weakness in the Eurozone amid their generally upbeat forecasts for the zone. This perhaps questions how much demand there will be in the Eurozone for U.S. goods.

The reaction to this economic release, initially positive, might have produced a slight "good news is bad news" effect. Market watchers worried about continued rate hikes don't want to see the GDP heat up too much, but the need to consolidate a several-day decline shouldn't be discounted as a factor in behavior of the markets.

The impact of rising crude prices shouldn't be discounted, either. Although crude prices declined after the inventories number and eventually closed at $70.05, well off its $71.05/barrel day's high, the specter of $75.00 crude doesn't seem far off now.

Analysts had expected a rise of 1.2-1.3 million barrels in crude inventories and a drop of 2.0-2.3 and 1.4-1.6 million barrels, respectively, in gasoline and distillate inventories. The range in expectations resulted from differing forecasts by various analysts. As happened other times recently, crude inventories rose more than expected, but gasoline and distillate inventories fell more than expected.

A drop of 3.9 million barrels in gasoline inventories puts supplies 1.9 percent below year-ago levels, the Energy Department reported. Distillate inventories declined 4.2 million barrels, but remain 12.3 percent above the year-ago level. Crude inventories rose 3.2 million barrels and are 7.8 percent above year-ago levels.

Especially during the pre-market session, but also during the day, many focused on company-specific news, too. Last night, Genentech (DNA) handily beat analysts' expectations, although the new options-accounting rules caused some confusion. By early this morning, Morgan Stanley had trimmed DNA's price target to $84.00, and some were citing disappointing outlooks for Rituxin as a reason for a post-report decline. Although DNA was down in pre-market, it soon bounced and exceeded Tuesday's close, but it couldn't hold onto that value. The stock was volatile as it probed for support and resistance and it ultimately closed lower, by 1.21 percent.

Harley-Davidson (HDI) arrived early Wednesday morning with its in-line report, but its rumble of mufflers wasn't going to impress investors. HDI gapped lower at the open and closed near its low of the day, down 5.92 percent. Circuit City (CC) also reported, with the retailer noting that strong sales in portable music devices, flat-panel televisions and notebook computers helped it to beat expectations. CC's stock bounced at the open and held onto almost all of its gains, closing higher by 8.28 percent.

Boeing's (BA) stock did more than bounce at the open: it surged. Since breaking over the top of a rising regression channel in place since 2002, BA had been consolidating sideways, but news that it had signed a contract to provide eighty more 737's to China Aviation Supplies Import and Export Group caused the stock to break out of the latest consolidation and soar higher. Morgan Stanley raised the price target to $110 from its previous $80 target and thought the price could go even higher. Although the stock could not hold onto its $84.23 high of the day, the pullback off that high was choppy and looked corrective, indicative of a possible further attempt to rise. BA closed at $83.21, up $2.64 and 3.27 percent.

Financial stock Progressive Corp. (PGR) was another reporting stock, bouncing after its first-quarter report. Unfortunately for PGR investors, prices fell into the upward gap after that initial pop and closed near the low of the day. While that's never a good sign, PGR did not close the gap and ended the day with a 2.22 percent gain.

In other news, JMP Securities downgraded Google Inc. (GOOG) to a market-perform rating from its previous strong buy rating and lowered its price target to $475 from the previous $550. An analyst with the firm also lowered the 2006 earnings forecast to $8.25 a share, down from the previous $9.25 a share. The firm believes that GOOG's Q1 and 2006 revenue growth will disappoint. Search queries fell below expectations, the analyst noted, and monetization of the Google Network and proprietary sites have not met expectations.

GOOG produced a doji within its recent consolidation zone and closed only $0.71 or 0.17 percent off the previous day's close, not giving much indication of next direction. Neither did the indices, but perhaps that will come tomorrow. Economic reports will include the standard initial claims and natural gas inventories. At the same 8:30 slot as initial claims, March export and import prices and retail sales will be released.

Retail sales, reported by the Census Bureau of the Department of Commerce, certainly have the ability to move the markets, if none of the others does. Retail sales are expected to climb 0.5-0.6 percent after the prior 1.4 percent drop. Ex-autos, the sales are expected to climb 0.5-0.7 percent after the previous 0.6 percent drop. The RLX, the S&P Retail Index, has been a good indicator index at times, and that index formed a doji above presumed strong support at 468.18-468.90, eventually closing at 470.64. The index appears ready to bounce or to fall further through that support.

