Option Investor
Newsletter

Daily Newsletter, Saturday, 10/28/2006

HAVING TROUBLE PRINTING?
Printer friendly version

Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Chips and Dip

It was a strong week for the indexes until 12:30 on Friday. The Nasdaq had rallied past resistance at 2375 and the S&P made it nearly to 1390. The Dow made it to 12167 on Thursday and another new high. At 12:30 on Friday news broke in the chip sector that pulled the rug from under the bulls. The dip was typical for a Friday in an extended bull market with unexpected bad news. The drop was slow and methodical as sellers exited and buyers waiting for a dip to enter finally got a break. The question this weekend is whether this break was really a buying opportunity or a preview of things to come.

Dow Chart - 60 min

Nasdaq Chart - Daily

Friday started off with an economic shock with the first reading on the Q3 GDP coming in at a meager +1.6% growth. This was substantially below the consensus estimates of +2.2% to +2.5%. The major negatives dragging it down were a sharp drop in housing construction and lower investments into business inventories. This was a definite shock to the system and brought back fears of a hard landing ahead. The biggest drag was a -17.4% drop in housing construction in addition to an -11.1% drop in Q3. This knocked nearly a full percent off the headline number. The weakness in the housing sector is not new and everyone has known it for the last nine months. What was not known was how sharp this drop really was at the GDP level. On the bright side consumer buying rose +3.1% stretching the string of consecutive quarters to 59 for positive consumption. Q4-1991 was the last time we saw a negative consumption rate. The sharp drop in GDP caused by housing should change the outlook by the Fed and the Fed funds futures reflected that change in perception almost instantly. Just last month they were showing a 50% chance of a cut as soon as January. Based on some economics and Fedspeak that reversed at the beginning of October to a 6-10% chance of a hike all the way out to September-2007 as of just last week. After Friday's GDP report the futures rocketed back to a 50% chance of a cut by May. That is a dramatic change in a very short amount of time and represents extreme volatility.

Next week we will see several critical economic reports including the PMI, ISM and Non-farm payrolls. The PMI rose +5 points last month and another strong gain could be problematic. The bigger report will be the ISM on Wednesday, which at 52.9 in September was the lowest level since May-2005. The consensus is for a slight rebound to 53.1 but those same analysts missed it significantly last month. Another decline could really ratchet up worries of a hard landing and increase the fire under the Fed for a future rate cut. Also weighing on the Fed consciousness will be the jobs report on Friday. Official estimates are for a gain of +133,000 jobs but analysts have missed estimates numerous times recently. Last month the estimate was for a gain of +125,000 when only 51,000 jobs were created. If this month's job creation follows the prior months weakness it will add further pressure to the Fed to ease sooner rather than later.

Despite the sudden downturn in economic indicators this is along the lines of what the Fed was expecting. It may be a little sharper drop than they would have desired but it should help remove inflation pressures a little more quickly. The Fed would actually like to see the unemployment rate rise to something in the 5% range from the current 4.6% because that would relieve pressures of wage inflation by supplying more workers for new jobs. Next week will be a minefield of economics and it will be interesting to see where the Fed funds futures end up next Sunday. The sudden drop in yields sent the inverted yield curve to its widest point in this economic cycle with the 10-year yield -43 points under the 90-day T-bill.

10-year Note Yields

Economic Calendar

The report that tripped the bulls on Friday was a report from Goldman Sachs that motherboard demand is "falling off a cliff." A motherboard is the main piece of electronic hardware that forms the electronic backbone inside a PC. If motherboard sales are dropping sharply then sales of all other components will also plummet. Goldman said they cut their estimates for sales this quarter by -20%. It sounds worse than it actually is. They are cutting sales forecasts from +10.8% growth to only +8.8% growth. It is still growth however you look at it but the worst may not be over. They said shipments declined in October by -4.2% compared to forecasts for +3.1% growth. They said the "decline in demand happened earlier and more significantly than we had expected."

Just last month another firm, Think Equity, issued a report on the same motherboard makers saying they were manufacturing for +20% growth in Q3 and were targeting another +20% growth in board output in Q4. They warned that this was far in excess of demand and would lead to a surplus of inventory at a time when there was no demand. The demand they were initially expecting was to be produced by the new Vista operating system originally due out earlier in 2006. The continued delays have pushed it out to January 2007 and caused Microsoft to postpone $1.5 billion in revenue in their earnings forecast this week. The fourth quarter is typically a strong quarter for PCs but this one could be a disaster. Buyers don't want to pop for a major computer purchase only to have the software out of date before the Christmas decorations are put away. Even with the Microsoft coupon ploy announced this week there is still a strong resistance to buying a computer and setting it up with Windows XP only to have to set it up again a couple months later. We all know most will never make the upgrade due to fears of ruining the current setup and then having compatibility issues with Vista. It is much simpler to just wait a couple months and have the manufacturer deliver it with Vista preinstalled and skip all those potential problems. It is one thing to say a computer is Vista ready and another to say Vista is preloaded.

Advertisement

QQQQ
The Most Profitable 4 Letters in Trading

Master them with Hotstix QQQ Trader. We'll show you exactly when to buy and sell the QQQQ and turn you into a master trader who knows how to cut your losses, nail short term gains and rack up some incredible profits.

30-Day FREE Trial:

http://www.hotstix.com/public/defaultqqq.asp?aid=755

I ran the Vista upgrade tool on a new PC I just added two weeks ago and nearly half the hardware components or software packages had compatibility problems. You can download it from here and test your own PC. From my desk I view Vista as a can of worms for an average technically inexperienced PC user and that means the average user will wait to buy that new PC until he can buy it preloaded. That could be well after January. The current Microsoft forecast for a January delivery of Vista could also be a clever ruse by Microsoft to promise it just after the holidays to tempt buyers to go ahead and make that PC purchase thinking Vista is just around the corner. Maybe not but I would not be surprised to see that January date slide once the holiday buying season has passed. Think about it. This is the biggest software company on the planet with $40+ billion in cash and tens of thousands of programmers. If Vista is really on track for a January delivery it would appear relatively simple to spend a few of those idle bucks on overtime and extra workers to move that date forward about 60 days in time for the holiday PC cycle. There are supposedly more than 100 million customers planning to either upgrade operating systems or buy a new PC with Vista as soon as it is released. That would really give tech stocks a shot in the fourth quarter arm but instead Microsoft is holding to its January target. Call me a conspiracy theorist but stranger things have happened.

Getting back to the topic of the chip weakness, the Friday tech selling was sharp. The SOX had rallied off its support lows at 445 on Wednesday and edged just past resistance at 460 before the news broke. In less than an hour the SOX gave back -2% and the Nasdaq imploded to the tune of -28 points. Intel lost -3%, PMCS -2%, AMAT -2%, RMBS -3.5%, LSCC -7%, VSEA -5% and ASYT -5%. There was already a run on chips due to some earnings problems Thursday night and those companies were even harder hit, Silicon Image lost -17%, Celestica -13%, Intersil -10% and Emulex -8%. The earnings parade has been producing some really big movers as we wade into the smaller companies with lower floats and higher short interest. I pulled a list of the top 30 winners and losers on Friday and there were some big numbers.

