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Daily Newsletter, Wednesday, 06/27/2007

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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

Drop n Pop

The stock market did a mirror version of the gap n crap move and caught the bears asleep at the switch. It was stealth rally at first with a very choppy move higher this morning. It looked just like another bear flag and the bears were only too happy to short it. The noon pullback then set the trap and the afternoon rally sprang it. All the way into the close you could hear the bears whining "not again". Masterfully done I must say.

The above table shows the strong market breadth with advancers all over decliners today. The new 52-week lows beating new 52-week highs is interesting. We're still near all-time highs for the major indices and yet new lows beat out new highs. Something smells funny.

The techs and small caps were especially bullish today and their daily charts show very bullish engulfing candles for a key reversal day (open lower, make a new low and then close higher). I had been recommending on the Market Monitor to look to buy this morning's dip as it looked like it was going to be a picture perfect ending to the descending wedges that were forming over the past week. I'll review that setup in tonight's charts. But as the bounce progressed this morning it started to look bearish and I began to wonder if the bulls could do it this week.

As many of you know, the last week of June is typically bullish and many were beginning to wonder what happened to the rally. In fact it's typically the last half of the week that's bullish, following a down beginning of the week. Assuming the market continues to rally then the rally started exactly at the middle of the week. This afternoon's rally had a bit of the "too much too fast" look to it, especially the techs and small caps so either it was made up primarily of short covering or else the fund managers are trying to stuff their portfolios with the sexier stocks that they know their customers like to see. If it's the latter then there will probably be a hangover in those stocks next week, maybe after the holiday.

As I usually do, I'll show both the bullish and bearish setups on tonight's charts and identify some key levels to keep an eye on in order to help us determine the next move. Basically we're at the edge of the cliff, which we peered over this morning before getting pulled back. Now the market will decide to either climb higher before jumping or make the jump from around the current levels. It could get interesting over the next week or so.

The banks are looking ugly right now (if you're a bull) and that should give all of us some reason to be very cautious about any additional rally. I'll review the banks and Merrill Lynch's (MER) charts since they could be telling us something. In the meantime I recognize the short term potential for this market to rally to a new high. The behavior of the market is amazingly similar to past periods where the rally continued beyond most expectations until it didn't. In other words the sharp spike up over the past year, and since March, is very reminiscent of past blow-off tops and that's what makes me cautious about forecasting new highs.

I came across some interesting information from Jeff Cooper whose analysis and pattern recognition, in both time and price, I've come to respect over the years. I've mentioned a couple of these things in the past but they're worth repeating:

Every year ending in 7 since the mid 1800's has experienced a sharp decline or panic. One could argue we've already had that in the February-March decline but that was a mild correction by historical patterns. Therefore one could easily argue we're still due.

The market tends to move in cycles, from decades long to ones measured in days. You've no doubt heard much about the presidential cycle which is the common 4-year cycle and then half that, so the 2-year cycle. There's a 50-year cycle, referred to as the Jubilee Cycle, and the 54-year Kondratieff Cycle which is currently being skewed by an effort by the Fed to fight the winter portion of the cycle through massive liquidity creation (Greenspan once said he wanted to be known as the man who stopped the Kondratieff Cycle--not too arrogant).

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The 50-year cycle has marked the dates of big moves. The two biggest lows in the 1900's were July 1932 and August 1982, 50 years apart. More interestingly for us right now is the fact that in 1957 there was a brief sharp price correction in February which was followed by a very strong rally into June/July of that year. Following that climb the DOW dropped from 520 to 420 for a -19% correction. The same correction for the DOW today would take it down to just under 11K.

Prior to 1957 was a collapse of the DOW in 1907 from 96 to 53, or a -49% drop. That whole year was down but the bulk of the decline happened in July. And of course 50 years from 1957 lands us in this year, which is the year of the decade that has always seen a major correction.

Following the 50-year cycle is the 20-year cycle (a multiple of the 4-year cycles). July 2002 saw a hard sell off and this followed 20 years after the end of the bear market in August 1982. Before that there was a hard decline in 1962. August of 1987 was the top before the market crash that followed. Twenty years from that date is around the corner.

Many people scoff at cycles but they tend to be accurate enough to require at least paying attention to them. So, regardless of how bullish you might feel about this market currently, just keep in mind that there are some cycles about to complete which could make for a nasty bite for complacent investors. Getting off margin should be priority one right now.

A reason that was given for the sell off since June 1st was inflation fears. This is ridiculous since the market has been rallying in the face of inflation fears. Now all of a sudden it sells off because of it? It's another example of analysts looking for a convenient excuse for why the market does what it does. Could it be investor mood? Nah, there's nothing there the analyst can hang his hat on and make the big bucks with silly explanations. Supposedly the bond market has been selling off on inflation fears as well. But why would gold sell off on inflation fears when exactly the opposite is usually the case?

All the selling we're starting to see is more likely a result of a drying up of credit. I've discussed in the past, ad nauseum, the huge increase in liquidity through the use of a massive growth in credit (debt). Jim did an excellent job again in his Tuesday Wrap in his discussion about the abc's of CDO's (credit derivatives) and I could certainly add a few pages more but his explanation was very good. Reread it if you have to because I think this will be the downfall of the market. Where there's smoke there's fire and where there's one cockroach there are more. Bear Stearns and their hedge fund fiasco with mortgage back securities fits the bill here. And the banks' charts are showing it.

