Option Investor

Daily Newsletter, Wednesday, 05/02/2007

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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

Another Day Another Dollar

I can just hear the bulls saying that as they wrap up another day with yet again new DOW highs, both intraday and closing. It's becoming old hat now and there's not much fanfare about it anymore. We've already captured the flag at 13K and we're not close enough to 14K to think we'll see that by next week (or will we?). So now it's just notching it higher each day and taking home another dollar in your long account. Certainly the bulls seem very relaxed about this process right now and there's no reason for them not to feel that way. At least that's what most are thinking. I can't tell you how many retired people I've been talking to lately that intend to stay fully invested this year so as to have a bigger nest egg on which to retire.

Anyone who understands trend lines can see the bullishness on the charts. And bullishness is clearly in the air. While there is a mixed picture in some of the shorter term charts, all big moves start with small moves and that's why we study the small details. We're looking for the warning flags. But the longer term up trends are clearly intact and there are very few who are worried about this market's ability to just keep chugging higher.

After speaking to some family members recently, I am very clearly the black sheep of the family when I suggest it might be wise to consider moving the bulk of their money into cash. Of course I'm getting used to the little pats on the head since I have been the black sheep ever since I said housing was topping back in July 2005. The pattern in the home builders could not have been clearer and I was calling a top in them at that high. Now I've got a sister sitting on a vacant home for over a year (in the NY metro area) who is convinced she'll get a better offer than the low ball offer she received a couple of months ago. Multiply her by hundreds of thousands and I know what's coming, or at least I think I have a pretty good idea.

I had mentioned in the weekend Wrap that our job as traders is to look for what's wrong. I recently read another analyst/trader (whose name currently escapes me) who described himself as a professional worrier. I thought that's actually a very good way of looking at it. The day we become complacent about our trade is the day the market will take a 2x4 to the side of the head and catch our attention (usually involving lost money). When you think about it, most of the technical indicators we use for our analytical work are counter-trend. Candlesticks? Most of what we look for are reversal patterns. Oscillators? We look for overbought/oversold and negative divergences. Trend lines? We look for breaks of them. Same for moving averages such as the moving average cross-over.

So when I say I'm looking for warning flags this is what I'm talking about. I look for confirmation of the rally we're in but what I'm really looking for are bearish divergences (and just the opposite in declines) or holding/breaking of support. The lack of volume during a rally, or the lack of new 52-week highs or a-d with new price highs, and of course loss of momentum on the oscillators are all examples of some of the things we look for every day we're trading. We are in fact professional worriers. And here I'm constantly telling my wife to stop worrying. The next time someone tells you not to worry, be happy just remind them that you are happy because you do worry.

And I'm worried. I'm worried that we've gone too far too fast. I'm worried about the abundance of signals that tell me this market could be topping and topping soon. I'm worried that not enough people are worried. But topping "soon" is a relative term and it could be at today's high or it could be another couple hundred DOW points later this month. The bottom line is I think this continues to be a market that is vulnerable to a fast reversal from the exuberant climb off the March low and I'll show why in the charts.

But I can be worried and still enjoy the ride. I might be worried while on a huge ferris wheel (I hate heights) but enjoy the view at the same time. I can participate in the bull run as long as I don't get complacent about my positions and assume the ride will continue higher. Sooner or later the ride stops and so we're trying to figure out where that point will be. The easiest way right now is to keep an eye on the uptrend lines or moving averages, whichever is your preference and use those as your guide as to where to follow this up with your stops.

As part of my effort to figure out where this market is headed, both in time and price, I use as many tools as I can get my hands on (and understand). Cycle studies help with the time factor, as do Fibonacci time projections. There is very often symmetry in the market and you'll find the market moves in equal increments of time. I showed this DOW chart over the weekend that shows the 40-week cycle:

DOW chart, Weekly, 40-week cycles

The right-most vertical line on the chart (this week) shows the next turn date. As I had mentioned before, the fact that this is a low-to-low-to-high pattern it sets it up as a potentially stronger turn date. Since we're rallying into the turn it should mean a reversal. I say should because these turn dates are sometimes (rarely) acceleration dates. In this case the blow-off top that we appear to be in could actually get out of hand and accelerate higher. You don't want to get in the way of that kind of move (don't be a stubborn bear) but you sure do want to be careful if you're long. The longer this goes now, the harder will be the fall. It would appear at this time that we've got the needle heading up that will prick this bubble.

A couple of other comments on this chart--the negative divergence shown on the weekly MACD is an early call (MACD could continue higher if the rally keeps going) but it is a warning flag (for us worriers). The decline in volume since the highs in early 2006, as shown by the 10-week moving average of volume, is another warning flag. Lastly, the October 2002 low is just off the left side of the chart but when I measure the move from that low to the January 2004 high and then project the same move up from the August 2004 low it gives us 13257.80 for equality. Equal moves like this are often reversal points. Today's high in the DOW was 13256.33. Was it THE high? Who knows but entering the turn week in the 40-week cycle and hitting equality in that move does make you want to go hmm...