Top 30 Winners and Losers

The earnings cycle is quickly coming to a close. After Friday's reports 66% of S&P companies have reported. According to Thomson Financial 73% have beaten estimates, 12% reported inline and 15% have missed estimates. By next Friday's close more than 80% of all companies will have reported. The earnings cycle will be over except for a gaggle of stragglers that will drag out over the next month. That leaves investors with little to focus on for motive power other than economics and we know how fickle those can be.

Earnings Sample

There were some high profile earnings reports on Friday led by Hartford Financial (HIG). Hartford earnings rose +41% but as you know it is all about the guidance. The CEO said underwriting profits in the property and casualty industry may have peaked in 2006. He said increased competition, increased loss costs and higher reinsurance rates would pressure profits. This was a banner year with no material hurricanes and few losses. It would be tough for the industry to repeat in 2007. HIG lost -3.96 for the day and led the sector into the tank.

Next Tuesday is the fiscal year end for most mutual funds. This gives them the SEC required 60 days to produce their year-end statements. It also tends to produce some sudden market volatility as some funds make last minute adjustments to portfolios both before and after Oct-31st. Given the rally to new highs this would be a prime opportunity for funds to liquidate positions they don't want to carry forward into the coming year or window dress their portfolios. Since 1982 the plan on the street has been to buy Oct-27th and sell on Nov-1st. By gaming the fund year-end this way only one year has failed to post gains out of 24 years. Not all funds make major changes ahead of their fiscal year end but enough do to make for an interesting week. Despite the sterling record of the fund fiscal year-end rally we all know that once a trend is firmly established everybody tries to anticipate that trend by taking action ahead of it. I believe the rally over the last two weeks was due in part to traders and funds positioning themselves ahead of Oct-31st. Also, several analysts feel the current October rally borrowed significantly from later in the quarter. Last year the Dow rallied off the October lows for +800 points to the high for the quarter at 10950 on the day after Thanksgiving. It remained range bound in a 250-point range for the rest of the year. This year the Dow has rallied +1484 points since July 18th. It is due for some range bound consolidation or worse.

This year we have the election as a market motivator but that may be a negative over the next week. The apparent Democratic sweep ahead is prompting fears, right or wrong, that Democratic control will be negative for sectors like pharmaceuticals, defense and big oil. Right or wrong it may produce some selling and could make it tough to make any new highs next week. Add in the problems in the PC/chip sector and the road ahead is looking less rosy. Once past month end it could get even rockier.

The major oil companies have reported and the top five companies posted earnings of more than $20 billion for the quarter. That equated to profits of nearly $240 million a day. Analysts are coming out of the closet and beginning to recommend them again with PE ratios actually falling due to the strong earnings and guidance. Multiple major analysts like Goldman, JP Morgan, UBS, etc have reiterated expected oil prices to average between $67-$75 in Q4. Since one month of Q4 is already over that suggests they think prices will rise as the quarter progresses. However, not all earnings were met with applause. Baker Hughes (BHI) posted profits that rose +29% and beat estimates slightly. The CEO repeated the caution already voiced by others that the record surplus of natural gas today "could" slow exploration some in 2007 "if" we did not have a normal winter. According to everyone there has not been any decline in drilling, yet, but just in case it does come they want to be on record in advance. Everybody is trying to talk down expectations just in case. BHI lost -$4.16 on the comments despite the positive earnings. Investors are getting very nervous at this point on the calendar and have little patience for any cautious comments.

Oil prices rose slightly after news broke that coalition forces had moved in to protect offshore oil installations in the Middle East. It appears Al Qaeda had plans to attack Saudi Arabia installations specifically Ras Tanura. Ras Tanura handles nearly 8% of the worlds total oil exports. A successful attack there would mean instant $100 oil. Al-Qaeda has repeatedly threatened over the last two years to target oil facilities in the Gulf, most recently in a broadcast by Ayman al-Zawahiri, the second in command, on Sept-11th. Britain said they received specific and credible information that an attack was in the planning stages. With naval forces moving in to protect the installations that threat should now be over. Iran also raised the level of energy anxiety by announcing they had begun to enrich uranium in a second network of centrifuges. Iran was emboldened by the lack of material sanctions placed on North Korea and the lack of material sanctions on itself by the UN Security Council after a year of threats. I fear that once the election is over the intensity against Iran will increase sharply. The Washington Times ran an editorial a couple weeks ago saying Bush would be forced to attack Iran before his term is out. Most feel he is keeping the issue out of the US press until the elections are over. Iran has threatened to close the Straits of Hormuz if they are attacked. 40% of the world's oil flows through that strait.

December Crude Chart - Daily

Ingersoll-Rand (IR) missed estimates and warned that the housing weakness had taken its toll on the equipment it makes for landscaping and construction. The "Bobcat" division, equipment for very small contractors, produced the majority of the earnings drag. This knocked CAT back for a loss after a nice rebound from last week's earnings disaster. It should have been common knowledge since CAT had already confessed concerning this sector. Heck, IR had already taken a significant hit on the CAT earnings and then got whacked again on Friday. Terex (TEX) has no material home contractor business and it was also knocked for a -5% loss on guilt by association. This is what the rest of the earnings cycle is going to look like. If somebody stumbles it will trip the entire sector.

