Option Investor

Daily Newsletter, Saturday, 04/28/2007

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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

Records Are Made To Be Broken

I (Keene Little) will be filling in for Jim this weekend.

With the DOW up 19 out of the past 21 days it has now made a new record. Never mind another all-time closing high, ho hum, that's old news. We've heard it before. But wow, 19 out of 21 days, now that's an accomplishment. Not since 1896 when Charles Dow created the DOW Industrials has the index managed this feat. The bulls are saying "see, I told you we have a bull market" and the bears are saying "nice blow-off top, I'll see you at the bottom."

The good news is that several indices and sectors are punching into new highs, including the DOW and NYSE. The bad news is that this is happening on consistently lower volume and negative market breadth, just as it was doing into February's high. The DOW's new high on Friday was thanks to 12 of the 30 stocks, and really thanks to MSFT and GE, so unfortunately the new high was once again on negative breadth. But when you look at the price charts of the major averages it's easy to feel good about this market. In fact it's easy to feel downright bullish. Just stay aware that looks can be deceiving--a look at the numbers in the chart above shows you that Friday's "rally" was on weaker volume and negative breadth. This can't and won't continue.

The good news is that there is a lot of money flowing into the big stocks like MSFT and GE, two companies who are a fair representation of the technology world and our economy. The bad news is that there is a lot of money flowing into these bluest of the blue chips. The small caps (RUT) dropped Friday and while the techs held up (thanks to MSFT) the semiconductors did not. After a strong earnings report from MSFT and a huge gain in that stock on Friday, many of the other techs were conspicuously absent. When we see money rotating from small caps and techs into blue chips we're left to wonder if it is a defensive move by money managers.

It is far easier for large funds to sell millions of dollars of their holdings from a big stock like IBM, MSFT or GE than from the much smaller tech and small caps. A large sell order in a small cap could cut its price significantly and not enable the manager to get out with most of his capital intact. The same amount of selling in GE barely causes a blip. There are many who look at Friday's big rally in GE and MSFT as a very bullish sign for the broader market but I'm not so sure about that.

Other than the thought that a move into the bluest of blue chips could be considered a defensive move the chart patterns of both MSFT and GE look similar in that they both tagged what could be important resistance right at the time the bounce off the March low could be considered complete (neither have exceeded their January highs). For example, GE's pattern shows a clean impulsive (5-wave) move down from its December high which has now been followed by a 3-wave (A-B-C) bounce:

General Electric chart, Daily

The current bounce in GE could certainly continue higher but at this point the chart pattern tells me not to expect that. In addition to its downtrend line from 2000, where price stopped on Friday, the 5-wave move down from December tells us the new trend for GE is down. A 5-wave move followed by a 3-wave correction will be followed by at least another 5-wave move in the direction of the trend and in this case it's down. At this point, at least with GE, it's not difficult to call a top. MSFT's chart looks similar to GE, perhaps reflecting the fact that MSFT is moving more into "old economy" than technology.

Speaking of economy, it's not hard to see that there's a disconnect between what we're seeing in the economy and what the stock market is doing. If ever there were a time the stock market is off doing its own thing and not paying attention to what's coming, now is it. But that's what happens in bubbles. An article that's been making the rounds on the internet this past week is one done recently by Jeremy Grantham, a well know value fund manager the likes of Warren Buffet. In his recent letter to his clients he talks about a worldwide asset bubble, aided and abetted by an enormous growth in leverage (debt).


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In his discussion about the worldwide bubble he cited some research into past bubbles and found they're typically a 40-year event and he found 28 of them. Every one of them corrected hard and every one of them reverted back to the mean. Every one. And each time there was always the talk that it's different this time and because of the new paradigm we will see a sustained rally in (you name it). Today's paradigm, straight from the mouths of our Fed, is that we have new and creative financing vehicles which reduces the risk for institutions and investors.

We've seen an explosion in new credit deals, leveraged buyouts, resale of loans, etc. and the result has been an enormous increase in liquidity which has inflated nearly all asset classes. The inflation in asset classes has encouraged greater participation by investors who have been eager to leverage their investments to increase their gains. One is feeding the other and it's not hard to understand why bubbles are created, why a 50 cent tulip bulb can sell for $1000. But once again, understand that all bubbles pop and the popping sound is not a hissing sound, it's a pop. And this time around all asset classes will get hit.

The challenge for us traders is to participate in a strong move up but stay aware you're in dangerous waters here. This market could easily rally another 10-15% in a final orgy of stock buying. In previous Wraps (including last Wednesday's) I've shown the chart of 1987 how the market rallied 23% off the bottom of its correction in the spring. The DOW is "only" up 10% at this point. Another 13% would tack on another 1600 points on top of the nearly 1200 points it's rallied off the March low. It might not do it straight from here and instead take us through the summer but parabolic rises have a tendency to get a little carried away.

That's the upside risk. The downside risk is that these kinds of moves can stop and reverse hard on a dime, when it is least expected. The 1987 top was followed by a normal pullback, a bounce and then a crash. There was actually some warning by its pattern that it was coming. Whether we'll get that warning this time is an unknown but usually there are enough warning flags IF you're looking for them. So that's what I'm doing--I'm looking for the flags.

One of the warning flags, which I've been mentioning a lot lately, is the lack of market breadth and volume to confirm this move up. It's simply missing. Even the DOW continues to make new highs but on negative breadth. Here's some data passed along to me by one of our readers (thanks for the research John):

"Since the DOW is some 1370 points into record territory over its January, 2000 high, I thought it would be interesting to see how many of the 30 companies that make up that index had also made highs above their January, 2000 highs. What I found was revealing. Only eight (8) companies (26.6%) had exceeded their January, 2000 highs. They were as follows:

1. MMM
2. CAT
3. UTX
4. PG
5. XOM (This has more to do with the commodity they deal in than the company)
6. BA (Big Air)
7. AXP
8. MO (That's sad)

"JNJ attained its all-time high in the spring of 2005 but has not regained it. A number of companies, most notably GE and GM are only trading at a fraction of their old highs.

"I'm not sure what kind of conclusions you could draw from this analysis. I guess if you owned these eight companies you would be happy, but if you owned any (or all) of the other 22 you would not be (happy). The DOW has a gain of about 11% but when you consider the fact that it took 7 years to get there that's just over 1.5% gain per year. Given inflation you are going backwards. What is it that the 'buy and hold' crowd has told us expect a 10%-12% return per year over the 'long haul'? I guess that prompts me to ask, What the [heck] is the long haul?"

In addition to John's analysis above (which is excellent), it's been apparent that an effort has been made in the past many months to elevate the DOW by anointing a couple of stocks at a time. It's been just enough to keep lifting the DOW higher and making the news appear more bullish. But it has resulted in many negative breadth days. These breadth indicators don't tell us squat about the short term for the market but they give us a heads up that something smells a little fishy and that's why it's just a warning flag.