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Here are another couple of timing considerations. For those of you who have read any of Jeff Cooper's work, he uses a lot of cycle studies, Gann charts and a host of other technical trading tools. I find his analytical work to be very unbiased and helpful. He has often commented on the power of number 7 in the market. Things often happen around this number. The February 2007 high was the 7th month from the July low. This week is the 7th week since the March 14th low.

As Cooper reminded his readers though, the 7th week in this case could mark an acceleration point instead of a reversal. That would put us on a climax run similar to what happened in 1987. But unlike 1987 we did not get the same amount of consolidation before the run higher and therefore he believes this week could mark a turning point rather than an acceleration point. And this 7th week falls on the same 40-week cycle schedule. So heads up.

There's another analytical tool which relies on similar patterns playing out (based on we human beings reacting subconsciously (in a herd mentality kind of way). EW patterns are essentially fractal patterns playing out in different time frames. When comparing current patterns people very often look for happened in the past to see if a similar pattern plays out. The brief discussion of what happened in 1987 is an example. When the market is following a past pattern it is called an analog of it.

An example of an analog is how the crash of the Nikkei index followed the pattern of our stock market crash in 1929, including the recovery and further crashes after that. The collapse of the Nasdaq followed the same pattern as the crash of 1929:

DOW (1927-1932) vs. NASDAQ (1996-2002)chart

It's really remarkable how similar the patterns are and it's a good example of an analog. Most analogs break at a certain time so you always need to be ready for it. This particular analog broke after 1932 when the DOW rallied back up whereas the Nasdaq has languished nearer its lows ever since the 2002 low.

But along comes the small caps which seem to have taken the handoff of the baton by the techs. Since the 2002 low the small caps have strongly rallied and just like the DOW could be setting up a similar fate after the correction from the first crash:

DOW (1932-1938) vs. RUT (2002-present)chart

The red line is the DOW and so far the analog is working when comparing how the RUT is rallying. We don't know if it will continue to follow the DOW's pattern but once again this is a heads up. And this is happening as we have come to a potential turn week.

Bill Fleckenstein recently pointed out some other numbers that are fun to think about and make you want to go hmm... While he professes to not believe in the kinds of analogs I pointed out above, I'll quote him directly:

"Thus, I did a little checking and I found an amazing similarity between the last month and a half or so of the rise in Japan that ended on December 29, 1989 and the current advance in the Dow. Specifically, the last 32 out of 38 trading days in Tokyo were on the upside, with an initial run with a higher close on 19 out of 21 days, followed by 7 out of 11, followed by 6 for 6, before about a 40% drop in the course of nine months took place. Recently, from the lows of March 5, the Dow closed higher in 4 out of 6 sessions, followed by 7 out of 11, followed by 20 out of 22 -- for a grand total of 31 out of 39 days.

"Now, I am not a believer in analogs, but if the mindset in Tokyo back in those days was similar to the mindset that we're witnessing here today (which, by my reckoning, it is), I guess it's not impossible for that similarity to have some predictive power. I'm not putting up any money on the back of this idea just yet, but I thought it was so interesting that I wanted to have it on my radar screen, and I assumed others would, as well. While the bulls have been tickled silly over this incredible rip to the upside, history suggests that prior periods like this have in fact ended quite badly."

It's just another piece of our worry puzzle or to just stick away in your veritable treasure of trivia

Before getting to rest of the charts, we had three economic reports to cover.

Economic reports
It was a light day for economic reports had minimal impact on prices today (the market had an agenda). The two "official" reports were factory orders and crude inventories but we also got a preview of the jobs numbers by ADP's numbers released today.

Factory Orders
Orders for factory goods rose +3.1% in March which is the largest gain in a year and stronger than the expected +2.2%. Many analysts are pointing to the one-month gain as an indication that the months'-long slump is over. I say one month does not a trend make. We'll have to see how the following months do. A large part of the gain was due to a strong +38% increase in orders for civilian aircraft and an 11% increase in petroleum products. But a good sign was the +4.8% increase in core capital equipment which is the fastest pace in almost 3 years. The subcomponents were equally as strong--orders were up +3.7%, shipments +1.5% (highest in 10 months) and unfilled orders +1.8% (fastest pace this year). All in all it was a very good report.

Crude Inventories
Crude supplies were up by 1.1M barrels to 335.6M for the past week. Gasoline supplies dropped for the 12th week in a row, down 1.1M barrels to 193.1M. Distillate stocks were down 200K to 117.1M. All oil product prices dropped today.

ADP Employment
Private sector jobs increased by 64K in April which makes for the weakest job growth in nearly 4 years. This kind of news would normally have depressed the market because of the potential for a slowing economy. But I suppose in the market's never-ending quest for information that might show the Fed could reduce rates sooner rather than later, this was good news. Adding in +24K in government jobs the ADP payrolls number suggests we'll see Friday's nonfarm payrolls number come out around the 90K area. Right now expectations are for +115K. Any number around 100K would probably not affect the market.

