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Daily Newsletter, Saturday, 07/08/2006

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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

Jobs, What Jobs?

Bulls were surprised by the Wednesday ADP forecast for a gain of +360,000 jobs in Friday's Jobs report. Jobs estimates were revised upward by dozens of analysts based on that ADP forecast. Those same bulls were even more surprised by the actual headline number on Friday of only a +121,000 job increase that was substantially below anybody's forecast. Confusion reigned again and the markets slumped on fears that stagflation was returning. Helping to give the markets a strong push lower were earnings warnings by numerous companies led by Dow component 3M.

Dow Chart - 90 min

Nasdaq Chart - 90 min

SPX Chart - 90 min

The Jobs picture clouded on Friday after a tumultuous week. In the prior week the whisper numbers for non-farm payrolls had slipped to something in the 150K range and below the 175K consensus estimate. On Wednesday data from ADP suggested we could have a blowout jobs report somewhere in the 360K range. The markets gapped down at Wednesday's open on the combination of the strong new jobs forecast and the North Korea missile problem. The markets recovered later that day on the possibility the economy was much stronger than previously expected if jobs were really going to be over 300K. Estimates were revised higher and the whisper number began to climb. Fast forward to Friday's report and a below consensus shocker of only 121,000 new jobs. On the surface that headline number would suggest less chance of a continued Fed rate hike cycle but the internals told a different story.

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The unemployment rate held steady at the cycle low of 4.6% but hourly wage growth rose +0.5% and the second highest jump in nearly a year. Hourly wage growth for the last 12 months jumped to +3.9%, the fastest rate in over five years and clearly showing some wage inflation due to a tight labor market. The average weekly earnings also jumped sharply to 4.6% for Q2 on an annualized basis and the biggest jump since Q4-1997. The combination of low job growth, low employment and rising wages sent expectations of further rate hikes higher. Additional Fed pressure came from a strong back-to-back report of new jobs from the household employment survey. This is the companion report to the non-farm payrolls and the report that provides the unemployment rate. Household employment jumped +387,000 in June after a +288,000 jump in May. Household employment simply means work at home employment and those self employed. The BLS definition for this survey sample is "the civilian noninstitutional population 16 years and older." This sustained jump household employment in addition to the non-farm or institutional jobs plus the increase in wages and drop in productivity almost guarantees another rate hike in August. Officially the Fed Funds Futures are now at 65% chance of another quarter point but there are growing worries that the Fed will move to a 50-point hike instead. The Fed looks at both employment surveys and the sharply rising wage growth. After Friday's numbers there were a few analysts suggesting the Fed could move before the August meeting. Granted those are not mainstream forecasts but the fear is growing. May was revised higher by +17K and April revised lower by -15K.

Table of Nonfarm Jobs Versus Estimates

If you are only listening to the talking heads on TV or getting your data from the newspaper you are only getting half the story. In the first graph below I have contrasted the new nonfarm payrolls with the jobs from the household survey. You can see the household numbers typically run much higher than the nonfarm jobs. If you are trying to measure the health of the economy you can't depend on either one alone. On the second graph I combined the data to show the solid pace of new job creation averaging 369,000 jobs per month since June 2005. According to analysts it takes an average of +150,000 new jobs per month to absorb new workers into the system from immigration, graduation, etc. Using only the nonfarm average for that period of +154K it would seem the economy is only breaking even and not producing material employment growth. Once you look at the entire picture it shows an average surplus of +219,000 new jobs created each month. Simply put, the economy and the labor force is growing despite what we hear in the media.

Graph Showing New Nonfarm and Household Jobs

Graph Showing Combined Monthly Job Creation

Now for the bad news. Housing related jobs accounted for 23%, or 1.13 million of the 4.9 million jobs created since 2003. Total realtors jumped from 803,803 to 1.3 million. Home construction workers surged significantly as builders tried to open new communities at a record pace. Condo construction added workers by the thousands with over 250,000 units under construction nationwide as of January this year. The mortgage industry saw explosive expansion since 2002 as record low interest rates prompted more people to own a home, buy a more expensive home and/or refinance their existing mortgages. On Friday Ameriquest announced a workforce reduction of 3800 workers in their mortgage division. Washington Mutual announced a cut of 2500 workers. KB Homes, joined the builder layoff crowd with an announced cut of 7% of its 6600 workers. In the nonfarm employment survey the construction component lost -4000 jobs and the largest loss since Jan-2005. The good news is a steady growth of new jobs but they are no longer in the homebuilding sector. Leading areas of job growth in June were Government +31K, Education and Healthcare +26K and Professional Services +25K. To me that means more white-collar jobs and less blue collar but I could be wrong. Retail also lost ground to the tune of -7K along with a drop of -8K in temporary workers. The temporary worker component is often seen as a sign of future job growth. Firms will hire temporary workers until business increases to the point to allow full time hires. A drop in temporary workers suggests a slowing in job growth but at -7K it is hardly significant in this report. The bottom line for the jobs picture is still strong overall growth with rising wages and low unemployment. It almost guarantees another rate hike but the July report is due out before the August Fed meeting. A strong July report could compound the employment growth scenario and accelerate any Fed action with a potential 50-point hike. A weak July report could serve to slow the Fed's pulse and keep us on the incremental pace we have seen for the last 17 meetings.