Getting back to stocks, bonds and commodities selling off--it's a result of the credit expansion starting to slow. When it reverses then all asset classes will suffer this time, as will the global stock markets. They've benefitted from the massive liquidity expansion and they'll all suffer from the contraction. The bond market has quieted down after the large drop (spike in yields) but I don't think the selling is done (meaning higher yields to come).

10-year Yield (TNX) chart, Daily

The pullback in yields might be close to finishing, which would be a little faster than I thought. For EW followers, notice the alternation between the 2nd and 4th wave corrections in the rally from March. Wave-(ii) was a flat correction and wave-(iv) looks like it will be a sharp zigzag. This alternation doesn't always happen but it helps identify the wave count when it does. Two equal legs down for its correction from the recent high is at 49.73 which would be a retest of its broken downtrend line from January 2000. Currently I expect that area to hold for support (resistance for bond prices) and then see another rally in yields. Right now I have projections to a retest of the recent high and then up to 54.6. I'm not sure if that will end the yield rally or if a new high will be followed by another correction before pressing higher again. But the short term pattern is still pointing higher.

Today's rally in equities crushed the VIX. People were willing to pay significantly more for put options during the past few days and they couldn't exit them fast enough today. Assuming the rally will press a little higher, it'll be worth watching the pullback in the VIX:

Volatility Index (VIX) chart, Daily

Since last December VIX has been steadily making its way higher. As volatility in price movements has increased so has the VIX. If the stock market can continue its rally then watch for VIX to pull back to its uptrend line since that could very well mark the top of the stock rally.

Economic reports
It was a quiet day for economic reports, neither of which had any impact on the market (no real movement in the futures at 8:30 or stock prices at 10:00).

Durable Orders
There was a surprisingly large drop in durable goods orders, falling -2.8% in May, led by a large (-22.7%) drop in civilian aircraft orders. The expectation for the durable orders number was for a drop of -1.7%. This was the largest decline since the -4.2% drop in January. The slowing in business capital investment dampened the enthusiasm of those who have been saying business investment will continue to power the economy forward. It seems the only thing businesses are really investing in lately are their own stocks or the stocks of other companies. For the year, through May, orders are up 0.5% compared to the year-ago period. This report is not expected to have much of a bearing on the Fed's position.

Crude Inventories
Despite a capacity utilization rate increase for the refineries, from 87.6% to 89.4%, distillate stocks (includes heating oil and diesel) and gasoline inventories had an unexpected decline. Typically refinery utilization rates for this time of year run between 92% and 94% so that's quite a shortfall. Distillate stocks were down 2.3M barrels to 120.4M and gasoline stocks were down 700K barrels to 202.6M. Crude stocks increased (waiting for refineries) 1.6M barrels to 350.9M. The price of oil and oil products jumped higher today on the news.

And with that let's take a look at the charts to see where we go from here.

DOW chart, Daily

The daily chart shows the possibility for the market to have topped out on June 1st or has another high to go before topping out. Based on the short term pattern for the decline from last week I believe the pullback ended at this morning's low. I show a key level for the bearish wave count at 13250--any lower and it will likely be a bearish move. Theoretically the pullback could drop to 12992, the 162% projection for the 2nd leg down in the pullback from June 1st. But as shown on the 60-min chart below, the descending wedge pattern says the pullback is finished. Therefore if the DOW drops back down below this morning's low I would interpret that to mean we'll see a strong decline follow (dark red bearish wave count).

The bigger question at the moment is what happens next. If today's low marked the end of the a-b-c pullback from June 1st then we'll rally to a new high from here (green bullish wave count) for the 5th wave in the move up from March. I show a Fib projection for the 5th wave where it would equal the 1st wave (13793) and if it did it in the same amount of time as the 1st wave took then we should get there by July 9th (7 trading days). I'll be able to update this next Thursday (the market is closed on Wednesday and I'll be taking Linda's Thursday Wrap) and hopefully we'll have a better sense as to which wave count is playing out by then.

The 60-min chart zooms in how the move from here might look over the next few days:

DOW chart, 60-min

For an impulsive move higher for the 5th wave (bullish wave count), we'll need to see the small move off this morning's low turn into a small 5-wave move. That requires a small pullback tomorrow followed by a minor new high and then a larger pullback (shown in green). For the bearish wave count I show a larger pullback (could happen immediately on Thursday or after a minor new high) to be followed by another leg up (for a larger a-b-c bounce) into next week before rolling back over and heading for new lows.

The bottom line is I think you need to be bullish for at least the next few days--look to buy the dip (I'm talking about intraday traders here) but be aware that the rally could end quickly. Keep the exit door ajar. Any bounce from here that is followed by a break back below today's low will be a bearish signal. Until that happens I think the odds are that we'll see the rally to a new high. At the completion of that rally will be the next MOAP setup (mother of all puts).