I prefer the price patterns, specifically EW (Elliott Wave) patterns, because they tend to repeat in very predictable fashion. Whether it's a H&S pattern, saucers, wedges or A-B-C counts, these patterns reflect the mood of the market participants and we never change, as much as we'd like to think we do.

So before we get to the charts (got lots to cover this weekend) and find all those patterns, let's quickly review Friday's economic reports.

Economic reports
Friday's economic reports included GDP, the employment cost index and Michigan Sentiment. These reports continue to highlight concern that we are probably already into a period of stagflation.

GDP and Chain Deflator
The US economy slowed in the first quarter more than most economists had expected, coming in at +1.3% vs. expectations for +1.8% and was down from the +2.5% in Q4. Rising energy prices and a weak housing market got the blame and that of course prompts me to ask whether or not the economists were aware of these factors before now. This +1.3% GDP is the slowest we've seen in the past 4 years but thanks to the mighty consumer, who is willing to continue to pile on the debt, the growth number was not worse.

The higher energy prices led to a higher GDP price increase of +4%, the most in 16 years. So the economy is slowing and inflation is getting worse--if this is not stagflation then somebody changed its definition. The Fed has successfully painted itself into a corner--well done. The good news is that the core inflation rate, which excludes food and energy, increased at a lower +2.2% annual rate. That's still a tad higher than the Fed wants to see. The bond market reacted to this with a sell off (higher yields). The chance for a rate decrease by the Fed gets further and further away. And that of course prompts the question "so why is the stock market rallying?" That's a very good question.

Employment Cost Index
The ECI rose at a +0.8% rate, down from +0.9% for Q4 and lower than the expected +0.9%. This number is also watched closely by the Fed as they don't want to see inflationary pressures coming from higher wage costs that get passed along to the consumer. So the number was Fed friendly.

Michigan Sentiment--revised
The headline report was an improvement in consumer mood in April, rising to 87.1 from the initial reading of 85.3 two weeks ago. But shh, don't mention the fact that it's down from 88.4 in March. It's now at a 7-month low. And why is the stock market rallying? Silly question. But the stock market always follows sentiment so the disconnect won't last. Either the consumer will become overjoyed at the fact that the DOW made another new high by rallying 15 points, or the stock market will follow the consumer. But so far there's no evidence that consumers are reigning in their spending and that's what's helping keep the GDP from sinking further. That may also change soon.

Like all big moves, they start out small. While there is the chance this market has a long way to go to the upside, in a much larger blow-off top, it won't happen straight up from here (at least I don't think it will). Therefore we'll look for where the present leg up might end and offer at least a larger pullback. We'll start with the view from 30,000 feet and take a look at the DOW's weekly chart and some cycle studies.

DOW chart, Weekly

I had mentioned that the stock market follows similar patterns and these can be seen on various time frames. The same holds true for cycles. There are many different time cycles from the Kondratieff (54 years) down to weeks. This weekly chart shows the 40-week cycle and I've highlighted in yellow where the market has turned at each cycle. Sometimes the turn is only minor and at other times it's a major turn. The next turn week is this coming week. You don't know which way the market might turn at these cycle dates but can usually guess pretty well by the direction the market is heading into it.

In this case it looks like it could mark a turn down. These turn weeks are typically +/- a week so it doesn't help day to day trading but instead offers a heads up that a turn is probably coming. There's also a potentially important point about this turn that's coming up because of the low-to-low-high pattern that I noted on the chart. This pattern often marks a significant turn.

Moving in somewhat closer, the next chart is a daily chart that has been squeezed to show price action since late 2005. I show a parallel up-channel for price action since the July 2006 low.

DOW chart, Daily, 2005-2007

Since I use EW for my analysis I also use to create my trend lines. One technique in an uptrend, when you already have waves 1 through 4, is to draw the uptrend line from wave-2 to wave-4 and then attach a parallel line to the top of wave-3 and that's what I did on the chart above. Most often you will see wave-5 go to the mid line of the channel (not drawn here) or to the top of the channel. You can see that price is pressing up to the top of the channel. You can also see the sharpness of the recent rally. Quite simply this is not healthy. It's very strong but it's not the kind of rally that holds up well.

I also show some Fib projections that could be important. The first is based on the size of wave-1 and shows a 162% projection at 13132. Many times the 3rd wave will go to 162% of wave-1 but if it doesn't then I've seen the 5th wave very often stop there. Friday's high for the DOW was 13148. The other projection of interest is the one based on the size of wave-1 and then projected for the 5th wave. A very common relationship between the 1st and 5th waves is equality and that's up at 13453. However, wave-5 has already met the other normal projection which is where wave-5 = 62% of wave-1 (which is at 12875).

The bottom line as I look at this chart is that price objectives have been met and it tells me to be alert to the fact that it's possible the rally is topping here and now. The daily chart below tells me we are very close but possibly not quite there yet.

DOW chart, Daily

The larger parallel up-channel on this chart is the same one drawn on the first DOW daily chart above. This daily chart zooms in on the move up from the March low (the spike up). In this case I've drawn a trend line from wave-1 to wave-3 (I'm assuming for the moment that Friday's high was the end of wave-3) and attached a parallel line to the bottom of wave-2. This line is often where the 4th wave correction will find support and that's what I depict with the dark red wave count. This calls for a pullback next week that could be a couple of days to a week or more. Ideally it will then be followed by another push higher as the 5th and final wave of this rally

The risk for bulls at this point is that it's possible that we're finishing up the rally right now and that the next move will be hard down. That's not my preferred wave count at the moment but as shown on the first DOW chart you should understand that we're now "there". It may get a little confusing but on the 60-min chart I zoom in even closer on just the leg up from the April 12th low, with yet again another parallel and steeper up-channel.

DOW chart, 60-min

When you see trend lines get steeper during a rally that's your clue that we've gone parabolic. Parabolic rises tend to fall hard and that's why I say it's risky to chase this higher now. But the 60-min chart should at least provide some early clues. The uptrend line from April 12th was in danger of breaking all day Friday but thanks to just a couple of stocks they managed to hold it up. Price is now pressed tight into the corner at the top of its up-channel from July 2006 and the bottom of its steepest up-channel. It's possible that price will break out to the top (light green) but with the negative divergences starting to show up I'm guessing we'll see at least a pullback get started next week. The DOW is not in trouble until the longer term uptrend line breaks, currently approaching 12800.

SPX chart, Daily

While the DOW shows a parallel up-channel for price action since its March low, SPX is showing more of an ascending wedge. It also is pressing against the top of its parallel up-channel from July 2006 and because of its shorter term wedge pattern it's possible to count the rally as complete at Thursday's high (it did not make a new high on Friday and could be considered bearish non-confirmation). But like the DOW, it's quite possible SPX also needs a 4th wave correction followed by a final push higher in a 5th wave.