Next week we still have a flurry of earnings despite the cycle being nearly over. Most names you probably have never heard before. There is little to learn about the future from the lower tier players repeating what their blue chip brothers have already said. There are some blues left but they are dwindling. Next week should be more about economics than earnings. With the PMI, ISM, Productivity, Factory Orders and Jobs it will be a full week. The Fed's soft landing scenario will be tested by fire next week and then again in the mid month reports the week of the 13th. Right now it appears Bernanke and his team were correct to pause and Lacker, the lone dissenter was in error. There are some strong voices outside the Fed who feel there is a crash landing ahead not a goldilocks scenario. Nouriel Roubini, Professor of Economics at NYU, has been dead on with his economic predictions for the past year. He correctly predicted the 2.6 GDP in Q2 AND the 1.6 GDP for Q3 way back in July when everyone else was expecting much higher. He predicted the housing implosion and the continued misses in the jobs report. He is targeting a 0.5% GDP for Q4 and a recession beginning in Q1. He points to the slowing reports from the Philly Fed, Richmond Fed and Chicago Fed as warnings signs. I generally overlook the occasional interviews with an economic bear as a chicken little in analyst clothing. However, Roubini has the credibility of being right on every point I can remember for the last year. If his prediction of a 0.5 GDP in Q4 comes true the Fed will be firing off rate cuts in rapid succession but it may be too late. The Fed typically goes too far and waits too long before reversing position. I was hoping Bernanke had it right this time but we won't know for sure for another six months. That is what makes the economic reports next week so critical. If there is any signs of a rapidly falling economy in the ISM and Factory Orders or heaven forbid a negative jobs number the market will not react kindly. The Fed will have to react quickly and I doubt they will do it given their present slightly hawkish stance. The statement last week was slightly more hawkish than the one before but tame enough not to rock the markets ahead of the election. That election roadblock is going to be over in nine days and they will be free to act if they have the courage. This is why the economics next week will be critical. Personally I expect the numbers to be better than expected because it is a pre election event. While I would never accuse any party in power of outright manipulation of the numbers it would benefit the party in power if they were positive. They can always adjust them later as both parties tend to do. Anybody that follows the economics for long sees these unexplained revisions constantly. Most numbers are estimates anyway and are revised when the real data becomes available. Time will tell if there are going to be games played next week. According to several prominent analysts the GDP data on Friday was incorrect. Joe Carson, formerly a Commerce Dept Economist and now with Alliance Bernstein in New York said it should have been 0.9% not 1.6%. He claims the way auto sales are calculated actually produced a larger vehicle production number than actually occurred. Remember this was a quarter when all three automakers were cutting production not increasing it. The Commerce Dept calculates "inflation adjusted production" using the wholesale prices to project production. When automakers cut prices by 5.5% to unload extra inventory it had the opposite impact on the production numbers. Sounds like voodoo economics to me but Carson says the number will be revised down sharply. He also expects Q4 GDP to be 0.7% to 1.4% and more inline with Roubini's Q4 estimate rather than the 2.5%-2.7% consensus. According to John Mauldin stock markets drop an average of -43% during recessions so let's hope those economic bears are wrong about Q1-2007 beginning a recession.

The Friday decline did no real damage to the indexes. In fact the initial GDP shock had almost worn off before the chip news hit. The indexes had just hit their intraday highs at 12:30 when the Goldman Sachs downgrade hit the wires. The magnitude of the decline was inconsequential given the gains over the last few weeks. It was just simple profit taking on a Friday afternoon. What comes next is the key. If the Dow can hold 12075 on Monday the funds have a chance of escaping October in near record territory and will have nice year end reports for investors. There are no material economic reports on Monday. If the markets can't hold the high ground on Monday the outlook for the rest of the week could be grim. The Dow has support at 12075, 11950 and 11800 with a couple of minor tick supports along the way. If real selling developed I would expect 11800 to be the support level bought by the retail crowd and those funds looking to reinvest cash raised by dumping unwanted positions on Nov-1st.

SOX Chart - 180 min

Russell-2000 Chart - 180 min

The Nasdaq, despite it chipped Achilles heel, has decent support at 2330. This level has held for two weeks through all kinds of negative tech news. Backup support is 2300 and below that it gets ugly. We saw 2375 return as strong resistance after a higher close on Thursday. Given the chip and PC weakness now it will be even tougher to rebound back over that level. Not impossible, just difficult. The Russell was also a big loser on Friday at -1.31% and gave up its breakout gains from Thursday. Resistance at 770 reasserted control and like the Nasdaq, without chip support, it may be tough to recover. The Russell does have strong support at 760 so it is still in rebound range for Monday/Tuesday.

SPX Chart - Daily

The S&P managed to break the 1380 barrier on Thursday and I thought we were off to the races until that GDP problem tripped it up. Because of the series of weeklong consolidations since late September there is support about every ten points down to 1300. Hopefully we won't have to test them all. 1375 is the first support level followed by 1365 and then 1350. Once into November I would expect to test 1365 and probably 1350. This could be where a range develops that takes us into year-end. Many brokers have 2006 S&P targets of 1425 and that would be my upper target as well. You could make a lot of money trading a 75-point S&P range but I doubt it will be clear cut. Since any theory about market actions next week or any week is just educated speculation we want to remain with the trend until it breaks. I would continue to buy the dips to about 1363 but be prepared to go flat or short under 1360 with a new buy target at 1350. Hopefully we won't need any targets under 1350 for the rest of 2007. There is always a correction lurking in our future and as of Monday it will be 456 days without a -10% correction and the 4th longest streak in history. Like passes caught in consecutive games or a specific color turning up on a roulette table a streak will always come to an end. I once saw a streak of 27 consecutive reds that sucked in enormous amounts of cash from those betting on black. Eventually those betting on black won, at least those who could afford to keep betting until it hit. The farther we get into Q4 the better chance we have of our streak ending with a correction. It does not mean the bull market is over, just that it is time to take profits and reshuffle the deck.
 


New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None AMD CEPH
  AMZN NILE
  PCAR WFMI
  PTRY  

New Calls

None today.
 

New Puts

Advanced Micro Dev. - AMD - cls: 20.86 chg: -0.64 stop: 22.05

Company Description:
Advanced Micro Devices is a leading global provider of innovative processing solutions in the computing, graphics and consumer electronics markets. AMD is dedicated to driving open innovation, choice and industry growth by delivering superior customer-centric solutions that empower consumers and businesses worldwide. (source: company press release or website)

Why We Like It:
AMD reported earnings on October 18th and beat estimates by 4 cents but the stock sold off any way due to disappointing gross margins. AMD bounced from round-number psychological support at $20.00 but that bounce appears to be failing under the $22.00 level and its descending 10-dma. We see Friday's failed rally under the 10-dma as a new entry point to buy puts. The semiconductor SOX index has been under performing the broader market over the past couple of weeks and after Friday's comments from Goldman Sachs about plunging motherboard sales we expect that the chips will continue to see weakness. We admit that this is probably an aggressive entry point with tested support at the $20.00 level and more conservative traders may want to wait for a decline under $20.00 before considering new put positions. We do note that most of AMD's gaps tend to get filled but we're expecting some market weakness in early November that could weigh on the stock and the sector. Our target is the $17.50-17.00 range.

Suggested Options:
We are suggesting the December puts. Novembers only have three weeks left.

