With the exception of the excitement surrounding the Nymex IPO's debut, Friday proved to be a quiet day on the markets. Contrarians might have found the VIX's dip to 10.05 and the VXO's (old VIX) dip to 9.74 somewhat alarming, but it's easy to discount their behaviors during option expiration week. The only other excitement occurred in the few minutes following the 8:30 am release of October's Housing Starts and Building Permits. Few other developments interrupted a boring day.
Breadth measurements proved lackluster, and volume was lower than on other recent days. Indices chopped around, with the closing levels mixed. The SPX inched higher again. The Dow, of course, hit another new record closing high, but the Nasdaq, Russell 2000, TRAN, and SOX all moved lower.
Early this week, the FOMC minutes focused traders' attention on the Fed's continued worry about inflation. This had been a long-term worry for market watchers afraid of continued rate hikes. While so many considered that worry of primary importance, this morning's October Housing Starts refocused attention on another worry: that of a harder landing than had been anticipated.
Futures had already weakened before the Commerce Department released the housing
starts figure. Crude-related stocks had been hit over the previous days as crude
had dropped ahead of the expiration of the front-month contract. Some long the
crude futures may also have been frightened by the temporary excitement Tuesday
when Cambridge Energy Research Associates' much-hyped report stated that the
peak oil theory was a myth. The world isn't running out of oil, CERA's report
claimed. Jim Brown, still on vacation this week, sent the following link for
those who would like to read a rebuttal of CERA's conclusions:
Whatever the reason for crude's decline, the stocks related to crude failed to lend their support to the SPX early Friday morning. In addition to crude's drop, Exxon Mobil (XOM) had been downgraded Friday morning, and that company's stock is the most heavily weighted of the SPX. Although XOM was to scramble back into positive territory by the close, the stock gapped lower at the open and moved down to a daily low of $71.76 before making that scramble back into positive territory, helping to carry the SPX into positive territory, too.
The zooming of interest rates on Thursday may have hurt the Russell 2000, with those small-cap companies more interest-rate sensitive than large-caps. Interest rates dropped again Friday, but momentum traders likely refocused their action on the Nymex IPO rather the often momentum-driven small caps.
It's easy to search for a reason and say this one or that one explains what happened, but perhaps no reason was needed. As early as Wednesday, charts had cautioned that it was time for another of the sideways-to-sideways-up corrections that have been a part of the SPX's and Dow's run-up-then-go-sideways patterns for months.
Annotated Daily Chart of the SPX:
Reaching round-number resistance at 1400 was reason enough for the SPX to consolidate a few days, continuing its recent pattern. It forms that consolidation along the midline of this rising channel, too, another technical point at which consolidation sometimes occurs. Option-expiration antics also supplied another reason for the stall, as such a stall often occurs beginning on opex Thursday.
So far, the SPX continues its recent pattern as it has climbed through its rising price channel. Nothing long-term bearish can yet be found on the charts. Some might point to the possible warning offered by potential bearish price/RSI divergence. RSI attempted a breakout above the trendline it broke through in early November, however. Unlike on some other indices, RSI with this setting often stays high for a long while on the SPX, so we can't read too much into its current "overbought" status. The possibility remains for RSI to climb with price and undo that potential bearish divergence, too.
The SPX does begin to look overdue for another test of its 10-sma. I wouldn't be surprised to see that test occur next week, although, as of Friday's close, intraday Keltner charts suggested it could zigzag its way higher into a retest of Thursday's high.
While the SPX rose along the midline of its channel, the Dow hadn't quite reached the midline of its hand-drawn rising channel.
Annotated Daily Chart of the Dow:
The midline of that channel is a best-fit one, so might not be exact. By Monday, the midline of this rising channel will be located at about 12,387-12,398, depending on how the line is drawn. With the exception of the relationship of prices to the midline of the chart, the SPX's and Dow's chart show many similarities. There's potential bearish price/RSI divergence that can be erased by a continued rise in the RSI level. That's suggested as a possibility since RSI is breaking through its rising trendline again.
