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Daily Newsletter, Saturday, 12/30/2006

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Table of Contents

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

Market Wrap

U.S. Stocks End 2006 With Best Gains in Three Years

That's the headline that's splashed all over the news and it has in fact been a remarkable year for the stock market. Other than a quick sell off at the end of the day on Friday, those gains were held right to the very end of the year. The year has literally finished at the top of its game.

The big number in the news is of course the DOW. With a 16% annual gain that's a very impressive number for the public to see. As we enter the new year everyone feels good about the stock market and as they make their new year's resolutions and make their financial plans there will be many who pour money into the stock market so that they can capture this great bull market of ours. We know the market needs a rest but it was important for smart money to hold the market up into the end of the year for multiple reasons.

From a tax standpoint it was very important to fund managers that they didn't have to sell this year's gains and have to deal with the capital gains tax issues. It's much better to sell in 2007 and worry about capital gains a year from now. Keeping the public bullish is also very important, especially right now. Many fund managers, and I include hedge funds here, would probably like to see an early sell off in the stock market. By selling off early in the year, taking their profits, tucking some away in money market reserve accounts for next year's tax payment and then buying stocks after they've pulled back, they'll have a better chance of capturing additional gains in 2007.

The easiest and most profitable way to unload so much stock is to do it gradually so as not to spook the public. Smart money needs the public to stay excited about the stock market so that Joe Retailer continues to express interest in buying. Holding the market's gains into the end of the year was a critical part of that process. A controlled bleed off of the helium out of this balloon now becomes job #1 for many money managers. Hand off the inventory to the public without scaring them away. Once the public gets scared by a sell off then we run the risk of a no-bid situation where the selling gets carried away because the buyers step back and wait.

So this is what we're probably facing as we head into January. New money (retirement and other funds that typically come in at the beginning of the month) and more people deciding they want to invest more in the stock market this coming year could give us an early lift in January (the January effect) but smart money will probably be using the beginning of January to unload their inventory.

If you look at the price pattern in the techs it appears that that distribution effort has been going on for weeks. Money has been rotating into big caps which is a defensive move as it's a lot easier to sell fast from a big cap than a small cap (without hammering the price lower). But again, if we don't have enough buyers coming in then we could see selling get out of hand, even if for only short periods of time. That's the risk I see as we enter January.

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Projections for 2007

There are of course some longer term risks that the market faces but that's been true for a while now. I've discussed much of this before but I'll lay out why I think 2007 will be a very challenging year for the stock market. The market has actually been rallying in the face of some developing bad economic news. This too will probably not last long and smart money knows it's time to get out of Dodge with their stolen money before the sheriff catches them. Helping them escape will be the Fed--as long as they keep creating money at the furious pace of the recent past then the market will continue to benefit from that prop. This is the latest chart of calculated M3 money supply:

M3 Money Supply, calculated, courtesy nowandfutures.com

This chart is updated as of Friday so it's current for the latest week. The light blue line is the annualized rate of change and it tipped over slightly in the past week. M3 remained flat for the week. The dark black line is calculated M3 whereas the green line is confirmed M3 from actual figures received later. It's way too early to tell what the Fed will do here but if they start to pause in their money creation efforts then we could see the stock market lose another leg of it's stool.

While the Fed continues to worry about inflation, and may hold interest rates steady at least through the summer (if not raise them), they are clearly worried about a slowing economy which has a lot to do with the slowing in the housing market. As discussed many times before, the housing market has a huge influence in our economy, probably more now than ever before. With one out of every three jobs that have been created in the past 5-6 years associated with the housing market (from real estate agents to home builders to furniture and appliance employees), any hit to the housing market will automatically cause pain in the job market.

Any hit to home values will cause more people to feel poorer than any hit to the stock market (due to more people owning homes than stocks and homes being a bigger part of a person's feeling of wealth). And of course if home values are no longer increasing, or worse decreasing, then there will be less money available for home equity withdrawals. Spending would have to slow down in that case. With $600-700B extracted each year from home equity, that's a huge shot in the economic arm of our country. Take that money away and retailers won't be the only ones squealing about poor business.