BUY PUT DEC 22.50 AMD-XU open interest= 768 current ask $2.40
BUY PUT DEC 20.00 AMD-XD open interest=2662 current ask $1.00
BUY PUT DEC 17.50 AMD-XW open interest= 757 current ask $0.30

Picked on October 29 at $ 20.86
Change since picked: - 0.00
Earnings Date 10/18/06 (confirmed)
Average Daily Volume = 23.0 million

---

Amazon.com - AMZN - close: 38.24 chg: -0.06 stop: 40.25

Company Description:
Amazon.com, Inc., a Fortune 500 company based in Seattle, opened on the World Wide Web in July 1995 and today offers Earth's Biggest Selection. Amazon.com, Inc. seeks to be Earth's most customer-centric company, where customers can find and discover anything they might want to buy online, and endeavors to offer its customers the lowest possible prices. (source: company press release or website)

Why We Like It:
We want to warn readers right from the start that this is a speculative play. Shares of AMZN soared on October 25th following a better than expected earnings report from the company. AMZN beat estimates, came in higher on the revenue numbers and guided higher for the fourth quarter. The news produced a short squeeze that may not be over yet. The most recent (early October) data put short interest at over 14% of AMZN's float. While the earnings news was very positive we suspect that AMZN will "fill the gap". The post-earnings rally stalled just under resistance at the $39.00 level (see chart). There is additional resistance near $40.00. We're suggesting put positions now but we need to allow room for AMZN to trade near $40 is necessary. More patient traders may want to try and time an entry on another failed rally near $39 or if the rally continues then near $40. Our target is the $35.00-34.00 range.

Suggested Options:
We are suggesting the December puts.

BUY PUT DEC 40.00 ZQN-XH open interest= 517 current ask $2.75
BUY PUT DEC 37.50 ZQN-XU open interest=3109 current ask $1.50
BUY PUT DEC 35.00 ZQN-XG open interest=2035 current ask $0.75

Picked on October 29 at $ 38.24
Change since picked: + 0.00
Earnings Date 10/24/06 (confirmed)
Average Daily Volume = 7.9 million

---

PACCAR Inc. - PCAR - cls: 59.42 chg: -0.70 stop: 62.51

Company Description:
PACCAR is a global technology leader in the design, manufacture and customer support of high-quality light-, medium- and heavy-duty trucks under the Kenworth, Peterbilt and DAF nameplates. It also provides financial services and information technology and distributes truck parts related to its principal business. (source: company press release or website)

Why We Like It:
PCAR reported earnings this past week and managed to beat analyst estimates but the stock responded with a failed rally at $62.50, the second one in a two-day time period. Since the earnings report shares of PCAR have continued to slide lower and now the daily chart's MACD indicator has produced a new sell signal. The close under the $60.00 level is also bearish. We're suggesting puts with PCAR under $60.00. Our target is the rising 100-dma but we're going to use an official exit in the $56.00-55.50 range (for now). We are using a wide stop loss but more conservative traders may want to try and keep theirs near $61.00 to reduce their risk.

Suggested Options:
We are suggesting the December puts.

BUY PUT DEC 60.00 PAQ-XL open interest=270 current ask $3.10
BUY PUT DEC 55.00 PAQ-XK open interest= 49 current ask $1.00

Picked on October 29 at $ 59.42
Change since picked: + 0.00
Earnings Date 10/24/06 (confirmed)
Average Daily Volume = 1.4 million

---

Pantry Inc. - PTRY - close: 54.05 change: -1.35 stop: 57.05

Company Description:
Headquartered in Sanford, North Carolina, The Pantry, Inc. is the leading independently operated convenience store chain in the southeastern United States and one of the largest independently operated convenience store chains in the country, with net sales for fiscal 2005 of approximately $4.4 billion. As of September 28, 2006, the Company operated 1,493 stores in eleven states under select banners, including Kangaroo Express(SM), our primary operating banner. (source: company press release or website)

Why We Like It:
Shares of PTRY spent over a week in October trying to breakout over resistance at the $60.00 level. The stock eventually produced a "breakout" but the direction was down. The company pre-announced that earnings would come in below analyst expectations and naturally the markets sent the stock lower. The oversold bounce from its 50-dma and 100-dma is already fading and we expect the next move to be lower. However, this is an aggressive entry point since PTRY is likely to have support in the $53.00-52.50 region. We're suggesting put positions now with PTRY under $55.00 but more conservative traders may want to wait for a decline under $52.50 before opening new put plays. Conservative traders may also want to consider a tighter stop (maybe near $56.00). Our target is the $48.00-47.00 range. We do not want to hold over the November 16th earnings report.

Suggested Options:
We are suggesting the December puts.

BUY PUT DEC 55.00 PQR-XK open interest= 77 current ask $3.60
BUY PUT DEC 50.00 PQR-XJ open interest=155 current ask $1.60

Picked on October 29 at $ 54.05
Change since picked: + 0.00
Earnings Date 11/16/06 (confirmed)
Average Daily Volume = 383 thousand
 

New Strangles

Cephalon - CEPH - close: 69.35 change: -0.87 stop: n/a

Company Description:
Founded in 1987, Cephalon, Inc. is an international biopharmaceutical company dedicated to the discovery, development and marketing of innovative products in four core therapeutic areas: central nervous system, pain, oncology and addiction. Cephalon currently employs approximately 3,000 people in the United States and Europe. (source: company press release or website)

Why We Like It:
Earnings for CEPH are coming up on Thursday, November 2nd. Shares have been consolidating sideways near the $70.00 level for the past few days and now the stock looks like a good candidate for a strangle play. CEPH looks pretty overbought from its bounce near $55.00 in late September and while the technicals are turning bearish there is no way to know what direction the stock will move on the earnings news. That's why we're suggesting strangles in the $69.00-71.00 range. The closer to $70.00 we can open the position the better. We do not want to open plays after the earnings report.

Suggested Options:
A strangle involves buying both an out-of-the-money call and an OTM put. At current prices our estimated cost is $3.45. We plan to see if either option rises to $4.90 or more.

BUY CALL DEC 75.00 CQE-LO open interest=118 current ask $1.55
-and-
BUY PUT DEC 65.00 CQE-XM open interest=469 current ask $1.90

Picked on October 29 at $ 69.35
Change since picked: + 0.00
Earnings Date 11/02/06 (confirmed)
Average Daily Volume = 2.0 million

---

Blue Nile - NILE - cls: 38.92 chg: -0.60 stop: n/a

Company Description:
Founded in 1999, Blue Nile is the leading online retailer of diamonds and fine jewelry. It has built a well respected brand by providing consumers with a better way to buy diamonds and fine jewelry. (source: company press release or website)

Why We Like It:
NILE spent weeks consolidating sideways between $35 and $38 but last week the stock broke out higher. This could be the beginning of a new leg higher. However everything could change after the company's earnings report. NILE is due to report earnings on Monday, October 30th after the closing bell. That gives us one day to open positions. The stock has a history of big moves following the company's earnings reports so a strangle seems like a good bet here. You'll notice that NILE isn't trading near any one specific strike price so traders will need to take extra care to try and balance the amount invested (not the number of contracts) on both the call side and put side to keep this strategy neutral. We're suggesting entries in the $38.00-41.00 range. We do not want to open plays after the earnings report on Monday night.

Suggested Options:
A strangle involves buying both an out-of-the-money call and an OTM put. At current prices our estimated cost is $2.40. We plan to see if either option rises to $3.90 or more.