So far, however, prices act just as they've been acting for several months. I would expect a more sideways direction or an actual downturn toward the 10-sma if that channel's midline resistance is approached, however.
As of Friday's close, intraday Keltner charts suggested that, without another real push, the Dow's current rise might be about tapped out. Consider the possibility that the drop toward the 10-sma could occur at any time and plan your approach if that should happen.
The Nasdaq may have already begun a drop toward its 10-sma.
Annotated Daily Chart of the Nasdaq:
The Nasdaq's 10-sma still rises sharply toward the midline of the Nasdaq's price channel. If the Nasdaq does drop toward that average or move sideways until the midline and 10-sma support catch up, expect a bounce attempt from that potential support. If you're thinking about a new long entry in a Nasdaq stock or the QQQQ's when that support is hit, be aware that a bottom-of-the-channel test may be overdue, and it's possible that a bounce attempt from the 10-sma or midline might fail. Before you enter any new long trade at midline or 10-sma support, plan how you'll react if the Nasdaq rolls lower again. Will your stop be a broad one, below the channel's bottom or a tighter one that gets you out ahead of that test? You have time to plan the play.
As has been true for some time, the SOX's chart proves a little more difficult to interpret.
Annotated Daily Chart of the SOX:
Although the SOX's slide along that trendline is dropping prices, the SOX is still producing daily closes above the trendline, and so could legitimately be considered as consolidating along it. However, the SOX's RSI doesn't tend to trend at its current level, as does the RSI of some of the other indices. Its current level signals some concern for bulls. I've been noting for many weeks that something was wrong with the SOX's bearish picture after it had broken down from its price channel, and now it's possible that there's some concern about the bullish picture, too, now that the SOX has broken back above its 200-sma. So far, though, the SOX performs mostly in accordance with what bulls would want to see.
The intraday chart showed the possibility that the SOX is forming a bearish right triangle with the support at about 479.25. The SOX needs to produce a higher intraday high and break to the upside again to violate that pattern. Otherwise, the SOX may be vulnerable to a drop to 478.60-480.68 or possibly even the 200-sma. Neither of those events would be particularly bearish if all that's accomplished is a retest of the 200-sma, but if in a SOX-related play, evaluate your willingness to weather such a test, if one should occur.
Like the SOX, the RUT's RSI doesn't tend to trend at its current level, making the RUT vulnerable to a downturn, too.
Annotated Daily Chart of the RUT:
Unlike the SOX, however, the RUT's intraday pattern looks more like a bull flag, with the RUT just attempting an upside breakout above the descending trendline of that flag as of Friday's close. Bulls need to see a high higher than Thursday's to confirm that bull-flag breakout, however, especially since the flag was somewhat wide in comparison to the RUT's movements as it rose last week. That indicates more volatility while the flag formed than is optimum. If RSI turns lower, bulls would like to see the RUT consolidate in a mostly sideways movement rather than drop quickly with the RSI.
In the RUT's case, the (black) 30-sma looks like stronger support than the 10-sma. It's possible that the RUT might need to test that 30-sma if a rollover begins.
The TRAN, too, may be due for a pullback, but a pullback within a formation that is, for now, potentially long-term bullish while intermediate-term bearish.
Annotated Daily Chart of the TRAN:
When viewed on a one-year chart, the TRAN's formation looks a bit like a potential inverse head-and-shoulders, but these formations are no longer reliable, particularly when they form as a continuation pattern and not as a bottoming formation. However, in the climate since the spring of 2003, many of these have confirmed to the upside and have been followed by a strong rally. Even if that's what is eventually in store for the TRAN, that formation still lacks a real right shoulder, and so could conceivably drop back for a one- to two-month period to complete the right shoulder. Although the TRAN played catch-up this week, its performance remains relatively weaker than that of other indices. Unless it really "is different this time," that urges some caution on the part of Dow and other bulls, too.