The preliminary April Michigan sentiment will be reported at 9:50. Forecasts are somewhat wide-ranging, from 88.5-89.0, with the previous number at 88.9. Thursday's reporting companies include INFY and PII, but earnings don't really heat up until next week.

The SPX looked as if it might try a bounce early tomorrow morning, but an economic report will intervene and could change that impression. Whether any early bounce will carry it up toward the 30-sma or fail lower, at 1293-1294 or even at 1289, was not yet clear. If the SPX does climb to 1293-1294, bulls should take steps to protect profits and bears could begin looking for rollover opportunities, as long as the TRAN is weak. It must be remembered that although the TRAN declined steeply off Friday's new record intraday high, it did not violate a rising trendline off the January low and it sprang well off the day's low today. It's had a steep pullback, but no enduring technical damage has been done yet.

In addition, the RLX tested strong support and sprang higher. My inclination is to expect a bounce attempt and then to look for potential rollovers if there are bounces in the SPX, OEX or Dow, but watch the RLX and TRAN indices tomorrow, and don't count on steep declines in the SPX, OEX or Dow as long as the RLX and TRAN are still bouncing off yesterday's lows.

The RUT also looks ready to retest yesterday's high and perhaps climb toward 750-751. The SOX gave little indication of next short-term direction, but if both indices should bounce, sentiment might carry the Nasdaq higher, too. I don't like the Nasdaq's behavior for those seeking bullish plays, but I wouldn't be interested in touting a bearish one at resistance if both the RUT and the SOX were climbing, either.

The indices are consolidating big several-day losses. A balancing act is underway, with bulls who wanted to accumulate at the dip squaring off against bears. Not even the Russell 2000 pushed above a 50 percent retracement of the last drop from Tuesday's high, so none of these indices did anything particularly bullish Wednesday, except that they held their own in the face of several pressures. The Thursday before opex week can see crazy behavior, and the TRAN's action today argues that the underlying bid in the markets hasn't yet been completely undone, so be careful.
 


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

Arch Cap. Grp. - ACGL - cls: 57.86 chg: -0.05 stop: 55.95

ACGL continues to consolidate sideways but given the intraday action today our suspicion that shares will test the $57.00 level are only growing stronger. We're not suggesting new bullish positions. We'd rather wait and watch for a bounce near $57 as a potential entry point. Our target is currently the $62.50-63.00 range. We do not want to hold over the late April earnings report.

Picked on April 03 at $ 58.15
Change since picked: - 0.29
Earnings Date 04/27/06 (unconfirmed)
Average Daily Volume = 195 thousand

---

Amerada Hess - AHC - close: 143.89 chg: -1.31 stop: 139.95

News that crude oil inventory levels in the U.S. rose again sparked some profit taking in oil and oil stocks despite growing concerns over a confrontation with Iran. AHC continued to dip lower but the stock appeared to be on the rebound late this afternoon. We would wait for a bounce back over $146 before considering new bullish positions. Currently our target is the $154.00-155.00 range. We do not want to hold over the April 26th earnings report.

Picked on April 05 at $146.51
Change since picked: - 2.62
Earnings Date 04/26/06 (confirmed)
Average Daily Volume = 1.5 million

---

Anadarko Petrol. - APC - cls: 103.67 chg: -2.11 stop: 98.90

We warned readers to expect a dip to the 10-dma and APC delivered today. If shares don't bounce near the $103 level then the stock may be headed for technical support at the 50-dma, near round number support at $100. Our target remains the $109.50-110 range. The P&F chart remains bullish with a breakout buy signal that points to a $127 target. We do not want to hold over the late April earnings report.

Picked on March 28 at $102.10
Change since picked: + 1.57
Earnings Date 04/28/06 (unconfirmed)
Average Daily Volume = 2.5 million

---

Burlington NrthSanta Fe - BNI - cls: 83.03 chg: +0.49 stop: 79.95

Transportation stocks managed to post a gain today thanks in part to a strong session for Boeing. We are encouraged by the intraday rebound in shares of BNI today and this might be a new bullish entry point. Our target is the $87.50-90.00 range. We do not want to hold over BNI's late April earnings report.

Picked on March 27 at $ 82.51
Change since picked: + 0.52
Earnings Date 04/25/06 (unconfirmed)
Average Daily Volume = 2.1 million

---

ConocoPhillips - COP - close: 67.33 chg: -0.03 stop: 62.45

We see no change from our previous updates on COP. Short-term support appears to be in the $64.50-65.50 region. Our target for COP is the $69.00-70.00 range.