Economic Calendar

The economic calendar for next week is littered with reports but none are especially important or market moving. All eyes will be on the earnings parade, which begins with Alcoa on Monday. We got a hint of what that parade will look like with a flurry of warnings on Friday. 3M knocked the Dow for a substantial loss after warning that earnings would be below expectations. MMM lost -$7.29 or -9%, roughly 47 Dow points, after saying that growth had slowed in its optical division. This is the division that makes the film for LCD TVs. LG Phillips (LPL) warned on Thursday night that sales of flat panel televisions had slowed dramatically saying there was a glut of components in the system. Seems everyone stocked up for an expected flurry of buying ahead of the World Cup and it did not materialize. The LPL warning makes the MMM announcement less of a news event but MMM was punished hard. The $74 close was a four-month low and well off its $88 high in May. MMM was thought to be untouchable as a blue chip safe haven but that view was crushed on Friday. This caused investors to reexamine their thoughts on blue chip safety and only seven Dow components posted gains on Friday with only two posting gains of more than a quarter, MRK and GM.

OOPS! At 5:46 AM Friday JP Morgan (JPM) upgraded MMM to overweight from neutral citing valuation. "We think 3M is poised to benefit from cyclical leverage to high-quality growth in the late stages of the economic cycle." At 9:AM 3M warned of lower profits. You know there were some stunned faces at JPM when the news hit the wires. I guess that valuation argument makes even more sense now at $74 than it did at the $82.50 premarket levels.

Big cap tech stocks fell even further out of favor after several smaller techs warned. AMD warned that Q2 sales would be below expectations due to the current price war with Intel. Intel cut its expectations back on March 2nd and AMD has fallen -42% since that announcement on fears of the coming price war. Intel has only fallen -8% during that same period but did see a low of $16.75 in June on chip weakness and high inventory levels. PC sales have been weak and are expected to remain weak and that means Intel and AMD are waging war with the only tool at their disposal, prices. Most analysts expect Intel to miss estimates and lower guidance when they report on July 19th. This also puts pressure on IBM, HPQ and Dell on increasing signs of growing weakness in the PC sector and techs in general.

Intel Chart - Monthly

WebMethods (WEBM) warned that they would post a loss instead of a profit for the quarter on -10% lower than expected sales. WEBM now expects a loss of -1 to -5 cents compared with prior expectations of a 12 to 15 cent profit. WEBM lost -3.06 or -32% for the day. Business Objects (BOBJ) lost -5.76 or -21.5% after warning profits would be below expectations.

Labranche (LAB) lost -24% after warning that the difficult market and challenges posed by electronic trading had caused a -57% decline in its market making business. LAB said it would now post a loss for the quarter of -8 cents per share compared to First Call estimates for a profit of +8 cents. LAB said trading revenue declined from $47 million to $20 million for the quarter. The company said making a market during the steep declines in May caused it to be on the wrong side of the market especially in the emerging market ADRs. They also admitted the human factor on the NYSE trading floor was no longer able to keep up with electronic trades in fast markets. It was only a matter of time until this happened and this should be an example for expectations of other market makers. Market maker Knight Capital (NITE) lost -3% in sympathy but I would expect more weakness as investors become more cautious.

Starbucks (SBUX) lost -5% after warning that same store sales fell short of estimates for June. Estimates were for +7% growth and sales came in at +6%. No big deal for me but the stock was hammered. Brokers lined up to cut estimates after a UBS analyst said new Frappuccino products were not ramping up as hoped. I think this is overdone because Starbucks is still predicting revenue growth of up to +7% through the end of 2006. I would not buy SBUX personally because I believe there are much better companies available but $35 is decent support for those not looking for a strong return.

Best Buy (BBY) and Circuit City (CC) both lost ground due to the MMM and LPL warnings about slow LCD sales. BBY also lost ground after Radio Shack (RSH) named former Kmart and Sears executive Julian Day as CEO. Day is seen as a turnaround pro and could provide BBY with additional competition. BBY reaffirmed its outlook in an SEC filing for profits between $2.65 and $2.80 per share. However, it said profits could be flat to down modestly as compared to a slight improvement they previously expected. BBY said it planned to boost sales and cut costs to offset the reduction. Sounds easy but shouldn't they already be doing that?

Lowe's Companies (LOW), a leader in the home building products sector, was downgraded to a hold by AG Edwards before the open. This is the 4th consecutive downgrade for the company and shows how analysts are distancing themselves from the housing sector. LOW lost -4.4% and sank to a new eight month low. Home Depot (HD) lost ground as well but is was only fractional but enough to push it to a new 15 month low. You would think that slowing new home sales and rising interest rates would make fixing up existing homes even more appealing. If you are going to live there or spruce it up to sell you still need HD and LOW for supplies. I would be a buyer of these companies ONCE a bottom begins to appear.

EBAY fell again on Friday to $26.65 and to levels not seen since Nov-2003 but it was not due to any warning. EBAY has been dropping for weeks and the new Google Checkout service is just more incentive to sell. On Friday Ebay announced it would not accept Google Checkout for Ebay auction payments. Ebay said it was one of 39 online payment services not accepted. The official reason was an insufficient track record but I am sure everyone can read between the lines. Google is being seen as a bigger threat to PayPal than previously expected. Ebay also announced that Jeff Jordan, President of PayPal, was leaving to spend more time with his family. That move was seen as highly significant given the sudden appearance of the Google threat. It also suggests a bigger competitive threat than previously thought. If you are going to leave now would be the right time. No reason to sit in the big chair and take fire for the next couple years while your PayPal advantage slowly dwindles away.

