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Daily Newsletter, Wednesday, 01/17/2007

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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

"An Out-Sized PPI Sure Doesn't Help"

This quote came from a CNBC commentator just prior to the cash-market open. It indicated one possible reason for a pre-open dip in the futures, with the futures having until then weathered the blow Intel had dealt them. Although the FOMC reportedly gives more credence to the CPI, the Consumer Price Index, than to the PPI, the Producer Price Index, this morning's hotter-than-expected PPI did heighten rate-hike fears.

Introduction

Logic would also suggest that worries about Intel's (INTC) margins and the stock's subsequent decline would also pressure indices since it's an important component of so many, but what would a market day be without a new Dow record? By early afternoon, the Dow was achieving its intraday high of 12,614. Moreover, the SPX had also reached its own record, a six-year record intraday high of 1,435.27. A rise in CAT, PG, JNJ, some financials and crude-related companies' stocks countered the effects of INTC's decline, helping the Dow and SPX produce those new or six-year records.

Neither was to hold those levels into the close, however. The Beige Book and afternoon comments from FOMC member Janet Yellen added to the worry about tomorrow's CPI. A downgrade of CSCO prompted it to join INTC as one of the day's decliners, and indices softened as the close drew near.

Charts

Annotated Daily Chart of the SPX:

Despite the nominal new six-year intraday high today, the daily candle indicated indecision more than it did conviction. The SPX may need sideways consolidation or an actual dip to the converging 10- and 30-sma's to confirm their support. If the RSI has reached down to touch the bottom of its triangle, I would expect a bounce attempt, however successful or unsuccessful it might be, to occur at that level. However, if RSI has not yet reached the bottom of that triangle, any bounce attempt might be temporary and another 50-sma test might be needed.

If the SPX is strong, it may not need much of a dip but instead may wait in place until the 10-sma rises beneath it. Keltner charts from the 30-minute up through the daily chart show it ringed by support and resistance that appear about equally weighted, but the CPI is just the release to change that balance. The 15-minute chart showed a likelihood that the SPX would dip toward 1427.50-1428.50 but would likely find short-term support there, but those 15-minute chart setups are likely to be totally

The Dow also pulled back from its high, in this case another all-time high, albeit a record intraday high. The Dow closed below yesterday's record close.

Annotated Daily Chart of the Dow:

If the Dow should pull back rather than rise or consolidate sideways, watch the RSI for clues as to whether the 10- or 30-sma might serve as resistance. I would be reluctant to attempt even a short-term long if price had dipped to the 10-sma but the RSI had not also dipped to support. Also beware attempting a long if the RSI is breaking through its rising trendline. Bearish price/RSI divergence has continued for some time without meaning anything at all, but the DOW is also falling away from that rising trendline, the one whose underside it had been climbing previously.

The Dow's 15-minute Keltner chart provides little information, as prices were perched just above a line that has served as support all week. If the Dow breaks through support, next short-term support should be found near 12,540. This week, strongest resistance has been found at a line currently at 12,613.30, and I would look for short-term resistance just above that level on 15-minute closes, since the line will rise if prices do.

The Nasdaq neared a test of its 10-sma today.

Annotated Daily Chart of the Nasdaq:

On both the daily and the 15-minute nested Keltner charts for the Nasdaq, nearby resistance appeared stronger than support, but the Nasdaq doesn't have far to decline before it hits the 10-sma's support and the breakout level on that triangle. Unless the Nasdaq dives tomorrow, plunging lower, expect some buying to occur before or at the 10-sma, but keep stops tight if you're electing to participate in a long play. The daily Keltner chart presents a possibility for an eventual drop toward 2,425. Such a drop would not be welcome, if it should occur, because that would drop the Nasdaq back inside that green triangle, suggesting that the breakout had been a false one.

The semis didn't do much to support the Nasdaq today, with the SOX closing lower ahead of tomorrow evening's SEMI book-to-bill number.

Annotated Daily Chart of the SOX:

What once had been a solid band of moving-average support is now a separated band, with some moving averages now potentially resistance and some still support. The daily nested Keltner chart suggests that the 72-ema (dark green) or perhaps even 200-ema (neon green) may be retested, but it's not clear whether that would occur before or after a bounce attempt. The 15-minute chart suggests that a bounce attempt would likely occur from the 470-471.60 level before any further dip.

No evidence exists yet to suggest whether the SOX will eventually break through that weakening band of supporting averages or whether it will muster strength and maintain a break higher. A potential continuation-form inverse H&S shows up here. These aren't trustworthy--no H&S is these days--but I still urge that traders watch these formations to gain some insight into whether bears are bulls are strongest at the moment. Just based on the chart, I wouldn't expect much movement at all from the SOX tomorrow. Famous last words?