Picked on March 29 at $ 64.80
Change since picked: + 2.53
Earnings Date 04/26/06 (unconfirmed)
Average Daily Volume = 10.5 million

---

Lehman Brothers - LEH - close: 148.98 change: +0.98 stop: 143.49

LEH produced a bit of a bounce today and the long-term trend remains bullish but short-term it's a toss up with the technical indicators pointing both directions. The bounce from $148 is encouraging. We are suggesting that readers consider selling half their positions at $153.00 and then sell the second half of their position at $159.00. More conservative traders may want to exit completely near $152.50-153.00.

Picked on March 22 at $144.61
Change since picked: + 4.37
Earnings Date 06/14/06 (unconfirmed)
Average Daily Volume = 2.0 million

---

Marvell Tech. - MRVL - close: 56.51 change: +0.02 stop: 54.99

The semiconductor sector tried to bounce today but it did not make it very far. Shares of MRVL produced an even weaker bounce. We're not suggesting new bullish positions at this time.

Picked on April 06 at $ 60.18
Change since picked: - 3.67
Earnings Date 05/25/06 (unconfirmed)
Average Daily Volume = 5.9 million
 

Put Updates

Amgen Inc. - AMGN - close: 69.97 chg: -0.27 stop: 72.55

Rival biotech firm Genentech (DNA) reported earnings that were better than expected and the company gave positive guidance but the stock still sold off on the news. The positive earnings news helped fuel a bounce in the rest of the sector but shares of AMGN under performed and closed under the $70.00 level. Our target for AMGN is the $65.50 mark. Don't forget that we plan to exit ahead of the April 18th earnings report.

Picked on April 11 at $ 69.90
Change since picked: + 0.07
Earnings Date 04/18/06 (confirmed)
Average Daily Volume = 10.7 million

---

Apollo Group - APOL - close: 52.56 chg: -0.22 stop: 53.31

We see no change from our weekend update for APOL. We're suggesting a trigger to buy puts at $49.85, which is under support at the $50.00 level. If triggered we will have two targets. Our first target is the $45.50-45.00 range. Conservative traders can exit here, the rest of us we're suggesting sell half their position. We'll keep the other half open and target a decline into the $41.00-40.00 range, which is closer to the bottom of its channel.

Picked on April xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 06/22/06 (unconfirmed)
Average Daily Volume = 2.4 million

---

Express Scripts - ESRX - close: 84.61 chg: +0.70 stop: 90.01

ESRX continued to bounce today but the bounce began to fail after the stock filled the gap down from Monday morning. Plus, volume was pretty mild today suggesting a lack of confidence or conviction. This may be the failed rally we're looking for but watch for a decline back under $84 to initiate positions. Our short-term target is the $80.25-80.00 range. However, more aggressive traders may want to aim lower. The H&S pattern points to a target in the $73-74 range, which, coincidentally is where you'll find the simple 200-dma. We do not want to hold over the April 26th earnings report.

Picked on April 09 at $ 85.39
Change since picked: - 0.75
Earnings Date 04/26/06 (confirmed)
Average Daily Volume = 1.6 million

---

Genzyme Corp. - GENZ - close: 64.89 chg: +1.49 stop: 68.01

It looks like bulls were inspired (or the shorts were scared) by the strong earnings news coming from DNA. Shares of GENZ rallied higher right from the opening bell. However, the momentum stalled once GENZ hit resistance near $65.00. Watch for a failed rally in the $65.00-65.50 range as a new entry point. Yet keep in mind we have a short time frame here since we plan to exit ahead of earnings next week. Our target is the $61.00-60.00 range.

Picked on April 10 at $ 63.97 *gap lower*
Change since picked: + 0.92
Earnings Date 04/19/06 (confirmed)
Average Daily Volume = 2.1 million

---

Overseas Shipping - OSG - cls: 47.45 chg: -0.65 stop: 50.01

OSG lost 1.35% today on strong volume, which is a good sign for the bears. Shares also closed under what could have been support at the $47.50 level. We see no changes from our Tuesday play description. Our target will be the $43.00-42.50 range. Please note there is some support near $46.00 and we do anticipate a bounce there but the prevailing pattern is bearish. We do not want to hold over the early May earnings report.