SPX chart, 60-min

Within the ascending wedge on the daily chart there has been another smaller one inside that, and is shown on the 60-min chart. This one has the bearish divergences that go along with it. This looks very ready for at least a pullback. Assuming the pullback remains choppy and corrective (overlapping highs and lows), and can hold its lower uptrend line, then I would look for another rally leg to follow it. A break below 1474 would be a heads up that something more bearish may be starting.

OEX chart, Weekly

Since we have many OEX spread traders I thought it would be good to review the weekly chart to see where this could be headed. After a great setup for a top in this index in February (around the 670-675 Fib area), this one has shot higher as well. From being concerned about bull put spreads to now being concerned about bear call spreads it has been quite a turnaround. Having passed its 62% retracement of the 2000-2002 decline I'm now looking at Fib projections to help get an idea as to where to next. Two equal legs up from the March 2003 low (arguably the end of the bear market decline with a truncated low) is at 691.87. Using a parallel up-trend line as I showed on the DOW and SPX charts, the top of that channel is closer to 700. I think this is a very reasonable area for the OEX to find tough resistance. If your spreads are above 700 I think you'll be OK (famous last words).

Nasdaq-100 (NDX) chart, Daily

The NDX chart shows the same potential as the others--it could be topping right here, especially since it's up against the trend line along the January 2004 and January 2006 highs. Who knows, maybe it'll hit it again in January 2008. Overbought conditions can stay overbought for a very long time so the overbought oscillators here are only a warning and not a signal to get short. If we get a choppy pullback over the next week that holds support at its uptrend line from March 14th then I'd look for another press higher. A break below 1816 would suggest the bears are back in control.

Nasdaq-100 (NDX) chart, 60-min

Since 1816 is a long way down to help determine whether or not something more bearish may be starting, the 60-min chart shows some potential trend lines to watch. With the 40-week turn date coming up this week we could see a relatively short pullback and then a final push higher that tops out around 1920 or so. A break below each of the uptrend lines would have me watching for a move down to the next one. At this point I'm thinking you might want to test the long side at each of those support levels--the trend is clearly up so a short play at this point is still counter-trend, no matter how extended this move may seem. Just recognize the risk to long players at this point as the upside gain may not be worth the downside risk. Scalpers only.

I've shown the past couple of weeks the weak market breadth on the NYSE as it has made new highs. Whether its the lower volume or lack of new 52-week highs, the lack of participation in the NYSE rally has been bothersome. Since the techs have been coming alive recently I thought we'd look at the same thing there, using the Nasdaq.

Nasdaq (COMP) vs. Advancing-Declining Issues, Daily

For some reason QCharts won't show the a-d line when I have the 20-dma showing but it's the moving average that's more telling anyway. So the blue line on the bottom chart is the 20-dma of the a-d line and it clearly shows less participation as the COMP has rallied from its March low. Fewer stocks are pushing the average higher and that's not a healthy sign. This chart looks exactly the same for the NYSE.

Nasdaq (COMP) vs. Advancing Volume-Declining Volume, Daily

Same thing with the a-d volume--the blue line is the 20-dma and shows a tapering off of advancing volume as the COMP has pushed above the February high. And the downtrend line shows the lack of participation. This is not what new bull market legs are supposed to look like. But it is what the last hurrah typically looks like.

Russell-2000 (RUT) chart, Daily

After breaking its uptrend line from August, and with all the huffing and puffing this market has been doing, the small caps have still not been able to regain that uptrend line. In fact just the opposite. And with the uptrend line from March 14th it has clearly taken on the look of an ascending wedge. These are ending patterns and within the larger wave count this fits quite well.

I added two trend lines from past highs--the first is the one from March 2000 across the recent February high, and that's currently just above 840. The second one is from May 2006 across the February high and that's where price stalled on Thursday. The confluence of trend lines in this 830-840 area could mark the top for small caps. With the RUT in the red on Friday and the bluest of blue chips receiving all the attention, this is one of the factors that has me wondering if money is rotating into the big caps as a defensive move. As Jim often says, the RUT will probably be our canary so keep a close eye on this one.

Russell-2000 (RUT) chart, 60-min

A closer view of the ascending wedge shows the possibility for a continuation of the choppy move higher to the 840 area. But at this point it's just as easy to call the wave count as completed at Thursday's high. Once again the negative divergences are a heads up that this one is simply running out of steam.

Semiconductor Holder (SMH) chart, Daily

On Wednesday I showed the upside price targets for SMH once it broke out of its sideways triangle from the past 7 months. The short term pattern supports the idea that the little pullback we're getting right now will lead to a final push higher in which case I'm thinking it will be lucky to hit the 39 level. It might even be already done--it tagged its first upside target at the 37.48 Fib level, popped above its downtrend line from January 2004 and has now dropped back below the trend line. If it doesn't recover quickly it may be finished. Also on Wednesday I showed the weekly chart of this index and why I think this move up is finishing the entire correction from October 2002. The next move will be significantly lower.

BIX banking index, Daily chart

The banks are trying to hold up but clearly not doing as well as the broader market. If it can push a little higher then the Fib projection at 405.42 (for two equal legs up in its bounce) still beckons. But the March high seems to be acting as resistance right now. The brokers look like they could be finishing up here as well:

Broker/Dealer (XBD) index, Daily chart

Two equal legs up in its bounce off the March 14 low is at 253.03 and it's oh so close now. It has been pushing up underneath its broken uptrend line from June 2006 as if determined to ring that bell. When and if it does it should be a good short. The push up over the past week looks like an ending pattern (small ascending wedge).

The fact that the financials are not doing well, or at least not as well as the broader averages, is telling us something. The year-to-date rotations that we've seen in the various sectors tell us the market is getting more defensive. The poorer performance in the financials reflects concerns about higher inflation and higher interest rates. The inverted yield curve hurts lending vs. borrowing performance. There's been a move towards inflation sensitive stocks as well as defensive stocks.

As we head into the end of April it's noteworthy to see which sectors are doing better than others. While the S&P 500 is up about +2.4% the materials sector is up +12%, energy +7.5%, precious metals +3.3%, utilities +11%, healthcare +6%. Consumer staples are also up higher than the broader market.

John Murphy does a great job at identifying intermarket relationships and he has a chart that shows typical sector rotation as a market cycle evolves. One of the things that's important to note is that energy and consumer staples are typically the last to do well in a bull market cycle. So they tend to define the top of the market. Not surprisingly two of the weakest sectors have been financials (-2.8%) and homebuilders (-7.5%) as interest rate concerns and a slowing economy have hit them particularly hard (not to mention post-bubble price action in the homebuilders).