The Russell 2000 hasn't given any indication of final direction, either.

Annotated Daily Chart of the RUT:

The RUT's 15-minute Keltner chart shows it ending the day perched precariously on support. If it falls first thing tomorrow morning and doesn't quickly bounce, it sets up a target of 782, but the 50-sma is just under 784, and any piercing of that average may produce a bounce attempt back above it. Unless the CPI moves the interest rates greatly in either direction, I wouldn't expect big movement in the RUT tomorrow, either. If the CPI does surprise and send interest rates spiking, however, it could be possible to break the RUT through its 50-sma on a daily close. In that case, the RUT could be headed toward the 72-ema. Don't attempt a long from that potential support unless the RSI has approached 31-32 and, even then, be careful since it's possible that the RUT could break through support this time.

Annotated Daily Chart of the TRAN:

Watch the TRAN closely tomorrow, because the SPX, Dow, and OEX will have difficulty maintaining any gains if the TRAN is dropping. A look at the 15-minute Keltner chart for the TRAN showed an equal likelihood for a rise to 4,863.50 or a drop to 4,775.50.

Watching 10-year yields tomorrow morning will give traders some insight into how seriously bond traders are taking rate-hike fears.

Annotated Daily Chart of the Ten-Year Yields:


Today's Developments

Today produced a full slate of economic releases. At 7:00, the Mortgage Bankers Association released its weekly mortgage application volume survey for the week ending January 12. That volume decreased 0.6 percent on a seasonally adjusted basis after several weeks of rising volume. It rose on an unadjusted basis and was also higher when compared to the same week a year ago. It rose 9.8 percent when compared to that year-ago level.

Components were mixed. The Refinance Index rose 6.3 percent, and refinancing activity's share of total applications increased to 49.9 percent. Four-week moving averages rose for all components. The average interest rate for a 30-year fixed-rate mortgage rose from the previous 6.13 percent to 6.19 percent, and points increased.

Although these numbers begin to show favorable comparisons to year-ago levels, homebuilder Lennar Corp. (LEN) did not when reporting earnings. Earnings-per-share, net income and revenue comparisons with year-ago level were all unfavorable. LEN reported a loss of $1.24 a share with revenue of $4.27 billion. Thomsom First Call had drawn a consensus prediction of a $1.11 loss on revenue of $4.17.

The company anticipates that 2007's deliveries will be more than 20 percent lower than 2006's. The company expects to met or exceed 2006 earnings, however, with expectations that profitability will drop in the first half but rebound later in the year if certain conditions are met. That outlook or a burst of short-covering or other developments sent the stocks higher. The DJUSHB, the Dow Jones U.S. Home Construction Index, also rebounded, but neither LEN nor the DJUSHB has yet broken above a declining trendline established off December highs. Both will soon face that resistance if they continue climbing.

Another economic release addressed the housing market, the NAHB's January Housing Market Index. This index rose to 35 from its previous 33, the highest level since July, the NAHB concluded. The NAHB used the "worst behind them" phrase when talking about the housing market, but not all were to agree today on that conclusion.

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Fed governor Frederic Mishkin also weighed in on the housing market, saying that the Fed shouldn't try to pop a housing-market bubble, since a rapid collapse of any asset prices can damage economies, as happened in Japan in the 1990's. Articles put his comments in context, however, as he was speaking hypothetically and characterized the determination as to whether U.S. home prices had climbed above their fundamental values as "extremely hard to say." He believes that the Fed should remain vigilant to any sharp decrease in asset prices to ensure that there isn't a spillover into the economy, but he was still speaking hypothetically.

Fannie Mae (FNM) also addressed the housing market, saying that it expects new home sales to drop 7.1 percent this year and existing home sales to decline 8.1 percent. FNM's economists predicted the sales for this year would be the lowest since 2002, and the two-year downturn would be the biggest since 1989-1991.

Does anyone else remember that period the way I do? My husband lost his job during that period because the owner of the company for which he worked was heavily leveraged in real estate, and the owner was forced to sell the company for fire-sale prices when the value of his holdings decreased rapidly. My husband and I and the family of the other attorney with the company were forced to sell our houses and move out of the area. We were lucky to sell our home after only five months on the market and escape with only a $250.00 loss on the home we had owned for four years, but many others in the area were faring much worse. We had difficulty renting a moving van because so many were moving out of the area and none were moving in.