SPX chart, Daily

The SPX daily chart continues to look very similar to the DOW's. The same analysis holds here--it looks like SPX completed an a-b-c pullback from the June 1st high and now a 5th wave projection from this morning's low (to equal the 1st wave) is at 1557.89. This would get the bulls their new all-time high. They won't like what comes after that but we'll worry about that when the time comes. Just keep in mind that it could be soon. In the meantime, any bounce here followed by another move below this morning's low near 1484 would likely be very bearish.

For another view of where SPX might be headed, which is more bullish than what I show above, this daily chart shows price action for all of 2006 to the present:

SPX chart, Daily, 2006-2007

I want to keep this chart in mind because of the potential for it to be pointing to another rally that goes longer and higher than the daily chart projection above. Based on a potential wave count for the rally from July 2006, it's possible we'll see SPX head for the 1600 area by mid August. The Fibs and trend lines crossing in mid-August is eery when you think about the cycle studies I mentioned in the beginning of this report. The 20-year cycle points to August of this year for a top (20 years from August 1987). Keep this chart in mind when you're planning your longer term trades. I'm not saying this will happen but at this point I can't deny that it could.

SPX chart, 60-min

Again, similar to the DOW's 60-min chart, SPX holds the same potential. Considering the fact that the market often stagnates in front of the FOMC announcement, it would be fitting to see the market pull back correctively into the afternoon and then get a relief rally post-FOMC. That should then be followed by a larger pullback correction (or worse) before rallying into next week. The bulls do not want to see SPX near 1485 again.

OEX chart, Daily

The OEX has tended to trade very well technically and the reason for showing its chart tonight is because it could be the best forecaster for what's to come. Like the DOW and SPX, it looks like an a-b-c pullback correction from the June 1 high completed at this morning's low. A projection for the 5th wave up, for equality with the 1st wave, is at 716.39 and it crosses the top of its parallel up-channel (for price action since July 2006) on July 10th which is very close to equality with the 1st wave in time as well as price (as it typically is). This is the one index that may give us our answer over the next week.

Nasdaq-100 (NDX) chart, Daily

This NDX chart looks like a mess, just like its price pattern. The choppy mess since the beginning of May is just pure ugly (technical term for "difficult to put a wave count on"). So I'm showing a few possibilities. The first, the bearish count (dark red) says we'll get a bounce, perhaps into early next week, followed by new lows; i.e., a top is in. The dark green bullish count shows price continuing higher in a parallel channel into August up to a Fib projection at 2032 (there's that August again). In between is the light green bullish count that shows price chopping its way higher in an ascending wedge (which could also take us into August), topping out at the Fib projection (5th wave = 1st wave) pf 1972.67. I'm leaning towards one of the bullish scenarios until proven otherwise (which would be a drop below this morning's low).

Nasdaq-100 (NDX) chart, 60-min

While it's possible today's bounce was all we'll get before heading lower again (dark red bearish wave count), I'm leaning towards a pullback, either right away or post FOMC, and then a resumption of the rally into next week. The dark and light green price paths are a closer view of what is shown on the daily chart.

Russell-2000 (RUT) chart, Daily

Like the NDX the RUT is pure ugly. Just look at that choppy mess over the past two months. Good volatility if you caught the moves right. Great for credit spreads if you had your spreads above and below the range. But as far as figuring out direction from here it's almost a coin toss. But the pattern as of late is similar enough to the others where I'm thinking they're all in synch now and should act in concert. Therefore the same comments for the others hold for the RUT. If we're to get new highs, the first upside Fib target is near 860 and then 880-890.

Russell-2000 (RUT) chart, 60-min

Like the NDX we could see this roll right back over and head for new lows. If it breaks this morning's low you'll want to short every bounce in that puppy. Meanwhile look for a pullback to buy and take the run higher over the next week or so.

BIX banking index, Daily chart

Unless the banks are in a large ascending wedge, where price will continue to chop higher (and probably into August), the price pattern is bearish. A pig with lipstick is still a pig. It takes a rally back above 405 to turn this around and tell me that in fact it's looking like this will chop higher. Otherwise a bounce here should fail and head for new lows (dark red bearish count). The significance here is that the bearish wave count is building a set of 1st and 2nd waves down and when it lets go (assuming it will) it's going to let go with a vengeance.

What could cause that kind of selling in the banks? Oh, perhaps another Bear Stearns hedge fund collapse that starts to seriously unravel the mortgage-backed securities and all the CDO's (Collateralized Debt Obligations). I've said it before and I'll say it again--the massive credit expansion over the past several years, and the huge leveraging of debt, is a bubble waiting to be popped. The collapse will be mind-numbingly fast and take several banks down with it. Helicopter Ben had better have those helicopters with their buckets of cash on the 5-min alert pad.

Mother Merrill (MER) has consistently been a good forecaster for market direction. There's a reason floor traders watch MER, even on an intraday basis. They'll fade the market if MER is not participating. It's showing the same potentially bearish setup as the banks' chart:

Merrill Lynch (MER), Daily chart

After a clean impulsive move down from its January high, indicating a change in trend to the downside, MER got a corrective 3-wave bounce into the May high. It's now looking like it could be setting up a couple of 1st and 2nd waves to the downside. When the 3rd waves start to unwind in this count (assuming it will drop instead of rally) we should see a wicked sell off. So far MER has not been participating in the new highs in the broader market (such as the June 1st high) and when the banks don't participate that should always be a reason for concern. Keep your eye on Mother.