If people become worried about their finances, especially if they start seeing their friends and family members losing their jobs, and knowing credit is harder to come by, then they'll start saving more. If we get our savings rate out of negative territory, where it's been for almost two years, it would be good for individuals but bad for our economy. If demand for products dries up then businesses slow down, layoffs increase and people become more fearful.

Fearful people are not bullish people and that's why the stock market will take a hit in such a scenario. The bond market, with the inverted yield curve, has been pointing to a likely slowdown, if not recession, for quite some time now. We've received a slew of economic reports in the past month that point to a slowing economy and the Fed is making money at a furious rate to keep the economic pump primed. And while we've seen the housing market getting a little bounce it's not clear it's anything more than a dead cat bounce after a fast decline.

Bubbles don't land softly and I continue to believe the housing bubble will suffer the same fate as all other bubbles. I don't have a copy in front of me but I saw a chart of the decline in the Nasdaq in 2000-2002 with a chart of the home builders laid on top of it, matching the peak in home builders in July 2005 with the Nasdaq peak in March 2000. It's uncanny how similar the charts are and of course this just points out the similarities of post-bubble moves. That pattern calls for another year of declines in the home builders.

The stock market has remained out of touch and has its blinders on. People have been feeling bullish, with the help of an overzealous Fed, and that creates a bullish market. If housing turns back down then it's not a stretch of the imagination to believe people will become less bullish and more defensive. Adding to my belief that the housing market is not finished correcting (not by a long shot) is what the bond market did this week. This 30-year yield chart shows an important break out:

TYX.X chart, 30-year yield, Daily

By breaking its downtrend line from July (the same time the stock market started its rally) the jump in yields is potentially telling us the bond market is now worried the Fed will not lower rates and may in fact be forced to raise rates. I've felt for quite some time the Fed has painted itself into the inflation corner (due to the amount of liquidity and excessive credit available) and now can't get out. The drop in the value of the dollar is inflationary and with more countries talking about "diversifying" into euros, including oil money, which will only add to the downward pressure for our greenback and cause more inflationary pressure. If the bond market is getting a whiff of this then we could see much higher rates coming. Higher bond yields will start to attract money out of higher risk stocks into the safety of a guaranteed, and decent, return.

Higher interest rates will cause several problems not the least of which is a credit contraction. While the Fed has been creating money to beat the band and creating a credit expansion (banks can lend out more than 90% of their assets and when you ripple that through several layers of banks and lending institutions credit expands at a parabolic rate), the market may force a credit contraction, regardless of what the Fed is trying to do. A credit contraction is bad for the economy because less available money means less company growth, more layoffs, etc. etc.

Speaking of credit contraction and the housing market, Paul Kasriel, Sr. V.P. and Director of Economic Research at Northern Trust, wrote an article titled "Festivus Flow-of-Funds Stocking Stuffers" in his weekly commentary, "The Econtrarian", which was reprinted in John Mauldin's December 18, 2006 weekly newsletter. He discussed household mortgage debt and it was an eye-opener. This chart shows mortgage-related debt as a percent of disposable personal income (DPI):

Household Mortgage-Related Borrowing, courtesy Paul Kasriel

The light brown line is mortgage-related borrowing as a percent of DPI and shows the huge run-up since 1995 into 2005 and a steep drop in 2006 (coinciding with the peak in the home builders)). The dark blue line shows the year-over-year change and shows a huge drop in 2006, much larger than we've seen in the past. First, the large run up was unsustainable, its own bubble. It shows people getting out of whack with the amount of debt they were taking on. But more importantly is the very sharp decline. This is the kind of credit contraction I'm talking about and it represents the very fast correction that's in progress.

Not shown but going along with the chart Paul Kasriel discussed household liquidity--how much money is available for emergencies in savings accounts and money market funds. That measure dropped to a post-WWII low in Q3, 2006. Many feel that home equity replaced the need for liquid funds but as Kasriel pointed out, with home values now contracting, and home equity availability drying up, people are now more vulnerable than ever to financial shocks. As Kasriel stated, "In sum, households have never been as highly levered as they are now or as illiquid as they are now, and their single largest asset is in danger of actually falling in value. If the Fed had to resume raising interest rates in this environment, it would be 'Katy, bar the door' for household finances!"