So far, the DJUSHB maintains a rising trendline that it established as it began climbing off the summer's low. I would draw that trendline and watch it closely, however. In early December, the DJUSHB approached a 38.2 percent retracement of the steep decline off the 2005 high, at about 761, and promptly fell back. If the DJUSHB should continue to climb, watch that level as it is approached again, with strongest resistance likely to be near the 50-percent retracement at about 829.50.

The PPI, the Producer's Price Index, was released pre-market, too, like the MBAA's figures on the housing market. The PPI rose 0.9 percent in December, much higher than the anticipated 0.4-0.6 percent climb. While the FOMC reportedly pays more attention to the CPI, the Consumer Price Index, than the PPI when it's studying inflation risks from higher prices, the CNBC commentator was right when he said that this hotter-than-expected number "didn't help" the inflation outlook.

The volatile energy and food costs led to the increase, with the core PPI that excludes these costs seeing a much tamer 0.2-percent climb. That core reading had been expected to be flat, so it was still higher than anticipated. For the year, the PPI rose 1.1 percent, much lower than 2005's 5.4-percent increase. Core PPI rose 2.0 percent, however, more than 2005's 1.6-percent increase, and that increase isn't desirable, although not alarming yet.

While there's probably nothing here that will change the FOMC's stance one way or another, the PPI does raise the importance of tomorrow's CPI, given that the PPI was a bit hotter than expected. This is especially true since some components of the finished-goods component of the PPI rose, with prices of finished consumer goods rising 1.2 percent. While the PPI is not the FOMC's main gauge, this heightens concern that the CPI might show that the rising costs of finished consumer goods are being passed on to the consumer, and that might be reflected in a hotter-than-expected CPI number tomorrow.

December's Industrial Production was released about forty-five minutes after the PPI, and that number was also stronger than expected. Output was particularly strong in the high-technology and motor vehicle sectors, with those contributing to a 0.7-percent rise in output for November. December's industrial production rose 0.4 percent, much more than the expected 0.1-percent rise. Capacity utilization was 81.8 percent, in line with expectations. In addition, November's industrial production was revised to show only a 0.1-percent decline, with the original number pegged at a 0.2-percent drop.

Although crude inventories are normally released on Wednesday, this week's Martin Luther King, Jr. holiday postponed that release until tomorrow, January 18 at 1:00, with this information coming from the Department of Energy's website. Last night in his Wrap, Jim Brown addressed some of the speculations about a U.S./Saudi deal that would help the Saudi's weather lower crude prices and also lower the influence Iran has on decisions that would impact crude prices. This morning, the Saudi oil minister spoke in India, reportedly saying that crude prices are "very healthy," a statement that would not, on its face, be supportive of crude prices, especially with the February contract due to expire shortly. However, crude closed higher today, and was at $52.24 in extended trading as this report was prepared.

The other major economic event of the day was the 2:00 release of the Fed's Beige Book at 2:00. With the FOMC worried about inflation pressures, the twelve districts' report of tightening labor conditions, wage increases in business sectors and worries about rising benefit costs should not have been welcome. However, in the section concentrating on prices, the report noted several districts in which price pressures were easing, while "[o]verall prices increased moderately."

Economic growth was only moderate, the report concluded. The housing market continued to soften, with that softening impacting manufacturing in those companies that manufacture products for the residential construction industry. Perhaps to be expected, loan activity was lower in some districts, especially when focusing on residential lending. Vehicle sales were sluggish in several districts.

Good news included expansion in the services sector and "modest increases in retail sales," although reports were mixed across the districts. Also, commercial real estate markets were generally strong.

For those unfamiliar with the Beige Book, this report is produced eight times each year and is a compilation of anecdotal information from the twelve districts. Current economic conditions are broken into District and sector. For those who would like to read the entire report, it can be found at the following link: http://www.federalreserve.gov/FOMC/BeigeBook/2007/20070117/default.htm

After the Beige Book's release, San Francisco's Fed governor Janet L. Yellen was characterized as mulling over the question of why the labor market would be "going gangbusters" while the economy was not performing the same. Could that combination to be pointing to increasing inflation pressure? She posed this question, although not in these exact words, when speaking to the Arizona Council on Economic Education. According to some listeners, Yellen's interpretation was that the wage pressures would likely soften, the more benign of the two possible resolutions. She reportedly believes that the FOMC is well-positioned to rein in inflation pressures but confessed that she believes that the current weighting of risk might not change for many months or perhaps even longer. It's may take some time, she concluded. While this statement is "the company line," as a CNBC commentator tagged it, it's still not what equity bulls want to hear.