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

I keep expecting the home builders to get a bounce but each day they drop a little lower. Perhaps this morning's low was it for the first leg down from the May high. If so we should see a stronger bounce develop, maybe back up to the 50-dma/50% retracement around 611, before resuming its southbound trek.

Oil chart, ETF (USO), Daily

I'm back to showing the USO fund rather than the oil contract. I've drawn several parallel channels on the chart because I've noticed that oil tends to trade them well. Assuming we're going to see oil make a move higher, two equal legs up from the January low is at 59.03 and it's off the chart to the right, but that could occur in August. There's that August again. Remember, all asset classes will sell off. It takes a break below 47.39 to negate the bullish potential I see on this chart.

Oil Index chart, Daily

The oil stocks index broke down below its parallel down-channel(s). Today's bounce took it back up to potentially retest the bottom of the lower parallel trend line. It could certainly continue higher again, especially if oil does, but I get a bearish sense from this chart (daily oscillators look bearish as well).

Transportation Index chart, TRAN, Daily

The choppy pullback in the Trannies since mid June looks corrective, meaning it looks like another leg up is coming. Whether that turns into a new high (green count) or a lower high (dark red count) is hard to say. It might form a choppy ascending wedge to a marginal new high but regardless, I don't think the Trannies have much left before they start a more serious decline.

U.S. Dollar chart, Daily

The US dollar trades channels and trend lines very well also. Therefore I remain bullish the dollar as long as its short term up-channel from its April low continues to support price. A drop below 82 would start to look more bearish but until that happens I expect the current pullback to lead to a strong move up and over its downtrend line.

Gold chart, ETF (GLD), Daily

If the US dollar can rally and break its long term downtrend line then it won't be good for gold. I've been bearish the metals since the beginning of the year and I don't see a reason to change that opinion. But it wouldn't take much for me to switch sides (I have no loyalty to the bears or bulls, just the winning side). If gold rallies back above its recent mid-June high then it would also be a confirmed break of its downtrend line from May. That would leave the choppy looking decline over the past 2-1/2 months as a setup for another run higher (probably within the ascending wedge pattern you can make out on the chart), as per the green bullish count.

But if that choppy looking decline is instead a series of 1st and 2nd waves to the downside then gold is about to get hammered. Right now GLD is finding support at the 200-dma (the August contract has broken that support) and a break of it is what could usher in the strong selling. Keep an eye on the US dollar since a break of support there could get the gold bulls back in and get gold to break resistance above.

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

Tomorrow will be a little busier for economic reports but nothing that should move the market. I expect the market will be mostly on hold while waiting for the FOMC announcement. Most expect no change to rates and no change to policy. The only thing holding traders back is what-if. That's why I think we'll see a relief rally follow it. Whether that holds into Friday is a different question (I'm thinking probably not).

SPX chart, Weekly

The weekly chart of SPX looks bearish when I look at the sell signals from the oscillators. It's possible we'll get the minor new high (light red) that gives us all kinds of bearish divergences (as it should for a 5th wave) but this chart says it might not be wise to expect a new high from here. As per the discussion above, tighten up your stops now--just below this morning's low is an ideal place. Then let the market take you out, or enjoy the ride to a new high.

So in summary I expect some consolidation of today's rally, especially in front of FOMC. If we get a slow sideways/down choppy pullback then that will make the setup look better for a post-FOMC rally. But as with this morning's bounce, which looked like a bear flag, if a bull flag pattern forms tomorrow then beware a drop out the bottom. Failed flag patterns tend to fail hard. This afternoon's rally was evidence of that. So play the bounce but be ready to bail quickly if price drops below any consolidation pattern (it might form a sideways triangle consolidation instead of a flag).

After the post-FOMC rally, assuming we get it, we should then be ready for a larger pullback which I'll be looking at to buy for another rally leg into next week. Once we get a larger 3-wave move higher (again, assuming we'll get it) that's when I'll be testing the waters on the short side just in case it fails and we start heading lower. But if we again see a choppy consolidation after another leg up then that will be a good sign that we're going to get the new market highs. But before that happens I should be able to provide some updates next Thursday.

Until then good luck in this choppy whipsaw environment. Swing and position traders keep your powder dry. We might have a nice short setup (again) by the end of next week or early the week after. In the meantime I'll be on the Market Monitor trying to figure this out as we go. See you there.
 


New Plays

New Option Plays

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

New Calls

None today.
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

Ashland - ASH - cls: 62.99 change: 0.90 stop: 59.95

Shares of ASH followed the market higher and like many of the sector indices today ASH produced a bullish engulfing candlestick pattern. The move looks like a new bullish entry point even though there is potential resistance in the $63.25 area. We're thinking about raising our target toward the $66-67 range but for now our target is the 200-dma at $64.47. We would not hold over the late July earnings report.