And speaking of the homebuilders:

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

The home construction index was able to do it--they got another bounce on some reports by the home builders and tagged the 200-dma. I thought on Thursday it might be able to tag its 38% retracement at 669.65 but it didn't make it. The short term pattern looks complete now and that should finish the a-b-c wave count from the March 13 low. It should be downhill from here. One heads up for this index continues to come from the price of lumber, which of course is greatly affected by the demand (or lack thereof) from the home construction market.

U.S. Home Construction Index vs. Lumber (July contract), Daily

I drew two vertical blue lines to show how the price of lumber gave us a heads up that the bounce in the homebuilders was probably just a bear market rally. The first one was the rally off the January low--the homebuilders rallied above the December high while the price of lumber broke below the December low. The homebuilders followed soon thereafter. And now we have the home builders rallying above the mid-March high and once again the price of lumber has dropped below the March low. Care to guess which way the homebuilders are headed next?

Part of the reason (or justification) for the rally on Thursday in the homebuilders was attributable to the report from Beazer Homes (BZH). This was clearly a case of seeing the glass with only a little water in it as one that at least had some water. BZH reported a loss for their 2nd quarter and said they were giving up on forecasting the rest of the year. They mentioned that orders came in above expectations and that's all traders needed to hear--the stock rallied almost 9% at its high and closed +5.1%.

BZH was forced to write off more than $54M in land charges (cancelling land purchases) and that's a strong indication that they don't see enough demand coming to justify purchasing the land now and sitting on it. Excluding that write-off they earned $11.2M vs. $104.4M in the year-earlier quarter. Quite a change. They continue to offer large financial incentives to move the inventory they currently have. I still like the comment from the CEO of one of the homebuilders who said essentially 2007 will "suck, all 12 months of it." You don't often hear such refreshing honesty.

The number of unfinished homes and total unsold homes for BZH declined from the 1st quarter so there were many analysts declaring a bottom for the homebuilders, hence the big rally on Thursday. That was followed by a good-sized red candle the following day. And speaking of inventory, a chart of vacant homes for sale is not encouraging, especially for those who are caught in this (my sister being one of them).

Vacant Housing for Sale, 1973-2007

This is a long term chart and what is significant is the huge jump in vacant homes for sale since the housing peak in 2005. Much of the housing boom was a result of speculators (flippers, landlords, investment property) and 2nd homes (vacation homes). These are your weakest holders. When times get tough these are the people who first put their homes back on the market and hope to get out at least even. This is happening in droves and is one of the reasons for the excess inventory currently on the market (not to mentioned the huge increase in the foreclosure rates around the country).

The large increase in the number of vacant homes reflects those who will be more willing to aggressively price their house to sell, and that in turn will further depress the value of the market in general. So while the homebuilders have reduced the number of homes they're building, they're still adding to an over-supply of homes on the market.

Oil chart, ETF (USO), Daily

I redrew the up-channel for oil (USO) since the top of it fits the price action well. Based on this channel it looks like oil is headed higher. But first it needs to break its downtrend at $52. If it turns back down and breaks below $50 then oil will likely head to new lows or at best consolidate for a while between here and the low $40s. But if it can break above $52 then upside potential is into the upper $50s.

Oil Index chart, Daily

Oil stocks have finished a potential upside wave count with what looks like an ending pattern (small ascending wedge) over the past week. Bearish divergences suggest topping action as well. The trend line along recent highs may have capped this off. I believe this is headed lower from here.

Transportation Index chart, TRAN, Daily

The Trannies did not follow the broader averages higher the past two days. On a short term basis this is bearish non-confirmation of the DOW's rally. The short term chart can be counted well as completing the rally from the March 14th low but there is still the possibility for it to push higher one more time to tag the top of its up-channel near 5300. Whether it's from here or slightly higher I believe the Trannies are topping if not topped on Wednesday.

U.S. Dollar chart, Daily

The currency that everyone loves to hate. The daily sentiment index is as bearish as it's ever been, and at levels that identified market bottoms in the past. It's just the opposite for the euro. The trend line along the lows and bullish divergences suggest the dollar is pounding in a bottom here. There is a Fib projection at 81.03 that could yet be tagged and if it is then we'd have a little throw-under to finish its descending wedge (seen better on the weekly chart or the "squeezed" daily chart that that I included in Wednesday's Wrap). The bullish divergences with this bullish descending wedge, and the very bearish sentiment, fully support a coming rally out of this, one that should take the dollar at least up towards $90.

Gold chart, StreetTrack Gold ETF (GLD), Daily

After breaking back below its downtrend line from May 2006 and its short term uptrend line from March 14th, gold got a bounce on Friday that took it back up to those trend lines. Now we'll find out on Monday if the pullback was just a correction and watch it press higher or if instead Friday's bounce is the kiss goodbye. Keep an eye on the US dollar for clues.

Results of today's economic reports and tomorrow's reports include the following:

This coming week will be busy with potentially market-moving economic reports. Monday's numbers are watched closely by the Fed since they're part of their "data dependent" formula for their inflation watch. Tuesday's ISM (Institute of Supply Management) and home sales, Wednesday's factory orders, Thursday's Productivity, and Friday's payroll numbers are probably the biggest ones. With what I see as potential topping action in the markets, for at least a pullback, my guess is that the market will be volatile around these reports if not bearish.

SPX chart, Weekly, More Immediately Bearish

Lastly, there's not much of a change to the weekly SPX chart that I showed on Wednesday--it's down about 60 cents from Wednesday's close. The upside Fib projection at 1510 is still a good level to look to (it's where the 2nd leg of the move up from July 2006 equals 62% of the 1st leg up). The pattern here counts well as an expanding triangle which is a version of a broadening top.

Everything looks to be coming together at this point for a top of major significance. We've got trend lines, wave counts, Fibs, cycle dates, bearish divergences, excessive bullish sentiment, defensive sector rotation, rotation out of small caps into large caps, and many other technical and sentiment indicators that suggest we should be looking for a top instead of a bullish outbreak from here.

The big caution is that if we're truly in a blow-off top, as it appears we are, they can develop a life of their own and technical indicators be damned--throw them out the window because they become worthless. Those who were calling a top in the techs in 1999 watched in amazement as it doubled from there. My best advice at this point is watch the moving averages and trend lines. The trend is strongly up right now and that's how you have to trade--they don't call it your friend for nothing.

But keep an eye on the exit door. When it gets bolted shut and someone yells fire you could be stuck looking for a way out. The decline from the February high was just a fire drill. If you can't watch the market during the day have protection plans in place. I mentioned this during the rally in February and said we'd get a fast break down when it happened and you could come home from work to find the DOW down 500-800 points. I'm thinking the next break down will be harder and faster than the February break.