Whether due to the Beige Book's influence, Yellen's statement, a combination of the two, or a compilation of the effects of the day's releases that served to heighten worries about tomorrow's CPI rather, the indices softened about that time. Some big-cap companies saw their stock prices softening ahead of Apple's (AAPL) after-the-close earnings report, too, and that certainly weighed against the indices.

Cisco (CSCO) collected its third downgrade this week, this one from Merrill Lynch. The stock was downgraded to a neutral rating, with the analyst citing valuation as a primary cause for the downgrade. After closing Friday at $28.92, the stock closed at $26.94 today, losing almost $2.00 in two days of trading.

Reporting companies included JP Morgan Chase (JPM) with the company reporting $1.26 a share, including a $622 million after-tax gain that resulted from the company's exit of the corporate trust business. Income from continuing operation was $1.09 a share. Revenue and earnings-per-share comparisons to year-ago levels were all favorable. Thomsom First Call reportedly expected earnings-per-share of $1.09. JPM closed at $48.43, above Tuesday's $48.39 close, but the day's candle was an ugly one with long upper and lower shadows and with a close below the day's open.

After hours, Apple (AAPL) reported earnings. Piper Jaffray called the numbers "blockbuster numbers," with earnings-per-share at $1.14 versus an expected $0.78 and with revenue blowing away expectations, too. IPod sales were 21 million units versus 16 million units expected for the quarter. However, the company issued what was considered conservative guidance and Mac sales were 1.5 million, below the expected 1.7 million units. Many were looking forward to the conference call to clarify how disappointing the guidance might be considered and how to weigh the mixture of strong iPod, revenue and EPS performances against the other disappointments. Discussions during the day had also considered what might happen with the options investigation and how that might impact Jobs' presence with the company. Much discussion was devoted to whether a criminal charge would result from the investigation and whether investors might be too severely punished if such a charge resulted. AAPL said it was voluntarily providing the government with options-dating data. As this report was prepared, the stock traded at $94.11 in after-hours trading, down from the day's $94.95 close. This was down significantly from an after-hours spike to $98.00.

Tomorrow's Economic and Earnings Releases

Tomorrow will include many important economic developments, including December's CPI, to be released at 8:30, the same time as both weekly jobless claims and December's New Residential Construction. Expectations for the CPI are for a rise of 0.4 percent, and traders don't want that figure to come in too much hotter or higher than that. December's New Residential Construction could impact markets on a normal day, but it may fall by the wayside on a day with so many other important events.

Fed Chairman Bernanke's testimony before the Senate Banking Committee comes next, with that testimony to begin at 10:00. The Conference Board's December LEI figures will be released at the same time, but that's not typically a market-moving release, and it shouldn't be when it's pitted against Bernanke's testimony, either.

Natural-gas inventories will be released at 10:30. After that comes the important January Philly Fed Survey, with this survey of manufacturing strength often moving the markets because it is one of the two that provide some insight into the ISM. The Department of Energy's site lists the crude inventories release time as 1:00. After the market close, the December SEMI Book-to-Bill number will be released.

Important companies announcing earnings tomorrow include MER, UNH, SLM, COF and BK.

What about Tomorrow?

My gut feeling last week wasn't as helpful as I wanted it to be, so this is 'fess up time. My best guess was that we would see some upside follow-through on some indices Thursday morning, which did occur, but I thought that that traders ought to watch for rollover potential at key levels that I pinpointed. Last Wednesday, neither the RUT nor the TRAN had fully participated in that day's rally, and I warned that they had to do so in order for the rally to continue even over the short-term. I showed traders levels to watch for upside breakouts on charts, particularly on the Nasdaq's chart.

I did suggest that participation by the RUT and the TRAN might mean that gains would persist, and also noted that the Thursday before opex week tended to produce results that weren't particularly amenable to technical analysis. I warned traders not to persist in a losing position. However, my gut feeling was that the advance would stall or roll over, and that didn't happen. The RUT and TRAN participated, with the RUT's participation occurring despite rising treasury yields. The rally continued that day. So, that's my confession.

Tomorrow is opex Thursday, the last trading day for SPX, RUT and SOX options. Opex Thursdays tend to feature prices that clamp down about midday, producing lots of frustration for traders who entered plays early and then got caught in non-performing plays. Several charts present configurations that support the thought that a similar event could occur tomorrow. The SOX and RUT are two of those indices, for example. The SPX has produced one of those spike-higher-then-consolidate patterns that it's been so good at producing lately, and if the typical pattern holds, it needs another day or two of small-bodied candles before it moves big again. It does show a possibility for a 13-15 point move in either direction, but the pattern suggests that's the less-likely outcome.