In a continuing shift towards a service economy (with lower paying jobs), service-sector jobs were +106K while goods-producing businesses lost -42K including -20K in manufacturing. This is the largest drop in goods-producing jobs since November 2001. The impact of this trend cannot be underestimated--the consumer, as the engine behind GDP, will suffer has the average discretionary income continues to ratchet lower between higher inflation and lower paying jobs. The "all-knowing" market doesn't seem to know this.

The ADP report also shows a drop of 45K construction jobs (vs. the government's +29K). ADP feels the government's numbers will be revised lower. One of the impacts from a slower housing industry will be a loss of construction jobs so I tend to believe ADP over the BLS numbers.

Challenger Gray & Christmas reported corporate layoff announcements spiked 44% higher in April, thanks in large part to Citigroup's announcement to lay off 17K

After the above discussion about looking for evidence of topping (as part of my worrying efforts), I'll add that I like picking tops because I can control my risk better for short entries (just the opposite when picking bottoms) and that's what I do. So much of my analysis, as most of you know by now, is to identify where I think a top will be and then enter a short play if the setup looks good. I'll use EW (Elliott Wave), trend lines, Fibonacci and resistance levels to help identify where I want to enter a trade and then look for bearish divergences for confirmation as we get close in order to help build confidence that the rally really is running out of steam. No divergences and I tend not to take the trade. So the levels I provide on my charts are suggested places to look and then the shorter term charts will help you pinpoint your entries.

So with that let's take a look at today's charts.

DOW chart, Daily

While recognizing the vulnerability of this market as having gone too far too fast, which means it could top out at any time (especially considering the timing window of this week as discussed above), the EW pattern would look best as per the green wave count. This calls for a 4th wave pullback that could take a week or more and could drop back down towards 13K. That would then be followed by another rally leg up towards 13300. The risk for bulls is that we're topping out right now although the short term pattern also calls for a small 4th and 5th wave before the current rally leg is finished. Bears need to see a break of the steeper uptrend line before they can start declaring we've made a high of importance. Remember, the high that we make here is the 5th wave of the rally from July so once it's done we're going to get at least a larger correction of that rally.

DOW chart, 120-min

The pattern of the rally off Tuesday's low looks like it could use a minor new high before that leg up is finished. So perhaps an early pop on Thursday morning and then a turn back down before the end of the day. This chart shows the uptrend line from the April 12th low that needs to break before that rally leg can be declared finished. Then the form of the pullback from the high will provide clues as to what's next. A choppy sideways/down pullback would be the green wave-4 correction in which case it would suggest another rally leg coming. But a sharper decline below the lower uptrend line, currently near 12850, would suggest the entire rally is finished. Stick with the trend for now but understand the risk--a break down could happen very quickly after a blow-off top as it appears we're in.

SPX chart, Daily

SPX is similar to the DOW except in one important point--it looks like a clean ascending wedge from here. Why is that important? Because the little pullback to Wednesday's low fits very well as the 4th wave pullback (labeled in dark red) and today's rally is the final 5th wave in the pattern. The top of the wedge is up near 1510 but the top of the parallel up-channel from July 2006 is near 1503. This trend line held SPX down the entire time from November to February where it finally dropped hard. Same thing setting up? That's the way it looks from here.

The bullish wave count, like the DOW, calls for another larger pullback which will set up the final 5th wave higher, labeled in green. In that case we could get a final high closer to mid month and possibly as high as 1515-1520. The next decline will provide the clues as to which one is happening but I like the setup here to try a short.

The reason I have 1498 marked as a key level is because it's a Gann resistance number. This comes from the square of nine chart which is basically a spiral of numbers starting with one and spiraling out clockwise from the center. Think of a galaxy or seashell or the pattern in sunflower seeds--it's a Fibonacci based spiral. So, the numbers relate to each other in a Fibonacci way. Numbers that are directly across from each other on the chart, or near each other but on a different spiral, "resonate" off the other. It sounds hokey pokey but it's amazing how well hit works and it shows how well the market actually follows mathematical cycles. Here's a hard-to-see copy of a portion of the chart:

Gann Square of Nine chart

From the October 2002 low at 768 (circled near the top of the chart) if you circle around 5 times and then stop 180 degrees away from 768 (the red axis) you get 1498. Notice that SPX has been struggling with this level since the end of last week and again today. I snapped a picture of this particular Gann Square chart from Jeff Cooper's setup who introduced me to this concept a few years ago. Whether SPX stops at 1498, gives a little over-throw or just zooms right up through it is of course unknown but it's just another piece of the puzzle that says be careful if you're long this market. We just might be topping here.

SPX chart, 120-min

Similar to the DOW, the move up from Tuesday's low could use a minor new high on Thursday morning but at this point I think we're very close to at least a short term high. And if it does roll over from here you can see that it will be a double top with clear bearish divergences.