EBAY Chart - Weekly

Oil prices soared to a new all time high for a current month contract at $75.78 in early trading Friday morning. The August contract has traded higher but not as a current month contract. The spike was due to near record demand for gasoline in the week leading up to July 4th. The 9.645 million barrel demand was the second highest on record and second only to the same week in 2005 at 9.721 mb. The surge brought the 10-week average to 9.41 mb and nearly equal to the 9.414 mb for the same ten weeks in 2005 when gasoline averaged only $2.21 per gallon. The current ten-week average is $2.91 per gallon. Demand continues strong despite the high prices. Oil inventories fell by -2.4mb for the last reporting week but gasoline stocks rose by +800,000 bbls. The gain was due mostly to timing of import deliveries not excess refinery production. Oil inventories are still at multiyear highs and the price is being supported by high gasoline demand and geopolitical tensions. Even at these high inventory levels the oil supply on hand represents only 21 days of forward cover. That means if imports stopped today the refineries would run dry in 21 days without help from the strategic petroleum reserve. The gas demand table below shows the rising demand as summer kicked into high gear. With the July 4th weekend behind us I will not be running that table again but will keep you informed as the summer progresses. Demand should begin to slow after this week but increase again into Labor Day.

Fifteen year gasoline demand table

August Crude Oil Chart - Daily

Oil prices "should" begin to fall if inventory levels were the only consideration. Unfortunately for drivers that is the least of the factors impacting prices. Last week was supposed to be deadline week for Iran and the prospect of an obstinate response from Iran helped push prices to record highs. That potential was pushed into next week after a meeting with council diplomat Javier Solana. There will be another meeting on Tuesday but a senior Iran official made it clear that no response would be forthcoming. Iran's top negotiator, Ali Larijani, said again that "The timetable drawn up by other people has no influence on what we do" and "we will respond in August." The UN Council had pressured Iran for a response before the G8 summit on July 15-17. This is obviously not going to happen as Iran stalls for more time. Oil prices tanked late Friday afternoon after Javier Solana said the initial encounter was a "good start" and Larijani said the meeting was "fruitful and constructive." Obviously both are diplomats trying to avoid a confrontation but oil traders used the exchange of diplomatic pleasantries as an excuse to take profits. Most traders expect oil prices to rise again ahead of the G8 meeting and the likely increase in tensions as the lack of real progress become more apparent. Boone Pickens along with several other noted oil experts predicted last week that $80 oil is just around the corner. We have yet to see a hurricane appear and the clock is ticking. Once one appears headed for the Gulf the prices will head even higher.

Helping push tensions higher was the North Korean missile test. North Korea is a nuclear nation with at least a dozen nuclear weapons. There is nothing the US or anyone else can do militarily against NK as long as it holds those weapons. NK is holding Seoul South Korea, a city of 10 million, hostage with its nuclear capability. NK has threatened to nuke Seoul if it is attacked by anyone. With its scud missiles it would not be a challenge to act on that threat. Japan asked the UN to invoke sanctions on NK for its missile test but backed down after NK repeated its often-used threat. "If sanctions are imposed we will consider it a declaration of war." You can't negotiate with a hotheaded lunatic with nuclear weapons. He knows the US would turn NK into a smoking slag heap if he did attack Seoul but that would not help the 10 million people he killed in Seoul. This makes the NK standoff just another high profile case of brinksmanship that eventually can only be controlled by China. NK imports all its oil from China and it would get very tough in NK if that oil flow was stopped. Don't pull the tail of the sleeping bear. North Korea's Seoul threat carries far less weight in China than it does in the US. China needs that oil since it is already a net importer itself. I would not be surprised to see North Korea's supplies dwindling in the near future. That would make NK more reliant on the outside world and by necessity more prone to civilized behavior.

The Q2 earnings cycle has finally arrived beginning with Alcoa on Monday. S&P earnings for Q2 are expected to grow by +12.3% followed by +15.3% in Q3 and +14.8% in Q4. Those Q3/Q4 estimates have been rising after being in single digits for several months. The gains are being blamed on the energy sector with Q2 expectations for +28% growth and materials growth of +17%. Without the energy component S&P earnings would be in the +9% range. The weakest sectors are expected to be healthcare +3% and consumer staples at +4%. Not everyone believes the Q3/Q4 earnings story and the Q2 cycle could either provide a solid foundation for that scenario or deflate it quickly. Consumer confidence is beginning to erode as home sales slow and prices drop. Consumer sales are also slowing with Wal-Mart saying on Thursday that June sales grew only +1.2% due to budget constraints on shoppers. Wal-Mart said sales were focused on necessities. The higher gasoline prices are taking their toll. Abhijit Chakrabortti, U.S. equity strategist at JP Morgan said he expects only 7% earnings growth in Q2 as information-technology companies, financial-services firms and consumer-focused businesses disappoint. He feels the market will need to see a reasonable earnings beat for Q2 plus positive guidance for Q3 and beyond to rescue the markets from another dip lower. He said without a strong positive catalyst there is no reason to move higher. Just meeting current expectations will not be enough to provide market momentum given the doubts about the economy.

According to Chakrabortti technology companies are the most likely to disappoint in Q2. They already have lowered estimates to barely +10% growth and that is the lowest growth estimate in two years. They were predicted to show +15% growth when Q2 began and have been slipping steadily ever since. Husic Capital Management said technology firms are being actively shorted by hedge funds in anticipation of earnings shortfalls. Chakrabortti said he is seeing signs of a deepening slowdown for the sector based on a substantial decline in Taiwanese production of electronic parts and components. Expectations for banks have risen but so have their costs. They are having to pay more competitive interest rates to maintain deposits and could miss estimates slightly. Analysts at Fox-Pitt, Kelton expect more than a third of the banks they cover to miss Q2 estimates. Higher mortgage rates from $3 trillion in ARM resets and the new payment structure on credit cards will pressure consumers and therefore any company that relies on consumer discretionary sales.