Based on the history of opex Thursday action and these chart characteristics, an early CPI-produced move followed by consolidation seems the most likely outcome tomorrow, but I personally wouldn't be surprised by an actual downturn. That's not my best-guess prediction for tomorrow, because the CPI results could undo anything we're seeing on the charts tonight, but I just wouldn't be surprised to see it. Typically when the SPX begins consolidating above the 10-sma and the RSI reaches the top of its own trendline, the SPX eventually pulls back to the 10-sma, and I just wouldn't be surprised if that happened tomorrow rather than waiting the typical day or two until it happened.
 


New Plays

New Option Plays

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

Play Editor's note: The market's upward momentum seems to be stalling. Our bias would be to add more bullish candidates but it seems like everyone's talking about a pull back, which may turn into a self-fulfilling prophesy. Instead of adding new plays tonight we'll see if tech stocks get a bounce from the Apple (AAPL) better than expected earnings news. AAPL itself may be poised for profit taking given the after hours failed rally near the $100 level.


New Calls

None today.
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

Chaparral Steel - CHAP - cls: 44.93 chg: +0.46 stop: 41.99

CHAP out performed the markets on Wednesday with a continuation of the late Tuesday afternoon bounce from short-term support near $44.00. Today's gain (+1%) helped the daily chart's MACD produce a new buy signal. However, we are somewhat concerned that the major market indices might be forecasting a dip so readers should prepare for another pull back toward $44 in CHAP. A bounce near $44 can be used as a new entry point. Our target is the $49.00-50.00 range.

Picked on January 14 at $ 45.16
Change since picked: - 0.23
Earnings Date 03/20/07 (unconfirmed)
Average Daily Volume = 635 thousand

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iShares China Index - FXI - close: 106.25 chg: -1.14 stop: 99.49

It seems that we were not the only ones looking for a dip near $105 as a new entry point. FXI dipped to $105.10 this morning but quickly bounce. Readers can choose to go ahead and buy the bounce or wait for more confirmation with a breakout over its simple 10-dma near $107.25. We do have a wide stop loss. More conservative traders may want to use a tighter stop. Our target is the $115.00-117.00 range.

Picked on January 14 at $105.40
Change since picked: + 0.85
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 1.3 million

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Lehman Brothers - LEH - cls: 83.32 change: +0.79 stop: 77.99

We were expecting a pull back in the broker-dealer sector today after Tuesday's failed rally. The XBD index did lose 0.5% but it bounced from the 255 level. Shares of LEH out performed its peers and the market with a 0.9% gain as traders bought the dip near $82. If you are looking for a new entry point we'd still considering waiting for another pull back into the $80-82 region since the major averages look a little vulnerable. We have two targets. Our conservative target is the $84.85-85.00 range. Our aggressive target is the $89.00-90.00 range. LEH's Point & Figure chart shows a very bullish pattern called a bullish triangle breakout that points to a $111 target.

Picked on January 11 at $ 80.25
Change since picked: + 3.07
Earnings Date 03/15/07 (unconfirmed)
Average Daily Volume = 3.4 million

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China Life Ins. - LFC - close: 48.62 change: -0.31 stop: 43.95

LFC didn't move much on Wednesday. The stock posted a second day of trading sideways. Shares mirrored the general direction in Chinese markets. We remain bullish that LFC will bounce but readers have a choice. You can look for a dip into the $46.00-47.00 region or wait for a breakout over its 10-dma (near 49.50) or even wait for a breakout over $50.00. Just remember that our target is the $52.50-55.00 range. LFC is a more aggressive, higher-risk play and will tend to gap open every day.

Picked on January 14 at $ 46.86
Change since picked: + 1.76
Earnings Date 04/18/07 (unconfirmed)
Average Daily Volume = 1.7 million

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Lockheed Martin - LMT - cls: 96.50 change: -0.50 stop: 90.95

We do not see any changes from our previous updates on LMT. The stock is still looks bullish but shares hit some profit taking today. More conservative traders may want to take profits now if you have not already. We're not suggesting new positions as we aim for our more aggressive target in the $99-100 range. The stock has already hit our conservative target in the $94.85-95.00 range last week.