Nasdaq-100 (NDX) chart, Daily

NDX is struggling with the trend line across the January 2004 and January 2006 highs and the daily oscillators look ready to roll over. RSI is clearly negatively divergent at today's high. It takes a break of its uptrend line from March 14th to say a top is in.

Nasdaq-100 (NDX) chart, 120-min

If we are to get a larger 4th wave correction it could take many forms. A sideways coil as shown in green is just one idea and would be very common for a 4th wave. So if we chop sideways like this for a week or so then we'll have a clear idea that we're headed higher once it's done. A break below 1850 would tell me the rally is done. In the meantime, as with the DOW and SPX, a minor new high tomorrow (if we get it) would be a good setup for a short play. The very bearish divergences so far at a double top would be clear confirmation for trying to short this.

Semiconductor Holder (SMH) chart, Daily

The semis would look best with another high, even if it's just a minor one. The pattern for the move up from the end of March needs to be a 5-wave move and that means another high. A Fib projection at 37.99 (for equality between the 1st and 5th waves of this move up) makes for a great potential setup to short the semis. Look for short term bearish divergences to confirm first.

Russell-2000 (RUT) chart, Daily

BIG bounce in the small caps today. It was a real v-bottom reversal off Tuesday's low which left a very bullish hammer candlestick. That low near 807 is now the key level for the bears--break that and the top is in. Until then this could continue up (even with a pullback first) as it heads up towards resistance in the 840-845 area. But notice where the RUT stopped today--just shy of its broken uptrend line from March 14th.

As bullish as today's bounce looks it might have only been a 2nd wave correction to the 1st wave down from last week's high. If that's the case then the next move will be a fast and strong decline to follow. From a bearish perspective I really like this chart. Buying a few IWM (Russell 2000 ETF) puts could pay off handsomely. Thanks to Joe who informed me about some put option activity on IWM, there were a lot of May puts purchased on IWM last Friday, just before that big red candle down. Sure looks like someone knew something was about to happen to this index. There was again big volume on those puts today (May 81 and 82) but I'm not sure if they were closing trades or opening new positions. Watch out for the downside if they were opening trades.

Russell-2000 (RUT) chart, 120-min

As labeled on this chart, the dark red wave count calls Wednesday's bounce a 2nd wave correction and that interpretation calls for hard down from here. Otherwise we could get just a relatively small pullback that leads to another push higher. A break above 835 would negate the bearish wave count.

NYSE (NYA) chart, Daily

I wanted to show the NYSE chart because it supports the idea that we have already seen the completion of the 4th wave correction and Wednesday's rally is part of the final 5th wave up. The uptrend line from the 1st to the 3rd wave and then a parallel attached to the 2nd wave shows the 4th wave finding support there. That helps confirm the count. Now it's a question of figuring out how high the 5th wave will go. It could truncate (make a lower high) or head up to 9900 or anything in between. That's why it's risky trading 5th waves. And the failure from this rally could be very swift. A break below 9600 would suggest the rally is finished but until then the trend is clearly up.

NYSE vs. NYSE stocks hitting new 52-week highs, Daily

The NYSE did not make a new high today, unlike the DOW and SPX, so it's not a fair comparison of new highs to an index that didn't make a new high. But I think it shows continued weakness as measured by the lack of participation (negative divergence) in an index that is pressing towards new highs.

BIX banking index, Daily chart

The banking index is hanging around the high of its bounce and is making the short term pattern funky looking. It looks like it's consolidating for another run higher and there is the untagged Fib projection at 405.42 so that's still possible. A break back below its 200-dma at 394 would suggest the bounce is finished. It's another whole week before we get the FOMC's policy statement so I can't imagine the banks on hold until then but you never know. The interpretation of their wording relative to interest rates could be the next catalyst.

And speaking of rates, here's an update to the 10-year yield;

10-year Yield (TNX), Daily chart

I had drawn in the green price path based on my expectation back in the middle of April after the 10-year yield hit its downtrend line from June 2006. It has veered off course a little and it's a bit of a guess from here but so far I don't see much to change my opinion that we're going to see higher rates. We could see rates first drop to the bottom of the coiling pattern, currently near 4.56%. It takes a drop through the low at 4.47% to negate the bullish path for rates (bearish path for bonds).

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

The chart of lumber continues to make new lows and that chart looks like it might be setting up a bounce. But until it does so it's showing a lack of demand for lumber products and this while housing has been bouncing, all in the hopes that we're seeing a bottom. New calls for a bottom were made after this week's housing data came out even though there's no evidence to support that. So until I see something that tells me my expectation is wrong, the housing index looks ready to tank. In fact interesting setup on the 60-min chart:

U.S. Home Construction Index chart, DJUSHB, 60-min

There are many charts that have potential H&S patterns setting up. Some got busted today with the big rally but others are still possible. If the housing index drops below the neckline near 630 then the minimum downside objective out of the pattern is near 590 which is not far from its April low. That would likely be only a small part of the next leg down if the bearish wave count is correct on this one.