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Some market pundits blamed October's Housing Starts for the early weakness in the markets. New housing starts fell 14.6 percent to 1.49 million units, and the volume of building permits, a measure of future activity, dropped 6.3 percent to 1.54 million units. The Commerce Department termed that the largest decline in permits in seven years, although another source claimed that it was the largest decline in nine years.
Forecasters had predicted that housing starts would drop by 4.5 percent to 1.68 million units and that permits would see only a modest decline, to 1.63 million. Some revisions were made to September's data, with housing starts revised lower and building permits revised higher. Still, September's numbers had provided a an upside surprise and some dismissed October's drop because it had been in comparison to such a strong number.
Although the FOMC minutes had reassured markets that the FOMC had not yet seen any spillover into the economy from the decline in the housing sector, that decline had dragged the growth 1.1 percent lower than it otherwise would have been in the third quarter. Now some fear that the impact could be worse this quarter. Supposedly, that thought weakened futures early this morning and predicted the early morning decline in the cash markets.
If home builders might have suffered from the downturn in the housing sector, apartment developers, management firms and owners might be benefiting. Another report indicated that apartment rentals were up by four percent and that vacancy rates were the lowest in five years. A young real estate broker I know owns offices that handle both real-estate sales and apartment rentals. He says that the combination protects him because when house sales decline, apartment rentals tend to increase, and vice versa. It's like balancing a portfolio, and that's what the comparison of housing starts and permits and the rental data seemed to indicate.
The lead-up to the Nymex (NMX) IPO debut on Friday had been intense, with many comparisons to the CME and ICE debuts being mentioned all week. The IPO had been priced at a projected range of $54 to $57, but opened at a startling $120.00. Momentum players pushed it up to $152.00 before it dropped back by mid-afternoon, with the action reportedly catching Nymex Chairman Richard Schaeffer by surprise. It closed at 134.75, having traded 19,561,600 shares, according to one source. At least one analyst was terming the price action "frothy," however, and I imagine more were thinking that it was. CME had soared in the days leading up to Friday's NMX debut and punched to a new intraday high on Friday, but then spent the rest of the day moving sideways, closing modestly lower. ICE behaved similarly, although it closed modestly higher.
Reporting companies Thursday had included Starbucks (SBUX) and Hewlett-Packard (HPQ). Friday morning, traders evinced disappointment with SBUX's report, sending the stock lower in pre-market trading on Friday and closing it lower by $2.01 or 5.10 percent. The report matched forecasts of $0.17 a share excluding a change in the company's future costs of terminating leases, but the company reported its first profit decline in five years. HPQ issued upside guidance, saying that its price cuts had produced stronger demand and that the company had nearly tripled its fourth-quarter profits, but the SEC has now termed its formerly informal investigation as a formal one. In addition, the FCC has asked for information about the pretexting case leading to Patricia Dunn's resignation as chairwoman. HPQ was to close only modestly lower, however, by $0.36 or 0.90 percent.
Chip-manufacturer Marvell Technology Group Ltd. (MRVL) reported Friday morning, although an ongoing effort to restate earnings prevented the issuance of full quarterly results. Although sales beat expectations, they did drop nine percent for the third-quarter. The EPS also appeared to miss expectations by a penny, according to one analyst. A Morgan Keegan analyst cut the stock's rating to a "Market Perform" one. The stock moved lower in pre-market trading and was blamed by some for early Intel weakness since Marvell has a deal to acquire Intel's XScale business. Some analysts believed that business was more dilutive to Marvell than had been anticipated. MRVL closed lower by $0.57 or 2.91 percent, and INTC closed lower by $0.23 or 1.03 percent.