BUY CALL JAN 45.00 JWU-AI open interest= 284 current ask $0.85
-and-
BUY PUT JAN 35.00 JWU-MG open interest=1388 current ask $1.55

Picked on October 29 at $ 38.92
Change since picked: + 0.00
Earnings Date 10/30/06 (confirmed)
Average Daily Volume = 226 thousand

---

Whole Foods - WFMI - close: 64.75 change: -0.65 stop: n/a

Company Description:
Founded in 1980 in Austin, Texas, Whole Foods Market is a Fortune 500 company and the largest natural and organic foods retailer. The Company had sales of $4.7 billion in fiscal year 2005 and currently has 186 stores in the United States, Canada and the United Kingdom. (source: company press release or website)

Why We Like It:
After an impressive run up shares of WFMI have been consolidating sideways the past two weeks as investors wait for the company's next earnings report. The last couple of earnings reports produced some strong moves in the stock price and we want to use a strangle to capture any move. The company is expected to report earnings on Thursday, November 2nd after the market's close. We would not open positions after they announce. We're suggesting a $64.00-66.00 entry range to open positions with our preferred entry point as close to $65 as possible.

Suggested Options:
A strangle involves buying both an out-of-the-money call and an OTM put. At current prices our estimated cost is $3.15. We plan to see if either option rises to $5.40 or more.

BUY CALL DEC 70.00 FMQ-LN open interest=195 current ask $1.60
-and-
BUY PUT DEC 60.00 FMQ-XL open interest=147 current ask $1.55

Picked on October 29 at $ 64.75
Change since picked: + 0.00
Earnings Date 11/02/06 (confirmed)
Average Daily Volume = 2.1 million
 


Play Updates

In Play Updates and Reviews

Call Updates

BP Prudhoe Bay - BPT - close: 74.09 chg: -0.21 stop: 72.45

Energy stocks traded lower on Friday in spite of a bounce in crude oil futures. The profit taking was widespread across the market. Shares of BPT had been inching higher during the first half of Friday but the rally stalled at $74.70, under resistance at the $75.00 level. The overall pattern still looks bullish with BPT's chart suggesting an eventual breakout over resistance at the $75.00 mark. This past week we did see BPT breakout past technical resistance at the 50-dma and 200-dma but it didn't amount to much (yet). Currently we are suggesting a trigger to buy calls at $75.05. If we are triggered our target is the $79.00-80.00 range. FYI: A move over $75 would produce a new Point & Figure chart buy signal.

Suggested Options:
We are suggesting the December calls. Our trigger to open positions is at $75.05.

BUY CALL DEC 70.00 BPT-LN open interest=214 current ask $5.50
BUY CALL DEC 75.00 BPT-LO open interest=467 current ask $2.10
BUY CALL DEC 80.00 BPT-LP open interest=605 current ask $0.60

Picked on October xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 421 thousand

---

Cerner Corp. - CERN - close: 47.66 chg: +0.46 stop: 46.45

It has taken longer than expected but shares of CERN are finally seeing some upward follow through on the October 20th bullish reversal. Technical indicators are bullish and CERN Looks poised to breakout over resistance and the top of its trading range near $48.00. We are suggesting a trigger to buy calls at $48.05. If triggered then our target is the $52.00-52.50 range. The $50.00 mark might offer some round-number resistance so expect a pull back on the initial test of $50. FYI: The Point & Figure chart projects a $76 target.

Suggested Options:
We are suggesting the December calls. November options expire in three weeks. Our trigger to open plays is at $48.05.

BUY CALL DEC 45.00 CQN-LI open interest=512 current ask $3.90
BUY CALL DEC 47.50 CQN-LW open interest=478 current ask $2.25
BUY CALL DEC 50.00 CQN-LJ open interest=402 current ask $1.15

Picked on October xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/19/06 (confirmed)
Average Daily Volume = 662 thousand

---

Frontier Oil - FTO - close: 29.85 change: +0.05 stop: 27.99*new*

Be careful with FTO. The stock has struggled to build on any rally attempts lately. Friday saw FTO produce its third failed rally in three days near its 100-dma in the $30.50 region. We seriously considered an early exit right here and more conservative traders may want to think about jumping out. The rally in oil stocks looks tired and we are expecting a dip in the Monday-Tuesday time frame this week. The problem is that the dip could turn into a correction if the rest of the market suddenly heads south with any speed. Shares of FTO should still have some support near $28.00 (bottom of the previous trading range) and the 200-dma (now at $28.41). We're raising the stop loss to $27.99. We're not suggesting new bullish positions on FTO unless the stock can breakout over the $30.50 level. Our short-term target is the $32.50-33.00 range. It's short-term because we want to exit ahead of FTO's November 7th earnings report. FYI: The P&F chart is still bearish. Plus, the weekly chart might be building a big (bearish) head-and-shoulders pattern.

Suggested Options:
We are not suggesting new positions on FTO at this time.

Picked on October 15 at $ 28.90
Change since picked: + 0.95
Earnings Date 11/07/06 (confirmed)
Average Daily Volume = 3.2 million

---

NTL Inc. - NTLI - close: 27.23 chg: -0.27 stop: 25.99

After two days of gains the rebound in NTLI paused as the market experienced some widespread profit taking. Traders bought the dip in NTLI near $27.00 and the pull back looks like a new entry point to buy calls. Volume has been very big on the recent rally, which is a bullish signal. We have less than two full weeks before NTLI is expected to report earnings (still unconfirmed). Traders should bear that in mind if you're considering positions here. Our target is the $29.90-30.00 range. We do not want to hold over the early November (8th?) earnings report.

Suggested Options:
We are suggesting the November calls since we plan to exit before they expire. December strikes would also work.

BUY CALL NOV 25.00 NUD-KE open interest=2324 current ask $2.70
BUY CALL NOV 27.50 NUD-KY open interest=5306 current ask $1.00
BUY CALL NOV 30.00 NUD-KF open interest=1307 current ask $0.35

Picked on October 26 at $ 27.41
Change since picked: - 0.18
Earnings Date 11/08/06 (unconfirmed)
Average Daily Volume = 2.4 million

---

Vimpel Comm. - VIP - close: 65.07 chg: -0.99 stop: 61.90

VIP displayed some impressive strength earlier this past week with the stock breaking out to new record highs. VIP traded over $67 on Thursday morning before finally succumbing to profit taking. Friday's weakness was another round of profit taking spurred on by general weakness in the U.S. markets that afternoon. Technically the pull back has been on low volume, which is bullish. We'd look for a dip toward the 10-dma or the $64.00 level. Broken resistance at $64.00 should offer some support. Our target is the $67.50-70.00 range. We're not suggesting new positions at this time although a bounce from $64 could be used as a new entry point. We plan to exit ahead of the mid-November earnings report. FYI: We are seeing a bearish divergence between the price action and the RSI on VIP's daily chart.