Back to the chart above, the significant drop in borrowing means less money available for consumer spending. This Christmas season may have been the last "fling" and now with credit cards maxed out and home equity drained, it'll be time to pay the piper and spending could come to a screeching halt. Two more charts that Kasriel showed that I think are worth passing along:

Household deposits as a percent of liabilities, and liabilities as a percent of assets, courtesy Paul Kasriel

The first chart graphically portrays what Kasriel was talking about when he mentioned household liquidity is a post-WWII lows. The second chart graphically shows how vulnerable we are to any financial shock. With record high levels of debt would it be safe to assume we can just keep borrowing more? Higher interest rates would be very difficult to absorb in this climate.

Higher interest rates would all obviously kill any budding bounce we have in the housing market. We've all heard the stories of how painful it has become for people who have refinanced with aggressive and unscrupulous lenders only to find they have increasing payments and can no longer afford their homes. Sub-prime lenders are going out of business at an alarming rate. Foreclosures are increasing all over the country.

This is not a localized problem--it's on a national scale which we haven't seen in over a hundred years. Almost half of the mortgages in the last couple of years, especially in high-cost areas, have been "creative" loans designed to get people into homes who can't afford those homes. The number of houses that will come onto the market due to foreclosures will put tremendous downward pressure on the home market. Banks which own foreclosed homes are truly motivated sellers since homes on their books gets them a less favorable review by the Fed.

If you're in a home that's your home and you don't intend to move and you don't have an oversized ARM mortgage then you really have nothing to worry about. If your house value drops so does your neighbor's. Yes you lose equity but it was all fluffed up paper money anyway. But if you're forced to sell your home in the above environment (loss of job, divorce, etc.) then you become just another motivated seller who will drop his price in order to sell.

If this housing scenario plays out, and we could see bigger cracks in the foundation if this spring's sales don't meet expectations, then it's not difficult to understand the depressing effect that will have on peoples' psyches. Fearful people are not bullish people and the stock market will suffer.

OK, enough about what my crystal ball is showing for 2007. We ended a very bullish 2006 and those who have been long the stock market deserve a big pat on the back for hanging on for the ride. You rode the momentum wave and you participated in the gains. Unless you were in the DIA or DOW futures you didn't do quite as well as the DOW's 16% since the rest of the market, and individual DOW stocks, did not see those kinds of gains, but nevertheless you did well. So congratulate yourself, throw a party and now do yourself a favor and SELL! :-)

DOW chart, Daily

Not much has changed from yesterday's update so I won't rehash a lot on these charts. For additional info on what I expect to see you can reread Thursday's Wrap. I have an ascending wedge that I'm following and today's pullback is so far just a pullback within the wedge, a pullback I was hoping to see. If I've got the internal Elliott Wave (EW) count correct, we should get another leg up to finish the wedge. A drop below Tuesday's 12337 low negates the wedge pattern and would be a strong indication we've already seen the high for the market. Until that happens watch for another push higher to a Fib projection at 12626, 160 points higher. Whether it gets there, or stops there, who knows but that's what I'll be watching for.

DOW chart, 120-min

This 120-min chart is an update to the one I showed Thursday where I'm watching the development of the ascending wedge. Because this wedge pattern calls for an a-b-c move up for the 5th wave I was looking for a pullback against this week's rally to then be followed by another leg up to finish off the whole thing. I'm not sure if we'll see a little more pullback when the market opens on Wednesday or if we're now set up for the next leg up. My guess is that we're ready for the next leg up (based more on SPX).

SPX chart, Daily

SPX dropped to its 20-dma, 30-min 100-pma (often support and resistance) and near its uptrend line from July (which is at 1416). This should be good support to launch another leg higher and that's what I'm expecting to see on Wednesday. If the DOW pushes up to an upside target of 12626 then we should see SPX make it up to 1434. The big caution for bulls is the continuing bearish divergences on daily charts across the board. This can not be ignored and will result in a top very soon if it hasn't already occurred. If SPX drops below Tuesday's 1410 low then there's a good chance the top is in.