Next Week's Economic and Earnings Releases
Next week's economic calendar will be holiday-shortened one. On Monday, October's Leading Indicators will be released at 10:00, with expectations for a 0.2-0.4 percent rise after the prior 0.1 percent increase. The name proves misleading, however, as most of the information that goes into the computation of this number is already known. It doesn't tend to be a big market mover unless the number differs substantially from the prediction. On Wednesday, November's revised Michigan Sentiment will be released, with the number predicted to remain near the previous 92.3. Other than that, crude inventories on Wednesday and initial claims on Friday are the only releases. My calendar does not specify when natural-gas inventories, normally released on Thursday, will be released, but initial claims are postponed to Friday, and perhaps the natural-gas inventories will be, too.
Monday's reporting companies include CPB, LOW, MDT and JWN. The rest of the week also remains light for reporting companies.
What about Monday?
As I've frequently suggested as indices have climbed for the last months, long-term bulls have nothing to do but to keep ratcheting their stops higher as indices climb. Those in long-term bullish positions might be raising stops just underneath the support of those long-term rising channels seen on so many of the charts. New entries can be sought on pullbacks to the bottom-of-the-channel support, but stops need to be set tightly if such entries are sought. Although I see nothing too bearish on any of these charts, all traders should be aware by now that the rallies are becoming extended. Prices have been rising rather sharply. Even if the rally is going to extend further, the angle at which those channels are rising probably needs to decrease into a more sustainable one. Some day or other, prices are going to break down out of those channels and establish a new pattern.
Those seeking bearish entries could try entries at top-of-the-channel resistance, but, if so, they should be aware of the possibility that they'll be greeted with another sideways movement as the channels or the 10-sma's rise up to meet price and provide support. Another possibility lies in a channel breakdown, a rise to retest the channel's former support in the classic "kiss goodbye" scenario, and then a falling away again. Want-to-be-bears must be cognizant that overbought conditions can be relieved by a prolonged sideways movement rather than a prolonged decline, and they should plan their exits if such should happen.
I'd advise careful consideration of any new entries next week. Volume will be low toward Wednesday and again on Friday, and crazy things happen when volume is low.
Happy Thanksgiving week to all our U.S. readers.
Gilead Sciences - GILD - close: 69.43 chg: +1.15 stop: 66.75
Why We Like It:
BUY CALL JAN 65.00 GDQ-AM open interest=4106 current ask $6.20
Picked on November xx at $ xx.xx <-- see TRIGGER
Oregon Steel Mills - OS - cls: 58.96 chg: +2.11 stop: 56.99
We Like It:
BUY CALL JAN 55.00 OS-AK open interest=1157 current ask $6.70
Picked on November xx at $ xx.xx <-- see TRIGGER
Sepracor - SEPR - close: 54.69 chg: +2.22 stop: 50.75
Why We Like It:
BUY CALL JAN 50.00 ERU-AJ open interest= 9362 current ask $7.30
Picked on November 19 at $ 54.69
Bear Stearns - BSC - close: 154.63 chg: -0.32 stop: 147.95
Most of the market took Friday as a day of rest and experienced mild declines. The broker-dealers were no exception after a strong week of gains. Shares of BSC dipped 0.2% and traded sideways in a relatively narrow range. The stock is arguably short-term overbought so a dip early next week would not be unexpected. We would wait for a dip before considering new positions. Our target is the $159.00-160.00 range. We do not want to hold over the mid December earnings report. FYI: More conservative traders may want to adjust their stop loss closer to the $150 level.
Picked on November 14 at $151.89
Cerner Corp. - CERN - close: 49.07 chg: -0.13 stop: 47.90
CERN's short-term technicals and now the weekly chart's technicals are starting to falter and roll over into bearish signals. We remain very wary and if we don't see a bounce soon (next couple of days) it may be time to exit. Overall the larger pattern in CERN looks bullish with the breakout over resistance at $48.00. Broken resistance at $48 should now act as support. Unfortunately, the stock has just run out of momentum and has been unable to make any headway even though the major averages were hitting new relative highs. This relative weakness in CERN should put bullish traders on the defensive. We're not suggesting new positions at this time. Our target is the $52.00-52.50 range. FYI: The P&F chart is bullish with an $85 target.