The question of course is from what level that break will come. And will we get a small warning before the break, like the market did in 1987? The trouble is a small pullback looks bullish to many as they buy the dip once again and then it breaks down. We'll probably get the same thing again so I'd suggest watching the pullbacks and bounces from here--a pullback followed by a bounce that is then followed by another drop below that first pullback is your sell signal--get out fast before people lock the exit door. That way you can ride this for another DOW 1000 points if that's what's coming but always be ready to take your profits near the high.

Good luck with this market and let's see if we get just a pullback this week and then another push higher that could finish it off later in the week or perhaps the 2nd week. We're into the next window of opportunity for the bears' turn at the chow line. Now will the bulls be muscled aside is the question. I'll be back on Wednesday and on the Market Monitor on Monday. I'll do my best to try to figure out where the top might be (if it's not already in place).

New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays

New Calls

Play Editor's Note: The markets have been very bullish but they have become overbought and due for a correction. That doesn't mean they can't become more overbought before pulling back. Our concern is that the peak of earnings season has just passed and we're nearing the end of April. That means we'll start hearing more about the "sell in May and go away" theory. The trend is still up but we would be very careful about opening new positions at this time. We are adding new stocks to the newsletter but be extra careful about jumping in.


Armor Holdings - AH - cls: 70.81 chg: +1.30 stop: 68.99

Company Description:
Armor Holdings, Inc. is a diversified manufacturer of branded products for the military, law enforcement, and personnel safety markets. (source: company press release or website)

Why We Like It:
Defense stocks are a bright spot in the market. The DFI index rose to a new all-time high on Friday. Shares of AH have definitely enjoyed some strong gains this year. Friday's move in AH looks like a potential entry point with its bullish engulfing candlestick pattern. However, we would like to see AH breakout from its current two-week trading range. More aggressive traders may want to open positions now. We are suggesting a trigger to buy calls at $71.51. If triggered we will have two targets. Our conservative target is $74.75-75.00. Our aggressive target will be $77.50-80.00. The P&F chart is bullish and points to a $73 target.

Suggested Options:
We are suggesting the June calls. May calls expire in three weeks.

BUY CALL JUN 70.00 AH-FN open interest=1027 current ask $3.80
BUY CALL JUN 75.00 AH-FO open interest=2092 current ask $1.80

Picked on April xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/19/07 (confirmed)
Average Daily Volume = 482 thousand


Ctrip.com - CTRP - cls: 70.63 chg: +1.62 stop: 67.45

Company Description:
Ctrip.com International, Ltd. is a leading travel service provider of hotel accommodations, airline tickets and packaged-tours in China. Ctrip aggregates information on hotels and flights and enable customers to make informed and cost-effective hotel and flight bookings. Ctrip targets primarily business and leisure travelers in China who do not travel in group. (source: company press release or website)

Why We Like It:
CTRP is breaking out higher from a three-week consolidation near the $70.00 level. Volume has picked up on the breakout, which is bullish. Unfortunately, the cause behind Friday's late morning spike higher is a mystery. We can't find anything to account for the sudden rise but suspect it was a positive report from a competitor. We are suggesting call positions with CTRP above $70.00. Our short-term target is the stock's highs in the $74.50-75.00 range. The Point & Figure chart forecasts a $93 target. We do not want to hold over the May 16th earnings report.

Suggested Options:
We are suggesting the June calls.

BUY CALL JUN 70.00 QCT-FN open interest= 476 current ask $4.80
BUY CALL JUN 75.00 QCT-FO open interest= 533 current ask $2.55

Picked on April 29 at $ 70.63
Change since picked: + 0.00
Earnings Date 05/16/07 (confirmed)
Average Daily Volume = 389 thousand


General Dynamics - GD - cls: 80.27 chg: +1.17 stop: 76.45

Company Description:
General Dynamics, headquartered in Falls Church, Va., employs approximately 82,600 people worldwide and had 2006 revenues of $24.1 billion. (source: company press release or website)

Why We Like It:
We want to take advantage of the strength in defense stocks so we're adding GD as a call candidate. The stock broke out above significant resistance back on April 20th. Shares have since consolidated sideways but look poised to move higher. We are suggesting call positions in the $78.50-81.00 range. More conservative traders may seriously consider waiting for a breakout over resistance at $81.00 (or 81.25) before initiating positions. Our target is the 84.75-85.00 range. More aggressive traders may want to aim higher. The P&F chart has produced a triple-top breakout buy signal with a $96 target.

Suggested Options:
We are suggesting the June calls.

BUY CALL JUN 80.00 GD-FP open interest= 80 current ask $2.65
BUY CALL JUN 85.00 GD-FQ open interest=618 current ask $0.70

Picked on April 29 at $ 80.27
Change since picked: + 0.00
Earnings Date 04/25/07 (confirmed)
Average Daily Volume = 1.4 million

New Puts

AvalonBay - AVB - cls: 125.95 chg: -3.04 stop: 130.05

Company Description:
AvalonBay, an S&P 500 company, is in the business of developing, redeveloping, acquiring, and managing apartment communities in high barrier- to-entry markets of the United States. As of December 31, 2006, the company owned or held an ownership interest in 167 apartment communities containing 48,294 apartment homes in ten states and the District of Columbia, of which 17 communities are under construction and six communities are under reconstruction. (source: company press release or website)

Why We Like It:
The multi-year bull-run in AVB has hit a serious speed bump. Shares broke their up trend back in early March and have bounced around sideways since. Now investors are selling the stock following the company's latest earnings report. Odds are good AVB could see a lot more profit taking (just look at the weekly chart). We are suggesting a trigger to buy puts at $124.45, which would be a new relative low and a breakdown from the recent trading range. There is potential support at $120 but our target is the $112.50-110.00 range. The P&F chart points to a $110 target.

Suggested Options:
We are suggesting the June or July puts with a trigger to open plays at $124.45. We don't see any June puts under $125.

BUY PUT JUN 130 AVB-RF open interest= 0 current ask $6.30
BUY PUT JUN 125 AVB-RE open interest= 0 current ask $3.70

BUY PUT JUL 125 AVB-SE open interest= 91 current ask $5.20
BUY PUT JUL 120 AVB-SD open interest=207 current ask $3.30
BUY PUT JUL 115 AVB-SC open interest= 3 current ask $2.05

Picked on April xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 04/26/07 (confirmed)
Average Daily Volume = 770 thousand


British Airways - BAB - cls: 101.42 chg: -0.43 stop: 104.26

Company Description:
British Airways is the UK's largest international scheduled airline, flying to over 550 destinations at convenient times, to the best located airports. (source: company press release or website)

Why We Like It:
Normally we would never play BAB because the average daily volume is just too low. However, crude oil looks poised to breakout higher and that's going to impact the airlines. BAB is still a high-dollar stock and could see some significant declines. We're suggesting puts on BAB now with shares under the 50-dma (near $102.30). More conservative traders may want to wait for a decline under $100. Our target is the March lows near $95.00. We'll use a $96.00-95.00 target range. More aggressive traders may want to aim for the rising 200-dma near $92. We do not want to hold over the mid-May earnings report.