Oil chart, ETF (USO), Daily

Oil (USO) broke its lower uptrend line after failing to recapture its first uptrend line or break its downtrend line on the last bounce. It hasn't broken the key level at 49.15 but that looks like it could be next.

Oil Index chart, Daily

Down she goes, at least the way I see this one.

Transportation Index chart, TRAN, Daily

The Trannies found support at the May 2006 and the bottom of a parallel up-channel. If that dip was a 4th wave pullback then we should see this index rally to a new high. But if it turns back down and drops below Tuesday's low then the rally is finished.

U.S. Dollar chart, Daily

The US dollar is trying awfully hard here to get a bounce going. It's still not abundantly clear if a bottom has been found or if instead we'll see a final move down to tag the Fib projection at 81.03. The currencies usually do a real good job at hitting Fib levels. But the bottom of its descending trend line has been supporting this while bullish divergences build. This may finally be ready to rally. And if the dollar rallies then gold will fall.

Gold chart, StreetTrack Gold ETF (GLD), Daily

GLD found support at its 50-dma today so if that continues to hold then we could see a stronger bounce from here. If the 50-dma breaks then next support is close by at the uptrend line form October, currently near 65.60. The bears will have some work to do to get this to break down. As usual, keep an eye on what the US dollar is up to.

Gold chart, StreetTrack Gold ETF (GLD), 120-min

Gold, like many equity charts, is showing the potential for a H&S topping pattern. GLD broke its neckline at 66.50 today but then recovered shortly thereafter. If it can break the downtrend line near 67 then there's a good chance the H&S top will get negated. Otherwise another break down would have the minimum downside objective at 64.23 as the target. That would be a break of its uptrend line from October and likely mean a move down to its 200-dma near 63 and maybe down to its uptrend line from July 2005, currently near 62.50. Remember to multiply these levels by 10 to get an approximation for the move in the metal itself.

The interesting thing about the H&S pattern for gold is that this continues to trade closely with equities. That's not normally the case but for a while now gold and equities have been trading together. This supports my claim that the next time down will be in most if not all asset classes. That which has been inflated by the credit bubble will be deflated by the collapse of credit. Credit is not real money and all the fluff and high asset values in the current markets has been created not with real money but instead with credit.

All credit bubbles collapse and they collapse hard. This one will be no different and it's why the safest place to be soon will be in cash. Yep, boring old unloved cash. Get a 4-5% return risk-free (except for inflation) return on cash and avoid the heartache that's coming.

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

Thursday's productivity report is used by the Fed so there could be a reaction around that number if there's a surprise there. It could be the impetus behind an early morning rally that then fails to hold up. The ISM services number is usually not a market mover. Friday has the big guns of the economic reports and considering where this market is perched it could be dicey.

SPX chart, Weekly, More Immediately Bearish

We've still got two days to complete this week but it will be interesting to see how that candlestick finishes. It's currently a hanging man doji with price up near resistance, along with the bearish divergences on a weekly basis. Too bad it's not Friday--I could be tempted to take some shorts home with me over the weekend with that kind of signal.

Once the "bounce" off the March low became too impulsive and strong to be considered a correction of the Feb-Mar decline I had suggested it's looking like we're in a blow-off top. In that case I mentioned to throw away all your technical indicators such as overbought, bullish sentiment, how far we are from the standard deviation, etc. The reason it's called a blow-off top is because the move becomes parabolic and it gets stretched to the upside. That's what we have going on here. It could develop a life of its own as the momentum players just keep piling on, hoping they won't be left without a chair when the music stops.

There's no question this rally has stretched the limits of overbought but so what. It's dangerous to short the market based on that. I've mentioned I like picking tops and I think we'll see one earlier rather than later on Thursday and I would watch the short term charts for bearish divergences to pick an entry or two or three (on the 3rd try if I get stopped out I quit since it's clear I'm wrong about the strength of the move and I quit fighting it).

As usual if you can't watch the market intraday and you've got some long positions then you need to think about your stop levels. This can be done just as easily on your IRA mutual funds as well as individual stocks in your trading account. If you are margined at all in this market I can't stress enough the importance of liquidating your margin and be invested 100% at most. I think the next time down will put the Feb-Mar decline to shame and margin calls will be one of the reasons. Protect your gains rather than trying to squeeze every last drop out of this market. Remember hogs get slaughtered.

If you're able to watch and trade intraday then I think a shorting opportunity is at hand. If we get even a pullback for a week (which could be choppy and full of whipsaws) it could be good for 100-200 DOW points. If instead we're finishing up the rally then you'll have one heck of a winning short trade on your hands. Then if we start breaking firmer support levels you'll be able to add to your winning position.

Good luck with this wild market. I hope the bulls are enjoying the ride who will then be gracious enough to let the bears sit at the table and have a turn. There's plenty for both sides to enjoy. That's what's so great about the game we play. Have fun, be careful now (both sides) and I'll be back next Wednesday and on the Market Monitor Thursday where I hope to nail the top of this thing and see what we get from there.