Picked on June 10 at $ 61.49
Change since picked: 1.50
Earnings Date 07/23/07 (unconfirmed)
Average Daily Volume = 657 thousand

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Avery Dennison - AVY - cls: 66.37 chg: 0.78 stop: 64.90

AVY also produced a big rebound and a bullish engulfing candlestick pattern today. The rally back above the $66 level looks like a new entry point to buy calls. However, we note that AVY could not make it past the 10-dma near $66.40, which is a surprise. More conservative traders may want to see a little more strength before jumping in. The $67.00 level is AVY's next hurdle. Our target is the $69.75-70.00 range. We do not want to hold over the late July earnings report.

Picked on June 11 at $ 66.05
Change since picked: 0.32
Earnings Date 07/24/07 (unconfirmed)
Average Daily Volume = 728 thousand

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BP Plc. - BP - close: 70.95 change: 0.55 stop: 67.85

The weekly oil and gasoline report showed a drop in gasoline supplies, which launched a rebound in crude oil and the energy sector. Traders bought the dip in BP near $70.00 and the bounce today looks like a new entry point. The P&F chart points to a $90 target. Our target is the $74.85-75.00 range. More aggressive traders may want to aim higher. FYI: We do see some resistance near $73.50.

Picked on June 22 at $ 70.25
Change since picked: 0.70
Earnings Date 07/24/07 (unconfirmed)
Average Daily Volume = 3.5 million

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Cleveland Cliffs - CLF - cls: 76.53 chg: 0.57 stop: 74.99

We are still on the sidelines with CLF. The stock spiked lower this morning, breaking support near $75 and its 50-dma, but shares eventually turned around and closed higher. If CLF continues to bounce tomorrow then we'll keep it on the play list as a candidate. If it doesn't bounce then we'll drop it. We're sticking to our plan for now and suggesting a trigger to buy calls at $80.55. If triggered our target is the $89.00-90.00 range. We plan to exit ahead of the late July earnings report.

Picked on June xx at $ xx.xx <-- see TRIGGER
Change since picked: 0.00
Earnings Date 07/25/07 (unconfirmed)
Average Daily Volume = 1.6 million

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Chevron Corp. - CVX - close: 83.89 chg: 1.19 stop: 79.90

CVX is looking strong today. The oil and gasoline inventory numbers today fueled a rally in energy stocks. Traders bought the morning dip in CVX and shares closed up 1.4% and poised to breakout over short-term resistance near $84.00. We are suggesting new positions now but more conservative traders may want to wait for a new relative high first. Our target is the $89.00-90.00 range.

Picked on June 18 at $ 83.75
Change since picked: 0.14
Earnings Date 07/27/07 (unconfirmed)
Average Daily Volume = 9.1 million

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Deere Co - DE - close: 121.57 change: 1.44 stop: 117.45

We couldn't find any news to account for DE gapping down at $119.56 but fortunately traders bought the dip near $118.50 and the stock rebounded back into the green. The big bounce looks like a new entry point to buy calls. More conservative traders who haven't adjusted their stops yet might want to raise them toward today's low. We have two targets. Our first target is the $129.50-130.00 range. Our second, more aggressive target is the $134.00-135.00 range. The P&F chart is bullish with a $152 target.

Picked on June 20 at $123.55
Change since picked: - 1.98
Earnings Date 08/15/07 (unconfirmed)
Average Daily Volume = 2.6 million

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Global SantaFe - GSF - cls: 72.50 chg: 1.47 stop: 66.65

Bulls bought the dip at $69.77 and GSF produced a bullish engulfing candlestick pattern, which is normally seen as a bullish reversal. If you think GSF can trade past $75.00 then this looks like a new entry point. We're not suggesting new positions. Our target is the $74.50-75.00 range.

Picked on June 03 at $ 68.86
Change since picked: 3.64
Earnings Date 08/01/07 (unconfirmed)
Average Daily Volume = 4.8 million

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Russell 2000 iShares - IWM - cls: 83.59 chg: 1.85 stop: 81.35

The Russell 2000 and the iShares that follow it spiked lower this morning but traders bought the dip near $81.50. The smallcap index rebounded sharply, and on big volume, producing a bullish reversal with today's bullish engulfing candlestick pattern. This looks like a new entry point. Our target is the $86.50-87.50 range.

Picked on June 24 at $ 82.85
Change since picked: 0.74
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 71.6 million

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Manpower - MAN - cls: 93.21 change: 0.73 stop: 89.90

MAN's rebound today looks like another bullish entry point to buy calls. More conservative traders can wait for a new relative high before jumping in. Our target is the $99.50-100.00 range. The P&F chart has a triple-top breakout buy signal with a $110 target.

Picked on June 20 at $ 94.15
Change since picked: - 0.94
Earnings Date 07/20/07 (unconfirmed)
Average Daily Volume = 829 thousand

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Pacific Ethanol - PEIX - cls: 12.60 chg: -0.03 stop: 11.90

PEIX under performed the markets today but volume was very light so it can be tough to put a lot of importance behind today's session. We're still suggesting bullish positions but more conservative traders may want to wait for a rise past $13.35 or $13.50 before initiating new positions. There is potential resistance near $14.00, the 100-dma and the 200-dma. We're going to aim for the 200-dma, which means we'll use a $15.50-15.75 exit range for now. FYI: We cannot find a future earnings date for PEIX but suspect it will be in August or September.