Suggested Options:
We are suggesting the June puts.

BUY PUT JUN 105 BAB-RA open interest= 8 current ask $7.30
BUY PUT JUN 100 BAB-RT open interest=22 current ask $5.20
BUY PUT JUN 95 BAB-RS open interest=43 current ask $3.20

Picked on April 29 at $101.42
Change since picked: + 0.00
Earnings Date 05/18/07 (unconfirmed)
Average Daily Volume = 65 thousand


Ceradyne - CRDN - cls: 59.08 chg: -3.65 stop: 62.51

Company Description:
Ceradyne develops, manufactures and markets advanced technical ceramic products and components for defense, industrial, automotive/diesel and commercial applications. (source: company press release or website)

Why We Like It:
This is purely a technical play. The company reported earnings on Friday morning and the news was positive. Fundamentally things sound pretty good for CRDN. Yet the charts are screaming that this is the place to buy puts. Shares produced a failed-rally bearish reversal at resistance on Friday morning. We're suggesting puts now with CRDN under $60.00. Our short-term target is the $55.25-55.00 range. Watch out for potential support at the rising 50 or 100-dma.

Suggested Options:
We are suggesting the June puts.

BUY PUT JUN 60.00 AUE-RL open interest= 414 current ask $3.10
BUY PUT JUN 55.00 AUE-RK open interest=2630 current ask $1.25

Picked on April 29 at $ 59.08
Change since picked: + 0.00
Earnings Date 04/27/07 (confirmed)
Average Daily Volume = 667 thousand

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Advance Auto Parts - AAP - cls: 41.67 chg: -0.10 stop: 39.90

The markets were relatively flat on Friday and shares of AAP spent the session trading sideways. There was an intraday dip that was almost low enough to "fill the gap" from Wednesday morning. It looks close enough to us and we would expect AAP to bounce higher from here as long as the major averages don't see any serious losses on Monday. We are concerned that the market is short-term overbought so we're not suggesting new call positions on AAP at this time. We are adjusting our target to the $43.90-45.00 range. We do not want to hold over the mid-May earnings report. FYI: The P&F chart points to a $48 target.

Suggested Options:
We are not suggesting new plays on AAP at this time.

Picked on April 11 at $ 40.05
Change since picked: + 1.62
Earnings Date 05/17/07 (unconfirmed)
Average Daily Volume = 854 thousand


Abercrombie - ANF - cls: 83.39 chg: -0.97 stop: 79.85

The trend in ANF is still bullish and shares are trading near all-time highs. However, we have to comment on the short-term technical indicators, which suggest that momentum is stalling. ANF may be due for a correction. Thus far traders have been buying dips at the rising 10-dma, which is bullish. Technically we should be able to buy a bounce from here or on a dip (or bounce) near the 10-dma around $82.50. Yet our enthusiasm to buy new call positions is cooling with the major market indices looking overbought. Our target is the $89.00-90.00 range. We do not want to hold over the late May earnings. FYI: The Point & Figure chart suggests a $109 price target.

Suggested Options:
We are cautiously optimistic with a big emphasis on cautious. We like the June calls. May calls only have three weeks left.

BUY CALL JUN 80.00 ANF-FP open interest=111 current ask $6.10
BUY CALL JUN 85.00 ANF-FQ open interest=330 current ask $3.20

Picked on April 22 at $ 83.51
Change since picked: - 0.12
Earnings Date 05/23/07 (unconfirmed)
Average Daily Volume = 1.9 million


Holly Corp. - HOC - cls: 64.15 chg: -0.15 stop: 59.49

Supply concerns, raised by the capture of terrorists planning to hit Saudi oil fields, sent crude oil higher on Friday. Yet the OIX Oil index and shares of HOC failed to post any gains on the strength in crude. The trend in HOC remains bullish and bulls did buy the dip intraday on Friday. This looks like another entry point to buy calls but if you are opening new positions now consider using a much tighter stop loss. Our target is the $67.50-70.00 range. The P&F chart is bullish with a $74 target. We do not want to hold over the May 8th earnings report.

Suggested Options:
If you are interested in new positions now we are suggesting the June calls.

BUY CALL JUN 60.00 HOC-FL open interest=2335 current ask $5.80
BUY CALL JUN 65.00 HOC-FM open interest=1081 current ask $2.70

Picked on April 22 at $ 62.30
Change since picked: + 1.85
Earnings Date 05/08/07 (confirmed)
Average Daily Volume = 669 thousand


Wynn Resorts - WYNN - cls: 104.52 chg: -1.41 stop: 99.95

WYNN suffered some profit taking on Friday. The trend remains bullish and shares have pulled back toward short-term support at its rising 10-dma. A bounce from here could be used as a new entry point but if you did launch new plays we'd use a tighter stop loss and target near $110 or higher. Unfortunately we're running out of time so we are not suggesting new positions. WYNN is due to report earnings on or near May 5th. We plan to exit ahead of the early May earnings report. Our target is the $108.00-110.00 range. More conservative traders may want to exit early near the late February highs around $106.60. FYI: WYNN's P&F chart points to a $120 target.

Suggested Options:
We're running low on time with WYNN so we're not suggesting new positions at this time.

Picked on April 15 at $102.44
Change since picked: + 2.08
Earnings Date 05/05/07 (unconfirmed)
Average Daily Volume = 1.4 million

Put Updates

Lockheed Martin - LMT - cls: 96.19 chg: +3.19 stop: 97.51

Warning - reversal alert on LMT. The company received some positive comments and a credit upgrade from Standard & Poor's on Friday. S&P raised their credit rating from BBB+ to A-. Shares of LMT reacted sharply and rose 3.4% on big volume to breakout back above $95.00 and its 10-dma. This looks like a big bullish reversal and more conservative traders may want to exit early immediately. We still see potential resistance near $97.50 and its 50-dma near $97.84. More aggressive traders may want to place there stop above the 50-dma. We are not suggesting new positions at this time.

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

Picked on April 24 at $ 94.82
Change since picked: + 1.37
Earnings Date 04/25/07 (confirmed)
Average Daily Volume = 1.7 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.)


Lockheed Martin - LMT - cls: 96.69 change: +3.19 stop: n/a

This is a strangle play so we don't care what direction LMT as long as it moves enough to make one side of the strangle profitable. Friday's big reversal in LMT was a surprise and shares are now facing resistance in the $97.50-98.00 range. We're not suggesting new strangle plays at this time. The suggested options we had listed were the May $100 calls (LMT-ET) and the May $90 puts (LMT-QR). Our estimated cost was $1.50. We want to sell if either option rises to $2.25 or more.