Nasdaq chart, Daily

As I mentioned Thursday, I'm just waiting for the COMP to do something. It's currently in the middle of a very busy 4-lane highway wondering which way to run.

SOX semiconductor index, Daily chart

Ditto my comment on the COMP.

BIX banking index, Daily chart

Of all the charts I reviewed for the weekend, this is one of the more bearish as far as the sell signal I'm getting from this one. After running up to the top of its parallel up-channel, in a clean 5-wave up from November, it sold off sharply and RSI has taken a dump. It dropped straight through its 10-dma which has supported the month-long rally. On an intraday basis it looks ready for a bounce but I'm thinking the banks have already topped out. If the broader market averages manage to push to a new high next week but are unaccompanied by the banks to a new high then I'd say the bearish non-confirmation is the kind of signal a bear wants to see and I'd be adding to my longer term short position.

U.S. Home Construction Index chart, DJUSHB, Daily

The home builders currently leave me wondering what's next for the short term. It looks ready for another bounce but I can't be sure enough of that to feel bullish here. But it's not looking bearish either. I'm holding off short term judgment for the moment even though longer term I fully expect to see this roll over and head for new lows.

Oil chart, January contract, Daily

Oil continues to pound $60 support. It should start its bounce higher now, and higher oil might be one of the contributing factors behind a topping stock market. A drop in the US dollar may also contribute to rising commodity prices, including oil and gold. Higher commodity prices will only add to inflationary problems which I should have mentioned above as far as what I'm expecting to see in 2007. If oil bounces a little here and then breaks below $60 I still see the high $50's as support but it might consolidate at this level for quite a bit longer before making a move.

Oil Index chart, Daily

Oil stocks rallied a little this week but were rejected at the 20-dma (green MA) and as long as that continues then this will likely roll back over towards new lows. If stochastics flattens out here (indicating a downtrend in progress) then RSI has a ways to go before it reaches oversold.

Transportation Index chart, TRAN, Daily

Stochastics flattening out in oversold (downtrend in progress), RSI turning back down and price rejected at its retest of the broken 200-dma. Looks like a recipe for a continuation lower.

U.S. Dollar chart, Daily

The US dollar looks ready to continue lower.

Gold chart, February contract, Daily

Gold has made it up through resistance from its moving averages and should be able to continue higher. Next resistance level is at its November high near 655.

Next week's economic reports include the following:

There are no pre-market reports so we'll get to see how the cash market reacts to some potentially market-moving reports at 10:00 on Wednesday. Construction spending and ISM will be scrutinized carefully for signs of growth or slowing. How the market reacts to that news is always a guess since we don't know if bad economic news will still be bullish (hoping for a Fed rate decrease) but I suspect most participants are starting to give up on the idea of a rate reduction soon.

Therefore bad numbers here could jolt the market to the downside. Watch the head fake move though--it could be an opportunity for the market to get jammed to the upside in order to get that bear fuel (short covering) to launch the next leg up. Then in the afternoon the FOMC minutes could move the market if there are any surprises (or rate reduction disappointments).

There are many people expecting a sell off in January to take profits and the bears are probably already positioned for it. If it doesn't happen right away, like it did in 2005 after rallying in December 2004 (a pattern the bears are hoping to see repeated) then I suspect many will jump out of their short positions and wait yet again for the next top. Any early sell off though could accelerate as people take profits/short the market in preparation for another January like 2005.

But we know what happens when too many expect something so beware any early selling that gets a quick reversal--it could carry quite a bit to the upside. The reverse is also true of course. Using January 2005 as an example, the day started bullishly and rallied nearly 90 points to match the December high before selling off sharply to end the day down -54 points. If nothing else, watch for potential volatility.

The SPX weekly chart, with the closing candle, shows price just hanging near its high with the threat of the oscillators rolling over. There's nothing bearish yet but by the same token I sure wouldn't want to buy this chart no matter what the time frame.