Picked on June 24 at $ 12.83
Change since picked: - 0.23
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 892 thousand

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Penn National Gaming - PENN - cls: 60.52 chg: 0.09 stop: n/a

We don't see any changes from our previous comments on PENN. This is a high-risk speculative play based on a possible bidding war if another suitor steps into the takeover scenario.

Picked on June 17 at $ 62.12
Change since picked: - 1.03
Earnings Date 07/26/07 (unconfirmed)
Average Daily Volume = 1.0 million

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SanDisk - SNDK - cls: 48.51 change: 1.20 stop: 43.45

This morning SNDK announced a new 4GB memory stock card for $99.99, which might have contributed to the 2.5% gain in the stock price. We have two targets. Our conservative target is the $49.50-50.00 range. Our aggressive target is the $52.50-55.00 range, which might be too optimistic given our time frame. We don't want to hold over the mid July earnings report.

Picked on June 17 at $ 46.40
Change since picked: 2.11
Earnings Date 07/19/07 (unconfirmed)
Average Daily Volume = 7.6 million
 

Put Updates

Allegheny Tech - ATI - cls: 103.39 chg: 0.38 stop: 110.15*new*

Target achieved! ATI spiked lower this morning. Shares hit $99.17 before bouncing back. We have two targets. Our first target is the $100.50-100.00 range. Our second, more aggressive target is the $95.50-95.00 range although we may need to adjust this to the 200-dma, which is rising and currently near $94.70. The P&F chart currently points to a $94 target. We are not suggesting new positions at this time. We are adjusting the stop loss to $110.15.

Picked on June 12 at $106.70
Change since picked: - 3.31
Earnings Date 07/25/07 (unconfirmed)
Average Daily Volume = 2.1 million

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Gilead Sciences - GILD - cls: 39.80 chg: 1.00 stop: 40.85*new*

GILD produced a big bounce today following a similar rebound in the BTK biotech index. This bounce looks pretty dangerous for the biotech bears. We're not suggesting new positions. Please note that we are adjusting the stop loss to $40.85, just above the simple 50-dma. Our post-split target is $37.62-36.25.

Picked on June 07 at $ 39.95 *split adjusted
Change since picked: - 0.15
Earnings Date 07/18/07 (unconfirmed)
Average Daily Volume = 4.1 million

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Las Vegas Sands - LVS - cls: 72.83 chg: -0.20 stop: 78.05*new*

We are suggesting that more conservative traders consider an early exit to lock in a profit with LVS. Shares dipped to $71.24 this morning before paring its losses. The move looks like a short-term bullish reversal inside its bearish trend. We are adjusting the stop loss to $78.05. Our target is the $70.50-70.00 range. More aggressive traders may want to aim lower.

Picked on June 17 at $ 76.78
Change since picked: - 3.95
Earnings Date 08/01/07 (unconfirmed)
Average Daily Volume = 3.0 million

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Mettler Toledo - MTD - cls: 95.55 chg: 0.53 stop: 99.11

MTD is still trying to bounce but remains under short-term resistance at its 10-dma. We remain bearish but traders might want to inch their stops down toward the simple 50-dma around $97.85. Our target is the $90.50-90.00 range. FYI: The P&F chart has reversed into a new triple-bottom breakdown sell signal with an $87 target (was $91).

Picked on June 19 at $ 96.75
Change since picked: - 1.20
Earnings Date 07/26/07 (unconfirmed)
Average Daily Volume = 215 thousand

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QUALCOMM - QCOM - cls: 43.42 change: 0.58 stop: 44.05

Be careful here! We seriously considered dropping QCOM right here to cut our losses. The stock rebounded from the $42.50 level and its rising 100-dma. Short-term technicals are suggesting the next move will be higher. More conservative traders should think about an early exit right here. The only reason we're not dropping QCOM is because overhead resistance at $44.00 has held so far. We're not suggesting new positions at this time.

Picked on June 10 at $ 41.87
Change since picked: 1.55
Earnings Date 07/18/07 (unconfirmed)
Average Daily Volume = 18.0 million

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Weyerhauser - WY - cls: 78.69 chg: 0.36 stop: 82.05

WY dipped to $77.23 before bouncing back into the green. We remain bearish but would wait for a failed rally under $80.00 before considering new positions. Our target is the $75.15-74.00 range. The P&F chart is very bearish with a $61 target.

Picked on June 25 at $ 79.49
Change since picked: - 0.80
Earnings Date 07/20/07 (unconfirmed)
Average Daily Volume = 2.1 million
 

Strangle Updates

None
 

Dropped Calls

Mastercard - MA - close: 163.03 chg: 1.21 stop: 157.99

Our aggressive play in MA is over. The stock spiked to $157.80 this morning. Our stop loss was at $157.99. Shares definitely under performed the rest of the market today, which doesn't look good for the rest of this week.

Picked on June 24 at $168.43
Change since picked: - 5.40
Earnings Date 08/01/07 (unconfirmed)
Average Daily Volume = 3.7 million

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Valero Energy - VLO - cls: 74.14 chg: -0.52 stop: 72.45

VLO hit our stop loss at $72.45. This morning before the bell a Citigroup analyst cut his ratings on multiple oil refining stocks. VLO was downgraded to a "sell" rating. The market reacted with VLO gapping down to open at $72.66 and spiking to $71.90 before bouncing back.