Suggested Options:
We're not suggesting new positions at this time.

Picked on October 12 at $ 62.17
Change since picked: + 2.90
Earnings Date 11/17/06 (unconfirmed)
Average Daily Volume = 1.0 million
 

Put Updates

Alcon Inc. - ACL - close: 107.34 chg: -1.03 stop: 110.41

ACL is moving our direction and closer to a new relative low. The stock broke down this past week after investors became disappointed with the latest earnings results. We suggested that more aggressive traders might want to buy puts on the failed rally under $110 on Wednesday. We are suggesting a trigger to open plays at $105.75, which is under last Tuesday's low. If triggered our target is the $100.10-100.00 level. We would consider this play slightly more aggressive due to the wide stop loss we're suggesting. Keep an eye on the DRG drug index. The DRG spent about six days failing to breakout past the 363 level and now the sector index is falling sharply. Short-term technicals have turned negative for the group but the overall bullish up trend is still intact (for now).

Suggested Options:
November puts have more open interest but they expire in three weeks so we're suggesting the December puts. Our trigger is at $105.75.

BUY PUT DEC 110.00 ACL-XB open interest= 64 current ask $5.40
BUY PUT DEC 105.00 ACL-XA open interest= 35 current ask $2.85
BUY PUT DEC 100.00 ACL-XT open interest= 0 current ask $1.30

Picked on October xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/23/06 (confirmed)
Average Daily Volume = 520 thousand

---

StanCorp. - SFG - close: 45.55 change: +0.61 stop: 46.01

SFG's rally on Friday was a surprise. Shares erased Thursday's post-earnings sell-off and did so on strong volume. Looking at the intraday chart most of the volume flooded in on Friday afternoon. The overall pattern still looks bearish so we're going to keep SFG as a bearish candidate for now. However, if shares close over $46 we'll drop it as a candidate. We're reposting our Thursday new play comments here:

The last couple of earnings seasons have been rough for SFG. The stock has experienced some major sell-offs (see chart). Shares managed to avoid a big sell-off when SFG announced earnings Thursday but unfortunately for shareholders the trend still appears to be down. The company reported earnings and the EPS numbers were a bit better than analysts expected but revenues were light and the company said fiscal year numbers would be toward the low end of previous guidance. This was effectively an earnings warning going forward. The stock lost 1.2% on strong volume and looks poised to challenge and probably breakdown under support at the $44.00 level. Short-term technicals are bearish and SFG has been trading in a very wide, long-term bearish channel for months. The P&F chart points to a $36 target but appears to have some support near $39.00. We are suggesting a trigger to buy puts at $43.89, which is under support at $44.00 and its September 25th low (43.92). If triggered at $43.89 our target is the $40.25-40.00 range. More aggressive traders may want to aim lower toward the bottom edge of its channel.

Suggested Options:
November puts have more open interest but they expire three weeks. Therefore we're suggesting the December puts. You the individual trader should decide which month and strike price works best for your trading style and risk. Our suggested entry point is $43.89.

BUY PUT DEC 45.00 SFG-XI open interest= 25 current ask $1.75
BUY PUT DEC 40.00 SFG-XH open interest= 0 current ask $0.50

Picked on October xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/26/06 (confirmed)
Average Daily Volume = 267 thousand

---

Univ.Forest Prod. - UFPI - cls: 45.26 chg: -0.27 stop: 50.01

Shares of UFPI continue to slink lower following the bearish, earnings-inspired breakdown from its three-month trading range about two weeks ago. The stock is currently testing round-number support at the $45.00 level. We were concerned that UFPI would bounce from the $45 mark but so far any bounce attempt has been anemic. At the moment we would suggest readers wait for a new relative low under $44.98 (we'd suggest 44.95) before opening new put positions. Or as an alternative you could look for a failed rally near its 10-dma near $47.50. More conservative traders may want to tighten their stop loss and reduce their risk. We're aiming for a decline into the $41.00-40.00 range. Our wide stop loss makes this a more aggressive play.

Suggested Options:
The November and January puts have more open interest but we're against using the November strikes for new plays because they expire in three weeks. Currently we're suggesting the December strikes.

BUY PUT DEC 50.00 UAD-XJ open interest= 3 current ask $5.60
BUY PUT DEC 45.00 UAD-XI open interest= 0 current ask $2.35
(we don't see any Dec. 40 puts available yet)

Picked on October 24 at $ 46.13
Change since picked: - 0.82
Earnings Date 10/16/06 (confirmed)
Average Daily Volume = 192 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.)

---

Bear Stearns - BSC - cls: 149.21 chg: -4.09 stop: n/a

Shares of BSC experienced a sharp reversal on Friday. The stock lost 2.66% on above average volume. The decline is a bearish breakdown under its 10-dma, the $150.00 level and its two-month trendline of higher lows. Friday's decline also produced a new sell signal on the daily chart's MACD indicator. Friday afternoon offered several chances to open new strangle positions very close to the $150.00 level. If you missed the chance it may not be too late but we'd try to keep new strangle positions in the $149.00-151.00 range. The closer to $150.00 the better. The options in our strangle are the November 155 call (BSC-KK) and the November 145 put (BSC-WI). Our estimated cost was $4.00. We're planning to exit if either option rises to $6.00 or more.

Suggested Options:
If you choose to open new plays you might want to consider the December strikes over the Novembers. November options expire in three weeks. A similar strangle using December $155 calls and $145 puts would cost about $6.00. You would need to adjust your target accordingly. Aggressive players might just want to speculate on just buying puts.

Picked on October 22 at $150.19
Change since picked: - 0.98
Earnings Date 12/14/06 (unconfirmed)
Average Daily Volume = 1.6 million

---

ConocoPhillips - COP - close: 61.19 chg: -0.65 stop: n/a

Lack of a strong post-earnings move has put a crimp in our strangle play on COP. The stock is reversing lower after a failed rally near its 200-dma. We still have three weeks left for this strangle strategy to play out but we'd be against opening new positions using November options. Our estimated cost was about $1.15. We are suggesting an exit if either option rise to $2.00 or more. Our suggested options were the November $65 call (COP-KM) and the November $55 put (COP-WK).

Suggested Options:
We're not suggesting new positions in COP at this time.

Picked on October 15 at $ 60.03
Change since picked: + 1.16
Earnings Date 10/25/06 (confirmed)
Average Daily Volume = 9.8 million
 

Dropped Calls

None
 

Dropped Puts

None
 

Dropped Strangles

None
 


Trader's Corner

The Least You Should Know

It happened again this month. A subscriber contacted me during expiration week. It was clear from this person's comments that this subscriber did not know that the futures that were the subject of the email were about to expire: the next day, in fact. This subscriber did not know what time of day this futures contract stopped trading or how or when the settlement figure was calculated. The subscriber didn't know how much would be gained or lost for each move up or down in the commodity price in the interim, but rather was just studying the profit/loss update provided by the subscriber's online broker. The subscriber didn't know whether the futures contract being discussed was cash-settled or would be settled with physical delivery of the commodity.