Picked on April 11 at $ 48.10
Change since picked: - 0.65
Earnings Date 05/02/06 (unconfirmed)
Average Daily Volume = 469 thousand

---

Reynolds American - RAI - close: 104.78 chg: +1.15 stop: 108.01

RAI produced an oversold bounce today but the rally struggled near the $105 level and resistance at the 50-dma (105.45). Watch for a new decline from here as a new bearish entry point to buy puts. Our target is the 100-dma near the $100.00 mark. We'll use an exit range of $100.50-100.00. We do not want to hold over the late April earnings report.

Picked on April 09 at $104.97
Change since picked: - 0.19
Earnings Date 04/27/06 (unconfirmed)
Average Daily Volume = 637 thousand

---

Texas Ind. - TXI - close: 58.52 chg: +0.18 stop: 61.11

TXI failed to do much of anything on Wednesday. The stock consolidated sideways in a narrow range on low volume. We remain bearish but more conservative traders may want to wait for a drop below $57.90 before initiating positions. Our target will be the simple 200-dma in the $54.00-53.50 range. A move under $57.00 would produce a new P&F chart sell signal.

Picked on April 11 at $ 58.34
Change since picked: + 0.18
Earnings Date 06/29/06 (unconfirmed)
Average Daily Volume = 423 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.)

---

Encana Corp. - ECA - close: 47.66 chg: +0.31 stop: n/a

We are not suggesting new positions. Our strangle strategy involves the April $50 calls (ECA-DJ) and the April $40 puts (ECA-PH). Our estimated cost is $3.45.

Picked on January 10 at $ 45.56
Change since picked: + 2.10
Earnings Date 02/15/06 (confirmed)
Average Daily Volume = 4.4 million

---

Ryland Group - RYL - close: 68.60 change: -1.11 stop: n/a

We do not see any change from our weekend update for RYL. We are not suggesting new plays. Our play involves the April $80 calls (RYL-DP) and the April $70 puts (RYL-PN).

Picked on January 22 at $ 75.19
Change since picked: - 6.47
Earnings Date 01/24/06 (confirmed)
Average Daily Volume = 1.1 million
 

Dropped Calls

Beazer Homes - BZH - close: 64.41 chg: -1.04 stop: 64.74

The homebuilders continue to suffer as investors worry over rising bond yields and interest rates. BZH broke down under its simple 200-dma today and we were stopped out at $64.74.

Picked on April 06 at $ 68.78
Change since picked: - 4.37
Earnings Date 04/27/06 (confirmed)
Average Daily Volume = 1.2 million

---

Deere Co - DE - close: 84.05 change: +3.10 stop: 76.90

Target achieved. Shares of DE gapped higher at the open this morning and surged to over $84.00 on strong volume today. The move was fueled by positive analyst comments. Prudential raised their price target on the stock from $83 to $100 on positive earnings expectations. Our target was the $84.00-85.00 range.

Picked on March 22 at $ 77.29
Change since picked: + 6.76
Earnings Date 05/16/06 (unconfirmed)
Average Daily Volume = 1.6 million
 

Dropped Puts

None
 

Dropped Strangles

None
 


Trader's Corner

Using Moving Average Envelopes

I wrote several articles recently on the use of moving averages in making trading decisions, but did not cover the use of moving average ENVELOPES; or, as are sometimes called, trading 'bands'.

There are basically 3 types of Indicators loosely known as moving average envelopes or trading 'bands':
1. Moving average envelopes
2. Bollinger Bands
3. Kelter channels.

Bolinger Bands and Kelter channels build volatility into their equations and can be used as so-called 'breakout' indicators and are not the subject of this article. 'Moving average envelopes' are my focus here.

Moving Average envelopes have 3 component lines. One line is a moving average and may or may not be shown when moving average envelopes are selected to 'apply' to a price chart. What IS always shown are TWO lines that 'float' above and below the moving average; and most of the price action.

In the moving average envelope Indicator you can at most, set the following different inputs or vary the:
1. Type of moving average; e.g., simple, exponential, etc.
2. Length of the moving average; e.g., the number of trading periods, averaging 10, 20 or 30 periods; i.e., days, hours, etc.
3. A percentage figure ABOVE the moving average in question.
4. A percent figure BELOW the moving average.

In some application programs, you will not be allowed to make the upper envelope percentage any greater or lesser than the lower envelope line; i.e., the lower moving average envelope line AND the upper moving average envelope can only be the SAME percentage; therefore, there is only ONE 'envelope' percent setting possible.