New Plays

New Option Plays

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

Play Editor's Note: The market's trend is obviously still up but that doesn't mean we can blindly buy new call positions here. Nothing goes up forever and the major indices are growing more overbought. We need to be disciplined about not adding a bunch of new bullish positions near a potential top. With that being said a bullish breakout over 1500 by the S&P 500 index could do a lot to refuel bullish sentiment.

New Calls

None today.

New Puts

None today.

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Advance Auto Parts - AAP - cls: 41.30 chg: +0.36 stop: 39.90

Today's 0.8% bounce was encouraging but hardly inspiring as AAP gave back most of its early gains. Today's rebound could have been nothing more than an oversold bounce after four days of declines. We hesitate to open new call positions here and the lack of volume behind today's strength doesn't add to our enthusiasm. If AAP doesn't continue to bounce tomorrow we may just drop it. More conservative traders may want to exit early. Our target is 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.

Picked on April 11 at $ 40.05
Change since picked: + 1.25
Earnings Date 05/17/07 (unconfirmed)
Average Daily Volume = 854 thousand


Armor Holdings - AH - cls: 72.08 chg: +1.39 stop: 68.99

Defense stocks were a bright spot on Wednesday with the DFI index breaking out from its trading range and hitting a new all-time high. Shares of AH also hit a new all-time high this afternoon. Volume behind today's 1.9% gain was very strong, which tends to be bullish. We have two targets. Our first target is the $74.75-75.00 range. Our aggressive target will be $77.50-80.00. The P&F chart is bullish and points to a $73 target.

Picked on April 30 at $ 71.51
Change since picked: + 0.57
Earnings Date 04/19/07 (confirmed)
Average Daily Volume = 482 thousand


Ctrip.com - CTRP - cls: 69.90 chg: -0.08 stop: 67.45

Danger! CTRP's relative weakness today is a warning sign. The stock looks poised to dip toward the $69-68 region. We would hesitate to open new positions although a rebound from here would look like a new entry point. 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.

Picked on April 29 at $ 70.63
Change since picked: - 0.73
Earnings Date 05/16/07 (confirmed)
Average Daily Volume = 389 thousand


General Dynamics - GD - cls: 79.82 chg: +1.33 stop: 76.45

GD shot higher this morning and ended the day with a 1.69% gain. This contributed a lot of strength to the DFI defense index, which broke out to a new all-time high today. If you missed buying the dip it might work better now to wait for a breakout over $81.00. 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.

Picked on April 29 at $ 80.27
Change since picked: - 0.45
Earnings Date 04/25/07 (confirmed)
Average Daily Volume = 1.4 million


Holly Corp. - HOC - cls: 63.78 chg: +0.64 stop: 59.49

Energy stocks participated in the very widespread rally today in spite of a pull back in crude oil futures. Shares of HOC rose 1% and looks poised to move higher. If you're feeling cautious consider tightening your 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.

Picked on April 22 at $ 62.30
Change since picked: + 1.48
Earnings Date 05/08/07 (confirmed)
Average Daily Volume = 669 thousand


Wynn Resorts - WYNN - cls: 107.05 chg: +5.67 stop: 99.95

WYNN turned in a very big day with a 5.59% gain on huge volume. We didn't see any stock-specific news so odds are good that today's rally in WYNN was fueled by the positive earnings surprise from ASCA last night. Rival LVS reported after the bell today and beat estimates by a penny. MGM is due to report tomorrow morning. More conservative traders may want to exit WYNN right here. The intraday high was $107.98. Our target is the $108.00-110.00 range. We are not suggesting new positions. WYNN is due to report earnings on or near May 7th. We plan to exit ahead of the early May earnings report.

Picked on April 15 at $102.44
Change since picked: + 4.61
Earnings Date 05/07/07 (confirmed)
Average Daily Volume = 1.4 million

Put Updates

AvalonBay - AVB - cls: 120.19 chg: -0.04 stop: 130.05

We don't see any changes from our previous comments. AVB continues to under perform the market but we're not suggesting new positions at this time. The $120 level is a good spot for the stock to produce an oversold bounce. More conservative traders may want to think about tightening their stops toward $126 or $125, which should be new overhead resistance. More conservative traders may want to think about taking a profit here. Our target is the $112.50-110.00 range. The P&F chart points to a $110 target.

Picked on April 30 at $124.45
Change since picked: - 4.26
Earnings Date 04/26/07 (confirmed)
Average Daily Volume = 770 thousand


Lockheed Martin - LMT - cls: 96.07 chg: -0.16 stop: 97.51

We are actually surprised that LMT didn't show more strength today. The DFI index broke out to a new all-time high. Yet LMT produced another lower high and a failed rally near $97.00, under its 50-dma. We're not going to complain about its relative weakness but we're not sure how long it will last. More conservative traders may want to tighten their stops toward $97.00. We're not suggesting new positions until we see a new decline under $95.