SPX chart, Weekly, More Immediately Bearish

And that's it. That wraps up a great year for the stock market and I wish I could say I see the same possibility for 2007. It's so much easier being bullish than bearish. I'm an optimistic person by nature and being bearish this market has me tagged as being a pessimist. Nothing could be further from the truth. I try to read the tea leaves and trade unemotionally and without a care as to which way the market goes. I can trade the short side as easily as the long side.

I've been way off on my call for a market top but I know I'm in good (bad?) company when I read a lot of market analysts I've come to respect over the years for calling it as they see it. One look at that shot up on the weekly chart from July says "blow-off top". And we know blow-off moves are irrational--lasting far longer than we can remain solvent trying to fight the move. It was a pure momentum play for those who stuck with the long side, helped by the Fed and their rapid increase in the money supply.

The question for 2007 is what happens next and I laid out as best I can why I think the bears will rule 2007. Trading the short side is more difficult than the long side because the buying spikes are much more difficult to deal with than selling spikes in a bull market. Volatility increases (with a higher VIX) and stop management becomes disproportionately more difficult. But we'll do the best we can here to help guide you through the mine fields. I hope you stick with us in 2007 as I see some very good money-making opportunities.

Happy New Year to everyone. Enjoy friends and family, don't drink and drive and we'll see you here next week. I'll see some of you on the Market Monitor on Wednesday where we'll try to catch the next move, and back here on Thursday when we'll hopefully be a step closer to identifying where that top might be. Have a great weekend.
 


New Plays

New Option Plays

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

New Calls

None today.
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

Lockheed Martin - LMT - close: 92.07 change: -0.24 stop: 88.99

Friday was a doji day for LMT. The stock had rallied into the afternoon but then suffered a quick sell off in the last hour that wiped out the day's gains. What that means for next week can't be known but bullishly we see the stock hanging above its 10-dma at $91.86. We're a little concerned about the light volume push higher and see the possibility for this stock to top out just above $94 but we'll reevaluate if and when LMT reaches that level whether or not we want to take profits a little early. Because it's reaching overbought and showing some bearish divergences at new highs we don't suggest any new plays at this time. A pullback to its uptrend line from June and its 50-dma, both located near $89.26, would provide a good opportunity for a new entry. If that support doesn't hold then we have our stop in the correct place. We have two upside targets--our conservative target is the $94.85-95.00 range; our more aggressive target is in the $99-100 range.

Picked on November 29 at $ 90.62
Change since picked: + 1.45
Earnings Date 01/23/07 (unconfirmed)
Average Daily Volume = 2.1 million
 

Put Updates

Mohawk Industries - MHK - close: 74.86 chg: -0.72 stop: 79.01

The low volume bounce this week was followed by a stronger sell off today. The 10-dma had been holding MHK down, on a closing basis, and today's drop found support at its 100-dma but is slightly below its 50-dma. Next moving average support is its 200-dma at $74.28 and then its uptrend line from July, currently near $73.60. Once it can get through this layered support it could be a quick drop to our downside target is the $70.75-70.00 range, near November's low. We'll keep our stop above the December highs in case we see a bounce to relieve its oversold conditions. Our

Picked on December 17 at $ 76.02
Change since picked: - 1.16
Earnings Date 02/22/07 (unconfirmed)
Average Daily Volume = 600 thousand

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3M Co. - MMM - close: 77.93 change: -0.23 stop: 80.01

After dropping from its November highs MMM has been consolidating during December in what appears to be a sideways coil. This should be a continuation pattern for another leg down so our short play continues to look good here, especially with the weekly stochastics pointing down. We are suggesting puts for the more aggressive traders with the stock under $79.00 while more conservative traders can look for a decline under $78.00 or the 200-dma near $77.53. We consider this to be an aggressive, higher-risk play because MMM does have support at its 200-dma (where it found support last Tuesday, now at $77.62) and is holding above its October gap up (top of the gap is near $77.35). It takes a break below $76.40 to enable bears to breathe a little easier. Our target is going to be the $72.50-70.00 range. The P&F chart is more bearish with a $47 target.