The potential for continued Q2 earnings warnings and actual earnings misses once the reporting begins should pressure the indexes over the coming weeks. The post jobs report Fed analysis will be the daily topic and there is no upside to that discussion for the market. Add in a few more earnings warnings and we could be on the slow road through the summer doldrums. I am still expecting lower lows ahead but they may not come until Sept/Oct. That gives us quite a while to argue economics and range bound markets. Eventually a real rally will arrive to take us to year-end but first we have to traverse the torture track ahead. I would love to be wrong and have the lows already in place but even if they are that gives us a 700-point range on the Dow for the foreseeable future. 10700 was the June low and 11425 is overhead resistance. Both extremes represent strong resistance/support and will likely hold without a strong catalyst to provide momentum. I would view a move over 11425 as a breakout and a nullification of my range bound theory. The internal range would be 10900-11325.

The internals are already showing a fading of bullish expectations despite the surprise low volume ISM bounce on Monday. New highs are declining, new lows rising and down volume increasing. Granted this was a very low volume week with total share volumes only barely over 4B shares per day but the internals still count. Ships can sink in calm seas.

Weekly Internals Table

The Nasdaq completed three days of losses with a -25 drop on Friday. This was -61 points off the Monday high and right back in the middle of its recent range. With the potential for Intel, Microsoft, HPQ and Dell to disappoint the outlook is not good. But, there is the possibility that far too much bearishness is already baked into the cake. With expectations so lousy a couple of strong earnings reports could produce another bear-b-que and short squeeze us back to resistance at 2185 or even 2225. I doubt we will see it but it is always a possibility.

We have seen far too many "Fed is done" rallies over the last nine months and so far they have all been wrong. After Friday's jobs numbers we are facing what appears to be at least one more hike but with wage numbers soaring it could be just one more in a continuing series. Now that 5.5% is nearly guaranteed and 6.0% in the Fed's sights the equity markets would normally begin to suffer interest rate altitude sickness. Factor in the potential for some disappointing earnings guidance and the queasiness should intensify. The lure of another "one and done" scenario is losing its luster given the reasons mounting against it. I believe the market is running out of supporting factors but that picture could change as earnings begin. If the first few reporters show up with sterling results the diehard bulls could try another escape attempt. The partial list of reporters for next week is far from inspiring and probably far from market moving. Between Alcoa on Monday and GE on Friday there are only a handful of material companies. This means far more attention will be paid to any earnings warnings than earnings reporters. The following week has nearly 400 reports.

Partial list of earnings next week

I would be careful adding any new long positions until the market picks an earnings direction. The energy sector may have further to rise with most of the earnings for energy the week of the 23rd but despite record oil prices on Friday many energy stocks were already showing weakness. Weak stocks on record oil prices should be a clue the market is unstable. Let that be your clue to wait patiently for a new trend to develop.
 


New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None APD DHI
  APOL KBH

New Calls

None today.
 

New Puts

Air Products Chem. - APD - close: 62.95 chg: -1.10 stop: 65.01

Company Description:
Air Products serves customers in technology, energy, healthcare and industrial markets worldwide with a unique portfolio of products, services and solutions, providing atmospheric gases, process and specialty gases, performance materials and chemical intermediates. Founded in 1940, Air Products has built leading positions in key growth markets such as semiconductor materials, refinery hydrogen, home healthcare services, natural gas liquefaction, and advanced coatings and adhesives. (source: company press release or website)

Why We Like It:
Everything appears to be pointing lower for APD. The Point & Figure chart is bearish and points to a $50.00 target. The weekly chart has produced a bearish engulfing candlestick pattern just this past week. The daily chart has seen APD produce a failed rally under $65.00 and its 50-dma and 100-dma. Meanwhile its MACD is nearing a new sell signal. The only thing bears would like to see more of is volume. We are suggesting that traders consider buying puts with APD under $64.00. Our short-term target is the $59.00-58.00 range. It's short-term because we do not want to hold over the late July earnings report.

Suggested Options:
We are suggesting the August puts. You, the individual trader, need to choose which strike price best suits your risk profile.

BUY PUT AUG 65.00 APD-TM open interest= 22 current ask $2.85
BUY PUT AUG 60.00 APD-TL open interest= 0 current ask $0.80

Picked on July 09 at $ 62.95
Change since picked: + 0.00
Earnings Date 07/26/06 (unconfirmed)
Average Daily Volume = 1.2 million

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Apollo Group - APOL - close: 49.92 chg: -0.97 stop: 52.51

Company Description:
Apollo Group Inc. has been providing higher education programs to working adults for almost 30 years. Apollo Group Inc., operates through its subsidiaries: The University of Phoenix Inc., Institute for Professional Development, The College for Financial Planning Institutes Corp., and Western International University Inc. The consolidated enrollment in its educational programs makes it the largest private institution of higher education in the United States. It offers educational programs and services at 97 campuses and 159 learning centers in 39 states, Puerto Rico, Alberta, British Columbia, Netherlands, and Mexico. (source: company press release or website)

Why We Like It:
APOL has spent the last four months consolidating sideways between $50.00 and the $56.00 region. If you look at the daily chart is looks like a new (bearish) double-top pattern. Friday's 1.9% decline pushed APOL under support at the $50.00 level and left the stock poised to move lower. The P&F chart is bearish and points to a $44 target. We are suggesting put options with APOL under $50.00 although more aggressive traders might want to consider a failed rally under $51.00 as a new entry point. We do expect some support near the $47.50 region (around the March lows) but our target is the $45.50-45.00 range.