Picked on June 18 at $ 77.55
Change since picked: - 3.41
Earnings Date 07/26/07 (unconfirmed)
Average Daily Volume = 13.2 million
 

Dropped Puts

None
 

Dropped Strangles

None
 


Trader's Corner

Seven Option Trading Mistakes to Avoid

Getting e-mails from Option Investor subscribers always helps make my day, as I otherwise feel that I'm flying blind about reader interest related to MY choice of topics to write about in these Trader's Corner articles. I got an mail question/comment, sent in after today's important trading session that I'm happy to respond to. The question also gives me a chance to mention a source that I will use in my answer as being from the current issue of "Technical Analysis of Stocks & Commodities" (July, 2007).

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for my answer or feedback to Click here to email Leigh Stevens support@optioninvestor.com with my name ('Leigh Stevens') in the Subject line.

SUBSCRIBER E-MAIL:
"What do you think are the most common mistakes made in trading options and how do you avoid these mistakes? Any comment on today's action. the S P and Dow held key support you mentioned on the weekend."

I'll take the later part first and show and comment on a couple of key index charts for starters.

CURRENT TECHNICAL CONSIDERATIONS:
Just to comment briefly on the current technical picture for the major market indexes, the most important aspect of today's price action in the S&P 500 (SPX), S&P 100 (OEX) and Dow 30 (INDU) is that prices tested, went below but only slightly, then rebounded well above the prior downswing low; this is highlighted on the OEX chart, which is the same pattern seen with SPX and INDU. As long as a decline does not pierce, on a closing basis, a prior reaction low an uptrend is considered INTACT. Stay tuned on what upside follow through will develop however!

In the case of the Nasdaq, demonstrated by the Nasdaq 100 (NDX) Index chart below, besides the fact that today's (upside) reversal and rebound occurred WELL above the prior (down) swing low at 1876, today's low was a rebound from the area of the internal up trendline dating back to early-March, which maintains a bullish chart. (An 'internal' trendline is one connecting the GREATEST number of highs or lows, rather than simply connecting JUST the lowest lows or highest highs.) Therefore, we can say that technical action in the NDX maintaining itself above this key up trendline is bullish chart/technical action.

OPTION TRADING MISTAKES TO AVOID

I mentioned initially the magazine "Technical Analysis of Stocks and Commodities" (TASC) one of my favorite reads relating to some smart writing on technical analysis techniques and trends. I've had articles published in TASC myself. Anyway, some thoughts from the pages of TA of Stocks and Commodities in the July issue and the following is real BASIC stuff, so if you know all this, skim for reminders of things that you haven't thought of in awhile.

First, a couple of random comments before getting into the seven trading mistakes to avoid as suggested by Ron Ianieri, a professional trader and former market maker in Philly.

VOLATILITY:
A reader said that he/she was taught to sell high volatility and buy low volatility. Someone who specialized in calendar and butterfly spreads and feels that this strategy is far superior to buying puts and calls outright (NOT NECESSARILY!), made the comment that high volatility means there is a 'tornado' in the air. The market is saying that something is going to happen and TRUST the market on this! And, when trading spreads, buy and sell volumes that are in line. If the difference between options is more than 6 points, investigate, or just look elsewhere. Interesting point this.

WEEKEND THETA DROP:
'Public' option traders (retail) sometimes think they'll come in the market on Friday and sell options, picking up two days of theta for free. [Theta or 'time decay' is an estimate of how much the theoretical value of an option decreases when 1 day passes and there is NO move in either the stock price or volatility. Theta is used to estimate how much an option's extrinsic value is whittled away by the always-constant passage of time.] Market makers are onto this strategy or thinking and will typically lower volatilities to cover this factor on Friday mornings.

RISK MANAGEMENT:
I can't emphasize this enough, but thought I would use the words of Dan Sheridan in TASC on this point, as I like to see sometimes how another professional expresses the message that people must get tired of hearing from ME all the time. In answer to the reader question on "the single most important thing to keep in mind when trading options"; the TASC reprinted answer from Sheridan and echoing my own convictions and experiences from a lifetime of trading, is as follows (all-CAPS are MY own emphasis):

The single most important thing to keep in mind when trading options:

"That's easy. Have a risk management plan. Be prepared for the position to move AGAINST you, don't be bushwhacked by it and sit there like a deer in the headlights like Bambi. Know your adjustment points on each and every trade when you put on the trade. Have your contingency orders IN the market immediately AFTER your trade is filled. Make it a BUSINESS, not a speculation. NONE of this: 'I'm going to WATCH it, or I'm going to take the pain.' Do your planning in times of 'peace', not in times of 'war'. If you do that, you'll do well over time."

SEVEN OPTION TRADING MISTAKES TO AVOID

As modified from the TASC July issue 'Trader's Notebook':

1.) Not understanding the independent effects of time and volatility on your option(s)

This is what happened to me big time when I started trading index options after years of trading stock index futures. I bought calls on an index or stock I thought was going to rise, only to have it lose value when it did not go up. Blame time and volatility! An example cited: you think XYZ stock is going to go up from its current price of $47, so you buy a call with a month to expiration. You select the 50 strike calls and buy them for $2.00. The stock moves up to $49 after 3 weeks. However, your calls are now worth only $1.00, a paper loss of 50%.