Picked on October 30 at $ 48.05
Deere & Co. - DE - close: 90.36 change: +0.94 stop: 88.95 *new*
Shares of DE displayed relative strength on Friday. The stock rallied from its lows on Friday morning and barely looked back. DE posted a new five-month closing high and looks poised to continue higher. Unfortunately, we're almost out of time. DE is due to report earnings on Tuesday morning. Naturally we do not want to hold over its earnings report. Therefore we're planning to exit on Monday at the closing bell. Given our time frame we're adjusting the stop loss to $88.95, which is about 15 cents under Friday's low. Our target is the $91.50-92.00 range.
Picked on November 08 at $ 87.45
FedEx - FDX - close: 117.44 chg: -0.70 stop: 113.90
Transports appear to be doing well with the Dow Jones transportation average breaking out over resistance at the 4800 level last week. The MACD on the daily chart for the TRAN has recently produced a new buy signal. Meanwhile FDX has broken out over resistance at the $117 level and its MACD has produced a new buy signal. The significant drop in crude oil futures over the past several days has been a boon for the transports. Given the bullish posture in the transportation sector we would use Friday's dip in FDX as a new bullish entry point to buy calls. We would expect a pull back at the stock's initial test of $120 and shares might bounce around the $117.50-120.00 range for a couple of days. However, our target is the $124.00-125.00 range. The P&F chart is more optimistic with a $153 target. FYI: We do not want to hold over the December earnings report.
BUY CALL DEC 110 FDX-LB open interest= 328 current ask $8.50
Picked on November 15 at $117.15
Fomento Econo. - FMX - close: 103.89 chg: -0.23 stop: 99.49
Friday's trading in FMX looks like a new entry point. The stock dipped toward $102 and its rising 10-dma on Friday morning and traders bought the dip sending shares back toward all-time highs before the closing bell. The overall pattern continues to look promising and the path of least resistance appears to be up. Our target is the $107.00-110.00 range.
Picked on November 08 at $102.09
Goldman Sachs - GS - cls: 195.04 chg: -1.68 stop: 187.45
Last week was a strong one for broker-dealer stocks. Shares of GS helped lead the group to new all-time record highs. It's really not that surprising to see a bit of consolidation/profit taking on Friday after a positive week. We would not suggest new positions at this time. Should the dip continue the nearest support is the 10-dma back near $190 although GS might have some support near $191.50. A bounce from either level could be used as a new entry point. Our target is the $199.00-200.00 range. We do not want to hold over the December earnings report.
Picked on November 14 at $190.36
KLA-Tencor - KLAC - close: 51.69 chg: +0.64 stop: 47.65
The SOX semiconductor sector index has struggled to build on Tuesday's big bullish breakout. Yet at the same time the sector has resistance any attempt at profit taking thus far. Depending on your perspective the semis are still showing some relative strength. One stock in the industry that is out performing its peers is KLAC. Traders bought the dip near $50 on Thursday morning and the rebound continued into Friday with a 1.25% gain on above average volume, which tends to be a bullish sign. Technical indicators are pointing higher and the P&F chart points to a $70 target. Our target is the $54.50-55.00 range. The stock appears to have solid resistance at $55.00.
Picked on November 14 at $ 50.81
Morgan Stanley - MS - close: 79.12 chg: +0.44 stop: 74.49
MS displayed some relative strength on Friday. The stock managed a 0.55% gain while the rest of the broker-dealer sector slipped on Friday. Shares appear to have found some (very) short-term support near $78.00. As long as the market is positive on Monday we might see MS rally into our target zone of $79.90-80.00. More aggressive traders may want to aim higher since the P&F chart points to an $83 target. We're not suggesting new positions at this time.
Picked on November 12 at $ 76.68
Thomas & Betts - TNB - close: 53.68 chg: -0.10 stop: 49.90
So far so good with TNB. The stock produced a strong week rising 4.5% and the technical picture has definitely improved. While we remain optimistic we would not suggest new positions at this time. The stock is challenging resistance near the $54 level. Odds are good that TNB might see some consolidation soon. A dip back toward $52 might be a new entry point to buy calls. Our target is the $56.00-57.00 range. Currently the P&F chart points to a $77 target.