Suggested Options:
We are suggesting the August puts. You, the individual trader, need to choose which strike price best suits your risk profile.

BUY PUT AUG 50.00 OAQ-TJ open interest=1704 current ask $2.10
BUY PUT AUG 45.00 OAQ-TI open interest= 646 current ask $0.50

Picked on July 09 at $ 49.92
Change since picked: + 0.00
Earnings Date 09/19/06 (unconfirmed)
Average Daily Volume = 1.4 million
 

New Strangles

D.R.Horton - DHI - close: 23.90 change: +0.09 stop: n/a

Company Description:
D.R. Horton, Inc., America's Builder, is the largest homebuilder in the United States, delivering more than 51,000 homes in its fiscal year ended September 30, 2005. Founded in 1978 in Fort Worth, Texas, D.R. Horton has expanded its presence to include 82 markets in 27 states in the Mid-Atlantic, Midwest, Southeast, Southwest and Western regions of the United States. The Company is engaged in the construction and sale of high quality homes with sales prices ranging from $90,000 to over $900,000. D.R. Horton also provides mortgage financing and title services for homebuyers through its mortgage and title subsidiaries. (source: company press release or website)

Why We Like It:
The month-long sideways consolidation in DHI and its upcoming earnings report sounds like a good recipe for a strangle. We are suggesting that readers consider opening strangle plays between $23.75 and $24.25. If the onset of earnings season doesn't spark some big moves in the market that DHI can follow then the company's own earnings report in late July (20th) should do the trick. This is one case where we do want to hold over the earnings report. We don't care which way DHI moves as long as it moves far enough before August expiration. Our estimated cost is about $1.70 so we need to see DHI move north of $26.00 or under $22.00 to put us in the green. Right now we're planning to exit if either option rises to $2.55 or more.

Suggested Options:
A strangle involves buying both a call option and a put option. Try and keep the amount invested relatively equal on both the call side and put side of the play otherwise the play is no longer neutral.

BUY CALL AUG 25.00 DHI-HE open interest=2587 current ask $0.90
-and-
BUY PUT AUG 22.50 DHI-TX open interest= 870 current ask $0.80

Picked on July 09 at $ 23.90
Change since picked: + 0.00
Earnings Date 07/20/06 (confirmed)
Average Daily Volume = 3.7 million

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KB Home - KBH - close: 45.76 change: -0.24 stop: n/a

Company Description:
Building homes for nearly half a century, KB Home is one of America's premier homebuilders with domestic operating divisions in some of the fastest-growing regions and states: West Coast--California; Southwest--Arizona, Nevada and New Mexico; Central--Colorado, Illinois, Indiana, Louisiana and Texas; and Southeast--Florida, Georgia, Maryland, North Carolina, South Carolina and Virginia. Kaufman & Broad S.A., the Company's publicly-traded French subsidiary, is one of the leading homebuilders in France. In fiscal 2005, the Company delivered homes to 37,140 families in the United States and France. KB Home also offers complete mortgage services through Countrywide KB Home Loans, a joint venture with Countrywide Financial Corporation. (source: company press release or website)

Why We Like It:
KBH is another homebuilder with a similar sideways consolidation. We suspect that the stock and the sector are poised to breakout but we don't know what direction. In order to capture the next move we're suggesting a strangle play. We could opt for a straddle play where you buy both a call and a put at the same strike, in this case the $45.00 strike, but that would cost about $4.75. The strangle will be less expensive. We are suggesting that readers consider strangle plays in the $46.00-44.00 range. At current prices our estimated cost is about $1.45. A significant move towards $50 or the $40 level should put us into the green. What makes this play different than DHI is that we don't have KBH's earnings report to use as a catalyst to move the stock and will have to depend on market and sector movement. We would like to exit if either option rises to $2.45 or more.

Suggested Options:
A strangle involves buying both a call option and a put option. Try and keep the amount invested relatively equal on both the call side and put side of the play otherwise the play is no longer neutral.

BUY CALL AUG 50.00 KBH-HJ open interest=1180 current ask $0.85
-and-
BUY PUT AUG 40.00 KBH-TH open interest=2206 current ask $0.60

Picked on July 09 at $ 45.76
Change since picked: + 0.00
Earnings Date 09/14/06 (unconfirmed)
Average Daily Volume = 2.4 million
 


Play Updates

In Play Updates and Reviews

Call Updates

Bear Stearns - BSC - cls: 139.23 chg: -3.15 stop: 134.95

Ouch! The profit taking in the broker-dealer sector was relatively heavy on Friday. The XBD index lost almost 2%. Shares of BSC fell 2.2% and took a big chunk out of our potential gains. We are not suggesting new bullish positions at this time. The close back under the $140.00 level is bearish. The best-case scenario here would be to see a bounce from its rising 10-dma near 138.50. However, if the markets continue to sink then BSC might hit $136.50 or $135.00. If you don't want to endure that kind of pull back consider exiting early right now! Our target is the $144.50-147.50 range. The P&F chart is still bullish with a $184 target.

Suggested Options:
We are not suggesting new call positions in BSC at this time.