Picked on December 17 at $ 78.31
Change since picked: - 0.38
Earnings Date 01/19/07 (unconfirmed)
Average Daily Volume = 2.8 million

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NewMarket - NEU - close: 59.05 change: -0.47 stop: 62.01

NEU is battling its 20 and 100-dma's at $59.73 and $59.09, resp. A little higher, at $59.07, it would face resistance at its 100-dma which has acted as support and resistance for the past six months. The bounce off the December 19th low continues to look like a bear flag. NEU has a longer term uptrend line from October 2005 where price bounced on 12/19, currently at $57.23. A break of that support would be another opportunity to enter a short play. Our stop level is now just above the downtrend line from October which makes it a good place to keep it for now although more aggressive traders can consider lowering it to $61.01. Our downside target is the $54.00-53.50 range. FYI: The P&F chart points to a $51 target. Plus, short-interest is about 7% of the 14.8 million-share float, which is probably enough to raise the risk of a short squeeze if NEU abruptly turns higher.

Picked on December 14 at $ 59.11
Change since picked: - 0.06
Earnings Date 01/29/07 (unconfirmed)
Average Daily Volume = 275 thousand

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Sears Holding - SHLD - close: 167.93 chg: -0.07 stop: 173.05

A trend line along the consolidation lows since October and the uptrend line from July intersect at $169.68 today and that's where SHLD stopped in this morning's early spike up. So support has turned to resistance now and made for another good short entry today. Our downside target is the $162.00-160.00 range. Aggressive traders can look for a further pullback to near $157 which is the October low and will be near the uptrend line from March 2006 by the time it gets there. Keep an eye on the simple 100-dma near $162.69 which might offer some support. If you missed the entry, any further retests of the $169.70 area should offer another opportunity for an entry.

Picked on December 22 at $167.90
Change since picked: + 0.03
Earnings Date 01/16/07 (unconfirmed)
Average Daily Volume = 29.3 million

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Yahoo! Inc. - YHOO - close: 25.54 chg: +0.18 stop: 27.05

YHOO got a big bounce with the rest of the this morning but gave most of it back by the end of the day. But price continued to hold above support at the bottom of the gap from October 30th. The 10-dma at $25.80 held down the bounce again. If it can bounce a little higher it should find layered resistance at its downtrend line from November ($26.26), its 50-dma ($26.29), 20-dma ($26.33). A bounce to this area would be another entry for a short play. The stop at $27.05 is now above the downtrend line from July and 100-dma which makes it a good location for additional short entries. A break below $25.13 could see some acceleration lower. Our downside target is the $22.65 level near the October low. More aggressive traders may want to aim lower. FYI: It might be worth noting that short interest is about 6.9% of YHOO's 1.2 billion share float.

Picked on December 20 at $ 25.85
Change since picked: - 0.31
Earnings Date 01/16/07 (unconfirmed)
Average Daily Volume = 29.3 million

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YUM Brands - YUM - close: 58.80 change: -0.30 stop: 60.26

YUM continues to consolidate in a bear flag since our play was triggered. It's consolidating on top of what could be a neckline (at $57.80) for a developing H&S pattern since October. YUM found resistance at its 20-dma ($59.63) and the top of its bear flag on Thursday and dropped back below its 10-dma ($59.06) today. Our stop is at the right place just above the 50-dma at $60.19. The 20-dma has crossed down through the 50-dma which should help our bearish play. A break below the neckline at $57.80 would offer an additional opportunity for a short play. Our downside target is the $55.75-55.00 range, which is near the top of the gap up on October 12, 2006. Closing the gap at $54.57 makes for another downside target.