Picked on November 29 at $ 90.62
Change since picked: + 5.88
Earnings Date 01/23/07 (unconfirmed)
Average Daily Volume = 2.1 million

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Altria Group - MO - close: 88.57 change: -0.72 stop: 84.75

MO is struggling to maintain its bullish, upward momentum. The stock lost 0.8% and dipped back toward short-term support at its rising 10-dma. News that tobacco stock UST was downgraded today may have influenced trading in MO. The pattern remains bullish but we hesitate to suggest new call positions here. More conservative traders might want to consider a tighter stop loss near $86. We are targeting a rally into the $92.50-95.00 range. The P&F chart currently points to a $114 target. We do not want to hold over the late January earnings report.

Picked on January 04 at $ 87.65
Change since picked: + 0.92
Earnings Date 01/31/07 (unconfirmed)
Average Daily Volume = 8.8 million

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Teleflex - TFX - close: 67.25 chg: +0.10 stop: 64.75

Traders bought the dip in TFX near $66.70 this morning. We don't see any significant changes from our previous comments. We would still consider new call positions here but it might pay to wait and look for a dip back toward the $66.00 region. More aggressive traders may want to put their stop under the 50-dma. Normally we would expect the $70.00 level to act as resistance but looking at TFX's history the stock seems to encounter resistance in the $72.00 region. Our target will be the $71.00-72.00 range.

Picked on January 14 at $ 67.11
Change since picked: + 0.14
Earnings Date 02/14/07 (unconfirmed)
Average Daily Volume = 202 thousand
 

Put Updates

eBay Inc. - EBAY - close: 29.95 change: -0.09 stop: 31.26

This is the fourth day in a row that shares of EBAY have struggled with overhead resistance near its simple 200-dma in the $30.50 region. The trend for the stock remains down but lack of momentum is beginning to worry us. Even with EBAY's relative weakness we hesitate to suggest new put positions given our time frame. The company is due to report earnings on January 24th and we do not want to hold over the announcement. Please note that we're adjusting our stop loss to $31.26. Our target is the $26.00 level.

Picked on January 08 at $ 29.70
Change since picked: + 0.25
Earnings Date 01/24/07 (confirmed)
Average Daily Volume = 14.5 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 - cls: 38.30 chg: -0.35 stop: n/a

We do not see any changes from our weekend update on NILE. Time is quickly running out. We're not suggesting new positions. We have adjusted our target to $1.20, which is half of our estimated cost. 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
Change since picked: - 0.62
Earnings Date 10/30/06 (confirmed)
Average Daily Volume = 226 thousand
 

Dropped Calls

Merrill Lynch - MER - close: 96.81 change: -0.05 stop: 93.99

Our time has run out on MER. The company is due to report earnings tomorrow so it was our plan to exit today at the closing bell. Unfortunately for us the rally stalled out on Tuesday. We do not want to hold over the report because typically the broker-dealers run up ahead of their earnings announcement, blow away the estimates, and then sell-off. MER reports tomorrow morning and Wall Street is looking for $1.92 a share.

Picked on January 10 at $ 94.44
Change since picked: + 2.37
Earnings Date 01/18/07 (confirmed)
Average Daily Volume = 4.6 million
 

Dropped Puts

None
 

Dropped Strangles

None
 


Trader's Corner

'Rectangle' Chart Patterns (2)

MEA CULPA
Last week (1/10/07) I wrote the article below about current noteworthy chart formations we had been seeing in the major stock indexes and then proceeded to send the RIGHT charts, but the WRONG article; by mistake I attached my Trader's Corner article from a year ago, which was, how can I say it, totally WRONG!! To make sense of the charts printed LAST week, I'm reprinting the right explanatory text with, first, the charts from last week, FOLLOWED by chart updates through today with an updated comment. I hope this will not confuse...its one snapshot in time, followed by today's chart snapshot for the major indexes, also in time. It's all about the sideways chart pattern called a rectangle, which in the current situation could be a top pattern, in some cases a 'consolidation' formation before another major move in the same direction as previously.

REPRINTING LAST WEEK'S DISCUSSION:
My mail brought a question from an Option Investor subscriber relating to the broad sideways trend in the market (and loss of the prior strong upside momentum) that's been going on since early-December that I've been commenting on in my recent weekend Index Trader columns.

QUESTION: "What do you make of this the sideways trend in the indexes? What does it predict about the future direction of the market, like it being a possible top or whatever."