Picked on June 29 at $137.51
Change since picked: + 1.72
Earnings Date 09/14/06 (unconfirmed)
Average Daily Volume = 1.5 million

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Fortune Brands - FO - close: 71.63 change: +0.33 stop: 69.74

We are electing to keep FO as a bullish candidate. On Thursday night we added FO to the play list but said that if the market did not respond well to the jobs report on Friday we would suggest that readers do not open new call positions. Surprisingly FO displayed some relative strength. Currently our market bias is flat to down so odds are good that FO will dip next week. We're going to continue to suggest bullish plays here but our preferred entry point would be on a dip into the $70.00-71.00 region. The simple 10-dma should offer some support near the $70.00 mark. We're going to set a short-term target at the $74.00 mark. We do not want to hold over the July earnings report (21st - unconfirmed). FYI: more aggressive traders may want to use a wider stop like under Wednesday's low.

Suggested Options:
Aggressive traders might want to consider trading the July calls. We're going to suggest the August strikes. Remember, we're not suggesting you buy both strikes. You pick the strike price that works best with your risk profile.

BUY CALL AUG 70.00 FO-HN open interest=116 current ask $3.10
BUY CALL AUG 75.00 FO-HO open interest=115 current ask $0.80

Picked on July 06 at $ 71.30
Change since picked: + 0.33
Earnings Date 07/21/06 (unconfirmed)
Average Daily Volume = 674 thousand

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Google - GOOG - close: 420.45 chg: - 2.74 stop: 399.00

What happened to GOOG on Friday afternoon? Shares were trading higher on Friday hitting $427.89 and then suddenly the stock plummeted more than ten points. Traders bought the dip around $416, which was near Wednesday's low. We didn't see any specific news to account for the weakness. At this time we remain optimistic but with a market bias that is flat to down GOOG could become a target for profit taking. More conservative types might want to lock in some profits right now. There is potential resistance in the $425-430 region with its trendline of lower highs. We are aiming for the $440 level.

Suggested Options:
We are not suggesting new call positions in GOOG at this time. Remember, we do not want to hold over the earnings report.

Picked on June 21 at $401.00
Change since picked: +19.45
Earnings Date 07/20/06 (confirmed)
Average Daily Volume = 9.8 million

---

Komag Inc. - KOMG - close: 46.83 change: -0.71 stop: 44.49

KOMG weathered Friday's market weakness pretty well, especially considering the nearly 2% decline in the DDX disk drive index. We would strongly hesitate to open new call positions now that the major market indices and the DDX all look vulnerable to more selling pressure. Currently we would expect KOMG to dip toward the $45.00 level and its 10-dma. A bounce from either could be used as a new entry point. We do expect some resistance near the $50.00 level but our target is the $52.25-54.00 range. We do not want to hold over the late July earnings report.

Suggested Options:
We are not suggesting new plays here but if you do buy a bounce we'd prefer the August calls.

BUY CALL AUG 45.00 QKX-HI open interest= 669 current ask $4.40
BUY CALL AUG 50.00 QKX-HJ open interest=1009 current ask $2.10

Picked on July 06 at $ 47.54
Change since picked: - 0.71
Earnings Date 07/26/06 (unconfirmed)
Average Daily Volume = 1.1 million

---

Union Pacific - UNP - close: 90.12 chg: -0.71 stop: 88.49 *new*

Traders need to be defensive here. The major indices are slipping and the transports are pulling back from resistance. More conservative traders might just want to cut their losses right here in UNP. We're keeping the stock for a couple of reasons. UNP has managed to hold on to the $90 level and both UNP and the Dow transports are still in their short-term bullish channels. We are going to raise our stop loss to $88.49. If you're not willing to exit yet but want to lower your risk you could try putting your stop under Friday's low (89.49). The P&F chart is still bullish. At this time we're not suggesting new call option plays.

Suggested Options:
We are not suggesting new call plays in UNP. Don't forget that we do not want to hold over the July earnings report.

Picked on June 29 at $ 91.54
Change since picked: - 1.42
Earnings Date 07/20/06 (unconfirmed)
Average Daily Volume = 1.6 million
 

Put Updates

Apple Computer - AAPL - close: 55.40 chg: -0.37 stop: 60.05

AAPL sank to a new eight-month low on Friday and while volume has been rising all week it failed to reach the daily average. The MACD on AAPL's daily chart is nearing a new sell signal. The P&F chart remains bearish with a $44 target. We are targeting a decline into the $50.50-50.00 range. We would consider new put options here or readers can watch for a failed rally under $58.00 as a new entry point.

Suggested Options:
We're suggesting the August puts. You pick which strike works best for you.

BUY PUT AUG 57.50 QAA-TY open interest=3070 current ask $4.40
BUY PUT AUG 55.00 QAA-TK open interest=6713 current ask $3.10
BUY PUT AUG 52.50 QAA-TX open interest=2965 current ask $2.05
BUY PUT AUG 50.00 QAA-TJ open interest=6880 current ask $1.30

Picked on June 28 at $ 56.85
Change since picked: - 1.45
Earnings Date 07/19/06 (unconfirmed)
Average Daily Volume = 33.1 million

---

Digital River - DRIV - cls: 40.12 change: -1.14 stop: 42.05

Market reaction to the jobs report on Friday helped pull DRIV to a 2.7% decline but volume continues to come in very low, which tends to indicate a lack of conviction. We would wait for a move under $39.50 before considering new put positions on DRIV. Technicals on the weekly chart remain bearish and the short-term daily technical indicators are rolling over. Plus, the P&F chart is still bearish with a $26 target. We're aiming for a drop into the $35.25-35.00 range, which is under the simple 200-dma. We do not want to hold over the late July earnings report.

Suggested Options:
We're not suggesting new plays in DRIV at the moment but if shares continue to drop we'd consider the August $40 puts.