This is a bit of an unfortunate limitation for trading the indexes. In the Indexes, in an uptrend, the moving average percentage will increase on the upper side. That is, the percentage values reached at a typical upswing peak will be higher than the lower envelope line; e.g., 4% versus 3%, or 3 versus 2%.

And, for the type of moving average, I use a simple moving average (SMA), so it a matter of adding the closing price of some number of trading periods (e.g., days, hours, etc.) and dividing by this same number, for example the sum of the past 10 closes divided by 10.

My favorite moving average length to use for Stock Indexes is 21, which I mostly use on Daily charts only. The regular blue chip market as represented by the S&P 500 Index in an 'average' market cycle or trend duration, will tend to see prices fluctuate in a range that is typically 2-3 percent above or below its 21-day average. As we are interested in also seeing the high and low extremes relative to the envelope lines, bar (or candlestick) charts are used.

In a volatile market, the S&P envelope line can expand to 4% or more, but it won't typically be more than this. With the Nasdaq, this percentage might be 5-6%. The percentage line we are looking for is the one that will then contain within it MOST of the rally highs and downswing lows that occur.

I am demonstrating the use of moving average envelopes for the INDEXES ONLY. Due to the bouts of volatility associated with earnings, business developments, etc., individual stocks tend to work less consistently than for the indexes, which 'smooth' out the individual stock hiccups and reversals.

A bar chart with a moving average envelope follows, which is an S&P 100 (OEX) chart, from the 2003 and 2004 period (the date at the top is todays date). This period was a time when SPX was trading pretty regularly from 2.5% above and 2.5% below the centered (magenta) 21-day moving average line.

The chart below shows the use of the same percentage envelope lines through todays trading. Youll quickly see that due to a lessening of the S&Ps volatility or fluctuations above and below the 21-day simple moving average, there arent any recent instances where the intraday highs or lows come even close to the upper or lower envelope lines.

MIDWEEK TECHNICAL UPDATE NOTE:
The decline below the up trendline dating from the Oct. low, looks like it could well result in a decline to test the prior 578 OEX low, but might not extend all the way to the lower envelope line. The percentage value looks like it needs to be set closer in to suggest the percentage value at which the Index here might be at a lowermost or oversold extreme.

In the next chart I have set or narrowed in the envelope lines considerably, to 1.5% above and below the 21-day average. I did this based on the fact that the LAST two HIGHS were very close to this envelope value. 'As above, so below' pertains here. My lower envelope line ALSO set to 1.5% in the same OEX chart below would be reached at around 580, an area where there is some other technical evidence of support.

In an uptrend I may set my UPPER band at a greater percentage above the center moving average. In a declining trend that goes on for a long period, the declines will typically bottom at a greater distance below the center moving average.

There is not typically a huge gap between the upper envelope percent and the lower envelope line percentage.

In an uptrend, a high probability trade is often to buy Index calls when prices fall to the lower envelope line, assuming OTHER evidence and indications ALSO point to this conclusion. The reverse is true in a sustained downtrend: buy puts on moves up to the upper envelope that has been "containing" the rallies that have occurred in the past 9-12 months.

After about 6 weeks of an uptrend or downtrend that has been closely hugging the upper/lower envelope lines, the odds increasingly favor a correction and can be favorable to a bet on at least a sideways trend ahead which suggesting selling option premium; e.g., shorting calls or puts.

Another example of an EQUAL upper and lower envelope line percentage is seen in the Dow chart below, which reflects the August 2004 to Feb. 2005 period.

However, in recent months the upper end price swings for the Dow have reached approximately 2% above the centered (21-day) moving average and (given the strong Uptrend) only 1.5% below the centered moving average as shown in my next chart of the Dow Average (INDU).

MIDWEEK TECHNICAL UPDATE NOTE:
INDU has touched and, so far, rebounded from the low end of its uptrend price channel noted at the green up arrow in the chart above. My lower envelope band (at 1.5%) or line intersects currently around 11000. Given the current pattern, I do not see the Dow going much below where INDU has reached already in its recent dip.

I tend to put more store, so to speak, in the trendline rebound that just occurred than on lower envelope line considerations. However, if the lower trendline is pierced, a next potential downside target would be to the lower envelope.

With the Nasdaq 100 (NDX) Index, often in recent years the most volatile of the major indices, my envelope setting for the period shown in the NDX daily chart below (2003-2004) was 4% for the upper band and 3% for the lower envelope line. Even here, it's not a huge difference between where the index tops out or bottoms, in percentage terms. However, there are other differences.