RESPONSE:
A sideways trend, as seen in the major market indexes in recent weeks, can be seen or defined (more or less) as a 'RECTANGLE' pattern. I make a definition of this in my book (Essential Technical Analysis) as follows; the pattern could form in a stock, stock index or any other market such as oil, Treasury bonds, or the dollar:

"A rectangle is a sideways 'trading range' forming after either an uptrend or downtrend and that most often is a consolidation of the prior trend, before a further move in the same direction as this trend. The name comes from the shape of the pattern, which requires a sideways trend that goes on long enough that the pattern's width is longer than the consolidation trading range is high. Sometimes a rectangle will end up forming a so-called rectangle-top or a rectangle-bottom pattern. The key is the direction of the a breakout move above or below the top or bottom lines drawn across the (trading) range's highs or lows."

There would typically be or should be 2-3 or more highs that form in the same price area, as well as 2-3 or more lows that get made in the same price zone; two lines drawn across these highs and across these lows then define an upper horizontal and a lower horizontal trendline.

This pattern, especially in stocks, classically will have a duration of months (e.g., 6 months), rather than weeks. Some analysts and market observers define TWO types of rectangles: a 'rectangle top' and a 'rectangle bottom'. However, this is for purposes mostly of separating two possibilities: that the pattern could be the formation of a top after a lengthily advance OR the formation of a bottom, after a lengthily decline. However, it should be noted that the rectangle pattern is not associated with a classic definition/prediction that EITHER a top or bottom should follow such a sideways trend. Rather we have to observe in WHICH direction is the next move, above or below the box like pattern.

The following two situations define when a rectangle is a CONSOLIDATION of the prior trend:

1. The market (or stock) has been advancing previously, which is the current situation and this is followed by a series of sideways, back and forth price swings that end in roughly the same areas on the upside and the downside. If the next significant price swing or 'leg' is up, carrying prices decisively ABOVE the top end of the rectangle, the pattern was simply a pause/'consolidation' of the prior advance.

2. The index or stock has been in a significant decline, followed by a series of back and forth price moves that tend to top out and bottom in the same area 2, 3 or more times. If the next significant price swing or 'leg' is BELOW, the 'line' of prior lows, the pause or sideways move (the rectangle) was simply a 'consolidation' of the prior downtrend, before the dominant bear trend continued.

When a rectangle defines a trend REVERSAL pattern is when:

1. The sideways trading range or rectangle pattern, after a prolonged advance, is followed by a breakout to the DOWNSIDE. This pattern then 'becomes' (is defined as) a rectangle-top.

2. The sideways trading range or rectangle pattern (after a prolonged decline) is followed by a breakout to the UPSIDE; the pattern then becomes defined as having been a rectangle-bottom.

A study done at MIT by Dr. Andrew Lo and which I cite in my book found that rectangle tops and rectangle bottoms were two (of 5) chart patterns that they found to be significantly correlated to a predictable outcome; that is, a REVERSAL. So, it seems from the situation that they studied that the pattern was more often a reversal pattern. Time will tell on the indexes and the sideways trading range is not that old yet.

Interestingly, the Nasdaq (Apple mania?) looked like it might break out to the UPSIDE of the sideways trading range that the Nas Composite, and to a lesser extent the Nasdaq 100 (NDX), whereas the S&P is nearer to the low end of the trading range that IT has been in for awhile now, in both the broader 500 (SPX) and the biggest cap 100 (OEX).

THE NASDAQ COMPOSITE (COMP)
With the Composite daily chart below, I outline the possibility that an upside OR a downside breakout could equal the 'classic' objective for a next price swing that is at least equal to the WIDTH of the rectangle. This is a starting point or 'rule of thumb' only. Bulkowski found in his work (Encyclopedia of Chart Patterns) that 'rectangle tops' with UPSIDE breakouts had a further gain of 50% of what had come before, with the average gain equal to between 20 and 30 percent.

CHART AS OF 1/10:

Consistent with the MIT study, Tom Bulkowski found that DOWNSIDE breakouts occurred somewhat more for this pattern; but, once the low end of the range was pierced, the average decline was just 20 percent.

My take on this all and its consistent with MY experience is that when the pattern you see above and below resolves itself to the UPSIDE, the further gain tends to be more than when the index (or stock) declines or breaks to the downside.

Hey, this might be the old saw that a trend in motion tends to STAY in motion. I tend to give the benefit of the doubt, as to which DIRECTION a breakout move will occur as to being in the SAME direction as the prior trend. However, the key to trading this pattern, as in any trading range, is to trade in the DIRECTION of the breakout, certainly not AGAINST it.