Picked on November 12 at $ 51.36
Cardinal Health - CAH - cls: 62.67 chg: -0.72 stop: 64.05*new*
The trend in CAH still appears to be down but the stock is struggling to make any headway (lower) given a bullish market environment and new relative highs for the major averages. The recent failed rally under $64 looks like a potential entry point for put plays but we would rather wait for a new relative low or at least another decline under $62.00. We are somewhat concerned at how the P&F chart's trendline of support has risen to the $59 level. Taking everything into consideration (lack of movement, bullish market, potential support), we would hesitate to open new put plays in CAH. Our target is the $58.00-57.50 range. Please note that we're adjusting our stop loss to $64.05.
Picked on November 10 at $ 61.99
Freeport McMoran - FCX - cls: 57.40 chg: +1.24 stop: 60.26
Target achieved. Shares of FCX gapped down to open at $55.50 and then dipped to $54.95 before bouncing back. We have two targets on FCX. Our conservative target was the $55.25-55.00 range, which was hit on Friday. Our aggressive target is the $51.00-50.00 range. We would be extra careful if you're still holding positions. The sharp rebound was fueled by strong volume this Friday and it looks like a short-term bullish reversal. At the least we would expect a bounce to the 10-dma overhead near $58.70 and it wouldn't surprise us to see a bounce towards $60. FCX's direction next week will depend on strength in the metal and mining stocks, gold and copper futures and to a lesser extent oil. As oil falls it makes gold less of an attractive inflationary hedge. We do note that the XAU gold & silver index produced a bearish signal in its MACD just two days ago. We're not suggesting new positions at this time.
Picked on November 08 at $ 59.05
(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.)
Caterpillar - CAT - close: 60.94 chg: -0.43 stop: n/a
We only have four weeks left for our strangle on CAT to pan out. That is certainly enough time for CAT to produce a big move but right now the stock is not suggesting it will move. Thus we would suggest against opening new strangle plays. The options in our strangle are the December $65 call (CAT-LM) and the December $55 put (CAT-XK). Our estimated cost was about $0.75. We want to exit if either options rises to $1.50.
Picked on November 08 at $ 60.10
Blue Nile - NILE - cls: 35.98 chg: -0.51 stop: n/a
It looks like NILE's second attempt at an oversold bounce has stalled under the $37.00 level. We are not suggesting new positions at this time. Our estimated cost was $2.40 and we're planning to sell if either side of our strangle rises to $3.90. The options in our suggested strangle are the January $45 call (JWU-AI) and the January $35 put (JWU-MG).
Picked on October 29 at $ 38.92
FreightCar Amer. - RAIL - close: 55.72 change: -1.29 stop: 53.49
Closing RAIL as a bullish candidate might seem a bit abrupt. After all the transportation sector turned in a relatively strong week thanks to a big drop in oil futures. Yet the railroad-related stocks didn't truly participate in the transportation rally. Most of the transports strength was in airlines (remember the merger news). Studying the railroad sector index and the relative weakness in RAIL on Friday we decided that it's better off to exit early. There is a chance that RAIl might bounce from its 10-dma near Friday's lows or bounce from the $55 level or even the $54 level. Yet at this time we just don't feel like risking it. We're suggesting an early exit to cut our losses.
Picked on November 08 at $ 56.08
Whirlpool - WHR - close: 86.50 change: -1.83 stop: 86.99
We have been stopped out of WHR at $86.99. Readers will note that we have been very wary of the stock over the last couple of days given the recent failed rallies near $90. Unfortunately, instead of exiting early it looked like WHR might bounce from short-term support near $88 and its 10-dma. Instead the stock plunged lower on Friday morning and quickly hit our stop loss closing the play.