Yikes. You really do not want a pile of pork bellies or some such thing being delivered to your doorstep because you didn't know that expiration was upon you and whether the contract was cash-settled or not.

That was a futures contract, but the same thing happens often with subscribers asking about options plays. Since this site focuses on options trading, we're going to discuss the least you should know before you even entertain the idea of entering an options play. After that, I'll discuss a calculation that I haven't seen explained elsewhere, but that is also the least you should know if you're holding an option as expiration approaches. This idea might help you make end-of-day decisions just before an option stops trading. This is particularly true for those of you who trade credit spreads, selling options as part of the spread. Those of you who already know the basics of options expiration can skip to the last half of this article for that information. Newbies need to read it all.

The least you should know before entering an option play is how much you're going to pay, where the underlying has to be for you to make money on that option when it expires, when the last trading day is, when it settles, and how the settlement value is determined. Of course, the least you should know also includes how much of your account you should devote to one position and how much you're willing to lose before you're stopped, but that's true of any trade, and this article will focus only on the particulars of options. You also need to know how an option moves when the underlying does and according to other factors, but that's also a topic for another article, one I've written in the past. This article focuses on settlement.

Before you can determine how much you're going to make if you happen to be holding an option into settlement, you first need to calculate how much you're going to pay. You need to know the multiplier for that option. Perhaps you see an option quoted at 1.95 bid and 2.25 ask, and you figure you'll offer 2.15 to buy it. You're going to pay some multiple of 2.15 for each contract of that option, if you're so lucky as to have your offer accepted. In most cases, that multiple is $100, but it isn't always. Don't assume it is. For example, if the option is on an equity and a stock split has occurred, the multiplier might be different. Check.

This information can often be found at www.cboe.com for options on both equities and most indices. Clicking on the "Products" tab presents you with a choice of equity options, index options interest-rate options and other choices. For example, you can follow the links through to the Russell 2000, and find that the Russell 2000's options do indeed have a multiplier of $100. If that were a Russell 2000 Oct. 770 call you had bought for 2.15, you'd have paid $215.00 for each contract, plus commissions.

That Oct 770 call might have been trading at about that level some time on opex Wednesday or Thursday. If you'd been buying that October contract on Wednesday, October 18, you had better have known that it was option-expiration week for the Russell 2000 options, as well as for other index and equity options. You needed to know the expiration date before you decide whether you'll buy a front-month (the current month) option or one further out. You don't want to buy a front-month option if it's opex week and you're legging in for an anticipated movement that might not happen until the next week, for example. Your front-month option will expire before then. The CBOE helps you out there, too, publishing an expiration calendar at http://www.cboe.com/AboutCBOE/xcal2006.pdf/ with another also already available for 2007.

October's expiration was October 21, but even that's not enough information. That's a Saturday. Obviously, the Russell 2000's options do not trade on a Saturday, so when would the October options stop trading? Some indices stop trading at the close the Thursday before option expiration; some on the Friday before opex. And when is a settlement value determined? Some settlement values are determined when markets open the Friday before option expiration and some at the close.

The RUT turns out to be one of the indices with options that stop trading Thursday afternoon and settle Friday morning, although you might not find out what that settlement value is until the afternoon. This next statement has been repeated often, both by me and by others, but bears repeating again: the settlement value is NOT the opening value for the Russell 2000 Friday morning. The settlement value is calculated by the opening value of all the component stocks. They don't all open at the same time, so if markets are declining near the open, even for a few moments, with prices cascading lower, the stocks opening a bit later than the first ones are likely to be hit and the settlement value could possibly be below the opening value. The opposite can happen when there's a buoyant mood in the markets, even if it lasts for only a few moments and the rest of the day is a down day. All this information about how settlement values are calculated is available on the CBOE site under product specifications for each option series.

On opex Thursday, the Russell 2000 closed at 767.39. The options stopped trading as of that close. If you had bought the 770 calls, doesn't that mean that you were out of luck and you lost that $215 plus commissions that you paid? If you had sold those options as part of a spread, does that mean you were safe? Not necessarily, in either case. Settlement value could have been radically different from Thursday's closing price as was stated in the paragraph above and as will be demonstrated later in the article.

If you'd been a buyer of that option and had held onto it that Thursday, where would the Russell 2000 have had to have settled in order for you to make money? It would have had to have settled above 770 (the strike you bought) + 2.15 (the price you paid for the option), and of course you'd have to add in your commission, too. If the settlement was above that price, then you would have been in luck.

A call option gives the call buyer the ability to buy at the strike price. If the underlying settles above that strike, the call is considered in the money. If you've bought a call on an equity or index and the call is in the money by an amount that your broker determines (mine says $0.05) at expiration, you're either going to find some money or some stock in your account.

If you bought a Russell 2000 call and the settlement had been above $770, were you in danger of having a bunch of Russell 2000 component stocks dumped into your account, with the need to pay for them? Nope. The RUT is cash-settled, information that's also found on the specifications page for the Russell 2000. Because the RUT also has European-style options, you don't have to worry about those options being exercised before opex, either. They are exercised only on the last business day before expiration.

If you had bought that Oct 770 RUT call on Wednesday, you could have sold it before option expiration, of course, and you may have wanted to do so. The least you need to know about options also includes the fact that their extrinsic value decays as time passes. An option's price is composed of its intrinsic value, the value by which it's in the money, and extrinsic value, commonly referred to as its time premium. That commonly used term is not the whole truth because there are other factors that go into an option's price other than time value, but if you paid $215 for a contract of Russell 2000 calls on the Wednesday of opex week, the truth was that all of that value was extrinsic value. With option expiration quickly approaching, that call's value was likely to begin decreasing rapidly if the Russell 2000 did not move up, and move up quickly on opex Thursday.

There's a tendency for prices to be pinned to certain numbers beginning about mid-morning on option expiration Thursday while premium evaporates out of those out-of-the-money options. Especially if trading during opex week, be aware of this tendency, the least you need to know about choosing options during opex week. If you have the opportunity to make a decent profit on an out-of-the-money option earlier in option-expiration week, you might want to consider taking that profit or at least locking in some profits. If the option is underwater as expiration approaches and you have to opportunity to recoup some of your losses, you also might want to consider taking that opportunity.

If you had held on to the call you'd bought until the last moment, you would have had to have made the last-minute decision as to whether to sell it or hold onto it that Thursday afternoon. If you had sold the option and not bought it, perhaps as part of the spread, you also had to decide whether you wanted to buy-to-close that option or just wait out settlement the next morning, fingers crossed. Thursday's close was out-of-the-money, but would the settlement value be?