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

Picked on April 22 at $ 95.40
Change since picked: + 1.29
Earnings Date 04/24/07 (confirmed)
Average Daily Volume = 1.7 million

Dropped Calls

FedEx - FDX - cls: 107.22 change: -1.05 stop: 106.85

We are giving up on FDX as a potential call play for now. The Dow Jones Transportation average is looking vulnerable after hitting new highs on Wednesday. Rising crude oil definitely impacts the sector. Shares of FDX are languishing under resistance and look poised to dip toward $105. It was our plan to buy calls on a breakout over $110 with a trigger at $110.55.

Picked on April xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 06/20/07 (unconfirmed)
Average Daily Volume = 1.8 million

Dropped Puts


Dropped Strangles


Trader's Corner

Ballistic Bullish Vertical Count

Point and figure charts are those funny looking charts with columns of X and O. Charts that Charles Dow used to monitor his extensive portfolio of holdings well before the computer age allowed for other methods of charting price action of securities you and I might trade.

As old as the point and figure methodology is, it is a charting system that simply measures supply (O) and demand (X), where the relationship between the two is reflected in price.

Point and figure charts are about as SIMPLE to read, or understand as any other chart (bar, Japanese Candle, line, etc.), but unlike the bar chart, the Japanese candle, or line chart, the point and figure chart construction pays little attention to measuring security price action as it would relate to a charting system that measures price action one day, then creates a different line, or bar, to measure the next day's price action.

The point and figure chart simply measures price action in a continuous motion.

The only belief a trader or investor must have when reading a point and figure chart is the belief that if demand is greater than supply, then PRICE will rise. The other belief one must hold is that if supply is greater than demand then PRICE will fall.

The following article regarding BULLISH vertical counts may be putting the cart before the horse for those that may not have a complete grasp of just how a point and figure chart is constructed, but just the mentioning of bullish vertical count generates questions on just how a "BVC" is generated, what its implications can be, and how it may help a trader/investor begin to assess not only reward, but risk!

Yes ... RISK!

Only when a trader/investor assesses BOTH risk and reward, can a more educated decision regarding purchase and sale of a security be established.

If somebody asked you to invest $500 in anything (a new business, a stock, a gizmo) and told you that you could potentially make 20% on your money, what might you then ask? I hope you'd ask, "How much could I lose?"

If he/she replied "50% to 100% of your money," you might reassess the investment.

Again, you don't need to be an expert, or have a full grasp of how a point and figure chart is constructed to grasp the concepts of the bullish vertical count.

You don't need to be a ballistics (the science or study of the motion of projectiles, as bullets, shells, or bombs; the art or science of designing projectiles for maximum flight performance.) expert either, though the bullish vertical count incorporates many of the principals of this art.

Now we're going to look at some "real life" examples of securities, identify the bullish vertical count column, see how the vertical count is established and then assess the RISK and the potential longer-term reward of the particular security.

Hold on traders! Don't let "longer-term" have you rolling your eyes and have you thinking the bullish vertical count is only an investment tool.

How the bullish vertical count is calculated.

1) Identify the FIRST reversing higher point and figure buy signal where a column of X exceeds a prior column of X.

2) Once the column of X is identified, multiply the number of X in that column by 3, then multiply that by the scale/box size of the point and figure chart, then add the total to the BASE of the X column.

Here is a point and figure chart of Cummins, Inc. (NYSE:CMI) which achieved its bullish vertical count of $106 on Friday. A textbook example at this point of identifying the bullish vertical count column, seeing how it was constructed, calculated, and then over time, monitoring risk reward as bullishness continued to develop, and most likely, traders and investors accumulated positions.

Cummins Inc, (CMI) - $1 box; $2 box

In the above chart, I'm covering several items, so it is a bit "busy" with text.

Let's first identify the bullish vertical count (BVC) column.

See the "1" on the chart? That's the first entry in January, where CMI generated what ends up being the last sell signal the stock had generated. Remember, the bullish vertical count column is identified when a security first gives a reversing higher point and figure buy signal (when a column of X exceeds a prior column of X).

On 1/29/07, CMI's trade at $63 is the first reversing higher point and figure buy signal, and this would be a point that signals demand is once again starting to outstrip supply.

Remember now, the point and figure chart is measuring continual motion, and over time, demand (X) continues to build and price eventually rises to $73 on 2/14/07. Eventually (pink box at $70) shares of CMI edge back and a 3-box reversal takes place. On a $1 box chart (see box scale to right) the point and figure charting system measures "meaningful" reversals when a 3-box reversal of PRICE is witnessed.

Once a 3-box reversal lower is witnessed, the bullish vertical count column is established. It is at this point that a trader/investor can begin to assess longer-term potential REWARD!

In the upper left corner of the chart, I walk you through the mathematical equation of how the bullish vertical count is tabulated.

In many of the plays you read in your newsletter each night, you will see mention of "bullish vertical counts." Now you can envision what is being described, know where the stock is trading relative to a longer-term potential target of reward.

Now let's cover how a trader/investor can begin to assess RISK and over time, while measuring against the longer-term bullish vertical count, constantly measure a stock's RISK/REWARD.

For the purposes of this article, I'm going to be defining RISK as how much dollar decline to a "sell signal" (where O would fall below a prior column of O) can be measured.

See the "brown box" on 3/19/07 at $71.00? That was a double top buy signal. For you more experienced point and figure chartists, you'll also recognize that as a bullish triangle pattern.

On 3/19/07 a trader/investor may have been assessing longer-term reward to $106, but what was the RISK to a sell signal? At $71, the RISK to a sell signal (red box with "R") would have been to $66.

Immediately a trader/investor could have assess RISK as being equivalent to $5, with REWARD being assessed as $106 - $71 = $35.

I don't know about you, but risking $5 to potentially make $35 is pretty good!

Option traders may well use that type of RISK/REWARD analysis to buy one (1) option contract that costs $5.00 or less, then begin to tabulate what that option might be worth should the stock ever trade $106 over time.

As we follow the chart of CMI, we see price continue to rise to $75, then a 3-box reversal back down to $72, then in April (after blue 4) CMI's point and figure chart gives another double top buy signal at on 4/20/07 at $76.

Once again a trader/investor can assess RISK/REWARD. Once you have the bullish vertical count, that's the potential REWARD you are constantly measuring against.

Institutions build positions over time, and traders/investors should take note, but understand how to constantly be measure risk/reward in the trade.

On 4/20/07 we could once again measure RISK = $5 with REWARD being equivalent to $106 - $76 = $30.