Picked on November 13 at $ 90.15
Capital One Finc. - COF - cls: 75.50 chg: -0.10 stop: 79.33
Target achieved. The relative weakness in COF this past week blossomed into a spike down to the $74.00 level thanks to an analyst downgrade on Friday morning. COF was downgraded from an "out perform" to a "market perform" and shares dipped to $74.00 before bouncing back. Our target was the $75.10-75.00 range.
Picked on October 31 at $ 79.33
Bear Stearns - BSC - cls: 154.63 chg: -0.32 stop: n/a
Our strangle on BSC using November options has expired. The stock tried but it never moved further than $5.91 from the $150.00 mark. We needed a bigger move to put one of the options in our strangle into a profitable position. Our estimated cost was $4.00. The options in our play were the November 155 call (BSC-KK) and the November 145 put (BSC-WI).
Picked on October 22 at $150.19
Cephalon - CEPH - close: 78.15 change: +0.95 stop: n/a
Target achieved. Biotech stocks displayed relative strength on Friday and CEPH continued to out perform the market and its peers. Friday's session saw CEPH add another 1.2% to close at a new eight-month high. The call side of our strangle hit $5.00 and our target was to sell at $4.90. Our estimated cost was $3.45. More aggressive traders may want to consider aiming higher and exiting as CEPH nears potential resistance at the $80 level. However, keep in mind that CEPH looks extremely overbought and due for a consolidation but until the bulls run out of steam they remain in control. The options in our strangle are the December $75 call (CQE-LO) and the December $65 put (CQE-XM).
Picked on October 29 at $ 69.35
ConocoPhillips - COP - close: 62.70 chg: +0.43 stop: n/a
The strangle on COP using November options has expired. Our estimated cost was $1.15 and we're going to need a strong move past $65 to see a chance at an exit. Our suggested options were the November $65 call (COP-KM) and the November $55 put (COP-WK).
Picked on October 15 at $ 60.03
For the last several articles, I've discussed "the least you should know" before trading options. Now it's time to delve into the Greeks of options. Don't worry that the article will be too technical, however. We're not going to delve too far into the Greeks.
Knowing something about the Greeks of options might have helped a trader who contacted me recently. This trader had gone long (bought) an SPX put. That put was so far out of the money that the trade had little chance of profiting even if the SPX did drop. One look at the Greeks would have explained why, if the trader had only understood them.
The trader contacted me soon after the SPX had begun moving down from a recent high, puzzled because the put's price had not changed. The answer to the trader's puzzlement lay in one of the Greeks, the delta.
Stated a bit simplistically, the delta of an option describes how much the option could be expected to move with the movement of the underlying. Another way of looking at the delta is to consider it the chance that the option will expire in the money.
For the benefit of newbies, an in-the-money condition occurs when the underlying has moved above the strike price of the option if it's a call and below the strike price if it's a put. For example, if the SPX is at 1402 and a call has a strike price of 1400, it is two points in the money. If a put has a strike price of 1400 and the SPX is at 1402, the put would be out-of-the-money. If 1402 was the SPX's settlement price obtained the Friday of opex week, the call would have been worth $2.00 x 100 (multiplier) = $200.00, but the put would have expired worthless.
The delta of this subscriber's put was -0.07. That meant that the option never had much chance of going into the money. If the delta of an option can be considered to be the chance that the option would expire in the money, that option had only a 7 percent chance of expiring in the money. The converse of that is that it had a 93 percent chance of expiring out of the money.
There was worse news for the trader who had hoped to benefit from a short-term move in the SPX. For every point the SPX dropped, the option's price could be expected to gain only about $0.07 (-$1.00 change in the SPX's price x -0.07).
Options traders should be aware that delta doesn't stay the same as the underlying's price changes. As the underlying moves closer to the strike price, the absolute value of the delta increases. As the underlying moves farther away from the strike price, the absolute value of the delta decreases. So, if the SPX had been moving closer to the put's strike price, the delta's value might have changed from -0.07 to -0.09, for example. It then might have moved about $0.09 for every point the SPX dropped. However, without the world coming to an end and the SPX suddenly crashing, the delta of that put was unlikely to change too much.