Picked on June 19 at $ 39.45
Change since picked: + 0.67
Earnings Date 07/27/06 (confirmed)
Average Daily Volume = 1.0 million

---

Intl. Bus. Mach. - IBM - cls: 76.42 chg: -1.67 stop: 78.75

The market sell-off and the DJIA's triple-digit loss helped push IBM to a 2.1% decline. Volume on Friday's drop came in above average, which is good news for the bears. Right now IBM is expected to report earnings in the July 18th-20th range. We do not want to hold over the report and that doesn't give us a lot of time so we're not suggesting new plays right now. Currently our target is the $73.50 level. More aggressive traders might want to aim lower in the $72-70 region.

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

Picked on June 06 at $ 78.75
Change since picked: - 2.33
Earnings Date 07/18/06 (unconfirmed)
Average Daily Volume = 5.2 million

---

IDEXX Labs - IDXX - close: 74.70 chg: -0.27 stop: 77.51 *new*

Volume came in very low for IDXX on Friday and shares spent the session consolidating sideways. Our market bias is flat to down so traders might want to open new put plays with IDXX under $75.00 but you'd probably need to adjust your target toward the $71-70 region. Our conservative target at $75.25 has already been hit and we're now aiming for the $72.00 level. Currently the Point & Figure chart points to a $64 target. We're going to lower our stop loss to $77.51, which is above technical resistance at the 50-dma. More conservative traders might want to adjust their stops toward last week's high near $76.50.

Suggested Options:
We are not suggesting new put positions in IDXX at this time.

Picked on June 12 at $ 77.95
Change since picked: - 3.25
Earnings Date 07/28/06 (unconfirmed)
Average Daily Volume = 144 thousand
 

Strangle Updates

None
 

Dropped Calls

Armor Holdings - AH - close: 53.90 chg: -1.07 stop: 52.99

We are suggesting an early exit in AH. The markets did not respond well to the jobs report on Friday and we have ongoing geo-political worries with N. Korea and Iran that could rattle the markets further. Looking at AH the intraday failed rally on Thursday was a (failed) test of AH's 38.2% Fibonacci retracement level of its spring-summer decline. While there is a chance that AH could bounce from its simple 10-dma (near 53.70) we're going to exit. We would keep an eye on the stock to see if it bounces near $52.

Picked on July 02 at $ 54.83
Change since picked: - 0.93
Earnings Date 07/20/06 (unconfirmed)
Average Daily Volume = 656 thousand

---

Allegheny Tech. - ATI - cls: 66.80 chg: -1.88 stop: 64.95

We are suggesting an early exit on ATI as well. The breakout over $67.50 and the $70.00 level has failed. The high on June 30th was a perfect failed rally near the 50% retracement of ATI's May-June decline. Traders bought the dip on July 5th but it looks like bears are back in control with Friday's breakdown below the 10-dma and 50-dma. The MACD on the daily chart is nearing a new sell signal. If you want to tough it out there is still potential support at the $65.00 level and ATI could bounce there. We're choosing to cut our losses here.

Picked on June 29 at $ 70.01
Change since picked: - 3.21
Earnings Date 07/26/06 (unconfirmed)
Average Daily Volume = 3.8 million

---

Burlington N.Santa Fe - BNI - cls: 75.71 chg: -0.65 stop: 74.90

We have been stopped out of BNI at $74.90. Shares dipped to $74.56 on Friday morning. Volume came in above average on the session and the MACD indicator on the daily chart is nearing a new sell signal. We're going to keep an eye on BNI for future plays. The stock should have support near its 200-dma. We'd also watch the Dow Jones Transportation index, which might be forming a double-top pattern under the 5000 level.

Picked on June 29 at $ 79.09
Change since picked: - 3.38
Earnings Date 07/25/06 (confirmed)
Average Daily Volume = 2.3 million

---

Chipolte Mex Grill - CMG - cls: 56.00 chg: -3.06 stop: 57.99

We have been stopped out of CMG at $57.99. After the jobs report the reaction in CMG shouldn't be a surprise. We've been growing more cautious and defensive on the stock for days now and have been warning readers that the situation was turning worse. We would expect a bounce near $55.00 and its 100-dma and nimble traders can watch to see if that bounce fails under $60 again as a potential entry point to buy puts.

Picked on June 18 at $ 61.76
Change since picked: - 5.76
Earnings Date 07/20/06 (unconfirmed)
Average Daily Volume = 384 thousand

---

Goldman Sachs - GS - close: 148.51 chg: -2.07 stop: 146.45

Our play with GS never opened! We are dropping GS as a potential bullish call candidate. It has been our plan to buy calls if GS could trade at $153.05 or higher. Thus far the stock has been unable to breakout past the $153.00 level and remains hampered by the 50-dma. We will keep an eye on the stock for new entry points. A bounce from $145 might be tempting.

Picked on June xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 09/12/06 (unconfirmed)
Average Daily Volume = 5.0 million

---

MicroStrategy - MSTR - cls: 87.27 change: -6.34 stop: 91.74

The GSO software index has traded lower three days in a row. Leading the plunge in the sector has been MSTR. After the failed rally under $100 on Wednesday, July 5th we warned readers to look for a dip toward $95. The stock slid further with a drop under $94 on Thursday. We didn't close the play since the market expectation for the jobs report on Friday was generally positive. We had been playing with a wide, aggressive stop because MSTR tends to be volatile. Now that shares have broken down under the $90.00 mark and its 200-dma it looks like a bearish put play candidate. We would have been stopped out at $91.74.