That's always a tough decision because anything can happen overnight. That's one reason I traded OEX options so long. They trade through opex Friday and settle at the close Friday. Although there were still some nasty surprises with settlement, you at least got to look at where settlement was likely to be when you're making that last-minute decision. When you make that decision on the RUT or the SPX, for example, you're making it Thursday at the close, not knowing what might happen overnight that could conceivable impact the open the next day.

The last least thing you need to know isn't often addressed. How far is the Russell 2000's settlement value likely to diverge from Thursday's close? Does the settlement value tend to be near Thursday's close or far from it? Although few writers address this issue, it's important for option buyers and sellers to know.

As has already been mentioned, the RUT closed at 767.39 on opex Thursday. Below, you'll find a table that displays the bid and ask for the Oct 770 as of Thursday's close.

Quote for the Russell 2000 Oct 770 Call as of the 10/19 Close:

As you can see, the bid and ask were 1.10 x 1.35. If you had been a buyer of that 770 call, should you have sold it at the close and taken your lumps after buying it for a higher price on Wednesday, but be grateful that you could collect anything for an out-of-the-money option? Should you hold on, hoping for a settlement value the next morning above 771.15? (This figure is the strike of your option, 770, plus an estimated 1.15 you might have been able to collect if you'd sold your call option Thursday afternoon, so represents where the RUT would have to settle for you to have been better off to have held it than to have sold it and taken your lumps Thursday afternoon. It does not represent a profit on the position, which wouldn't occur unless the RUT had settled above 772.15 plus the commissions you paid.) If you'd been a seller of the option, should you have bought it back near the close on Thursday, or held on and hoped that the RUT would settle below $771.25. (This is the strike plus the estimated $1.25 you would have had to pay to buy-to-close that option.)

To know that answer, you'd have to have had some idea how far the Russell 2000 typically settles above or below opex Thursday's close. That's the only way you were going to have any idea how much hope you might have had of recouping anything if you were a buyer of the option and decided to hold, or how much risk you might have had of shelling out some money if you were a seller of the option and decided to hold. The following table displays Russell 2000 closing prices on opex Thursdays for a year leading into October, as well as the corresponding settlement values determined on Friday morning, and the differences between those values.

The Difference of Russell Closes on OPEX Thursday and Settlement Values on Opex Friday:

If you use absolute values and average those, the average difference from opex Thursday's close to Friday's settlement is actually 3.155. However, you can see that three of the numbers--October 2005's, November 2005's and April 2006's--are far out of the norm. Averaging the other nine months produces an average of 2.53, relatively in line with the average difference listed above.

Each can have a different opinion, but it's my opinion that when making that choice about which figure to use that it would be better to use a difference calculated using the absolute value of the differences in the individual months. If October's opex had been average, the Russell 2000 might then settle 3.16 points away from Thursday's close, in either direction, since we're talking absolute values here. If you had been a buyer or a seller of the option, you were risking an average settlement that could be from 764.23 to 770.55, with each number 3.16 points away from the opex Thursday close of 767.39.

If you had been a buyer of that option, you could have calculated that the average settlement difference would still not result in an option that was in the money by the 1.15 or so that you might have been able to fetch for your call on Thursday afternoon. The average difference, absolute-value method, wouldn't come close to a figure above 771.15. You might have decided that the best course was to sell the call. Studying the chart further would have told you that four of the last 12 months saw positive differences big enough to bring that 770 option into the money, but only three of those would have resulted in a better position than selling at the close on opex Thursday. For the option buyer who might have bought the option on Wednesday, then, it appears that it would have been a better bet to have sold the option at the close and taken the loss, at least avoiding the potential for an even greater loss if settlement was within the average value.

If you had been a seller of that 770 call, you might have had a different outlook after studying that same chart. If the RUT settled 3.16 points above the opex Thursday close, or at 770.55, you were going to owe 0.55, the amount by which the call would have been in the money, so $55.00 per contract, plus the amount you'd be out your commissions.

That's less than the debit you'd have had to have paid to close out the position at the close on opex Thursday, however. Nine out of the twelve months, the option seller would benefit by holding pat and not doing anything, taking the risk of a bigger than average jump.

However, three of those months would have resulted in bigger losses for the option seller, and two of them would have been really big losses. What the option seller might have decided to do should have depended on the number of contracts sold, the account size, the option seller's tolerance for risk, and the state of the option-sellers stomach! Nine out of 12 chances of benefiting sound like good odds, but when the RUT settlement gets odd, it can get really odd! If you'd had one contract, you might have been prepared to stomach a few-hundred-dollar loss if you got a weird settlement value: if you had 20 or 30 contracts, the decision would have been tougher, but at least you were armed with this vital information.

So how did the RUT settle that Friday in October? The settlement value, RLS ($RLS on QCharts) was 770.06, 2.67 points above the opex Thursday close. This was a smaller one than the 3.16 one calculated using absolute values, which I think is probably the best to use, but roughly in line with the average calculated by the regular method, somewhat arguing against my opinion about the absolute value average. The RUT opened and moved up briefly but then dove through the early session. It never got anywhere near 770.06 that day, but that's how settlement works. Because it opened and climbed for just a few moments as component stocks were opening in domino fashion, the settlement was higher than the 768.32 high of the day.

If you'd been a buyer of that call option, it would have been better to have sold that option the day before; if you'd been a seller of the option, it would have in this case also have been better to hold out, paying only 0.06 (or $6.00 per contract) rather than the debit it would have cost you to buy it back near the close on opex Thursday. If you'd looked at the average difference between opex Thursday closes and Friday's settlement values, you would have been armed with vital information to make your decision. If you had been willing to accept the risk of a weird and out-of-whack settlement such as those few on the table above, you'd have been rewarded. I can't say it would have been a bad idea to close out the options, either, if your account could not stand the possibility of the kind of larger loss that occurred two months out of the previous year or if you couldn't stomach that possibility. Knowing the least you should know would have prepared you to make that decision.

Like many of you, I had been a seller of the 770's as part of a bear call spread. In fact, I'd sold 24 contracts of them. My decision? After performing all these calculations for myself on opex Thursday and looking at the bid/ask spread needed to buy-to-close that 770 call, I decided to take my chances and not close out the spread. I did throw out a low-ball order to close it, knowing that it was so low that it probably wouldn't be taken, and it wasn't, but it was worth the try anyway.

My decision turned out to be a good one in this case, and I retained most of the credit I'd collected when initiating that spread. It won't always turn out to be the right decision, as those sometimes-weird settlement values show. The average was on my side this time, and knowing the least I should know helped me make that decision.

Do your research, too. It's the least you should know.
 

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.

Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report and website should be independently verified.

To ensure you continue to receive email from Option Investor please add "support@optioninvestor.com"

Option Investor Inc
PO Box 630350
Littleton, CO 80163

E-Mail Format Newsletter Archives