Picked on December 12 at $ 58.49
Change since picked: + 0.31
Earnings Date 02/07/07 (unconfirmed)
Average Daily Volume = 1.6 million
 

Strangle Updates

(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)

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Blue Nile - NILE - close: 36.89 chg: -0.03 stop: n/a

NILE has been struggling to bounce off its December low but got a stronger bounce this week and has unfortunately worsened our strangle position by dropping the value of our puts while barely adding to the value of the call side. The daily chart has moved into overbought and we could see this turn back down any day now. This unfortunately continues to just chew up time. Our problem is time and we don't know if we'll see enough of a move before January expiration. 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), which is only $0.10, and the January $35 put (JWU-MG), which is bid at $0.40. Our best guess is that this stock is ready for a drop which would obviously help the put side of this trade. There's not much value left in the call side. A drop through $34.25 could see some acceleration lower but it will still need to get through its 200-dma at $33.71. For January expiration we'll need a closing price of $32.60 or less in order to cover our cost. There is still a reasonable chance that will happen if the broader market starts to sell off after the new year starts so use that as your guide as to whether or not you want to limit your loss and exit earlier. We'll continue to monitor this play into January expiration or an exit at $3.90 for either side, whichever comes first.

Picked on October 29 at $ 38.92
Change since picked: - 2.03
Earnings Date 10/30/06 (confirmed)
Average Daily Volume = 226 thousand
 

Dropped Calls

None
 

Dropped Puts

Intuitive Surgical- ISRG - close: 95.90 chg: -0.83 stop: 104.05

ISRG dropped today and closed its November 20th gap at $95.79 (today's low was the late afternoon spike down to $95.64). Our profit target had been changed to $95.80 since a close of that gap and an uptrend line from August could provide support here, especially with oversold oscillators. Slightly lower is the trend line along the lows since March, currently at $94.07. If you're still in this play then that would be the next downside target to consider taking profits (and consider a long play).

Picked on December 18 at $102.05
Change since picked: - 6.25 * hit profit target at $95.80
Earnings Date 02/01/07 (unconfirmed)
Average Daily Volume = 938 thousand
 

Dropped Strangles

None
 


Trader's Corner

Multi-Collinearity

cWhat's wrong with this chart?

Daily Chart of INTC:

Note: Charts in this article do not feature current values.

What's wrong with this chart is that the two indicators, RSI and CCI, are collinear. Both are momentum indicators that use a security's closing cost in their calculations. Because they're calculated using some of the same input, they're not truly independent studies. Traders can spot collinear indicators because their peaks and valleys tend to come at the same points, as do those of the RSI and CCI indicators seen on the chart. Traders who use RSI to confirm a CCI signal or vice versa are relying on methodology that any statistician would tell them was faulty.

Scan any number of disparate statistical studies and you'll locate sentences or even paragraphs devoted to the methodology used to avoid multi-collinearity or multicollinearity. (Various spellings abound, depending on the source researched.) Dictionary.com defines the term as "linear inter-correlation among variables." For example, a study on the relationship of transportation to job-interview-and-employment outcomes mentions one limitation of the study as its failure to account for the collinear relationship between car ownership and the employment outcomes being studied. Those who owned cars likely had better employment outcomes and those who found jobs likely had a higher percentage of car ownership. The two variables were not independent. Studies on outpatient medical care costs for children with special health care needs, the effect of political power in predicting genocide and mass murder, and the best methods to teach beginning readers all addressed the methodology they'd used to avoid multicollinearity.

If traders want confirmation that a signal is valid, they need the signal to come from indicators that are as independent as possible. If a momentum indicator such as RSI is used, its signal should be confirmed by an indicator that doesn't rely on closing prices for its computation. For example, a volume-based indicator such as the On-Balance Volume (OBV) or Chaikin Money Flow (CMF) index might be used.

Daily Chart of INTC with RSI and OBV:

How do traders find out which indicators rely on the same information for their calculations? Many charting platforms provide overviews and/or formulas for the indicators they allow. A search of www.investopedia.com will turn up both for many of the most popular indicators. For those who don't want to go to that much trouble, www.stockcharts.com provides a handy breakdown of the most popular indicators into three basic groups at the following link: http://stockcharts.com/education/TradingStrategies/Multicollinearity.html

Once you have the breakdown in front of you, it's as easy as choosing only one indicator from each of the three types listed: momentum, trend and volume. This should be a good starting place for beginning traders who want to avoid multi-collinearity when choosing the indicators they'll follow.
 

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

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