The answer to where the (NDX Index went AFTER the period shown above is below. The amount of the decline after February 2004 caused me to set my LOWER envelope line to the same 4% value.

CURRENT NDX CHART PICTURE:
With an upper envelope setting of 3% relative to the NDX and its 21-day moving average, the recent high came right up to the upper envelope line, as did the January peak. The recent low has stopped at the up trendline AND at the 21-day moving average, which suggests that NDX may hold at recent lows. If 1700 gives way then the 1660-1665 area is a next potential downside target.

A revised lower envelope setting at 2%, rather than 3 percent as is shown in the chart above, may be warranted and would suggest a possible oversold extreme at the same 1665 mentioned already. However, I have kept the envelope line setting at 3% above on NDX, based on wanting to keep a visual reminder on my chart as to where a LOW would equal the same percent distance from the 21-day average as was seen at the recent HIGH.

In a prolonged downtrend/bear market, there will tend to be MORE instances of the index topping out in the area of the centered moving average and there will be more 'touches' to the LOWER line. The reverse is true in a dominant uptrend or bull market, where there will tend to be a number of lows that are 'contained' or held at the centered moving average and more touches to and along the UPPER envelope line.

SUMMARY LIST OF MOVING AVERAGE ENVELOPE CHARATERISTICS:

1. Determination of what moving average to use somewhat arbitrary but is found by what 'works' in the most number of markets. The biggest variation is with the percentages above and below this line. I suggest using a 21-day moving average length for the Stock Indices. You can experiment yourself too with different lengths.

2. A common starting point for the Index envelope size is around 3% with the Dow and S&P and 3-4% in the Nasdaq. The envelope size varies from trend to trend and market to market. For an envelope size that 'works' or the percent figure that contains within it 90-95% of the price moves above and below the moving average; start with 3% and expand or contract the envelope size as is appropriate for the dominant trend.

3. If the last high was 4% above the moving average, the next high will often reflect the same extreme. Conversely, if the last significant downswing low was 3% below the moving average, keep this figure as the upper envelope setting until market action otherwise dictates.

4. If prices cross above the moving average, assume that this line will act as support on pullbacks and the next rally will have the potential to advance to the upper envelope line. In an UPTREND, the envelope line can act as a rising line of resistance for multiple rallies. Rally tops may 'hug' and move up along the upper envelope line. The rate of increase will SLOW, but the index may not reverse in the area of the upper line.

5. If prices cross below the center moving average, assume that this line will act as resistance on any rebounds and that downside potential now becomes for a move to the lower envelope line. If the trend is DOWN, the envelope line may act as a falling support line and there may be multiple downswings that touch or hug and move down along the lower envelope line.

6. In an uptrend, the optimum Index Call purchases are often the declines to the lower envelope line; this area will both define where the stock or other item is both 'oversold' and the specific price area that offers a opportune buying opportunity. If in a downtrend sell advances to the upper envelope line; this area will help define where the market is both 'overbought' and the specific price area most opportune as a selling point.

In an uptrend, when the index goes through and STAYS ABOVE the 21-day average it usually does it quickly and maintains a pattern of higher highs. When a rally 'fails' very quickly and fairly soon again falls under the center moving average, this pattern suggests adopting a bearish trading bias.

7. Even if there is an extension of a price swing to above or below the envelope lines, the probability for a significant further move in that direction is limited, especially if the price swing is a counter-trend move. At a minimum, there should be a reaction (countertrend move) once prices get very far above or below the envelope line in question.

There is not much more I can say about how to use envelopes except to say that the use of this technical indicator gives another kind of an idea about where a market might be at an EXTREME. While extremes don't happen all that often, when they do, it often marks a very good trading opportunity. And, we don't need more than a few of these to make for a profitable year trading index options.

The use of moving average envelopes in individual stocks is not something I can make as many generalizations about. Best moving average length and upper and lower percent values vary to a huge degree.

** E-MAIL QUESTIONS/COMMENTS **
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MY INDEX TRADER COLUMN:
This Wednesday Trader's Corner article also serves as an adjunct to my weekend 'Index Trader' column. In the article you're reading here I typically also do a brief midweek update of my in-depth weekend column.

You will normally see a web LINK to the Index Trader at the top of your weekend Option Investor Daily e-mail. Moreover, my Index Trader can always be found by going directly to the OptionInvestor.com web site and clinking on the Index Trader section at top.

** 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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