Risking $5 to potentially make $30 is still pretty darned good in my book. That's a risk/reward ratio of 1:6.

Boom! Now CMI is really on the move and price ramps to $91 by 4/24/07.

Then pulls back to $84 before seeing a 3-box reversal back higher to $87 by 4/26/07.

If a trader/investor had purchased addition shares on the 3-box reversal higher at $87, their RISK could have been identified as $4, with REWARD of $106 - $87 = $19.

There we would have assessed risk as $4 and potential reward as $19.

See what's happening here? As a stock nears its bullish vertical count, the point and figure charting methodology, even on 3-box reversal higher, has risk/reward starting to diminish a bit.

Still pretty good risk/reward though at roughly 2:9.

Then boom! Earnings come in much "stronger-than-expected" and stock surges as high as $107.23 on Friday, before closing back at $96.14, where I've placed blue "?."

See the brown box at $93? That's where CMI opened for trade on Friday, before it jumped to $107.23, or $106 and its bullish vertical count.

Now, at $93, RISK/REWARD for a new long/bullish entry would have been terrible, if measuring potential longer-term reward to $106.

While bullish vertical counts may NEVER be reached, we've seen many stocks EXCEED their bullish vertical counts, and not by just a dollar or two. There are some stocks that are more than DOUBLE the price of the previously established bullish vertical counts.

Hopefully, you can begin to appreciate how the bullish vertical count can be helpful in assessing longer-term reward for a bull, and equally important to a bear that may be considering shorting a stock that has bullish vertical count, regardless of just how "unreasonable" that bullish vertical count appears to be.

A diesel engine manufacturer signaling, "I'm going to $106, even though I'm trading in the $70s!"

Whenever a stock achieves a bullish vertical count, I strongly suggest traders/investors long the stock take profits.

I mentioned that the bullish vertical count is partially derived by the science/art of ballistics. When you look at the chart of CMI, and its bullish vertical count column, a trader/investor should see the length of a gun barrel.

Think about it. If you've ever seen a target shooter's rifle, the barrel of the gun is usually rather long. Depending on the distance the target shooter's target is (100 yards, or 1,000 yards) the amount of powder that explodes and moves the projectile is also important.

Look at some of those "X" columns on the CMI chart, with the bullish vertical count column being a focus. It takes some "explosion" to get a stock's price rising from $58 to $73 in one continual push higher without so much as a 3-box reversal having taken place in-between.

Do you believe that there weren't some trader/investors that "knew" CMI's earnings were going to be bullish enough to get the stock to $106 by Friday's earnings? Maybe, just maybe, the bulk of market participants following the stock knew it earlier this year?

One of the toughest things about being a chartist, is grasping the concept, or the belief, that the market is all knowing, and that it looks ahead, and knows what the future holds.

Often-times, our "beliefs" overrule what we actually see happening, and for a multitude of reasons, we can't surmise just what is driving a stock's price action, up or down.

Here's another stock to practice on. I'm not disclosing its name right now, but let's practice identifying the bullish vertical count column, and I want to show you how to calculate a bullish vertical count when a stock's box size/scale has the bullish vertical count being built between a $1 and $2 box size.

Mystery Stock - $1 and $2 box size

Here's a stock that many of us have heard of. In early April (blue 4) the stock generated a reversing lower double bottom sell signal at $94, and fell to $93.

Then reversed back up to $100.

A point and figure chartist would see that column of X from $94 to $100 being observed as a "low pole warning." This is a pattern that sometimes indicates a stock is "sold out" as it reverses more than 1/2 of a rather long column of "O."

You can see the stock begins working sideways as supply and demand come to some type equilibrium.

Then on 4/24/07 the stock gives a triple top buy signal at $102 and a trader/investor would begin calculating the bullish vertical count.

One thing that is different here, than with CMI's chart, is that the bullish vertical count column is being constructed when the box size/scale (right of chart) is now measured in not just $1 increments, but also in $2 increments.

You see, the point and figure charting system wants to measure prices as it would related to a more "meaningful" amount of price action.

When stocks get above $100, a $1 move in the stock price isn't as meaningful as a $1 move in a $30 stock. So, for stock's priced above $100 to as high as $200, the point and figure charting systems changes to $2 increments.

When we calculate a bullish vertical count that spans this type of transition, we need to calculate the bullish vertical count in two different formulas.

Actually, the ONLY difference is that the "multiply by scale" number is changed.

The Mystery Stock's bullish vertical count has us counting the X's from $98 to $100, for the $1-box. Then we count the X's from $102 to $110 for the $2-box scale.

See? We're still counting X's, and then multiplying by 3, but for the scale change, we need to separate things a bit. Once we get our sums 9 for the $1-box and 30 for the $2-box by the end of 4/26/07 trade (remember that the bullish vertical count is still being constructed) we can then continually add that to the base of the X column, which is $98.

Traders are you ready!

The Mystery Stock has generated a triple top buy signal, it is now above trend (bearish resistance trend), where usually, the first time a stock trades such trend is "painful for a bull."

Baidu.com (BIDU) - $1 and $2 box


In Thursday's extended session, BIDU did trade as high as $143 and in the OptionInvestor.com Market Monitor I suggested that traders long take profits if their initial target was $137.

Regular session trade, when all market participants are able to cast their votes, did see shares of BIDU trading as high as $132.80 before finishing out at $124.57 +13.89%.

What's a bullish trader's current RISK/REWARD assessment for a new long entry should the stock open at $126.00 Monday morning?

I come up with RISK to a sell signal, which would currently be viewed as $96 as being equivalent to $126 - $96 = $30 of risk.

Reward, using the still building bullish vertical count to $203 would be $203 - $126 = $77.

That's roughly better than 1 risk for 2 potential reward.

Dorsey/Wright and Associates posts the tabulation for us at 2.75 reward for every dollar of risk.

If you're interested in viewing some FREE point and figure charts, a great website is www.stockcharts.com

Here's there point and figure chart of Baidu.com and they too post the bullish vertical count.

Now you know what the bullish vertical count is. You know how to identify where it began. You also have learned one technique of how to assess RISK/REWARD in a security, based on what the longer-term bullish price objective is.

A bullish vertical count is "good" as long as the stock does not give a reversing lower point and figure sell signal. That means, as long as the stock doesn't give a "sell signal," a trader/investor can continually assess a longer-term price objective, which the market may have in mind for a stock, to its bullish vertical count.

Yes! There is also a BEARISH vertical count, which will be addressed in another Trader's Corner.

A great book I'd suggest ANY trader/investor read, is Point and Figure Charting, by Thomas J. Dorsey.

I don't recommend the book just to learn how point and figure charts are constructed, but to really drive home the "point" of how important it is to understand the simple laws of supply and demand, and the impact on price.

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


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