Picked on April 24 at $ 94.82
Change since picked: + 1.25
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: 96.07 change: -0.16 stop: n/a

There is no change from our previous comments on LMT as a strangle play. The lack of movement is bad news for this kind of strategy. We need LMT to pick a direction and go. If the stock doesn't break one way or the other soon more conservative traders may want to abandon this play early. 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.

Picked on April 22 at $ 95.40
Change since picked: + 0.67
Earnings Date 04/24/07 (confirmed)
Average Daily Volume = 1.7 million

Dropped Calls


Dropped Puts

British Airways - BAB - cls: 103.84 chg: +2.76 stop: 104.26

Caution! We're throwing in the towel with BAB. The stock rallied sharply adding 2.7% and breaking out above its short-term trendline of resistance and its 50-dma. The rally did run out of steam near resistance around $104.00. It's still possible that the $104 level of resistance will hold. However, we're not willing to bet on it at this time and would rather cut our losses and look elsewhere.

Picked on April 29 at $101.42
Change since picked: + 2.42
Earnings Date 05/18/07 (unconfirmed)
Average Daily Volume = 65 thousand


Ceradyne - CRDN - cls: 61.50 chg: +1.63 stop: 62.51

We are going to cut our losses early on CRDN as well. The bounce is looking too strong with today's 2.7% gain and breakout over its 10-dma. Last Friday's move looked like a bearish reversal and failed rally but there's been no follow through.

Picked on April 29 at $ 59.08
Change since picked: + 2.42
Earnings Date 04/27/07 (confirmed)
Average Daily Volume = 667 thousand

Dropped Strangles


Trader's Corner

Dow Theory Today

Someone wrote me the other day and asked about the current bull market in terms of Dow Theory and if (in terms of this theory) the major market outlook remains bullish. Oh, and by the way, "does Dow theory say anything about what levels could be reached?" NO, to this latter part of the question.

I do keep track of the two Dow Averages, the Transports and the Dow Industrials from week to week, month to month, especially where one of the Averages makes a new advancing high (or declining low) on a weekly or monthly closing basis. However, the aspects of the market that relate to Dow's original work is VERY long-term and 'investment' oriented: the year over year outlook as opposed to week to week or month to month which is what us options traders are so eager to ascertain. Just tell me the week's close on Monday and I'll be happy!!!

However, since most if not all of shorter-horizon traders also have long-term investments in stocks, it's interesting from time to time to look at the BIG picture. And Charles Dow was a big-picture market observer. By the way, Charles Dow's descendents, or Edward Jones' didn't end up owning Dow Jones & Co. This honor went to the Bancroft family who, as a group, just turned down an offer for the company from Rupert Murdoch's News Corp. This offer may or may not mean that the family will end up instead selling to the 'right sort', that being someone other than Mr. Murdoch; perhaps someone that is perceived as having more lofty journalistic principles. And the Dow Jones' flagship Wall Street Journal is sure near the top in terms of their reporting and quality of their stories. When I worked for Dow Jones I was asked, in terms of writing an article about Dow Theory for an internally produced customer magazine ("Markets"), whether it (the article) would reflect well on Dow Jones. Hey, this is a Tony outfit and very button down! I could tell you stories about that but won't!!

I started to write this article last week and got flight delayed on my way to NYC and to connect with some old ties to the Street of Dreams. Actually, today so much stock volume is controlled by the hedge funds scattered around the country in physical location, that it's hard to locate the epicenter of the financial world as being in lower Manhattan anymore. But the New York Stock Exchange is still there; it didn't succumb back when to the New Jersey siren call (gasp!) to move across the river. However, back around the turn of the last century, Wall Street certainly was the center of at least the U.S. financial universe and Charles Dow plied his reporter's beat there.

Its important to understand that Charles Dow considered his ideas on the market (he didnt call it a 'theory' at all) to be the broad strokes and provide the big picture for INVESTMENT purposes only. He used closing prices only and a monthly close at that; rather than on a daily or weekly basis. Ill get to how he expected the averages to behave relative to each other next. Let me start with a current look at the two weekly charts, one on top of the other, of the Dow Jones Transportation Average and the Dow Jones Industrial Average. By the way, my TradeStation software mislabels each Average as an 'Index' which, unlike the S&P 500 Index, they are not. Both are arithmetic (price) averages of the 30 stocks of INDU and 20 of TRAN; neither are capitalization-weighted.

I'll get back to the notations I've made on the chart above shortly. Dow Theory is not a system of market timing exactly, only a forecaster of the major or 'primary' trend (over years, not months or weeks) and a good forecaster of the deeper recessions. Of course there has not been more than a relatively mild recession for a long time.

Back in the 1880s and 1890s, Charles Dow (who, along with Edward Jones formed Dow Jones & Co.) came up with the first stock market averages, which became, over time, the Dow Jones 30 Industrial, 20 Transportation and 15 Utility stock averages as known today. I tend to call the Dow Industrials (INDU) the 'Dow 30' as these stocks have become more technological, manufacturing and service oriented and less industrial, unlike the case of the heavy industry stocks like U.S. Steel that were part of the early Dow Jones Industrial Average.