UPDATED COMP CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
As we'll see further along, with the inability of the S&P to follow through to the upside, the apparent 'breakout' to the upside as seen in the updated chart could have been a 'false' one. Telling for this, will be whether the Nas Composite now falls back into its prior price range, outlined by the rectangular outline I've drawn on the daily COMP chart here. The 2470 area is key. If the Index stays ABOVE its prior range, COMP has upside potential to the 2550 area. If COMP starts closing under 2470, its back in its 2390-2470 trading range; and with the question of the DIRECTION of the next big move left unresolved from a technical/chart standpoint.

THE NASDAQ 100 (NDX):

FIRST CHART IS AS OF 1/10:
The Nas 100/NDX pattern doesn't have the same 'definition' as the Composite in terms of having 2-3 or more 'touches' to a high in the same approximate area and a number of lows also around the same price zone. If we use a close-only (line) chart and assume that the Closing high to date and the closing low to date 'define' upper and lower ends of the same rectangle pattern we see in COMP, the following outline is projected for NDX, along with potential upside or downside price targets (on a Closing basis):

UPDATED NDX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
The same updated commentary applied with the Nas 100 below, was also true with the Composite chart above. The prior high Close in NDX, at 1820, may be threatened here. If the breakout is not going to turn into a short-lived and 'false' one, former resistance should 'become' support if NDX did recently begin a new leg higher. If this was not the case and NDX starts sinking under the prior closing high at 1820, look for initial support in the 1790 area, at the 21-day moving average, or around 1775, at the up trendline seen below; these figures are on a CLOSING basis. Which by the way, some portfolio managers really only focus on, as only the close is considered key.

THE S&P 500 (SPX):

FIRST CHART IS AS OF 1/10:
The limited time spent between the highs and lows that I've outlined below, doesn't give us a lot to go on in SPX; whereas, a longer DURATION sideways trading range tracing out a rectangle tends to becomes more and more significant. The upside or downside potential for a breakout move in either direction based on what we've seen to date (1/10) in SPX however, is presented next:

The SPX pattern above also looks a bit like it could be a rounding top, even an approximate double top.

UPDATED SPX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
The key aspect of the chart pattern being traced out in the S&P 500 here is that this major index remains basically within its trading range of recent weeks being traced out between the low-1400s and 1432/1435. This type rectangle pattern could be tracing out what will be seen later as a RECTANGLE-TOP. Time will tell and what will be telling is the DIRECTION of a breakout move.

One anticipated expectation for the S&P is that the Index probably won't continue for a lot more weeks locked in such a narrow price range. However, if it did, that would tell us something also. The LONGER that a major index trends sideways in a box-like trading range/rectangle pattern, the larger or more significant the breakout move tends to be when it does come, whether that's up or down.

THE S&P 100 (OEX):

FIRST CHART, AS OF LAST WEEK'S 1/10 CLOSE:
The OEX sideways trading range of late isn't highly defined in terms of duration, but there is a minimal trading range that has shaped up here in recent weeks. My projection/speculation as the upside or downside potential on a breakout above or below that range, is presented in my last chart. This chart serves as an illustration of the future price projections involving a rectangle, albeit one reflecting a trading range that has not gone on so long as to have great confidence in the upside and downside targets of future price swings. The more defined (i.e., in terms of duration) the trading range of a rectangle pattern, the more likely it is to see big follow through on a breakout above or below that range.

I have seen individual traders getting more excited about tech (hope springs eternal in Nasdaq for that next monster bull market) and it seems that individuals may be driving Nasdaq more, whereas there is some caution by institutional investors and a wait and see attitude here about the S&P stocks ahead of the full spectrum of earnings reports ahead.

UPDATED OEX CHART AND COMMENTS, AS OF TODAY'S CLOSE, 1/17/07:
No surprise here that the S&P 100 is also locked in a narrow trading range still like its cousin index, the S&P 500. The big cap OEX is still tracing out a sideways rectangle and a narrow price range. This is of course the proverbial 'kiss of death' to index option traders who are buying calls and puts as this kind of narrow range mostly only favors those selling premium in calls and puts or otherwise adopting strategies to capture premium based on prices remaining range-bound.

The longer that an index is range-bound like this after such a big advance that came before, the more we should be wary of thinking that this market is never going to top out. The expectation that this market was only going up was getting to be a widespread view. The reality usually signaled by a rectangle or trading side/sideways movement like we're seeing is that buying and selling forces get in balance and we don't know what events and which way or which direction the next large price swing will take. As traders, we need wait for a move and direction of that move, up or down. Even then, there are some occasions when 'false' breakouts come or ones not following through overly much such as in Nasdaq perhaps. Stay tuned on that!


GOOD TRADING SUCCESS!

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

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