Even if delta does change with the price action, the delta at the time an option is purchased provides traders with a fairly good estimate of how much the price might change if the SPX were to move to the trader's targeted price. That's important to know. If traders are buying a call with the thought that the SPX might be about to move up, and they expect the move to be under five points, that call better have a fairly high delta at the time it's purchased. When I was still trading intraday moves and hadn't switched to spreads, I liked a delta around 0.70, at least, for such short-term moves.
The SPX had dropped three points since the subscriber had bought the option, but the $0.21 gain that the delta predicted wasn't big enough to span the SPX's rather wide bid/ask spread and make the selling of the option profitable. The option was just too far out of the money to benefit by a small movement in the SPX without other forces, such as a big swing in the volatility, helping it along. That wasn't happening that day, as the VIX stayed low.
If the subscriber had instead bought an option with a delta of about -0.70, a three-point drop in the SPX's price might have raised the options price by about $2.10, give or take a little since the delta would have been changing slightly as the price dropped. If the subscriber had been adept at getting between the bid and the ask, that should have been enough to make selling that option profitable after the three-point drop. If the trader who had written me had understood this basic fact about options' Greeks, a different put might have been chosen.
Let's backtrack now and talk a little about the other Greeks. Greeks are the various risk measurements for options. Delta, gamma, vega or tau, theta, and rho comprise the various Greeks for options. While it's probably wise for all options traders to review the Greeks and obtain a basic working knowledge of what each represents, traders don't have to contemplate all this information each time an option is traded unless they're employing advanced strategies. To trade profitably, however, traders do need to understand roughly how the delta works.
Why was that delta negative in the example provided? The great Lawrence G. McMillan summarizes delta by saying that it measures "how much current exposure" an option trader's "option position has as the underlying security moves." Delta is considered positive for calls, which means that when the price of the underlying such as the SPX moves higher, the price of the call would, too. Delta is considered negative for puts, which means that as the price of the underlying moves higher, the price of the put moves down, moving opposite to the price of the underlying. When price drops, that negative delta is multiplied by a negative price change and the result is a gain in the put's price.
Delta ranges in value from 0.0 to 1.0 for calls and -1.0 to 0.0 for puts. That far out-of-the-money SPX put that the subscriber had bought had a delta of -0.07, a teeny delta. Options that are far out of the money have small deltas. Options that are at the money, so that the underlying is trading near the strike price of the option, have deltas near 0.50 or -0.50, in the case of a put. Options that are deep in the money have deltas that are closer to 1.0 or -1.0, in the case of a put.
For example, on November 2, with the SPX trading at 1366.31 shortly after noon, a November 1365 put would have been slightly out of the money. The delta of the November 1365 put was -0.44, as shown on the chart below, found at the CBOE site.
Price and Greeks Information for SXYWM, the SPX Nov 1365 Put:
Most online brokerages that cater to options traders will provide their customers with information about each option, including the delta of that option. For those who need another source, the CBOE's quotes provide it, too, as seen above. It's free from CBOE, although delayed. Even the delayed information will give you a fairly good idea of the current delta unless prices are moving quickly, and traders can sign up for a paid version that provides real-time quotes. Still, delayed is better than none if it's going to save traders from buying a put with a delta of -0.07. Obviously, deep-in-the-money options are more expensive, so options traders always balance the leverage that cheaper out-of-the-money options provide them against the propensity for more expensive in-the-money options to move more in lockstep with the underlying's price movement.
All kinds of strategies revolve
around the delta of an option, including the
delta-neutral combination plays that some advanced options traders employ.
Traders who are interested in such strategies might consult a more advanced text
or even the CBOE site. The purpose of this article is not to delve into such
advanced tactics, but rather to suggest that traders need to know the basics of
delta as they choose the option they'll buy.
Today's Newsletter Notes: Market Wrap and Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.
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