Unlike stocks, an option's price relies on MULTIPLE variables. Options are sensitive to the passage of time (theta, as noted above) and changes in implied volatility (vega). These variables are independent of each OTHER, the stock price movement and the option's sensitivity to it (delta).

So, in the above example for XYZ stock, its delta made us money as the stock went up, but unfortunately, it was also sensitive to TIME and VOLATILITY. These two variables depleted more value out of the option contract than the delta put into it, creating a loss even with the price of stock rising. Without understanding time and volatility, you of course would not know what happened in this scenario and get discouraged. For sure, we've all been there! Answer: learn more about time and volatility to be better prepared to select the proper option.

The other thing that I found is that it's necessary to work very hard on the TIMING of trade entry. For example, learning to buy calls or sell puts ONLY when the stock or index is into a value area but is out of favor (high bearish sentiment) and 'oversold' technically.

Buy puts or sell calls when the stock or index is probably overvalued as suggested by it being in a key resistance area, 'overbought' according to technical indicators like the RSI, perhaps accompanied by high bullish sentiment and when the stock or index starts to show resistance by topping repeatedly in the same area, especially at a prior high or congestion area and on declining volume.

A TIP: Buy an in-the-money (ITM) option with a delta around 80-85 when you want to use an option in place of buying the underlying stock, for a directional play. The option then will mimic the stock closely. ITM options are much less sensitive to the adverse effects of time and volatility.

2.) Forcing a pre-selected strategy on every opportunity

Those new to options trading especially will learn a particular strategy and then apply it to every stock or index that comes close to fitting the profile. Many different strategies are equally good under the right circumstances, but no strategy works in every condition. This idea of employing the right tool for the right job is also the best course in the field of market analysis, either fundamental or technical.

Let's take the example of the aforementioned strategy of 'selling high volatility and buying low volatility' versus some recent instances when the S&P Index has had 1-2 or a series of intraday spikes below its lower Bollinger Band, which is showing a situation of high volatility. This happened today, on at least a 1-day basis to date, when the intraday S&P 500 low dipped below its lower Bollinger band, indicating a low that was (at that moment) more then two standard deviations below the Index's 20-day moving average or well beyond the norm.

However, on this occasion today (at least on an intraday basis) and on the occasion of a cluster of such dips below the lower Bolli Band in early-June, indicating high downside volatility, this situation signaled a buying opportunity. Adopting a bullish strategy by buying calls for example was the opposite of a trading rule, which is sometimes right, to SELL in situations of high volatility. Of course, selling SPX puts in this example makes the 'sell high volatility' strategy work, but selling puts was another aspect of adopting a bullish trading strategy.

Instead of looking at a chart to see what the market is offering, with fresh eyes as it were, it's easy to force a strategy onto the chart in the way of trying to force a square peg into a round hole.

3.) Not understanding the proper way to use leverage in trading options; comparing apples to oranges

"Leverage" has two applications that apply to option trading. The first is the ability to use the same amount of money to create a larger position. The second definition of leverage is the ability to create the same-size position with less money.

As investors, the latter definition is the one we focus on. Investors would in most instances like to have the same position with less capital outlay, which shows a penchant for good risk management. This might at most mean buying stock on margin. It could mean the use of convertible bonds in certain situations and so on.

Unfortunately, we see the situation often in options trading where we take the same money we would apply to an unleveraged or partially leveraged situation and employ it in options, focusing on the first application of leverage, using the same money to create a LARGER position.

$10,000 invested in XYZ options does not carry the same amount of risk as $10,000 invested in XYZ stock; the option position of course has more risk. Buying 200 shares of XYZ at $75 would mean a total outlay of $15,000. The entire investment would only be lost if the stock traded to zero, a loss of 100% of its value and a very unlikely situation; there are not that many Enron's!

If instead we made the 'mistake' of buying 20 May 70 XYZ calls at $7.50 we would also be laying out the same $15,000, but to control 2,000 shares. Same money, controls far more. Our option position is 10 times greater than the stock position, which may well appeal to the speculative nature of those very bullish on XYZ.

The problem with the latter option leveraged situation is that we would lose our entire investment in call options if XYZ traded down to $70 by that option's expiration, which is only a 6.7% decrease in its price. Such a fluctuation in a stock trading at $75 is fairly commonplace. Obviously the risk scenarios in owning the stock outright, or even on margin, versus taking the same money and controlling 10-20 times that amount of stock by buying XYZ calls, is not at all balanced.

This example applies an incorrect use of leverage if we want to make money over the long haul. We spent the same amount of money to obtain a bigger position in options. Unfortunately, an inordinate amount of risk accompanies that position and gives the entire strategy a very imbalanced risk to reward equation. The example is a use of leverage, but not a balanced one when we apply the same dollars as we would in an UNLEVERAGED situation. Rather, an inverse relationship is what is called for. As risk through leverage goes UP, money committed should go down if we want to balance risk to reward.

OPPS, I'm out of time and I'll pick up on the next 4 basic mistakes in trading options NEXT WEEK.
Meanwhile, have continued....

GOOD TRADING SUCCESS!
 

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.

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