Picked on July 02 at $ 97.52
Change since picked: -10.25
Earnings Date 07/27/06 (unconfirmed)
Average Daily Volume = 333 thousand

---

Wynn Resorts - WYNN - close: 70.43 chg: -1.68 stop: 69.75

We have been stopped out of WYNN at $69.75. The stock was consolidating sideways between $71.50 and $70.50 for most of the session but then a late afternoon sell-off pushed shares to $69.71. Volume came in below average on the session. A drop under $69.50 might be used as a bearish entry point to buy puts and target the $65 region.

Picked on June 29 at $ 73.64
Change since picked: - 3.21
Earnings Date 08/02/06 (unconfirmed)
Average Daily Volume = 1.0 million
 

Dropped Puts

Amgen Inc. - AMGN - close: 66.39 chg: +0.45 stop: 67.05

We have been stopped out of AMGN at $67.05. The stock displayed relative strength during the first half of Friday and broke out above technical resistance at its 50-dma on an intraday basis. The rally eventually failed and this might be a new entry point to buy puts.

Picked on June 05 at $ 67.48
Change since picked: - 1.09
Earnings Date 07/18/06 (unconfirmed)
Average Daily Volume = 8.9 million
 

Dropped Strangles

None
 


Trader's Corner

The Corrective Fan Principle

After Callaway Golf (ELY) retested its October 2002 low in October 2004, investors must have been delighted to see the stock begin a bounce. That bounce eventually took the stock from its October 2004 low of $9.28 to a high of $17.40 reached in April of this year, almost a double. The stock's price then dropped through an ascending trendline off that October 2004 low and was trading at $12.99 as this article was prepared on July 2. Has the rally off that 2004 low ended?

Annotated Weekly Semi-Log Chart of ELY:

No averages are shown on this chart, but the downtrend since April has driven ELY's price sharply below its 200-sma, clearly a negative for investors. However, while the short-term trend remains down, the corrective fan principle suggests that prices could attempt a rise to retest this broken trendline. The longer-term rally may not quite have ended, although that corrective fan principle suggests that it may be on its third and last leg. Let's look at the principle and how it relates to ELY's move.

Martin Pring elucidated the corrective fan principle in his book, TECHNICAL ANALYSIS EXPLAINED. The first point of this principle can be illustrated by a closer look at ELY's initial rally off that October 2004 low.

Annotated Weekly Semi-Log Chart of ELY:

Such an explosive move is often characteristic as the last low or bottom is established and a rally begins. Such explosiveness is also typical of the first drop after a top has been established and a new decline begins. The explosiveness of those first moves off a bottom of a top can not be sustained, Pring explains, and that first trendline will then be broken and a more gradually rising or descending trendline established.

ELY's prices rose to retest that first too-sharply-rising trendline in mid-2005 but fell back without even touching the trendline. Some would have considered that a bearish sign, and it certainly was over the summer of 2005, but those who discounted the rally off the 2004 low were mistaken. ELY rose again in early 2006, establishing a higher high than any reached in 2005. While it was doing so, it established that second rising trendline, the red one, off that October 4 low.

According to the corrective fan principle, the second rising trendline is also too steep to sustain over an extended period, and prices may need to establish a third rising trendline with an even more gradual slope.

Annotated Weekly Semi-Log Chart of ELY:

Most technicians believe that it takes three points of contact to establish a trendline, not two, so ELY has not yet established that third trendline.

These three trendlines discussed in this article can also be called fan lines, since they fan out from the original low (or high, in the case a decline). Pring explains that the rally would be considered finished when prices broke through the third rising trendline or fan line. Similarly, a decline would have completed when prices broke up through a third descending trendline.

The fan lines can be open to interpretation, of course, and require some art and knowledgeable guesswork. Perhaps another technical analyst might find three fan lines already laid out on ELY's chart, with the third already violated.

However, many traders are surprised when prices violate a rising trendline, then soon bounce and climb the underside of that trendline into a new high. They might not be so surprised and so quick to assume a rally was finished if they kept the corrective fan principle in mind.

Traders who jumped into a bearish play on ELY when that first explosive move was exhausted and ELY violated the first fan line were rewarded since its drop was deep, but that isn't always true. That first fan line violation sometimes results in only a minimal move before another rally.

Annotation 240-Minute Chart of GM:

Note that GM's chart also is not the current one, but one annotated on July 2, when this article was first prepared.

The corrective fan principle can be utilized when studying charts across any time frame, although the longer the time frame, the more reliable the information. Be sure to switch to semi-log charts if you're studying movements that occur across many months. In addition, the principle can be used to watch both rallies and declines. Declines, in particular, often demonstrate explosive first moves.

Pring cautions that the break of the third trend or fan line often suggests a change in trend.

Annotated 120-Minute Chart of FDX:

Notice how well FDX's decline fit the corrective fan principle. The first drop was precipitous. A break of the first fan line did not signal that the down trend had been completed. In fact, FDX's prices were to drop lower than the May low. However, that first fan line descended too steeply for that movement to be sustained. A new and more sustainable trend or fan line was established. When it was broken, a third was established, but it was to be sustained only a short while before FDX was to break through that fan line again.

As FDX's chart demonstrates, trading a rally or a decline when a third trend or fan line is being established can be a dangerous endeavor. Those who might be long ELY, the rally example that may be currently establishing that third fan line or trendline, should remain cautious about long positions. Although prices that are bouncing up from or back from a third trendline or fan line can still hit a new high in the case of a rally or a new low in the case of a decline, the establishment of a third trendline marks the time to start planning protective measures if that hasn't already been done.
 

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.

DISCLAIMER

Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

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