Today the common term by traders is 'the Dow', or the 'Dow Jones' for the Industrial average. This average of 30 stocks is not capitalization weighted, as is the case of the Standard and Poor 500 or Nasdaq Composite index. Dow stocks of companies that have become price laggards, even if theyre much smaller companies than say General Electric, can have more of a dragging effect in the PRICE weighted Dow 30 average than indexes that give more weight to the larger companies with far more shares outstanding; e.g., the S&P 500(SPX). Conversely of course, stocks in the Dow that soar can put INDU to a new all-time high way ahead of the S&P, which is the case currently.

Only the Dow Industrials and Dow Transportation (TRAN) Averages are used in what became known as 'Dow theory'. Charles Dow as I noted earlier called the market principles he wrote about OBSERVATIONS on how the economy and the market functioned. Dows principles were later discussed in a book by William Hamilton called "The Wall Street Barometer"; Hamilton was the Wall Street Journal Editor that came after Dow. Robert Rhea is credited with distilling the ideas of Dow further and wrote a book in the early-30s called "Dow Theory".

One of Dow's most important contributions was the idea that 'confirmation' of the primary trend must exist by the actions of BOTH the Industrial and Transportation averages. A related aspect to this, really the flip side of it so to speak, is the concept of 'divergence'. Charles Dow spoke mostly about confirmation; use of the term 'divergence' as between averages and between prices and volume or, between price action and technical indicators, is mostly what came along in the 20th century as formulated by various technical analysts.

Dow said that if the Industrials moved to a new closing high or low, without the Transportation average following suit at some point ('confirming' the other Average), or if the Transports went to a new peak or bottom without the same action in the Industrials, no change in the primary trend was suggested. The two averages need to have the same action as far as new highs or lows (to be in synch) otherwise a potential REVERSAL of the primary trend could be in the offing.

The rationale regarding the two averages confirming each other is simple in hindsight, but accounted for a very astute observation on Dows part. For example, industrial or manufacturing activity could continue to be very strong for a period of time while orders for those goods were slowing. This would result in the build up of inventories and an eventual slow down in the economy and in stocks. Where such a slowdown in manufacturing orders would show up FIRST is in transportation orders and activity. Slowing orders in the transportation sector, as fewer goods were shipped, would result in a fall off of those companies' revenues. Astute followers of these stocks would notice this and selling would start to show up in these stocks, either keeping a 'lid' on stock prices or actually driving them lower.

Conversely, manufacturing could start picking up but might not be at first reflected in a pick up in those stocks especially when inventories were being worked down first. However, an increase in shipping would be noticed more readily and cause the Transportation stocks to begin rising based on rising shipping activity. The Dow Industrials might even fall to a new low in such a case, but NOT be followed by the Dow Transports.

In summary, a new high or low in the Industrial average, not 'confirmed' by the Transportation average or vice versa, should be looked at closely. In the case of a new high in the Industrials not confirmed by the Transportation stocks, it may indicate slowing earnings and hence stock prices, will show up later on in the INDU average.

In 1999 both the Dow 30 AND the Transports went to new closing highs as you can see on my first chart above and which is shown again below. Then in early-2000 TRAN went to a new closing low, which was not confirmed by INDU at least in that same year. However, in 2001 INDU 'confirmed' the action in the Transports by also falling to a new closing low; both lows are noted by blue up arrows. In a real sense the action in TRAN was forecasting trouble ahead in the overall U.S. market. It's just that that view wasn't confirmed by the other average until many months later.

In 2001, lower closing reaction lows were made in both averages and this action was 'confirming' a bear market still.

The 'mother' of all Dow theory divergences, at least in recent years, came in 2003 when the Dow Transports made a double bottom closing weekly low and therefore did NOT 'confirm' the lower lows in the Industrial average that had occurred in 2002. After the double bottom TRAN low, INDU made a higher reaction low on the pullback into early-2003. This was THE time to put everything that you could have had committed to stocks into the market. The big money is made when new trends are realized early!

As to new closing highs, one was made in early-2004 in the Transports, but wasn't confirmed, at least by any significant degree, in the Dow Industrials as noted at the dark-red down arrow. By the 3rd Quarter of 2004, TRAN started a sharp advance, which was only barely confirmed by INDU in late-2004/early-2005, but it WAS confirmed. In a real way here the action in TRAN was forecasting the very strong bull market that followed beginning in late-2005. This was a lag of nearly a year before the same kind of powerful rally was seen in the rest of the market sectors (not just in key transportation stocks), but as said before, long-term trends can unfold slowly.

All in all this story of Charles Dow and notes relating to his market theory as seen over the past several years might be more riveting than the current stated non-state of play regarding Dow's namesake newspaper and whether it ends up in the hands of new owners (Bancroft family ownership dates to 1902!), but stay tuned...there are often surprises in the takeover game. Hey, you got to convince the younger family members too!!


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


Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

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